Corporate Debt Financing and Earnings Quality

Authors

  • Aloke (Al) Ghosh,

    1. The first author is from Stan Ross Department of Accountancy, Baruch College, The City University of New York. The second author is Associate Professor of Accounting, School of Business, Yonsei University, Seoul, Korea. They are greatly indebted to Peter Joos, Darius Miller, Steve Young, and an anonymous referee for their numerous comments and suggestions that improved our thinking on this topic. They also thank Val Dimitrov, John Elliott, Larry Harris, Prem Jain, Bill Ruland, Jonathan Sokobin and the participants at the 2006 Annual AAA Meetings and 2006 FMA Meetings for their comments.
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  • Doocheol Moon

    Corresponding author
    1. The first author is from Stan Ross Department of Accountancy, Baruch College, The City University of New York. The second author is Associate Professor of Accounting, School of Business, Yonsei University, Seoul, Korea. They are greatly indebted to Peter Joos, Darius Miller, Steve Young, and an anonymous referee for their numerous comments and suggestions that improved our thinking on this topic. They also thank Val Dimitrov, John Elliott, Larry Harris, Prem Jain, Bill Ruland, Jonathan Sokobin and the participants at the 2006 Annual AAA Meetings and 2006 FMA Meetings for their comments.
    Search for more papers by this author

Address for correspondence: Aloke (Al) Ghosh, Stan Ross Department of Accountancy, Baruch College, The City University of New York, Box B12-225, One Bernard Baruch Way, New York, NY 10010, USA.
e-mail: Aloke.Ghosh@baruch.cuny.edu

Abstract

Abstract:  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.

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