Business Management
3 min read

The link between corporate debt and earnings manipulation

An insightful overview of an unexpected consequence of financial leverage.

Among the many COVID-19-related uncertainties, increasing corporate debt levels represent a major challenge, even though this is nothing new. Global corporate debt has been soaring since the sub-prime crisis and reached USD 72 trillion at the end of Q1 2019 (excluding financial companies) (Statista). Looking at the current crisis,things are not likely to improve any time soon. In many countries, governments are widening their support for corporate debt to help companies face the economic slowdown caused by the pandemic. In Europe and in the United States, the amounts raised in recent months (March-May) in investment grade corporate bond markets increased alarmingly compared to the same period in 2019. According to an analysis made by LCD (a division of S&P Global Market Intelligence) focusing on more than 200 corporations, in March 2020, hotels, resorts and cruise lines ranked among the largest withdrawers from revolving credit facilities with USD 13 billion, (only automobile manufacturers withdrew more with USD 32 billion). Among the top 15 withdrawers, Carnival Corporation & PLC borrowed USD 3 billion and Marriott International Inc. borrowed USD 2.5 billion. As a matter of fact, companies are scrambling to face the COVID-19 economic slump and solvency concerns are rising. In this short article, we propose to see the glass both “half full” and “half empty” to understand if any good can come out of this “debtful” situation.

 

Debt is a double-edged sword

Debt can act as a double-edged sword. Firms with higher debt levels suffer from a greater default risk as interest is a fixed expense, and debt servicing (the payment of interest and principal) negatively impacts cash flows. In contrast, leverage (i.e. the proportion of financial debt with respect to equity) has the potential to amplify returns, interest expenses are tax-deductible (tax shield), and shareholders maintain ownership when issuing debt (vs. share issuances – an alternative way to raise capital – which dilute ownership). Obviously, the use of debt is an attractive financing option when the company has the choice. However, amid the current pandemic context, issuing debt is like a “bridge” helping firms to ford the crisis. For companies with weak balance sheets, using that bridge might be a perilous venture, confirmed by recent data indicating that junk-bond defaults climbed to a 10-year high (JPMorgan) and U.S. default rates are topping historical averages (LCD News).

Taking an investor’s perspective, corporate debt levels are an important input to consider in firm analysis, but it is also crucial to understand the consequences of higher leverage on other metrics used for investment decisions, such as earnings. Earnings are used by capital providers for investment decisions or performance evaluation, and it is particularly important that earnings reflect actual corporate performance. However, as accounting rules require a company’s management to make judgments, managers have considerable leeway in how to prepare financial statements. They also have various motivations to disclose earnings that do not really reflect the true economic performance of the firm (e.g. boost managers’ compensation, impact contractual relations with various stakeholders, meet earnings targets). Extreme examples of hospitality managers misrepresenting earnings have captured a great deal of attention in recent decades (e.g. Cendant Corporation, Boston Chicken, Krispy Kreme), in some cases leading to losses in market value that stretched into the billions of U.S. dollars.

 

Why should debt levels impact earnings manipulation?

Two opposite views exist regarding the association of corporate debt levels with earnings quality (quality earnings are not manipulated). On the one hand, creditors need to make sure debt covenants are respected and closely monitor the quality of accounting information disclosed by managers. On the other hand, managers may be tempted to manipulate earnings (e.g. to artificially boost performance)to limit the pressure coming from debtholders. Clearly, this relationship remains an open question, and to answer it, contextual factors such as the strength of investor legal protection [1], should not be ignored. In countries with strong investor protection, litigation risk is higher which may prevent managers from misreporting earnings. Conversely, when investor protection is weaker, it is less risky for managers to distort financial information for private benefit.

 

What does research say about it?

In a recent study, Poretti, Schatt & Jérôme (2020) [2] examine the impact of hospitality firms’ debt level on earnings quality. Using a sample of 642 large companies [3] from 26 countries over 15 years, they show that, in general, higher financial leverage leads to lower earnings manipulation, especially in countries with strong investor protection. In other words, debt can act as a disciplinary mechanism on managers due to the increased in-depth monitoring undertaken by debt-holders to ensure that earnings reflect the true economic reality of the firm and that debt covenants are respected. Knowing they are under high scrutiny, managers are more likely to publish realistic earnings.However, this effective monitoring only works when institutions protect shareholders from managers’ misbehavior - that is to say, when litigation risk is high.

 

Conclusion

The use of leverage has pros and cons, and the companies that benefit from it are the ones with strong balance sheets. Following the 2008-2009 financial crises, exceptionally low interest rates and quantitative easing have been driving corporate borrowings to the upside. Raising leverage levels are alarming in terms of solvability, especially during a cash flow crisis like the one we are currently experiencing. Taking an investor’s point of view, recent research focusing on the hospitality industry indicates that when considering a given firm as a potential investment, contextual factors such as the institutional context should not be ignored. Indeed, weaker investor legal protection magnifies the risk of earnings manipulation, potentially misleading investors. In contrast, when the institutional context is strong, higher levels of debt tend to decrease earnings management.

 

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[1] Investor legal protection includes the rights prescribed by regulations/laws, and the effectiveness of enforcement.
[2] Poretti, C., Schatt, A., & Jérôme, T. (2020). Impact of Leverage on Financial Information Quality: International Evidence from the Hospitality Industry. Journal of Hospitality Financial Management, 28(1).
[3] The sample is composed of firms in five sub-industries: Restaurants and Bars (27%), Hotels (24%), Travel and Tourism (21%), Recreational Services (16%), and Gambling (11%).

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Assistant Professor of Accounting at EHL

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