Legal Enforcement, Short Maturity Debt, and the Incentive to Manage Earnings
Posted: 3 Aug 2007
Prior research contends that weak legal regimes discourage lender enforcement of contracts by making it either costly or ineffective. However, Diamond (2004) 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 this in turn serves to create ex-ante incentives for lenders to enforce their contracts. Given this role of short term debt, 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 ten year period covering 1995-2004, we find 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. Our results are robust using alternative specifications, including the endogeneity of debt maturity.
Keywords: legal enforcement, Short-Term Debt, Earnings management
JEL Classification: G3
Suggested Citation: Suggested Citation