Earnings Management and the Cost of Debt

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