Private Firms’ Incentives and Opportunities to Manage Earnings: Evidence from the use of Inflation Adjustments

Abstract

We examine the behavior of a large sample of private firms before and after the elimination of an inflation adjustment system in Colombia in 2007. We find that firms avoid reporting small pre-tax losses by exercising considerable discretion in their use of inflation adjustments, and find that this discretion is greater for firms that rely more on bank financing. Furthermore, firms that manage earnings to report small positive profits issue more bank debt the year following the reporting. After the law change, firms resort to other means to report positive earnings. In particular, the use of non-operating earnings increases, attributable in part to a higher incidence of tangible asset sales.

Keywords: bank monitoring, private firms, earnings management, accounting discretion, inflation adjustments

JEL Classification: M4, M41, G21