Understanding earnings quality - MIT Sloan School of Management
Understanding earnings quality - MIT Sloan School of Management
Understanding earnings quality - MIT Sloan School of Management
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5.1.3 Firm debt 43<br />
Watts and Zimmerman (1986) suggest the debt covenant hypothesis: Firms closer to<br />
violating debt covenants will make income-increasing accounting choices to avoid covenant<br />
violations. Early research used debt-equity ratios or other indirect proxies for the existence <strong>of</strong> debt<br />
covenants (e.g., Bowen, Noreen, and Lacey, 1981; Zmijewski and Hagerman, 1981; Daley and<br />
Vigeland, 1983; Johnson and Ramanan, 1988). 44 These papers provide consistent cross-sectional<br />
evidence that more highly-levered firms choose income-increasing accounting methods. 45 In<br />
addition, Balsam, Haw, and Lilien (1995) suggest that firms time the adoption <strong>of</strong> income-increasing<br />
accounting methods when leverage is highest. LaBelle (1990) finds that greater leverage and lower<br />
interest coverage are associated with accounting method changes in Canada. Specifically in the oil<br />
and gas industry, Johnson and Ramanan (1988) and Malmquist (1990) identify operating<br />
characteristics associated with the choice <strong>of</strong> successful efforts vs. full cost accounting, and find that<br />
leverage-related variables are incrementally important determinants <strong>of</strong> the choice.<br />
Three papers examine choices other than accounting methods. Bartov (1993) finds that firms<br />
time asset sales to use the gains to reduce <strong>earnings</strong> volatility and to avoid debt covenant violation.<br />
The smoothing and debt covenant explanations for the real <strong>earnings</strong> management are incremental to<br />
each other. Kinney and McDaniel (1989) find that more highly levered firms are more likely to<br />
correct previously reported <strong>earnings</strong>, which implies that they had misreported, and Efendi et al.<br />
(2007) find that firms with lower interest coverage ratios (higher ratio <strong>of</strong> interest to income) are<br />
more likely to restate. In addition, Dechow et al. (1996) find higher leverage ratios for manipulation<br />
43<br />
We include debt as a firm characteristic, although debt may also be viewed in its role as a monitor, much like the<br />
monitors discussed in Section 3.3.<br />
44<br />
Daley and Vigeland (1983) also find that the firms that choose income increasing voluntary accounting methods have<br />
higher ratios <strong>of</strong> dividends to retained <strong>earnings</strong>, which is another proxy for the extent to which debt covenants are likely<br />
to be binding.<br />
45<br />
See Christie (1990) for a rigorous statistical meta-analysis <strong>of</strong> existing studies <strong>of</strong> theories <strong>of</strong> accounting method choice.<br />
He finds that size and leverage are consistently related to accounting choice.<br />
83