Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 37(5) & (6), 538–559, June/July 2010, 0306-686X
doi: 10.1111/j.1468-5957.2010.02194.x

Corporate Debt Financing and Earnings

Quality

Aloke (Al) Ghosh and Doocheol Moon∗

Abstract: Our study establishes linkages between two extensively researched areas, debt
financing and the quality of earnings. Debt can have a ‘positive influence’on earnings quality
because managers are likely to use their accounting discretion to provide private information
about the firms’ future prospects to lower financing costs. For high debt, it can also have a
‘negative influence’ on earnings quality as managers use accruals aggressively to manage earnings
to avoid covenant violations. Using accruals quality as a proxy for earnings quality, we document
a non-monotonic (curvilinear) relation between debt and earnings quality. The relationship is
positive at low levels of debt and negative at high debt levels with an inflection point around
41%. Our results suggest that firms that rely heavily on debt financing might be willing to
bear higher costs of borrowing from lower earnings quality because the benefits from avoiding
potential debt covenant violations exceed the higher borrowing costs.
Keywords: debt financing, earnings quality, accruals quality

1. INTRODUCTION
Our study establishes linkages between two extensively researched areas, corporate debt
financing and earnings quality, where earnings quality refers to the ability of earnings
to predict future cash flows. Although few studies, if any, empirically examine whether
debt financing is associated with earnings quality, some researchers often presume that
such a relationship exists. For instance, Pope (2003, p. 281) claims that:
the balance between debt and equity financing will produce demands for accounting
information and may explain differences in disclosure patterns.
Similarly, O’Brien (1998, p. 1253) posits that:
if financial reporting exists to serve the needs of external capital providers, then we
should expect differences in accounting to coincide with differences in the arrangements
for providing capital.
∗ The first author is from Stan Ross Department of Accountancy, Baruch College, The City University of New
York. The second author is Associate Professor of Accounting, School of Business, Yonsei University, Seoul,
Korea. They are greatly indebted to Peter Joos, Darius Miller, Steve Young, and an anonymous referee for
their numerous comments and suggestions that improved our thinking on this topic. They also thank Val
Dimitrov, John Elliott, Larry Harris, Prem Jain, Bill Ruland, Jonathan Sokobin and the participants at the
2006 Annual AAA Meetings and 2006 FMA Meetings for their comments. (Paper received December 2008,
revised version accepted December 2009, Online publication February 2010)

Address for correspondence: Aloke (Al) Ghosh, Stan Ross Department of Accountancy, Baruch College,
The City University of New York, Box B12-225, One Bernard Baruch Way, New York, NY 10010, USA.
e-mail: Aloke.Ghosh@baruch.cuny.edu

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and 350 Main Street, Malden, MA 02148, USA. 538
 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 539

Earnings are often considered better predictors of future cash flows than current
cash flows because accounting accruals, a key component of earnings (the other being
cash flows), are informative about future cash flows. However, accruals may also serve as
noisy predictors of future cash flows because of manipulation and biases. Because debt
affects managerial incentives and reporting choices, the linkages between debt and
earnings quality depend on accruals quality. A key contribution of our study is that we
posit a non-linear relationship between debt and earnings quality; earnings quality first
increases and then declines with debt. Our tests are based on accruals quality which is
used as a basis for drawing inferences on earnings quality.
One contracting view suggests a positive association between debt and the quality
of reported earnings. Debt holders demand higher quality information, especially
earnings, to assess the continued creditworthiness of borrowers (Grossman and Hart,
1982; and Jensen, 1986). When earnings predict future cash flows more accurately,
creditors have lower risk because they can estimate solvency risk, liquidity risk and
bankruptcy risk more precisely. Debt also bonds management to pre-commit to high
quality information because of lower borrowing costs (Diamond, 1991). Since debt
reduces various agency conflicts (Jensen, 1986; and Stulz, 1990), managers have few
reasons to mask economic performance using their accounting discretion. Thus, debt
has a ‘positive influence’ on earnings quality through its effect on accruals, and earnings
are better predictors of future cash flows, because (1) accruals are less prone to
managerial manipulations, and (2) managers acting in the interests of debt holders
can use their accounting discretion to provide private information about the future
prospects of the firm thereby lowering the cost of borrowing (Feltham et al., 2007).
A contrasting viewpoint is that debt has a ‘negative influence’ on earnings quality.
When debt is relatively high, managers have strong incentives to make accounting
choices and reporting decisions that reduce the likelihood of possible debt covenant
violations (Watts and Zimmerman, 1986). 1 Opportunistic managers are more likely to
use their financial reporting discretion because (1) financial leverage frequently serves
as a proxy for closeness to accounting-based covenant violations (Billett et al., 2007;
Dichev and Skinner, 2002; Press and Weintrop, 1990; and Smith, 1993), and (2) the
cost of violating debt covenants is large (Beneish and Press, 1993). Therefore, when
debt is high, accounting numbers may not represent faithfully the underlying future
economic performance because of the aggressive use of accruals to manage earnings
in an effort to avoid covenant violations (Sweeney, 1994; and DeFond and Jiambalvo,
1994). One implication is that accruals are noisy predictors of future performance,
which suggests a negative relationship between debt and earnings quality.
The distinctive dual role of debt suggests that the interactions of the positive
and negative influence of debt ultimately determine earnings quality. For low debt,
firms have incentives to reduce the cost of debt by reporting high quality earnings.
Concurrently, firms are less likely to manage earnings because the risk of a covenant
breach is either low or non-existent. Therefore, for low debt, debt and earnings quality
are positively associated because the positive influence of debt dominates the negative
influence. In sharp contrast, for high debt, debt and earnings quality are negatively
associated because the negative influence dominates the positive influence. Because

1 Corporate debt typically includes financial covenants that restrict the borrowers’ activities. The principal
purpose of financial covenants is to manage the conflicts of interests between lenders and borrowers (Smith
and Warner, 1979).


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540 GHOSH AND MOON

the risk of breaching a covenant is large for highly leveraged firms, earnings are prone
to being manipulated to avoid covenant violations. Thus, when the costs of violating
covenants are sufficiently large, managers are willing to forego lower borrowing costs
from reporting high quality to avoid even costlier covenant violations.
Our proxy for earnings quality is based on the measure developed by Dechow and
Dichev (2002), McNichols (2002) and Francis et al. (2005). These studies determine
accruals quality based on the mapping between current period working capital accruals
and operating cash flows in the prior, current, and future periods while controlling
for changes in revenues, and property, plant and equipment. Accruals, and therefore
earnings, quality is negatively related to the extent that working capital accruals do not
map into the explanatory variables because of estimation errors and/or managerial
opportunism.
The contracting literature suggests that private debt is more effective as a monitoring
device than public debt and that private debt has more restrictive covenants (Smith,
1993; Smith and Warner, 1979; and Bharath et al., 2008). Therefore, we restrict our
sample to firms with private debt only. Based on a large sample of US nonfinancial
firms for the period 1992 to 2004, our preliminary evidence is consistent with a
non-monotonic (curvilinear) relationship between earnings quality and private debt
financing. Partitioning the sample into quintiles based on debt (total debt to total
assets), we find that earnings quality improves monotonically for the first four quintiles
and then declines for the fifth quintile.
In the multivariate regressions, we use a non-linear specification that includes debt
and debt squared in the same regression. After controlling for other determinants of
earnings quality such as length of operating cycle, firm size, standard deviation of sales,
standard deviation of operating cash flows, frequency of negative earnings, the cost of
debt, the probability of default, market to book, and R&D investments, we find that
the coefficient on debt is negative while the coefficient on the debt squared term is
positive with an inflection point around 41%. Our results are very similar when we use
an alternative spline functional form with breakpoints of 40% or 45% to model the
non-linear relation.
The results suggest that for the most part (almost 80% of the sample), earnings
quality improves with higher private debt levels. However, once debt levels are high,
earnings quality declines with higher debt. Private creditors have stringent and detailed
covenants when debt is high. Because the likelihood of covenant violation is large at high
debt levels, managers’ immediate concern is to avoid costly debt covenant violations
rather than report earnings that are more informative about future cash flows.
We conduct additional analyses to assess the robustness of our results. First, to address
concerns that earnings quality and debt are simultaneously determined, we use a two-
stage least squares model to jointly estimate earnings quality and debt. Second, instead
of only relying on a balance sheet measure of debt, we also consider interest expense
deflated by sales as an alternative measure of leverage based on the income statement.
Another advantage of analyzing interest coverage ratio is that this measure is often used
to construct covenants. Finally, we also use debt to equity ratio as an alternative balance
sheet measure of debt. Our results are robust to these supplementary tests.
In a related analytical study, Feltham et al. (2007) suggest that accounting precision
(or quality) improves with debt when debt is high or when firms are close to violating
debt covenants. However, debt has little effect on accounting quality when firm value is
either very high or very low relative to debt covenant thresholds. While our study and


