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(776242849) Ghosh and Moon (2010)   Corporate Debt Financing and Earnings Quality (1)

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Journal of Business Finance & Accounting
Journal of Business Finance & Accounting, 37(5) & (6), 538–559, June/July 2010, 0306-686X
doi: 10.1111/j.1468-5957.2010.02194.x
Corporate Debt Financing and Earnings
Quality
Aloke (Al) Ghosh and Doocheol Moon∗
Abstract: Our study establishes linkages between two extensively researched areas, debt financing and the quality of earnings. Debt can have a ‘positive influence’on earnings quality because managers are likely to use their accounting discretion to provide private information about the firms’ future prospects to lower financing costs. For high debt, it can also have a
‘negative influence’ on earnings quality as managers use accruals aggressively to manage earnings to avoid covenant violations. Using accruals quality as a proxy for earnings quality, we document a non-monotonic (cur vilinear) relation between debt and earnings quality. The relationship is positive at low levels of debt and negative at high debt levels with an inflection point around
41%. Our results suggest that firms that rely heavily on debt financing might be willing to bear higher costs of borrowing from lower earnings quality because the benefits from avoiding potential debt covenant violations exceed the higher borrowing costs.
Keywords: debt financing, earnings quality, accruals quality
1. INTRODUCTION
Our study establishes linkages between two extensively researched areas, corporate debt financing and earnings quality, where earnings quality refers to the ability of earnings to predict future cash flows. Although few studies, if any, empirically examine whether debt financing is associated with earnings quality, some researchers often presume that such a relationship exists. For instance, Pope (2003, p. 281) claims that:
the balance between debt and equity financing will produce demands for accounting information and may explain differences in disclosure patterns.
Similarly, O’Brien (1998, p. 1253) posits that:
if financial reporting exists to ser ve the needs of external capital providers, then we should expect differences in accounting to coincide with differences in the arrangements for providing capital.
∗The first author is from Stan Ross Department of Accountancy, Baruch College, The City University of New York. The second author is Associate Professor of Accounting, School of Business, Yonsei University, Seoul, Korea. They are greatly indebted to Peter Joos, Darius Miller, Steve Young, and an anonymous referee for their numerous comments and suggestions that improved our thinking on this topic. They also thank Val Dimitrov, John Elliott, Larr y Harris, Prem Jain, Bill Ruland, Jonathan Sokobin and the participants at the
2006 Annual AAA Meetings and 2006 FMA Meetings for their comments. (Paper received December 2008, revised version accepted December 2009, Online publication Februar y 2010)
Address for correspondence: Aloke (Al) Ghosh, Stan Ross Department of Accountancy, Baruch College, The City University of New York, Box B12-225, One Bernard Baruch Way, New York, NY 10010, USA. e-mail: Aloke.Ghosh@baruch.cuny.edu
 C 2010 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA. 538
Earnings are often considered better predictors of future cash flows than current cash flows because accounting accruals, a key component of earnings (the other being cash flows), are informative about future cash flows. However, accruals may also ser ve as noisy predictors of future cash flows because of manipulation and biases. Because debt affects managerial incentives and reporting choices, the linkages between debt and earnings quality depend on accruals quality. A key contribution of our study is that we posit a non-linear relationship between debt and earnings quality; earnings quality first increases and then declines with debt. Our tests are based on accruals quality which is used as a basis for drawing inferences on earnings quality.
One contracting view suggests a positive association between debt and the quality of reported earnings. Debt holders demand higher quality information, especially earnings, to assess the continued creditworthiness of borrowers (Grossman and Hart,
1982; and Jensen, 1986). When earnings predict future cash flows more accurately, creditors have lower risk because they can estimate solvency risk, liquidity risk and bankruptcy risk more precisely. Debt also bonds management to pre-commit to high quality information because of lower borrowing costs (Diamond, 1991). Since debt reduces various agency conflicts (Jensen, 1986; and Stulz, 1990), managers have few reasons to mask economic performance using their accounting discretion. Thus, debt has a ‘positive influence’ on earnings quality through its effect on accruals, and earnings are better predictors of future cash flows, because (1) accruals are less prone to managerial manipulations, and (2) managers acting in the interests of debt holders can use their accounting discretion to provide private information about the future prospects of the firm thereby lowering the cost of borrowing (Feltham et al., 2007).
A contrasting viewpoint is that debt has a ‘negative influence’ on earnings quality. When debt is relatively high, managers have strong incentives to make accounting choices and reporting decisions that reduce the likelihood of possible debt covenant violations (Watts and Zimmerman, 1986).1 Opportunistic managers are more likely to use their financial reporting discretion because (1) financial leverage frequently ser ves as a proxy for closeness to accounting-based covenant violations (Billett et al., 2007; Dichev and Skinner, 2002; Press and Weintrop, 1990; and Smith, 1993), and (2) the cost of violating debt covenants is large (Beneish and Press, 1993). Therefore, when debt is high, accounting numbers may not represent faithfully the underlying future economic performance because of the aggressive use of accruals to manage earnings in an effort to avoid covenant violations (Sweeney, 1994; and DeFond and Jiambalvo,
1994). One implication is that accruals are noisy predictors of future performance, which suggests a negative relationship between debt and earnings quality.
The distinctive dual role of debt suggests that the interactions of the positive and negative influence of debt ultimately determine earnings quality. For low debt, firms have incentives to reduce the cost of debt by reporting high quality earnings. Concurrently, firms are less likely to manage earnings because the risk of a covenant breach is either low or non-existent. Therefore, for low debt, debt and earnings quality are positively associated because the positive influence of debt dominates the negative influence. In sharp contrast, for high debt, debt and earnings quality are negatively associated because the negative influence dominates the positive influence. Because
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1 Corporate debt typically includes financial covenants that restrict the borrowers’ activities. The principal purpose of financial covenants is to manage the conflicts of interests between lenders and borrowers (Smith and Warner, 1979).
 
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the risk of breaching a covenant is large for highly leveraged firms, earnings are prone to being manipulated to avoid covenant violations. Thus, when the costs of violating covenants are sufficiently large, managers are willing to forego lower borrowing costs from reporting high quality to avoid even costlier covenant violations.
Our proxy for

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