Earnings Management to Avoid Losses: a cost of debt explanation

José A. C. Moreira () and Peter F. Pope ()
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José A. C. Moreira: CETE, Faculdade de Economia, Universidade do Porto
Peter F. Pope: ICRA, Management School, Lancaster University

CEF.UP Working Papers from Universidade do Porto, Faculdade de Economia do Porto

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.

Keywords: earnings management; earnings thresholds; earnings discontinuities; cost of debt (search for similar items in EconPapers)
JEL-codes: C21 L29 M41 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2007-04
New Economics Papers: this item is included in nep-acc
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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