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the Feltham et al. (2007) study are related, there are key differences. First, they examine
the conflicts between equity holders and managers, while we concentrate on conflicts
between debt holders and managers. Second, we draw inferences about the relationship
between earnings quality and debt based on contracting reasons, while Feltham et al.
(2007) derive inferences based on the considerations of equity holders. Third, our
nonlinear prediction is the outcome of debt- and equity-holder considerations. At low
debt levels, managers are able to reduce the cost of debt financing when earnings
are more informative about future cash flows. As residual owners, equity holders also
benefit from lower debt costs. At high debt levels, managers’ immediate concern is to
avoid costly debt covenant violations even though their actions might destroy equity
values because earnings are less informative.
Our research provides an interesting insight. Several studies emphasize the role of
earnings quality in reducing the cost of external financing (e.g., Easley and O’Hara,
2004; Francis et al., 2005; and Diamond, 1991). However, our results suggest that firms
that rely heavily on debt financing might be willing to bear higher costs of borrowing
from lower earnings quality because the benefits from avoiding potential debt covenant
violations exceed the higher costs of borrowing.
The rest of the paper is organized as follows. Section 2 links debt and earnings quality.
Section 3 outlines the research design, and Section 4 reports the sample description.
Section 5 discusses the empirical results, and Section 6 concludes.

2. LINKS BETWEEN DEBT FINANCING AND EARNINGS QUALITY

(i) Positive Influence of Debt on Earnings Quality

In large, diffusely held public corporations, managers have incentives to expropriate
wealth from shareholders and bondholders (Jensen and Meckling, 1976). Atomistic
shareholders have few reasons to monitor managerial actions because the costs of
monitoring are high while the benefits are low. In contrast, private debt holders have the
incentives to monitor and limit potential managerial wealth expropriation. In order to
be willing to risk capital, private lenders including commercial banks require the ability
to continuously monitor client firms throughout the maturity period and demand high
quality information because of the need to assess the risk of their loans (Slovin et al.,
1990). In markets with limited capital, firms also have incentives to supply high quality
information to reduce the cost of borrowing (Diamond, 1991).
In a related study, Grossman and Hart (1982) consider debt as an example of a
‘precommitment’ or ‘bonding’ device. Debt bonds managers to act in the interest of
shareholders because of the desire to avoid bankruptcy, which in turn increases market
value. Grossman and Hart (1982) offer three reasons why self-interested managers
have incentives to issue debt to increase firm value. First, managers’ salaries are often
dependent on firm value through incentive schemes. Second, the probability of a
takeover is low for firms with high market value because acquiring firms have to pay
more. A third reason is that it is easier to raise capital for managers when firm value is
high, which increases the opportunities for perquisite consumption.
Similarly, Jensen (1986) views debt as a disciplinary instrument. Because contractual
debt payments absorb free cash flows and reduce internal cash flows available for
unprofitable investments, managers are unable to invest excess cash in negative net
present value projects.


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542 GHOSH AND MOON

Collectively these arguments suggest that debt has a positive influence on earnings
quality. Other things remaining constant, debt holders have lower credit risk when
firms report earnings that are more informative about future economic performance.
Managers have influence over earnings because of their discretion over accruals which
are based on accounting choices, assumptions, and estimates. Managers acting in the
interest of debt holders and equity holders have incentives to use their accounting
discretion to report more informative earnings to reduce the firms’ cost of borrowing.
As residual claimants, equity holders benefit when firms lower their financing costs.
Thus, earnings quality improves with debt because accruals are more informative about
future cash flows.
Both the bonding and the agency arguments suggest that the incentives to report
high quality earnings are stronger for private debt than for public debt because private
lenders are better as monitoring and bonding agents. Managers are less likely to use
their accounting discretion to mislead stakeholders about the economic value of the
firm when firms have private debt; rather, they are more likely to devote their energy
towards maximizing firm value (Warfield et al., 1995).

(ii) Negative Influence of Debt on Earnings Quality

Debt can also have a negative influence on earnings quality. Because of various agency
conflicts between managers and bondholders, debt holders resort to contractual
arrangements, many of which are based on financial accounting ratios, to reduce
expropriation of wealth by managers (Watts and Zimmerman, 1986). Bond covenants
are contractual arrangements that protect the lender and restrict the actions of the
borrower.
Bondholders are likely to rely more heavily on the use of covenants as debt increases
to mitigate agency conflicts. Since the cost of default is high (e.g., Beneish and Press,
1993; and Chen and Wei, 1993), 2 opportunistic managers have incentives to use
accounting methods that reduce the likelihood of debt covenant violations (Dichev and
Skinner, 2002; and Beatty and Weber, 2003). Managerial opportunism is expected to
increase with financial leverage because prior research provides evidence that leverage
is associated with closeness to debt constraints on earnings, retained earnings, leverage,
tangible net worth and working capital (Billett et al., 2007; Press and Weintrop, 1990;
Duke and Hunt, 1990; and Christie and Leftwich, 1990).
Under the debt covenant perspective, the extent of accounting manipulation is
expected to increase with debt as firms try to avoid potential covenant violations. 3
Further, prior studies document that loan covenants are much more stringent in private
debt than in public debt (Smith, 1993; and Smith and Warner, 1979). Low renegotiation
costs provide private lenders with incentives to write detailed and tailor-made contracts
and stringent covenants (Bharath et al., 2008). Thus, firms with private debt are more

2 Beneish and Press (1993) find that borrowing terms change for 48 of the 91 firms reporting technical
default in their sample. Interest rates increase for 31 of the 48 firms, decrease for 3 firms, and remain
unchanged for 14 firms. The mean change in interest costs is large, nearly 1% of the market value of equity.
Chen and Wei (1993) also report that violations generally result in serious consequences rather than waivers.
3 Lenders could respond to covenant violations in a number of ways: (1) terminate lending agreements,
(2) demand immediate repayment, (3) increase collateral, (4) increase interest rates, (5) impose additional
debt covenants, and (6) waive the violation (Dichev and Skinner, 2002; and Gopalakrishnan and Parkash,
1995).


