The effect of earnings management on external loan price: evidence from China

Abstract

PurposeThis paper aims to explore how external creditors assess firms’ financial aggressiveness in China.Design/methodology/approachUsing bank loan-specific data, the authors investigate whether firms exhibit greater costs of bank loans when they engage in earnings manipulation and whether this association changes when restrictions on lenders’ compensation are promulgated.FindingsThe authors find compelling evidence that bank executives charge higher premiums on firms with accrual earnings management to compensate for additional financial risk but do not charge extra loan prices for firms conducting real earnings management (REM). The authors also find that the enactment of Robust Bank Executive Compensation (REBC) enhances the vigilance of bank executives on the overall client firms’ earnings manipulation, with the exception of REM conducted by state-owned firms.Originality/valueThe authors extend the current literature on the cost of external loans by focusing on bank loans and the influence of REBC. This study offers implications for policymakers in China and other emerging economics to control loan default and financial risk.