Bank Financing as an Incentive for Earnings Management in Business Start-Ups

Abstract

In this paper, we investigate whether business start-ups in need for external financing manage their earnings in the years prior to obtaining a first bank loan. Newly established firms typically face valuable growth opportunities whereas their external financing sources usually are limited to bank loans and trade credit. Due to lack of track record, information asymmetries between entrepreneurs and potential financiers tend to be large. Business start-ups, as a result, may manage their earnings upwards when applying for a first bank loan, to influence the lending decisions of banks. We use a unique sample of Belgian start-up firms to test this hypothesis. Earnings management behavior is captured through two measures of current accruals: trade accruals and non-cash working capital accruals. Our multivariate analyses indicate that, after controlling for elements that affect the normal level of accruals, business start-ups indeed have significantly increased levels of current accruals and thus earnings in the years preceding a first bank loan. However, we find no evidence that bank lending decisions are actually influenced by this earnings management behavior.