Earnings Management to Avoid Losses: a cost of debt explanation
AbstractIn 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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Bibliographic InfoPaper provided by Universidade do Porto, Faculdade de Economia do Porto in its series CEF.UP Working Papers with number 0704.
Length: 44 pages
Date of creation: Apr 2007
Date of revision:
earnings management; earnings thresholds; earnings discontinuities; cost of debt;
Find related papers by JEL classification:
- M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
- C21 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models
- L29 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Other
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