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 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 543

likely to use accounting choices to avoid covenant violations when debt is high (Dichev
and Skinner, 2002).
A key implication is that the quality of reported numbers is low when private debt
is high because managers make accounting choices that do not reflect the firms’
underlying economic performance. A higher level of managerial intervention with
respect to accounting choices, whether it is income-increasing or income-decreasing,
erodes accruals, and earnings, quality because accruals are noisy predictors of future
cash flows. 4 Hence, when debt is high, the association between the quality of reported
earnings and debt is negative.

(iii) Relationship Between Debt Financing and Earnings Quality

The two conflicting perspectives of debt suggest that the relationship between debt
financing and earnings quality is ultimately determined by the interactions of the
positive and negative influence of debt. For low debt, firms are expected to have
fewer and less restrictive debt covenants which diminish the risk of a covenant breach.
Therefore, managers are less likely to manipulate and report low quality earnings when
the risk of breaching a covenant is low or non-existent. On the other hand, firms
have strong incentives to reduce the cost of debt by reporting high quality earnings.
Therefore, for low debt, debt and earnings quality are positively associated because the
positive influence of debt outweighs the negative influence.
In contrast, when firms have substantial debt, debt and earnings quality are negatively
associated because the negative influence of debt dominates the positive influence.
Although firms continue to have incentives to report high quality earnings to reduce
the cost of debt when debt is high, firms also have high risk of violating covenants.
Because the cost of breaching a debt covenant is large (e.g., higher borrowing costs,
immediate repayment of principal, reputation costs), managers are expected to use
their accounting discretion to avoid breaching such covenants. Thus, managers may
be willing to forgo the benefits of high earnings quality because the potential costs of
violating covenants are even larger. Thus, at sufficiently high debt levels, the negative
influence of debt is expected to be the dominant factor.
Accordingly, we hypothesize that earnings quality first increases and then declines
with increasing debt levels. Because there is no theory guiding us on the inflection
point, we let the data inform us on the debt level when the negative influence of debt
outweighs the positive influence.

3. RESEARCH DESIGN

(i) Construct for Earnings Quality

Accounting accruals, a cornerstone of financial reporting, recognize revenues earned
and expenses incurred regardless of whether cash is exchanged contemporaneously
(Wild et al., 2007). The Financial Accounting Standards Board (FASB) states that
earnings based on accrual accounting provide a better indication of a firm’s ability

4 Some examples of managerial judgments with regard to accounting decisions and choices include estimates
for uncollectible receivables, useful lives of assets, future healthcare benefits, write-offs, restructuring charges,
and inventory methods choices.


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to generate future cash flows than a measure based on cash receipts and payments
(SFAC No. 1; and FASB 1978).
While cash flows are more reliable, earnings are more informative about future cash
flows or more relevant for capital market participants (e.g., Dechow et al., 1998; and
Dechow, 1994). 5 Because accruals involve accounting choices and judgments, managers
have more flexibility in manipulating earnings through accruals than using cash flows.
Consequently, the quality of earnings is expected to vary through the use of accruals
depending on the incentives and the nature of the business contracts.
The accruals quality metric developed by Dechow and Dichev (2002) with the
modifications suggested by McNichols (2002) is frequently used as a measure for
earnings quality. For instance, Francis et al. (2005) use this modified version of the
Dechow and Dichev (2002) model to examine the relation between earnings quality
and the cost of debt. In this framework, working capital accruals (Accruals) are regressed
on operating cash flows (Cash flow) in the current (t), prior (t−1), and future (t+1)
periods, changes in revenues (Revenue), and property, plant and equipment (Fixed
assets) as follows:

Accruals t = β0 + β1 Cash flow t−1 + β2 Cash flow t + β3 Cash flow t+1

+ β4 Revenue t + β5 Fixed assets t + εt (1)

where Accruals is measured as Accounts receivable + Inventory − Accounts

payable − Taxes payable + Other assets (net). All the variables in equation (1)
are scaled by average total assets.
Equation (1) is estimated each year and for each industry, where industry is defined
using Fama and French (1997) 48 industry groups with at least 20 firms in each year.
Annual cross-sectional estimations of equation (1) yield year- and firm-specific residuals
(ε). Residuals for a firm in any given year are the standard deviation of its residuals (ε)
from equation (1) computed over five years from years t−4 to t. Larger Residuals indicate
poorer earnings quality. 6
The earnings quality measure estimated from equation (1) is ideally suited for our
tests because our objective is to capture the degree of the mapping of accruals on future
cash flows while controlling for growth because growth is associated with accruals and
debt financing. Changes in revenues and fixed assets are proxies for growth in the
Dechow and Dichev (2002) specification.

(ii) Debt Financing and Earnings Quality

We estimate the relationship between earnings quality and debt financing using the
following regression:

Residuals = β0 + β1 Debt + β2 Debt 2 + β3 Operating cycle + β4 Size + β5 Sales σ

+ β6 C as h flowσ + β7 Losses + β8 Cost of debt + β9 Z -Score
+ β10 Growth + β11 R&D + ε (2)

5 The quality of earnings is often considered to be higher than the quality of cash flows because accruals
result in earnings being more persistent, less volatile, more strongly associated with future cash flows, and
more strongly associated with current stock price than cash flows.
6 Consistent with prior studies (e.g., Francis et al., 2005), we winsorize the extreme values of the Residuals
distribution to the 1 and 99 percentiles.


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 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 545

where Debt is defined as the ratio of total (long-term+short-term) debt to total assets;
Operating cycle is the logarithmic transformation of the sum of days accounts receivable
and days inventory outstanding; Size is the logarithmic transformation of the average of
the beginning and ending total assets; Sales σ and Cash flow σ are the standard deviation
of sales and operating cash flows, respectively; Losses are the proportion of firm-years
with negative earnings from years t − 4 to t; Cost of debt is interest expense deflated by
average total debt; Z-Score is Altman’s Z-score; Growth is the sum of the market value of
equity and the book values of preferred stock and debt scaled by the book value of total
assets; and R&D is research and development expenditures scaled by the book value
of total assets. 7
Since Residuals are computed using a five-year rolling window from years t − 4 to t,
we use the same time period to compute the independent variables. Therefore, Debt,
Operating cycle, Size, Cost of debt, Z-Score, Growth and R&D are measured as the average of
the five annual values for years t − 4 to t. The two standard deviation variables (Sales σ
and Cash flow σ ) and Losses are also computed using five annual observations over the
same time period.
As in Dechow and Dichev (2002) and Francis et al. (2005), we include operating
cycle, firm size, volatility of sales and cash flow, and proportion of losses to capture the
innate or non-discretionary components of earnings quality. The innate factors capture
the influence of operating environment and business model on earnings quality, which
is different from the discretionary component. We also control for cost of debt and
Altman’s Z-score because debt might be correlated with the cost of debt financing and
financial distress (Francis et al., 2005). Further, we include market to book ratio and
R&D expenditures to proxy for growth opportunities which affect both the accrual
generating process and debt.

