Private Benefits Extraction and the Opposing Effects of Income Smoothing on Private Debt Contracts

Abstract

We provide evidence that a prevalent discretionary accounting action, income smoothing, affects private debt contract design in a manner that is fundamentally distinct from the effects of other accounting attributes. In particular, lenders use their understanding of the threat of private benefits extraction in the contracting environment to infer whether observed discretionary smoothing is associated with higher or lower expected credit loss. Discretionary smoothing decreases cost of debt within low extraction threat environments, consistent with lenders viewing smoothing as revealing managers' private information about economic earnings in low threat settings. In contrast, discretionary smoothing increases cost of debt within environments where the ability of insiders to extract private benefits is less well controlled, consistent with lenders viewing smoothing as attempts to enable the extraction of private benefits in high threat settings. We also find evidence that these effects are more pronounced for firms with relatively high credit risk.