Sign Reversal in the Relationship between Income Smoothing and Cost of Debt

Abstract

Despite the fact that income smoothing by managers is a pervasive phenomenon that has been widely researched, extant literature provides incomplete evidence on how smoothing is associated with cost of debt in general, and in the private loan market in particular. The institutional factors associated with private loan contracts, combined with the theoretical motivations for smoothing, make it unclear whether smoothing will be positively, negatively, or not associated with loan spread. Using both cross-country and within-country analyses on an international sample of private loans, we predict and provide evidence that income smoothing is associated with lower cost of debt when the threat of private benefits consumption by managers is low, but is associated with higher cost of debt when the threat of private benefits consumption by managers is high. We provide the first evidence in the literature that the garbling effect of smoothing can predictably dominate the signaling view of smoothing in debt contract design, and we identify private benefits consumption threat as the feature of the contracting environment that empirically reveals a sign reversal in the relation between smoothing and cost of debt.

Keywords: Income smoothing, Private benefits, Debt contracts

JEL Classification: F34, G15, M41