4. DATA AND SUMMARY STATISTICS

Our sampling frame consists of all firms covered on the 2006 Compustat (active and
inactive). Cash flow and variables to compute Accruals are from the cash flow statement
and they are available from 1987. Because Residuals are constructed based on five-
annual residuals (t − 4 to t) estimated from equation (1), which includes lead and
lag Cash flow, the sample is restricted to firms with at least seven consecutive years of
accounting data (we include firm-year observations with five-year lag and one-year lead
data). 8 Therefore, the first year we examine the effect of debt on earnings quality is
1992. The 2006 Compustat covers accounting data up to 2005 and thus the final year
included in the sample is 2004. Data on debt and other firm characteristics are also
obtained from Compustat files. We confine our sample to firms with private debt and
also exclude firms in the financial sector (6000s SICs) and the public sector (9000s

7 Days accounts receivable is 360/(Sales/Average accounts receivable), days inventory outstanding is

360/(Cost of goods sold/Average inventory), and Z-score is estimated as 1.2×(Working capital/Total
assets) + 1.4×(Retained earnings/Total assets) + 3.3×(EBIT/Total assets) + 0.6×(Market value of
equity/Total liabilities) + (Sales/Total assets).
8 This restriction is likely to introduce a survivorship bias in our sample with firms being larger and more
successful than the population. However, as Francis et al. (2005) conclude, this restriction reduces the
variation in Residuals thereby introducing a downward bias.


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SICs). Similar to Faulkender and Petersen (2006), firms without available S&P debt
ratings are considered as having private debt. 9
Consistent with prior research, we winsorize the top and bottom one percent of
observations for the variables included in the regression analyses with the exception
of Operating cycle, Size and Losses to remove the influence of outlier observations. 10
This sample selection procedure results in 8,240 firm-year observations used to test the
relationship between earnings quality and debt over a thirteen-year period from 1992
to 2004.
Table 1 reports descriptive statistics on Residuals and other firm characteristics. Some
of the variables (such as Debt, Operating cycle, Size, Cost of debt, Z-Score, Growth and R&D)
are first averaged using a five-year rolling window to be consistent with Residuals and
the rest of the variables. The mean (median) Residuals are 0.058 (0.045), which is
similar to the findings in Francis et al. (2005). Although Dechow and Dichev (2002)
also provide descriptive statistics for Residuals, our results are comparable to Francis
et al. (2005) because we follow their procedure to estimate Residuals. Using 91,280
firm-year observations extending over 32-years from 1970 to 2001, Francis et al. (2005)
report a mean (median) Residuals of 0.044 (0.031).
The mean total debt to total assets ratio is 0.248, with a standard deviation of 0.181.
The mean (median) operating cycle transformed in logarithmic values is 4.865 (4.930).
The mean and median of Size, Losses, and two volatility measures appear to be similar
to those in Dechow and Dichev (2002) and Francis et al. (2005). A mean (median) cost
of debt is 10.5% (8.8%). Firms in our sample tend to be financially healthy, with mean
(median) Z-Score of 3.809 (3.336). The mean (median) market to book ratio is 1.953
(1.409), whereas the mean (median) R&D investments relative to total assets are 4.7%
(0.5%).
Table 2 provides Pearson correlations for variables in equation (2). The variable
with the highest correlation with Debt is Z-Score−the correlation is −0.50. Among the
other variables, Cash flow σ has high correlations with Size, Sales σ , Losses, Growth and R&D.
These correlations are −0.47, 0.48, 0.55, 0.48 and 0.46, respectively. Correlations across
most other variables are relatively low. Overall, multicollinearity does not seem to be
severe. 11

5. RESULTS
Petersen (2009) compares different methods of addressing the issue of cross-sectional
and time-series dependence of the residuals for panel data, and shows that clustered
standard errors from pooled regressions provide unbiased estimates of the true
standard errors. Following his recommendation, we report pooled regression results

9 This sample selection procedure excludes firms with S&P debt ratings. There are substantial size differences
between firms with and without S&P debt ratings. The median firm with S&P debt ratings has total assets
of $2,016 million, while that without debt ratings has total assets of only $69 million. Although larger firms
tend to be excluded from the sample, it is balanced against the closer monitoring and tighter covenants in
private debt.
10 Because we use the logarithmic transformation of operating cycle and firm size, and Losses lies between
0 and 1, the outlier problems for these variables are not as severe as those for other variables.
11 Our multivariate findings are unlikely to be affected by multicollinearity. The condition indexes (Belsley
et al., 1980) in the last two regressions in Table 4 are 24.51 and 28.78, which are lower than the cutoff of 30
suggested by Belsley et al. Further, when we exclude from the regressions Cash flow σ that is highly correlated
with other explanatory variables, our results in Table 4 remain unchanged.


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Table 1
Descriptive Statistics
Variables Mean Standard Deviation Lower Quartile Median Upper Quartile

Earnings Quality
Residuals 0.058 0.044 0.027 0.045 0.074
Private Debt
Debt 0.248 0.181 0.110 0.218 0.346
Innate Factors
Operating cycle 4.865 0.659 4.563 4.930 5.275
Size 4.270 1.699 3.041 4.233 5.355
Sales σ 0.215 0.174 0.094 0.165 0.283
Cash flow σ 0.087 0.074 0.038 0.065 0.109
Losses 0.212 0.313 0.000 0.000 0.400
Cost of debt 0.105 0.071 0.072 0.088 0.113
Financial Health
Z-Score 3.809 4.334 2.058 3.336 5.055
Growth Opportunities
Growth 1.953 1.678 1.098 1.409 2.150
R&D 0.047 0.080 0.000 0.005 0.065
Notes:
The sample contains 8,240 firm-year observations over the periods 1992 to 2004 that do not have
an S&P debt rating. Residuals are the standard deviation of the residuals from years t-4 to t from the
regression of working capital accruals on operating cash flows in the prior, current, and future periods,
changes in revenues, and property, plant and equipment. Debt is the ratio of total (long-term+short-term)
debt to total assets. Operating cycle is the log of the sum of days accounts receivable and days inventory
outstanding, where days accounts receivable is 360/(Sales/Average accounts receivable) and days inventory
outstanding is 360/(Cost of goods sold/Average inventory). Size is the log of the average of the beginning
and ending total assets. Sales σ and Cash flow σ are the standard deviation of sales and operating cash flows
scaled by average total assets from years t-4 to t, respectively. Losses is the proportion of firm-years with
negative earnings from years t-4 to t. Cost of debt is interest expense deflated by average total debt. Z-Score
is Altman’s Z-score, where Z-score is estimated as 1.2×(Working capital/Total assets) + 1.4×(Retained
earnings/Total assets) + 3.3×(EBIT/Total assets) + 0.6×(Market value of equity/Total liabilities) +
(Sales/Total assets). Growth is the sum of the market value of equity and the book value of preferred stock
and debt scaled by the book value of total assets. R&D is research and development expenditures scaled by
the book value of total assets. Debt, Operating cycle, Size, Cost of debt, Z-Score, Growth and R&D are the average
of the five annual values for years t-4 to t.

with statistical significance based on Rogers (1993) clustered standard errors that
account for within-firm and within-year correlations.

