Abstract
State laws vary with respect to protecting a corporation's creditors vis-a-vis its shareholders. In particular, states vary in their limits on payouts which potentially transfer wealth from creditors to shareholders. We hypothesize that states with tighter constraints on payouts generally decrease the opportunity for earnings management leading to better accrual quality. Based on a large sample of corporations covering the period from 1987 to 2004, we find evidence consistent with this hypothesis. We also extend the debt covenant hypothesis to state payout restrictions and find cross-sectional variation within states with tighter constraints. Our findings show that accrual quality suffers as firms approach their payout constraint. Overall, the results suggest that stronger creditor protection laws have an impact on firm financial reporting quality.
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