The effect of earnings management on external loan price: evidence from China

• DOI: https://doi.org/10.1108/IJAIM-11-2021-0225
• Published date: 15 March 2022
• Date: 15 March 2022
• Pages: 277-300
• Subject Matter: Accounting & finance,Accounting/accountancy,Accounting methods/systems
• Author: Rong Huang,Xiaojun Lin,Xunzhuo Xi,Desmond Chun Yip Yuen

The ef‌fect of earnings

management on external loan

price: evidence from China

Rong Huang

Faculty of Business Administration, University of Macau, Macau SAR, China

Xiaojun Lin

International Business School,

Guangdong University of Finance and Economics, Guangzhou, China, and

Xunzhuo Xi and Desmond Chun Yip Yuen

Faculty of Business Administration, University of Macau, Macau SAR, China

Abstract

Purpose –This paper aims to explore how external creditors assess f‌irms’f‌inancial aggressiveness in

China.

Design/methodology/approach –Using bank loan-specif‌icdata, the authors investigate whether f‌irms

exhibit greater costsof bank loans when they engage in earnings manipulation and whetherthis association

changeswhen restrictions on lenders’compensation are promulgated.

Findings –The authors f‌ind compelling evidence that bank executives charge higherpremiums on f‌irms

with accrual earnings management to compensatefor additional f‌inancial risk but do not charge extra loan

prices for f‌irms conducting real earnings management (REM). The authors also f‌ind that the enactment of

Robust Bank ExecutiveCompensation (REBC) enhances the vigilance of bank executives on the overallclient

f‌irms’earningsmanipulation, with the exception of REM conductedby state-owned f‌irms.

Originality/value –The authors extend the currentliterature on the cost of external loans by focusing on

bank loans and the inf‌luence of REBC. This study offers implications for policymakersin China and other

emergingeconomics to control loan default and f‌inancial risk.

Keywords Earnings management, Cost of external loans, Robust bank executive compensation,

Agency problem

Paper type Research paper

Introduction

Earnings management is collectively regarded as a severe information risk to external

stakeholders (Francis et al., 2005;Graham et al., 2005;Ge and Kim, 2014;Chen et al., 2011b;

Abad et al.,2018). Independent creditors’discernment and treatment of earnings

management have attracted growing attention from scholars (DeFond and Jiambalvo, 1994;

Bharath et al.,2008;Prevost et al.,2008;Hsieh and Wu, 2012).However, due to a lack of data,

researchers generally rely on estimated but noisy measurements to proxy for debt cost,

which is a mixture of loan, bond and f‌inancing lease costs. To investigate the more precise

relationship between borrowers’earnings management and the cost of loans issued by

external f‌inancial institutionsin China, this study focuses on the raw bank loan interest rate

JEL classif‌ication –G2, G21, M4, M48

External loan

price

277

Received3 November 2021

Revised27 January 2022

Accepted12 February 2022

InternationalJournal of

Accounting& Information

Management

Vol.30 No. 2, 2022

pp. 277-300

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-11-2021-0225

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

and its spread from basic rate, which directly and preciselymeasures how outside creditors

value borrowers’solvency [1], to avoid measurement noise. In addition, we consider the

impact of the regulation, RobustBank Executive Compensation (RBEC) [2], in our study and

analyze its inf‌luence on external creditors’assessment of f‌irms’earnings management in

China. RBEC was launched in 2010 in China to clamp down on the excessive remuneration

of executives working in f‌inancialinstitutions. Specif‌ically, the regulation requires f‌inancial

institutions to delay at least 40% of executives’performance bonus payment for morethan

three years, along with both paid and deferred bonuses being withheld if the lender’s

lending decisions result in signif‌icantloss due to high-risk exposure. Thus, RBEC decreases

the pay-for-performancesensitivity of bank executives, restricts lenders’aggressivelending

behaviors and rectif‌ies this systemic weakness in the f‌inancial industry. Since RBEC

directly relates lending managers’compensation with the default risk of theirissued loans,

and earnings management is normally associated with high loan default risk, we believe

that lending managers would become more cautious with their clients’earnings

management to avoid large reduction of their renumeration. In brief, we address two

concerns in this study: how the level of borrowing f‌irms’earnings management impacts

external creditors’assessment to determine bank loan rates and whether the RBEC

improves the eff‌iciencyand reduces the risk of f‌inancial resource misallocationin China.

Superior disclosure quality can improve banks’predictability of borrowers’future cash

f‌lows, which is essential for capital recovery (Song, 2016). When normal business

performance is covered up by earnings manipulation, earnings quality deteriorates and

information risk surges (Lo, 2008;Hadani et al.,2011;Dechow et al.,2010;Bhojraj and

Swaminathan, 2009;Abad et al.,2018). Consequently, a premium would be charged as risk

compensation to the manipulation f‌irms (Leuz et al.,2003;Guay et al., 1996b). In developed

economies, such as the USA and the UK, both abnormal accruals and abnormal real

operational activities are corroborated to have an adverse price impact on the cost of debts

(Bharath et al.,2008;Francis et al.,2005;Ge and Kim, 2014). For example, if borrowers

attempt to improve the perceptionsof their earnings by manipulatingdiscretionary accruals

(DA), creditorsare capable of detecting suchintervention and would chargea higher price to

punish the borrowers (Prevost et al., 2008).Since earnings management can leadto high loan

default risk (Bharath et al.,2008), whether banks can detect and compensate for earnings

manipulation is vital for their economic health. However, few existing studies focus on

emerging economies regarding this topic. Emerging economies, such as China, are

characterizedby highly concentrated ownershipstructures, intensely politicized institutional

arrangements andfrequent rent-seeking behaviors (Bailey et al.,2011;Qian et al.,2015). The

f‌inancial market of the emerging economies is highly intervened by mandatory forces. In

addition, entities in the emerging marketface lenient requirements of accounting recognition

and disclosure(Chen et al., 2011a ),so the opaque information environmentprovides a hotbed

for earnings manipulation. Due to its special institutional environment, we expect the

mechanismsthrough which earnings managementaffects f‌irm f‌inancing c ost might differ in

the emerging e conomies. Specif‌ically, we expect lending agents to be less concerned with

client f‌irms’level of earnings manipulation as businesses in the emerging economies are

largely based on relationships (Fan and Wong, 2002), so that the actual performance of the

borrower could be discounted during debt f‌inancing. Our study then focuseson how lenders

react to their clients’level of earnings management using the China setting. In addition, we

use unique bankloan data that are hand collected andprocessed from the RESSET database

and f‌irms’publicannouncement f‌iles. Our proxyfor loan price is the loan ratecharged by the

direct creditor,which is independent of the noisy factorscontained in the estimated debt cost

that was widely applied by prior studies (i.e. Li et al.,2018;Kim et al.,2011) and directly

IJAIM

30,2

278