(i) Debt Financing and Earnings Quality

Table 3 provides preliminary insights into the relationship between earnings quality
and debt financing using Residuals as a proxy for earnings quality. The sample is sorted
annually into five portfolios based on Debt. Debt 1 consists of firms with the lowest levels
of debt (mean Debt is around 4%), while Debt 5 includes firms with the highest debt
levels (mean Debt is around 53%). Panel A reports mean and median values for Residuals
across debt quintiles.
Our results in Panel A suggest a non-monotonic relation between earnings quality
and debt financing; the mean and median Residuals first decline and then increase
across increasing levels of debt. The mean Residuals monotonically decrease from 0.060
in Debt 1 to 0.051 in Debt 4. For higher levels of Debt, we find a reversal in pattern for
Residuals; the mean Residuals increase to 0.063 for the fifth debt portfolio. The median


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548 GHOSH AND MOON

Table 2
Pearson Correlation Matrix
1 2 3 4 5 6 7 8 9 10 11

1. Residuals 1.00
2. Debt 0.08 1.00
3. Operating cycle 0.18 −0.09 1.00
4. Size −0.47 −0.04 −0.14 1.00
5. Sales σ 0.46 0.10 −0.06 −0.37 1.00
6. Cash flow σ 0.64 0.04 0.16 −0.47 0.48 1.00
7. Losses 0.53 0.13 0.23 −0.45 0.33 0.55 1.00
8. Cost of debt 0.22 −0.13 0.07 −0.20 0.14 0.26 0.25 1.00
9. Z-Score −0.21 −0.50 0.01 0.15 −0.14 −0.16 −0.28 −0.01 1.00
10. Growth 0.36 −0.01 0.11 −0.23 0.23 0.48 0.41 0.16 0.25 1.00
11. R&D 0.37 −0.16 0.28 −0.25 0.14 0.46 0.47 0.18 −0.03 0.50 1.00
Notes:
This table provides Pearson correlation matrix for the sample. Residuals are the standard deviation
of the residuals from years t−4 to t from the regression of working capital accruals on operating cash flows in
the prior, current, and future periods, changes in revenues, and property, plant and equipment. Debt is the
ratio of total (long-term+short-term) debt to total assets. Operating cycle is the log of the sum of days accounts
receivable and days inventory outstanding, where days accounts receivable is 360/(Sales/Average accounts
receivable) and days inventory outstanding is 360/(Cost of goods sold/Average inventory). Size is the log
of the average of the beginning and ending total assets. Sales σ and Cash flow σ are the standard deviation
of sales and operating cash flows scaled by average total assets from years t − 4 to t, respectively. Losses is
the proportion of firm-years with negative earnings from years t − 4 to t. Cost of debt is interest expense
deflated by average total debt. Z-Score is Altman’s Z-score, where Z-score is estimated as 1.2×(Working
capital/Total assets) + 1.4×(Retained earnings/Total assets) + 3.3×(EBIT/Total assets) + 0.6×(Market
value of equity/Total liabilities) + (Sales/Total assets). Growth is the sum of the market value of equity and
the book value of preferred stock and debt scaled by the book value of total assets. R&D is research and
development expenditures scaled by the book value of total assets. Debt, Operating cycle, Size, Cost of debt,
Z-Score, Growth and R&D are the average of the five annual values for years t − 4 to t.

numbers also indicate a similar pattern. The median Residuals decrease from 0.049 in
Debt 1 to 0.037 in Debt 4, and then increase to 0.046 for Debt 5.
Panel B shows the differences in mean and median Residuals and their statistical
significance between debt quintiles. The difference in mean (median) Residuals
between Debt 4 and Debt 1 is −0.009 (−0.012), which is statistically significant at the
1% level. The difference appears to be economically meaningful; the decline in mean
(median) Residuals is about 15 (24) percent of the mean (median) Residuals in Debt 1.
The magnitude of the differences in mean and median Residuals between Debt 4 and
Debt 5 is also large and economically significant; the difference in mean (median)
Residuals is 0.012 (0.009) which is about 24 (24) percent of the number in Debt 4. Since
Residuals are inversely related to earnings quality by construction, the univariate results
in Table 3 suggest that earnings quality first improves and then declines with higher
debt.
Figure 1 illustrates the non-linearity of the relationship between Residuals and Debt. It
shows the mean and median Residuals across the debt quintiles. The upper line plots the
mean Residuals and the bottom line plots the median Residuals. Since earnings quality is
inversely related to Residuals, debt and earnings quality are positively associated between
Debt 1 and Debt 4, which is consistent with the debt monitoring view. However, between
Debt 4 and Debt 5, the two variables are negatively associated, which is consistent with
the managerial opportunism perspective.


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 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 549

Table 3
Debt Financing and Earnings Quality (n = 8,240)
Debt Residuals
Debt Quintiles Mean Mean Median

Panel A: Residuals Across Debt Quintiles

Debt 1 (Low) 0.043 0.060 0.049
Debt 2 0.131 0.058 0.048
Debt 3 0.218 0.057 0.045
Debt 4 0.318 0.051 0.037
Debt 5 (High) 0.529 0.063 0.046
Panel B: Differences in Residuals
Debt 4 – Debt 1 −0.009 −0.012
(t-statistic; z-statistic) (−5.88)∗∗ (−8.33)∗∗
Debt 5 – Debt 4 0.012 0.009
(t-statistic; z-statistic) (6.54)∗∗ (5.46)∗∗
Notes:
The sample is sorted into five portfolios based on Debt from 1992 to 2004. Residuals are the standard
deviation of the residuals from years t − 4 to t from the regression of working capital accruals on operating
cash flows in the prior, current, and future periods, changes in revenues, and property, plant and equipment.
Debt is a five-year average of the ratio of total (long-term+short-term) debt to total assets for years t − 4 to t.
∗∗ denotes statistical significance at the 0.01 level for a two-tailed test.

Figure 1
Debt Financing and Earnings Quality
0.07

0.06

0.05
Residuals

0.04

0.03

0.02

0.01

0
1 2 3 4 5
Debt Quintile

Mean Residuals Median Residuals

Notes:
This figure reports the mean and median Residuals across increasing debt levels. Residuals are the
standard deviation of the residuals from the regression of working capital accruals on operating cash flows
in the prior, current, and future periods, changes in revenues, and property, plant and equipment. Earnings
quality is inversely related to Residuals by construction. Debt is the sum of long-term and short-term debt
deflated by total assets. The sample is sorted into five portfolios based on Debt.


C 2010 Blackwell Publishing Ltd.
550 GHOSH AND MOON

Table 4
Debt Financing and Earnings Quality: Multivariate Results (n = 8,240)
Dependent Variable: Residuals
Variables (1) (2) (3) (4)

Intercept 0.053 (56.09)∗∗ 0.067 (59.00)∗∗ 0.016 (5.08)∗∗ 0.021 (5.97)∗∗

Private Debt
Debt 0.019 (5.27)∗∗ −0.103 (−12.25)∗∗ −0.019 (−3.23)∗∗ −0.024 (−3.59)∗∗
Debt 2 0.175 (13.11)∗∗ 0.035 (3.80)∗∗ 0.029 (3.21)∗∗
Innate Factors
Operating cycle 0.004 (8.11)∗∗ 0.004 (7.65)∗∗
Size −0.003 (−15.90) −0.003 (−15.79)∗∗
∗∗

Sales σ 0.043 (13.62)∗∗ 0.043 (13.84)∗∗

∗∗
Cash flow σ 0.222 (22.36) 0.200 (18.65)∗∗
Losses 0.026 (15.62)∗∗ 0.020 (10.81)∗∗
Cost of debt 0.010 (1.70)
Financial Health
Z-Score −0.001 (−5.96)∗∗
Growth Factors
Growth 0.001 (3.40)∗∗
R&D 0.014 (1.74)
Adjusted R 2 0.6% 4.6% 50.5% 51.2%
Notes:
Residuals are the standard deviation of the residuals from years t−4 to t from the regression of
working capital accruals on operating cash flows in the prior, current, and future periods, changes in
revenues, and property, plant and equipment. Debt is the ratio of total (long-term+short-term) debt to
total assets. Operating cycle is the log of the sum of days accounts receivable and days inventory outstanding,
where days accounts receivable is 360/(Sales/Average accounts receivable) and days inventory outstanding
is 360/(Cost of goods sold/Average inventory). Size is the log of the average of the beginning and ending
total assets. Sales σ and Cash flow σ are the standard deviation of sales and operating cash flows scaled by
average total assets from years t−4 to t, respectively. Losses is the proportion of firm-years with negative
earnings from years t−4 to t. Cost of debt is interest expense deflated by average total debt. Z-Score is Altman’s
Z-score, where Z-score is estimated as 1.2×(Working capital/Total assets) + 1.4×(Retained earnings/Total
assets) + 3.3×(EBIT/Total assets) + 0.6×(Market value of equity/Total liabilities) + (Sales/Total assets).
Growth is the sum of the market value of equity and the book value of preferred stock and debt scaled by the
book value of total assets. R&D is research and development expenditures scaled by the book value of total
assets. Debt, Operating cycle, Size, Cost of debt, Z-Score, Growth and R&D are the average of the five annual values
for years t−4 to t. We report the coefficients and the corresponding t-statistics in parenthesis. Statistical
significance of the reported coefficients is based on Rogers (1993) clustered standard errors correcting for
within-firm and within-year correlations.
∗∗ denotes statistical significance at the 0.01 level for a two-tailed test.

