Legal Inforcement, Short Maturity Debt, and the Incentive to Manage Earnings

Manu Gupta, Inder K. Khurana and Raynolde Pereira

Journal of Law and Economics, 2008, vol. 51, issue 4, 619-639

Abstract: Prior research contends that weak legal regimes discourage lender enforcement of contracts by making it either costly or ineffective. However, Diamond observes that this lender passivity can be overcome by structuring debt as a short-term loan. His argument is that an arrival of bad news in the presence of short-term debt can result in externalities that will trigger a run on the firm and that this in turn creates ex ante incentives for lenders to enforce their contracts. We examine whether short-term debt creates an incentive for borrowers to delay the recognition of bad news through earnings management. Using a sample of firm-level data from 33 countries over a 10-year period, we find that short-term debt induces greater earnings management. This impact of short-term debt is especially greater in countries with weak legal regimes. This evidence is consistent with the hypothesis that borrowers will manage earnings to circumvent lender enforcement. (c) 2008 by The University of Chicago. All rights reserved.

Date: 2008
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