The purpose of this study is to examine how lenders alter their behavior when faced with real earnings management.
This study uses the incremental R-square approach as in Kim and Kross (2005) to examine how much lenders rely on income statement and balance sheet ratios as the degree of real earnings management increases.
As real earnings management affects mostly the income statement, the authors find that lenders rely less on income statement ratios in making credit decisions in the presence of real earnings management. The authors also find that lenders do not alter their reliance on balance sheet ratios when faced with real earnings management.
This paper is the first to study how lenders alter their reliance on financial statements in making credit decisions in the presence of real earnings management. The findings of this paper could help the regulators set standards to improve the usefulness of financial statements. The findings of this paper could also help practitioners (borrowers and lenders) understand how real earnings management affects credit decisions.