Table 4 presents our main regression results. In column 1, we only include Debt which
serves as a benchmark case for the relation between earnings quality and debt financing;
the coefficient on Debt is positive (0.019, t-statistic = 5.27). A positive relationship is
consistent with the view that earnings quality decreases with debt.
Because univariate results suggest a non-linear relation between debt financing and
earnings quality, we include Debt and Debt 2 in column 2. Although the regression model
includes only one more variable, the explanatory power jumps substantially; an adjusted
R 2 increases to 4.6% in column 2 from 0.6% in column 1. Further, the coefficient on Debt
is negative and significant (−0.103, t-statistic = −12.25), while the coefficient on Debt 2
is positive and significant (0.175, t-statistic = 13.11), confirming the non-monotonic
relationship documented in Table 3. Consistent with our hypothesis, we find a nonlinear
relationship between debt and earnings quality. When debt is relatively low, the positive


C 2010 Blackwell Publishing Ltd.
 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 551

influence of debt dominates the negative influence of debt because managers are less
likely to manipulate earnings when the probability of violating a covenant is not high.
However, at high debt levels the risk of breaching a covenant becomes so high that it
is more valuable to the firm to impair earnings quality in order to avoid the covenant
breach than to continue to offer reliable views of the future prospects of the firm.
Results from the reduced model excluding control variables might be overstated
because they do not account for the other factors that explain the variation in earnings
quality. Therefore, in column 3 we include a number of other factors associated
with earnings quality, as in Dechow and Dichev (2002) and Francis et al. (2005).
Although the magnitude of the coefficients becomes smaller, the results in column 3 are
virtually unchanged; the coefficient on Debt remains negative and significant (−0.019,
t-statistic = −3.23), and the coefficient on Debt 2 also remains positive and significant
(0.035, t-statistic = 3.80). 12
In column 4, we include four more control variables in addition to the control
variables in column 3. We add Cost of debt since Francis et al. (2005) find a significant
association between earnings quality and the cost of debt, and Z-Score to control for the
probability of bankruptcy that might be associated with Debt. Finally, we include Growth
and R&D because growth opportunities are a key determinant of debt financing. The
inclusion of the four additional variables does not change our results. The coefficient
on Debt is negative and significant (−0.024, t-statistic = −3.59), and the coefficient on
Debt 2 is positive and significant (0.029, t-statistic = 3.21). 13 Our point estimates from
column 4 results suggest that the relationship between earnings quality and debt is
curvilinear with an inflection point around 41%. 14
Results for the control variables are consistent with findings in prior studies and with
our expectations. Coefficient estimates on Operating cycle, Sales σ , Cash flow σ , Losses and
Growth are all positive and significant, which suggests that earnings quality is lower for
firms with longer operating cycles, firms with higher volatility of sales and operating
cash flows, firms with more incidence of negative earnings realizations, and firms with
higher growth opportunities. Coefficient estimates on Size and Z-Score are negative and
significant, indicating that earnings quality is higher for larger firms with less financial
difficulty.

(ii) Sensitivity Analysis

(a) Alternative Research Design: Spline Regressions

Our regression results are based on a non-linear specification that includes Debt and
Debt 2 in the same regression. We also use an alternative research design based on spline

12 While we include all the control variables in Francis et al. (2005), and Dechow and Dichev (2002)
in our tabulated results, we also try including several combinations of these control variables to analyze
the robustness of our results. We find that the results on the coefficients on Debt and Debt 2 from these
specifications are very similar to those reported in Table 4.
13 Since financial health might also affect the association between Debt and Residuals, we also interact
Altman’s Z-score with Debt and Debt 2 . In unreported results, we find that none of the interaction terms,
Debt×Z-Score and Debt 2 ×Z-Score, are significant. More important, coefficient estimates on Debt and Debt 2
continue to be highly significant.
14 Since the relation between Debt and Residuals is curvilinear, the inflection point is the level of Debt at
which Residuals is the minimum. Thus, δResiduals/δDebt = −0.024 + 2×0.029×Debt = 0, which implies that
Residuals is the lowest when Debt is about 41%.


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552 GHOSH AND MOON

regressions. In particular, we estimate the following model:

Residuals = β0 + β1 Debt (0,0.40) + β2 Debt (0.40,1) + β3 Operating cycle

+ β4 Si ze + β5 Sales σ + β6 Cash flowσ + β7 Losses + β8 Cost of debt
+ β9 Z -Score + β10 Growth + β11 R&D + ε. (3)

We divide Debt into low and high range categories using 40% as a breakpoint.
Specifically, Debt (0,0.40) equals Debt if Debt lies between 0 and 40%, and 40% otherwise
(low range). Debt (0.40,1) equals Debt minus 40% if Debt is greater than 40%, and 0
otherwise (high range). All the other variables are as previously defined.
Table 5 reports results of estimating equation (3). Consistent with the results in
Table 4, we again document a non-linear relation between earnings quality and debt.
When we include all control variables in column 3, the coefficient on Debt (0,0.40) is
negative (−0.011, t-statistic = −3.24), but that on Debt (0.40,1) is positive (0.023, t-statistic =
3.05). In untabulated results, we find that when we use 45% as an alternative breakpoint
to divide Debt into low and high range, our results remain unchanged.
In sum, consistent with the earlier findings, results in Table 5 also suggest that debt
has a positive influence on earnings quality at low levels of debt but that this effect
reverses at high debt levels.

(b) Endogeneity: Using Simultaneous Equations

One concern with ordinary least square regressions is that the results might be biased
and inconsistent if debt financing is an endogenous variable (Wooldridge, 2002). We
address possible endogeneity concerns using a two-stage least squares (2SLS) estimation
procedure that jointly estimates the relationship between debt and earnings quality. In
particular, we estimate equation (2) in conjunction with the following equation, where
Residuals and Debt are endogenous variables:

Debt = β0 + β1 Residuals + β2 Size + β3 Cash flow σ + β4 Z −Score + β5 Growth + β6 R&D

+ β7 Fixed assets + β8 Cash flow + β9 ITC + β10 NOI + Industry/Year dummies + ω
(4)

where ITC and NOL are indicator variables for investment tax credits and net operating
loss carry forwards, respectively. To be consistent with the time period used to compute
Residuals, the above variables are the average of the five annual values for years t − 4
to t. All the other variables are as previously defined.
The empirical specification for debt in equation (4) is largely based on the functional
form used in Fama and French (2002). Size, Cash flow σ , Fixed assets and Cash flow measure
expected bankruptcy cost, which is predicted to be negatively associated with debt. Z-
Score measures financial health. Growth and R&D represent investment opportunities,
which are also expected to be negatively associated with debt. ITC and NOL capture
non-debt tax shields and are again expected to be negatively associated with debt.
In columns 1 and 2 of Table 6, we report results based on 2SLS estimation for all
sample firms. Once again, our results confirm earlier findings that the relationship
between Debt and Residuals is non-monotonic. Coefficient estimates on Debt and Debt 2
in column 1 are −0.059 (t-statistic = −5.79) and 0.027 (t-statistic = 3.78), respectively.


