Private Firms’ Incentives to Manage Earnings: Evidence from a Quasi-Natural Experiment
65 Pages Posted: 19 Sep 2017 Last revised: 13 Jun 2018
Date Written: June 2, 2018
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 show that firms avoid reporting small 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, we show that firms that manage earnings to report small positive profits are able to 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 revenues increases, driven at least in part by higher use of real activities through asset sales. Finally, we evaluate the performance of model-based earning management measures commonly used in the literature. We highlight the potential difficulties in relying solely on these conventional measures where “normal” reporting has to be modeled in order to estimate “abnormal” behavior.
Keywords: bank monitoring, private firms, earnings management, accounting discretion, inflation adjustments
JEL Classification: M4, M41, G21
Suggested Citation: Suggested Citation