Earnings quality and the cost of debt for SMEs under severe information asymmetry

Pietro Fera,Gianmarco Salzillo

doi:10.22495/jgrv10i3art11

Pietro Fera, Gianmarco Salzillo

Open Access

https://doi.org/10.22495/jgrv10i3art11

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Abstract

The banking system has undergone substantial changes that boosted the relevance of transaction-lending technologies and the role of financial reporting in the bank-firm relationship. Due to the growing emphasis on accounting data, this study investigates the impact of earnings quality on the cost of debt for a sample of SMEs during the global financial crisis. Relying on a sample of Italian non-financial SMEs, empirical findings show a positive relationship between discretionary accruals and the cost of loans, highlighting the negative consequences of low-quality earnings. Further analysis reveals the different impacts that negative and positive abnormal accruals can have on the cost of debt: low values of the former can convey private information and positively affect the response variable, which shows a positive and quadratic relationship with the latter. These findings confirm the increasing importance of hard information in credit markets and point out the significant impact of the quality of the borrowers’ earnings on the cost of debts. However, the distinctiveness of the study from the previous literature relies on evidence that, even during a credit crunch period, financial institutions weigh up the expected return from lending transactions, relying on both the sign and the magnitude of discretionary abnormal accruals as a vehicle to get firms’ private information.

Highlights

The funding model of small and medium enterprises, Italian ones, is strongly addicted to banks (Forestieri, 2014)
Due to the growing emphasis on accounting data, this study investigates the impact of earnings quality on the cost of debt for a sample of SMEs during the global financial crisis
Moving from findings highlighted by previews studies, the aim of this paper is to analyze the existence of a possible correlation between the quality of the annual report and the cost of debt, during the global financial crisis, for a sample of SMEs operating in a context historically characterized by high information asymmetry and a consolidated relationship lending system, extending the focus of the literature concerning the role of financial reporting in the bank-firm relationship

Summary

Introduction

The funding model of small and medium enterprises, Italian ones, is strongly addicted to banks (Forestieri, 2014). A thorough comprehension of factors, which are relevant in defining the relational dynamics between banks and firms, becomes a key issue to identify the main drivers for the economic growth of firms and their business environment. In this way, it is useful to analyze the role played by the borrowers’ financial reporting in determining the contractual conditions of financing transactions, focusing on the potential impact exerted by the quality of accounting numbers on the pricing of lending transactions. There is no doubt that during the last decade, the steady concentration process in the banking industry and the regulatory changes, introduced by Basel II and Basel III, have radically changed the relationships between banks and firms, emphasizing the importance of lending transaction technologies — based on hard information obtained from economic and financial quantitative data, which are actionable and codifiable — instead of qualitative information, or the so-called soft information, that are traditionally used in the relationship-based business models and are referred, for example, to the degree of confidence in the entrepreneur and the solidity of the relationships built over time between the firm and its suppliers (Rajan & Zingales, 2001; Berger, 2006).

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