Abstract
This study investigates the implications of earnings management on corporate loan pricing. Through two competing hypotheses (smoothing hypothesis and managerial opportunism hypothesis), we find that both accruals and real activities management are associated with higher loan spreads. Banks view earnings management as a value-destroying process that hampers a borrower’s capacity to repay a loan. Therefore, banks demand a marginal increase in loan spread to compensate for future uncertainty and monitoring costs. Furthermore, we examine the cross-sectional effects of lender reputation and lending relationship. Reputable and relationship banks demand even larger spreads for earnings management, consistent with them identifying and viewing earnings management as a risk-increasing activity. Additional analyses on simultaneity, loan contracting fees, covenant restrictiveness, and propensity matching method show consistent results.
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