Earnings quality and cost of debt: evidence from Portuguese private companies

Abstract

Purpose The purpose of this paper is to test the relationship between earnings quality and the cost of debt for private companies in a “code-law” country (Ball et al., 2000). The analysis controls for company size, debt level and audited information. Design/methodology/approach The paper uses the ordinary least squares regression technique to test the relationship between earnings quality and the cost of debt. Findings The collected empirical evidence shows a negative relationship between earnings quality and the cost of debt and controls for company size and debt level. Such a relationship is stronger when the company information is audited. Research limitations/implications Similar to other studies, this paper has two main limitations. There was no access to specific data on the interest rates charged on bank loans, implying that the cost of debt is measured by the ratio of the interest expense to interest-bearing debt. The research only uses earnings quality measures based on abnormal accruals. Practical implications The collected evidence suggests that earnings quality have economic consequences for private companies by affecting their cost of debt, similar to those observed in previous studies for listed companies. This evidence can be seen as an incentive for private companies to increase their financial information quality. For debt providers, namely, financial institutions, the findings can be of interest to help them price properly the loans they make available to private companies. In general, the findings of this research can be of interest for company managers and financial institutions in countries with an institutional environment similar to that of Portugal. Originality/value The relation between earnings quality and the cost of debt has been so far studied for listed companies in “common law” countries. This paper provides new and complementary evidence about such relation for private companies and “code-law” country.

The effects of audit quality on the costs of capital of firms in Ghana

“…They argue that Big 4 auditors increase the credibility of private and young firms financial statements which result in a fall in debt monitoring cost and finally to a reduction in the interest rate. Carmo et al (2016) examined the relationship between earnings quality and the cost of debt for Portuguese private companies. They employed ordinary least squares regression technique to test the relationship between earnings quality and the cost of debt.…”

Does earnings quality affect the cost of debt in a banking system? Evidence from French listed companies

“…Similarly, using a large sample of Belgian SMEs, Vander Bauwhede et al (2015) show that firms’ FRQs have a negative relationship with the cost of debt. Likewise, Carmo et al (2016) for a sample of Portuguese and Beltrame et al (2017) for Italian firms find a negative relationship between the information risk proxied by earnings quality and the cost of debt.…”

“…Previous literature shows that financial reporting can resolve the agency cost of debt, as it plays an informative role in lending decisions. Lenders, and especially banks, use earnings to assess the risk of business default (Carmo et al, 2016) since accounting earnings provide more information on the characteristics of a company’s financial performance (Dechow et al, 2010).…”

“…The relationship between financial reporting quality (FRQ) and debt pricing has been widely demonstrated in studies dealing with information risk through earnings quality (Aldamen and Duncan, 2013; Barath et al, 2008; Carmo et al, 2016; Francis et al, 2005; Gray et al, 2009; Vander Bauwhede et al, 2015; Zhang, 2008). Most of these studies were conducted for firms in common-law countries and the results documented a negative association between earnings quality and the cost of debt.…”

“…This study contributes to the existing accounting literature by extending rare evidence on the effect of earnings quality on the cost of debt in a code-law market and provides new and complementary evidence on this relationship in a different context with a different regulatory and institutional environment. Our research allows interaction among two comprehensive research areas: earnings quality and cost of debt and adds to the literature on the economic consequences of earnings quality primarily conducted on common-law countries (Biddle et al, 2009; Carma et al, 2016; Francis et al, 2005).…”