Accounting-based performance pricing and real earnings management
Performance pricing links the interest rate of a loan to the borrower’s performance. When the performance is measured through accounting ratios, incentives are created to manage earnings. The purpose of this paper is to study whether accounting-based performance pricing in debt contracts induces real earnings manipulation, the drivers of such behavior, and its consequences on future performance. I use the DealScan database to obtain details of private debt contracts from the years 1994 to 2011 and find that companies with performance pricing in their contracts engage in abnormal levels of activities consistent with real earnings manipulation, as measured by Roychowdhury (2006) and Gunny (2010). Moreover, I find that companies with accounting-based performance pricing in their debt contracts use real earnings management as a substitute for accruals earnings management, possibly driven by a stronger scrutiny by lenders over accounting information. Further, I find that this effect is driven by the proximity to a performance pricing grid threshold and the monetary benefits from meeting one of the thresholds. I also document evidence that companies that manage earnings have higher contemporary and future return on assets than their industry-year peers. In addition, when the potential debt cost reductions due to crossing an accounting-based performance pricing threshold are high, companies that engage in real earnings management show even higher contemporary and future returns on assets, while companies that do not engage in such behavior face reduction in their returns on assets. However, these results do not translate, in general, into market returns. ^
Susan G. Watts, Purdue University, Mark E. Bagnoli, Purdue University.
Business Administration, Accounting