C 2010 Blackwell Publishing Ltd.
 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 553

Table 5
Debt Financing and Earnings Quality: Spline Regression Estimation (n = 8,240)
Dependent Variable: Residuals
Variables (1) (2) (3)

Intercept 0.063 (67.06)∗∗ 0.015 (4.79)∗∗ 0.020 (5.71)∗∗

Private Debt
Debt (0,0.40) −0.038 (−9.42)∗∗ −0.009 (−2.78)∗∗ −0.011 (−3.24)∗∗
Debt (0.40,1) 0.127 (12.61)∗∗ 0.024 (3.66)∗∗ 0.023 (3.05)∗∗
Innate Factors
Operating cycle 0.004 (8.09)∗∗ 0.004 (7.63)∗∗
Size −0.003 (−15.79)∗∗ −0.003 (−15.68)∗∗
Sales σ 0.043 (13.56)∗∗ 0.043 (13.79)∗∗
Cash flow σ 0.223 (22.46)∗∗ 0.200 (18.66)∗∗
Losses 0.026 (15.61)∗∗ 0.020 (10.76)∗∗
Cost of debt 0.011 (1.85)
Financial Health
Z-Score −0.001 (−5.93)∗∗
Growth Factors
Growth 0.001 (3.45)∗∗
R&D 0.014 (1.78)
Adjusted R 2 4.6% 50.5% 51.2%
Notes:
Residuals are the standard deviation of the residuals from years t−4 to t from the regression of
working capital accruals on operating cash flows in the prior, current, and future periods, changes in
revenues, and property, plant and equipment. Debt is measured as a spline variable: (1) Debt (0,0.40) equals
Debt if Debt lies between 0 and 40%, and 40% otherwise; and (2) Debt (0.40,1) equals Debt minus 40% if Debt
is greater than 40%, and 0 otherwise. Operating cycle is the log of the sum of days accounts receivable and
days inventory outstanding, where days accounts receivable is 360/(Sales/Average accounts receivable) and
days inventory outstanding is 360/(Cost of goods sold/Average inventory). Size is the log of the average
of the beginning and ending total assets. Sales σ and Cash flow σ are the standard deviation of sales and
operating cash flows scaled by average total assets from years t−4 to t, respectively. Losses is the proportion
of firm-years with negative earnings from years t−4 to t. Cost of debt is interest expense deflated by average
total debt. Z-Score is Altman’s Z-score, where Z-score is estimated as 1.2×(Working capital/Total assets)
+ 1.4×(Retained earnings/Total assets) + 3.3×(EBIT/Total assets) + 0.6×(Market value of equity/Total
liabilities) + (Sales/Total assets). Growth is the sum of the market value of equity and the book value
of preferred stock and debt scaled by the book value of total assets. R&D is research and development
expenditures scaled by the book value of total assets. Debt, Operating cycle, Size, Cost of debt, Z-Score, Growth
and R&D are the average of the five annual values for years t−4 to t. We report the coefficients and the
corresponding t-statistics in parenthesis. Statistical significance of the reported coefficients is based on
Rogers (1993) clustered standard errors correcting for within-firm and within-year correlations.
∗∗ denotes statistical significance at the 0.01 level for a two-tailed test.

Thus, accounting for simultaneous relationship between debt and earnings quality, our
results suggest that earnings quality first increases and then decreases with higher debt
levels. In column 2, we find that the coefficient on Residuals is not significant (0.287,
t-statistic = 1.27).

(c) Interest Expense and Earnings Quality

Accounting-related covenants are frequently based on leverage, net worth, current
ratio, and interest coverage ratio (Sweeney, 1994). We focus on leverage because of
the distinctive dual role of debt in influencing earnings quality (i.e., from a theoretical


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554 GHOSH AND MOON

Table 6
Debt Financing and Earnings Quality: Two-Stage Least Squares Estimation
(n = 8,240)
Residuals Debt
Dependent Variables = (1) (2)

Intercept 0.038 (7.63)∗∗ 0.225 (9.10)∗∗

Endogenous Variables
Debt −0.059 (−5.79)∗∗
Debt 2 0.027 (3.78)∗∗
Residuals 0.287 (1.27)
Instrumental Variables
Operating cycle 0.004 (7.00)∗∗
Size −0.003 (−13.69)∗∗ 0.002 (1.50)
Sales σ 0.044 (18.43)∗∗
Cash flow σ 0.193 (27.29)∗∗ −0.210 (−3.47)∗∗
Losses 0.021 (13.61)∗∗
Cost of debt −0.004 (−0.70)
Z-Score −0.002 (−8.57)∗∗ −0.023 (−37.95)∗∗
Growth 0.003 (8.13)∗∗ 0.030 (19.48)∗∗
R&D −0.021 (−2.38)∗ −0.660 (−23.61)∗∗
Fixed assets 0.020 (3.03)∗∗
Cash flow −0.071 (−4.11)∗∗
ITC −0.113 (−4.73)∗∗
NOL 0.014 (3.02)∗∗
Industry/Year dummy Included
Adjusted R 2 49.7% 38.7%
Notes:
Residuals are the standard deviation of the residuals from years t−4 to t from the regression of
working capital accruals on operating cash flows in the prior, current, and future periods, changes in
revenues, and property, plant and equipment. Debt is the ratio of total (long-term+short-term) debt to
total assets. Operating cycle is the log of the sum of days accounts receivable and days inventory outstanding,
where days accounts receivable is 360/(Sales/Average accounts receivable) and days inventory outstanding
is 360/(Cost of goods sold/Average inventory). Size is the log of the average of the beginning and ending
total assets. Sales σ and Cash flow σ are the standard deviation of sales and operating cash flows scaled by
average total assets from years t−4 to t, respectively. Losses is the proportion of firm-years with negative
earnings from years t-4 to t. Cost of debt is interest expense deflated by average total debt. Z-Score is Altman’s
Z-score, where Z-score is estimated as 1.2×(Working capital/Total assets) + 1.4×(Retained earnings/Total
assets) + 3.3×(EBIT/Total assets) + 0.6×(Market value of equity/Total liabilities) + (Sales/Total assets).
Growth is the sum of the market value of equity and the book value of debt scaled by the book value of total
assets, R&D is research and development expenditures scaled by the book value of total assets, Fixed assets
is property, plant, and equipment divided by average total assets, Cash flow is operating cash flows scaled by
average total assets, and ITC and NOL are indicator variables for investment tax credits and net operating
loss carry forwards, respectively. Debt, Operating cycle, Size, Cost of debt, Z-Score, Growth, R&D, Fixed assets, Cash
flow, ITC, and NOL are the average of the five annual values for years t-4 to t. We report the coefficients and
the corresponding t-statistics in parenthesis. Statistical significance of the reported coefficients is based on
Rogers (1993) clustered standard errors correcting for within-firm and within-year correlations.
∗∗ and ∗ denote statistical significance at the 0.01 and 0.05 level, respectively, for a two-tailed test.

standpoint debt can have a positive or a negative influence on earnings quality). Most
other measures do not have this dual characteristic with the notable exception of
interest coverage ratio. While financial leverage is a balance sheet measure of debt,
interest coverage ratio can be considered as an income statement or ‘flow’ measure of
debt.


