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Corporate Debt Financing and Earnings Quality
Author(s) -
Ghosh Aloke Al,
Moon Doocheol
Publication year - 2010
Publication title -
journal of business finance and accounting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.282
H-Index - 77
eISSN - 1468-5957
pISSN - 0306-686X
DOI - 10.1111/j.1468-5957.2010.02194.x
Subject(s) - earnings quality , accrual , business , earnings , debt , internal debt , earnings management , earnings response coefficient , finance , monetary economics , financial system , economics
Our study establishes linkages between two extensively researched areas, debt financing and the quality of earnings. Debt can have a ‘positive influence’on earnings quality because managers are likely to use their accounting discretion to provide private information about the firms’ future prospects to lower financing costs. For high debt, it can also have a ‘negative influence’ on earnings quality as managers use accruals aggressively to manage earnings to avoid covenant violations. Using accruals quality as a proxy for earnings quality, we document a non‐monotonic (curvilinear) relation between debt and earnings quality. The relationship is positive at low levels of debt and negative at high debt levels with an inflection point around 41%. Our results suggest that firms that rely heavily on debt financing might be willing to bear higher costs of borrowing from lower earnings quality because the benefits from avoiding potential debt covenant violations exceed the higher borrowing costs.