Earnings Management and the Cost of Debt

45 Pages Posted: 14 Jan 2008 Last revised: 29 Aug 2008

See all articles by Andrew K. Prevost

Andrew K. Prevost

University of Vermont

Ramesh P. Rao

Oklahoma State University - Stillwater - Spears School of Business - Department of Finance

Christopher J. Skousen

Utah State University - School of Accountancy

Date Written: August 28, 2008

Abstract

This paper examines the relation between earnings management and the marginal cost of debt to the firm using a sample of traded corporate bonds for the period 1994-2005. The marginal cost of debt is captured by market determined yield spreads, while earnings management is proxied by three alternative estimates of abnormal discretionary accruals. The standard regression models reveal that non-investment grade bonds in particular are penalized for higher abnormal accruals but the same does not appear to hold for investment grade bonds. In regression models that control for potential bias due to firms self-selecting into aggressive and non-aggressive earnings management groups based on certain firm attributes, we find that abnormal accruals have a negative price impact on all bonds generally. However, we also find that the effect is more severe for non-investment grade bonds. Thus, we conclude that creditors are able to see through managers' attempts to influence earnings perceptions and penalize firms for doing so by demanding a higher rate of return.

Keywords: Earnings management, cost of debt, yield spreads, accruals

JEL Classification: G10, G12, G14, M41, M43, G32

Suggested Citation

Prevost, Andrew K. and Rao, Ramesh P. and Skousen, Christopher J., Earnings Management and the Cost of Debt (August 28, 2008). Available at SSRN: https://ssrn.com/abstract=1083808 or http://dx.doi.org/10.2139/ssrn.1083808

Andrew K. Prevost

University of Vermont ( email )

Burlington, VT 05405
United States

Ramesh P. Rao (Contact Author)

Oklahoma State University - Stillwater - Spears School of Business - Department of Finance ( email )

Spears School of Business
Stillwater, OK 74078-4011
United States
405-744-1385 (Phone)
405-744-5180 (Fax)

Christopher J. Skousen

Utah State University - School of Accountancy ( email )

College of Business
Logan, UT 84322-3540
United States

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