Credit Default Swaps and Earnings Management

Abstract

In this study, we examine the association between the initiation of credit default swaps (CDS) trading and firms’ earnings management behavior. Since CDS contracts help creditors transfer credit risk, creditors tend to be tough in debt renegotiations. Anticipating tough creditors, CDS firms may be forced to manage earnings upward to avoid debt renegotiations rather than deflate earnings to extract covenant claim concessions from creditors. Consistent with our expectation, we find that the introduction of CDS trading is positively associated with firms’ income-increasing discretionary accruals. Our findings remain robust after we control for the endogeneity of CDS trading using the propensity-score matching method, the placebo test, and the two-stage instrumental variable approach. Furthermore, we find that the positive association between CDS initiation and discretionary accruals is more pronounced for firms with tighter financial constraints and poorer information environment. We also find that CDS initiation is negatively associated with firms’ real earnings management activities, suggesting that firms substitute the less costly accrual-based earnings management for the more costly real earnings management after CDS-initiation. Overall our study suggests that firms respond to the “empty creditor problem” created by CDS trading through earnings management tools.