Borrowing capacity and earnings management: An analysis of private loans in private firms

This empirical study investigates whether borrowers manage earnings to ameliorate their accounting portrait and to achieve a better borrowing capacity in the private loan market. We analyse the impact of borrowers’ earnings management activity on the amount and costs of their private loans both at the time of lending (ex post earnings management) and before a lending agreement is made (ex ante earnings management). We test our hypothesis on a panel sample of 465 small and medium-sized private corporations from the debt-dependent southern EU economies of Italy, Portugal and Spain over the 2002–2012 period. Using a generalized method of moments (GMM) model to control for endogeneity, we find that the discretionary earnings management activity of borrowers favours larger loan amounts, both ex post and ex ante. By contrast, we find no impact of borrowers’ earnings management activity on the costs of loans. Interestingly, we find that the relationship between earnings management and firms’ borrowing capacity is not significant before the enactment of the Basel II regulation; however, in the period following its enactment, we find a positive and systematic impact of earnings management (both ex post and ex ante) on the amount of bank loans, as well as some positive impact on the costs of bank loans. Our results indicate that borrowers manage earnings to signal better quality to lenders and to ameliorate their borrowing capacities, regardless of the excessive costs of doing so. In addition, we find that the introduction of the Basel II rules likely strengthened this tendency. The findings of this research should alert bank regulators to the feasibility of an unintended economic consequence of rigid discipline with respect to bank risk taking—namely, reducing borrowers’ transparency may lead to less prudent assessments of borrowers’ creditworthiness.