Default Risk as a Factor Affecting the Earnings Response Coefficient

Abstract

Studies of factors affecting the earnings response coefficient (ERC) have long been a theme in capital market research. One lesser researched factor suggested in a series of paper by Dhaliwal, Lee and Fargher (1991) as possibly affecting the ERC is the variable of default risk. In particular, based upon an option theory of risky debt, they predicted, but did not empirically test the hypothesis, that the issue of debt would increase default risk and would lead to a reduction in the ERC, while a redemption of debt would decrease default risk and be associated with an increase in the ERC.

The purpose of this study is to test this theory using Standard and Poors, US Industrial companies data. The results produced estimates of the ERC with signs the opposite of those expected. The main conclusion of the study is that issues and redemptions of debt appear to be associated with factors other than default risk and are therefore probably not reliable indicators of that construct. Various possible alternative explanations for the results are discussed.

Keywords: Default risk, ERC, omitted variables

JEL Classification: G12, G32, M41