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Legal Inforcement, Short Maturity Debt, and the Incentive to Manage Earnings

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  • Manu Gupta
  • Inder K. Khurana
  • Raynolde Pereira

Abstract

Prior research contends that weak legal regimes discourage lender enforcement of contracts by making it either costly or ineffective. However, Diamond observes that this lender passivity can be overcome by structuring debt as a short-term loan. His argument is that an arrival of bad news in the presence of short-term debt can result in externalities that will trigger a run on the firm and that this in turn creates ex ante incentives for lenders to enforce their contracts. We examine whether short-term debt creates an incentive for borrowers to delay the recognition of bad news through earnings management. Using a sample of firm-level data from 33 countries over a 10-year period, we find that short-term debt induces greater earnings management. This impact of short-term debt is especially greater in countries with weak legal regimes. This evidence is consistent with the hypothesis that borrowers will manage earnings to circumvent lender enforcement. (c) 2008 by The University of Chicago. All rights reserved.

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  • Manu Gupta & Inder K. Khurana & Raynolde Pereira, 2008. "Legal Inforcement, Short Maturity Debt, and the Incentive to Manage Earnings," Journal of Law and Economics, University of Chicago Press, vol. 51(4), pages 619-639, November.
    • Handle: RePEc:ucp:jlawec:v:51:y:2008:i:4:p:619-639
    DOI: 10.1086/590128
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    3. Ghaly, Mohamed & Dang, Viet Anh & Stathopoulos, Konstantinos, 2020. "Institutional investors' horizons and corporate employment decisions," Journal of Corporate Finance, Elsevier, vol. 64(C).
    4. Fung, Simon Y.K. & Goodwin, John, 2013. "Short-term debt maturity, monitoring and accruals-based earnings management," Journal of Contemporary Accounting and Economics, Elsevier, vol. 9(1), pages 67-82.
    5. Ammar Hussain & Minhas Akbar & Muhmmad Kaleem Khan & Marcela Sokolová & Ahsan Akbar, 2022. "The Interplay of Leverage, Financing Constraints and Real Earnings Management: A Panel Data Approach," Risks, MDPI, vol. 10(6), pages 1-21, May.
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    7. Lemma, Tesfaye T. & Negash, Minga & Mlilo, Mthokozisi & Lulseged, Ayalew, 2018. "Institutional ownership, product market competition, and earnings management: Some evidence from international data," Journal of Business Research, Elsevier, vol. 90(C), pages 151-163.
    8. Gupta, Manu & Prakash, Puneet & Rangan, Nanda K., 2017. "Determinants of underwriting spreads internationally: Evidence from SEOs," Journal of Multinational Financial Management, Elsevier, vol. 41(C), pages 1-22.
    9. Wu, Julia Yonghua & Opare, Solomon & Bhuiyan, Md. Borhan Uddin & Habib, Ahsan, 2022. "Determinants and consequences of debt maturity structure: A systematic review of the international literature," International Review of Financial Analysis, Elsevier, vol. 84(C).
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