Earnings Management and the Cost of Publicly Issued Debt

Abstract: The purpose of this study is to empirically test whether earnings management (both accruals-based and real) has an impact on the cost of public debt (approximated by credit ratings and bond yields) issued on the European bond market. Using a cross-sectional approach, accruals-based and real earnings management are estimated. The estimates are then used as explanatory variables in both an ordered regression, using bond ratings as dependent variables, and an OLS regression with the yield spread as dependent variable. The theoretical framework consists of previous research on earnings management and its impact on credit ratings and bond yields, as well as main theories such as the agency theory, signaling, asymmetric information and moral hazard. The findings of this study suggest that the real earnings management practice of sales manipulation of issuing firms has a significant negative relation to the issue’s bond yield. Overall, earnings management does not appear to have any major influence on the credit rating decision of credit rating agencies nor the pricing of bonds.