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Earnings Management to Avoid Losses: a cost of debt explanation

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  • José A. C. Moreira

    ()
    (CETE, Faculdade de Economia, Universidade do Porto)

  • Peter F. Pope

    ()
    (ICRA, Management School, Lancaster University)

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    Abstract

    In this paper we analyze firms’ earnings management behavior to avoid losses conditional on the (asymmetric) incentive underlying market (positive/negative) returns. Our intuition is that firms with negative returns in the period (bad news, BN) face a higher incentive to undertake earnings management, and that their ultimate intention is to hide from credit markets a signal (loss) that could be translated into a negative impact on their cost of debt. The empirical evidence supports this intuition. BN firms show higher earnings management pervasiveness than their counterparts with good news (GN), and the set with simultaneous BN and prior period positive earnings undertake more pervasive earnings manipulation than BN firms in general. Within this restricted set of firms, and consistent with a cost of debt explanation, we find that firms with larger needs of debt show a higher incidence of earnings management to avoid losses. The overall empirical evidence challenges the implicit assumption in Burgstahler and Dichev (1997) that the incentive to manage earnings is homogeneous to all firms, and suggests that the discontinuities around zero in the earnings distributions are driven, at least partly, by firms’ earnings management behavior.

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    File URL: http://www.fep.up.pt/investigacao/cete/papers/DP0704.pdf
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    Bibliographic Info

    Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series CEF.UP Working Papers with number 0704.

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    Length: 44 pages
    Date of creation: Apr 2007
    Date of revision:
    Handle: RePEc:por:cetedp:0704

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    Related research

    Keywords: earnings management; earnings thresholds; earnings discontinuities; cost of debt;

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    1. Givoly, Dan & Hayn, Carla, 2000. "The changing time-series properties of earnings, cash flows and accruals: Has financial reporting become more conservative?," Journal of Accounting and Economics, Elsevier, vol. 29(3), pages 287-320, June.
    2. Cindy Durtschi & Peter Easton, 2005. "Earnings Management? The Shapes of the Frequency Distributions of Earnings Metrics Are Not Evidence Ipso Facto," Journal of Accounting Research, Wiley Blackwell, vol. 43(4), pages 557-592, 09.
    3. DeFond, Mark L. & Park, Chul W., 1997. "Smoothing income in anticipation of future earnings," Journal of Accounting and Economics, Elsevier, vol. 23(2), pages 115-139, July.
    4. Healy, Paul M., 1985. "The effect of bonus schemes on accounting decisions," Journal of Accounting and Economics, Elsevier, vol. 7(1-3), pages 85-107, April.
    5. McNichols, Maureen F., 2000. "Research design issues in earnings management studies," Journal of Accounting and Public Policy, Elsevier, vol. 19(4-5), pages 313-345.
    6. Degeorge, Francois & Patel, Jayendu & Zeckhauser, Richard, 1999. "Earnings Management to Exceed Thresholds," The Journal of Business, University of Chicago Press, vol. 72(1), pages 1-33, January.
    7. Sweeney, Amy Patricia, 1994. "Debt-covenant violations and managers' accounting responses," Journal of Accounting and Economics, Elsevier, vol. 17(3), pages 281-308, May.
    8. Basu, Sudipta, 1997. "The conservatism principle and the asymmetric timeliness of earnings," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 3-37, December.
    9. Burgstahler, David & Dichev, Ilia, 1997. "Earnings management to avoid earnings decreases and losses," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 99-126, December.
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    Cited by:
    1. Sondes Draief & Adel Chouaya, 2012. "Effet de la gestion comptable et réelle des résultats sur le coût de la dette : analyse avant et après SOX," Post-Print hal-00691020, HAL.

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