Real earnings management and the cost of debt capital: international evidence

ABSTRACT

This study examines the association between the extent of real earnings management and the cost of debt capital in an international setting. Using a sample of 14,654 observations across 18 countries from 1987 to 2013, we find that on average, the extent of real earnings management is positively associated with the cost of debt capital. Moreover, we find that debt investors impose more premiums on the cost of debt capital for the firms in countries with more developed debt markets. This study contributes to the literature in the following ways: To begin with, this is the first international study to examine the effect of firms’ real earnings management on the cost of debt capital. Next, this study suggests that the association between the extent of real earnings management and the cost of debt capital varies depending on the institutional environment of the country a firm is based in. Finally, this study implies that financial policy makers need to extend bond market development in order to encourage debt investors to price the negative effects of real earnings management on the firm’s future performance.

KEYWORDS:

• Real earnings management
• cost of debt capital
• international accounting

Disclosure statement

No potential conflict of interest was reported by the authors.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1. Some prior studies suggest that equity investors may misprice the negative effect of real earnings management on a firm’s future cash flows (Bhojraj et al. 2009; Alqerm et al. 2014; Cupertino, Martinez, and Da Costa 2015). Because the main research question of this study is to examine whether debt investors at least partially detect and price the negative effect of real earnings management on a firm’s future cash flows, we do not attempt to investigate the potential mispricing of real earnings management in the debt market. It is beyond the scope of this study, and so we leave it as an avenue for future research.

^2. One exception is the study by Chen, Chou, and Wang (2014), where they suggest that the institutional ownership structure of each country moderates the negative association between the extent of REM and the value relevance of accounting information.

3. The period of the bond rating data is from 1988 to 2014. This is because we use the one-year-ahead bond rating to proxy for the ex-ante cost of debt capital following prior studies (Jiang 2008; Ge and Kim 2014).

4. Our main results are the same even if we use raw value of BMDI to calculate the interaction term.

Additional information

Funding

This work was supported by the National Research Foundation of Korea [Grant no. NRF-2018S1A5A2A01036689].