CDS Channels of Influence on Discretionary Accruals

Abstract

This paper finds that the initiation of trading in credit default swaps (CDS) improves earnings quality by reducing absolute abnormal earnings accruals through specific channels in CDS firms. CDS initiation brought about more private information discovery via financial analysts, cross-market speculators, and hedgers. New results indicate that the channels of reduction in discretionary accruals are through a firm's high accounts payable and low cash holdings related to negative accruals and trade credit exposures. The high discretionary accruals compel the firm to improve cash holdings, cash flows, and working capital when probability of default increases. In the longer run, this leads to higher EPS and improved firm value. Thus the generation of public information via CDS market reduces information asymmetry in the context of the trade credit market and enforces greater discipline in discretionary accounts reporting.

Keywords: Credit default swaps, Earnings quality, Absolute abnormal earnings accruals, Trade credit exposures, Risk Management

JEL Classification: M40, M41, G30