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:
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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
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