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Revisiting the Relation between the Default Risk of Debt and the Earnings Response Coefficient

Posted: 15 Nov 1999  

Bruce K. Billings

Florida State University - Department of Accounting

Abstract

Theory suggests that earnings response coefficients (ERCs) are positively associated with expected earnings growth and negatively associated with equity risk. Dhaliwal and Reynolds (1994) (DR) hypothesize that equity beta fails to capture a default risk component of equity risk and demonstrate that ERCs are negatively associated with two measures of default risk -- bond ratings and debt/equity ratios -- in a regression model that contains equity beta. Bond ratings and debt/equity ratios are associated with expected earnings growth. This paper examines how the association between ERCs and default risk is impacted by the inclusion of expected earnings growth in the model. The relation between ERCs and bond ratings is not significant, while the association between ERCs and debt/equity ratios is weakened but is still significant. These findings suggest part of the reason for the negative association between ERCs and default risk in DR is that their default risk proxies also reflect expected earnings growth. In fact, there is no incremental association between ERCs and default risk when equity beta, bond ratings, and expected earnings growth are in the model.

JEL Classification: G12, G32, M41

Suggested Citation

Billings, Bruce K., Revisiting the Relation between the Default Risk of Debt and the Earnings Response Coefficient. The Accounting Review, Vol 74, No 4, October 1999. Available at SSRN: https://ssrn.com/abstract=185611

Bruce K. Billings (Contact Author)

Florida State University - Department of Accounting ( email )

Rovetta Business Bldg. (RBA)
College of Business
Tallahassee, FL 32306-1110
United States
850-644-7889 (Phone)
850-644-8234 (Fax)

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