Transaction-based lending and accrual quality

Abstract

PurposeThis study examines how lenders modify their behavior and their use of traditional, transaction-based lending models in credit decisions when faced with low earnings quality.Design/methodology/approachTo measure the earnings quality, following Bharath, Sunder and Sunder (2008), the authors use three measures of accrual quality and combine them into a simple parsimonious measure of accrual quality. Subsequently, the authors apply the incremental R-square approach used by Kim and Kross (2005) to determine the degree to which lenders modify their reliance on financial statement ratios when faced with low accrual quality.FindingsConsistent with prior literature, this study shows that the cost of debt is higher when accrual quality is low. In addition, this study extends prior literature by showing that lenders decrease their reliance on income statement data to make credit decisions as accrual quality decreases.Originality/valueThis paper broadens existing literature on the pricing of information risk in capital markets by being the first to show that lenders modify their reliance on financial statement data when faced with low-quality accruals. In addition, this paper extends the findings of Billings and Morton (2002) and demonstrates to managers the futility of using accrual manipulations to obtain more favorable credit terms. Lastly, this paper aids regulators and standard setters who seek to improve the usefulness of financial statements by showing that creditors do not appear to be misled by reporting choices that lower the quality of accruals.

Transaction-based lending and real earnings management

“…Consequently, the findings of this study imply that lenders rely more on the income statement to establish interest rates when earnings quality is high (REM is low) and that they do not regard the balance sheet as being any more or less useful when earnings quality changes. Similar to Gray and Premti (2021), this paper contributes to the literature by showing how lenders alter their behavior when faced with REM. The results of this paper, combined with the results of Gray and Premti (2021), show that lenders are able to detect when both components of earnings (accruals and cash components) are of low quality, and in both cases, they alter their behavior by relying less on ISRs when making their credit decisions.…”

“…The ratios above are the same ratios used in Gray and Premti (2021). As a robustness test, we also re-run our analysis by adding a few more ratios from the income statement and the balance sheet.…”

“…As a result, REM is more preferred by managers, and it is less likely to be subject to litigation (Gunny (2010), andEwert andWagenhofer (2005)). Thus, while Gray and Premti (2021) show that lenders are able to detect AEM and change their behavior accordingly, it is unclear whether lenders are able to detect REM and modify their behavior. Third, Zang (2012) and Shah et al (2020) find a negative and significant relation between AEM and REM.…”

“…Third, Zang (2012) and Shah et al (2020) find a negative and significant relation between AEM and REM. In this context, the companies that engage in more AEM in Gray and Premti's (2021) sample would engage in less REM, and therefore, it is unclear how REM would affect lenders' behavior. Fourth, studies have shown that REM and AEM can have different implications.…”

“…We follow the methodology of Zang (2012) [5] to calculate REM, and the methodology of Gray and Premti (2021) and the incremental R 2 approach as in Kim and Kross (2005) to measure changes in the informativeness in credit markets of earnings as REM changes. Specifically, changes in the incremental explanatory power of ISRs and BSRs for the COD were measured as earnings quality (REM) increased.…”