Abstract
We examine the association between real earnings management (REM) and the cost of new corporate bond issues. Three types of REM are considered: sales manipulation, overproduction and abnormal reduction of discretionary expenditures. Using the sample from 1993 to 2004, we find that cost of debt is negatively related to the proxies for sales manipulation, abnormal reduction of discretionary expenses and the overall REM for firms without using stock options to compensate their managers. These results suggest that bondholders perceive REM as evidence of operational efficiency and thus offer favorable pricing terms to firms with REM. When managerial compensation is linked to option awards, however, bondholders do not price REM. Overproduction does not show a significant effect on bond yield spread. Overall, these results imply that, in the primary bond market, bondholders do not see through REM, especially for firms that do not have executive stock option plans.
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