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 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 555

Although interest coverage is often defined as operating income before taxes to

interest expense, we avoid using that definition because the ratio is difficult to interpret
for firms with losses. One potential solution is to delete firm-year observations with
negative interest coverage ratio but that might result in firms that are central to our
hypothesis being discarded. Instead, we use interest expense deflated by revenues
(Interest expense) as a proxy for debt financing. This measure avoids problems associated
with loss firms and can be interpreted in the same way as Debt.
In Table 7, we report the results using Interest expense as an alternative proxy for debt
financing. As before, Interest expense is measured as the five-year average computed over
years t − 4 to t. Consistent with the Table 4 results, we find that the relation between
Interest expense and Residuals is also non-monotonic; when we include all control variables

Table 7
Relationship Between Interest Expense and Earnings Quality (n = 8,240)
Dependent Variable: Residuals
Variables (1) (2) (3) (4)
∗∗ ∗∗ ∗∗
Intercept 0.055 (102.02) 0.054 (84.43) 0.016 (5.04) 0.016 (5.04)∗∗
Debt
Interest expense 0.093 (7.35)∗∗ −0.151 (−5.79)∗∗ −0.044 (−2.50)∗ −0.114 (−6.15)∗∗
Interest expense 2 0.113 (2.71)∗∗ 0.043 (2.22)∗ 0.110 (3.33)∗∗
Innate Factors
Operating cycle 0.004 (7.81)∗∗ 0.004 (8.23)∗∗
Size −0.003 (−15.38)∗∗ −0.003 (−14.81)∗∗
Sales σ 0.042 (13.09)∗∗ 0.040 (12.60)∗∗
Cash flow σ 0.226 (22.57)∗∗ 0.199 (18.51)∗∗
∗∗
Losses 0.029 (16.01) 0.023 (11.95)∗∗
Cost of debt 0.022 (3.53)∗∗
Financial Health
Z-Score −0.001 (−8.49)∗∗
Growth Factors
Growth 0.002 (5.23)∗∗
R&D 0.006 (0.86)
Adjusted R 2 1.3% 1.5% 50.4% 51.5%
Notes:
Residuals are the standard deviation of the residuals from years t−4 to t from the regression of
working capital accruals on operating cash flows in the prior, current, and future periods, changes in
revenues, and property, plant and equipment. Interest expense is the ratio of interest expense to revenues.
Operating cycle is the log of the sum of days accounts receivable and days inventory outstanding, where
days accounts receivable is 360/(Sales/Average accounts receivable) and days inventory outstanding is
360/(Cost of goods sold/Average inventory). Size is the log of the average of the beginning and ending
total assets. Sales σ and Cash flow σ are the standard deviation of sales and operating cash flows scaled by
average total assets from years t−4 to t, respectively. Losses is the proportion of firm-years with negative
earnings from years t−4 to t. Cost of debt is interest expense deflated by average total debt. Z-Score is Altman’s
Z-score, where Z-score is estimated as 1.2×(Working capital/Total assets) + 1.4×(Retained earnings/Total
assets) + 3.3×(EBIT/Total assets) + 0.6×(Market value of equity/Total liabilities) + (Sales/Total assets).
Growth is the sum of the market value of equity and the book value of preferred stock and debt scaled by the
book value of total assets. R&D is research and development expenditures scaled by the book value of total
assets. Interest expense, Operating cycle, Size, Cost of debt, Z-Score, Growth and R&D are the average of the five
annual values for years t−4 to t. We report the coefficients and the corresponding t-statistics in parenthesis.
Statistical significance of the reported coefficients is based on Rogers (1993) clustered standard errors
correcting for within-firm and within-year correlations.
∗∗ and ∗ denote statistical significance at the 0.01 and 0.05 level, respectively, for a two-tailed test.


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556 GHOSH AND MOON

in column 4, the coefficient on Interest expense is negative (−0.114, t-statistic = −6.15),

while that on Interest expense 2 is positive (0.110, t-statistic = 3.33). Findings indicate that
earnings quality first increases and then decreases with higher interest expense levels.

(d) Alternative Deflator for Debt

In Tables 1 to 6, we deflate total debt by total assets (Debt). As a robustness check, we also
use the book value of common equity as an alternative deflator. As before, we measure
debt to equity (DE) as the average of the five annual values from years t − 4 to t.
Table 8 reports the multivariate regression results using DE as an alternative proxy
for debt financing. Consistent with the Table 4 results, the relation between DE and

Table 8
Debt Financing and Earnings Quality: Debt-to-Equity Ratio (n = 8,240)
Dependent Variable: Residuals
Variables (1) (2) (3) (4)
∗∗ ∗∗ ∗∗
Intercept 0.060 (97.43) 0.060 (99.30) 0.017 (5.18) 0.018 (5.43)∗∗
Private Debt
DE −0.004 (−8.22)∗∗ −0.010 (−12.82)∗∗ −0.003 (−4.35)∗∗ −0.002 (−3.97)∗∗
DE 2
0.003 (11.85)∗∗ 0.001 (3.99)∗∗ 0.001 (3.15)∗∗
Innate Factors
Operating cycle 0.004 (7.98)∗∗ 0.005 (7.77)∗∗
Size −0.003 (−15.87)∗∗ −0.003 (−15.86)∗∗
Sales σ 0.043 (13.63)∗∗ 0.043 (13.78)∗∗
Cash flow σ 0.222 (22.32)∗∗ 0.201 (18.56)∗∗
∗∗
Losses 0.025 (14.79) 0.020 (10.62)∗∗
Cost of debt 0.009 (1.55)
Financial Health
Z-Score −0.001 (−5.27)∗∗
Growth Factors
Growth 0.001 (2.91)∗∗
R&D 0.014 (1.78)
Adjusted R 2 1.3% 4.0% 50.1% 50.7%
Notes:
Residuals are the standard deviation of the residuals from years t−4 to t from the regression of
working capital accruals on operating cash flows in the prior, current, and future periods, changes in
revenues, and property, plant and equipment. DE is the ratio of total (long-term+short-term) debt to
common shareholders’ equity. Operating cycle is the log of the sum of days accounts receivable and days
inventory outstanding, where days accounts receivable is 360/(Sales/Average accounts receivable) and
days inventory outstanding is 360/(Cost of goods sold/Average inventory). Size is the log of the average
of the beginning and ending total assets. Sales σ and Cash flow σ are the standard deviation of sales and
operating cash flows scaled by average total assets from years t−4 to t, respectively. Losses is the proportion
of firm-years with negative earnings from years t−4 to t. Cost of debt is interest expense deflated by average
total debt. Z-Score is Altman’s Z-score, where Z-score is estimated as 1.2×(Working capital/Total assets)
+ 1.4×(Retained earnings/Total assets) + 3.3×(EBIT/Total assets) + 0.6×(Market value of equity/Total
liabilities) + (Sales/Total assets). Growth is the sum of the market value of equity and the book value
of preferred stock and debt scaled by the book value of total assets. R&D is research and development
expenditures scaled by the book value of total assets. DE, Operating cycle, Size, Cost of debt, Z-Score, Growth
and R&D are the average of the five annual values for years t−4 to t. We report the coefficients and the
corresponding t-statistics in parenthesis. Statistical significance of the reported coefficients is based on
Rogers (1993) clustered standard errors correcting for within-firm and within-year correlations.
∗∗ denotes statistical significance at the 0.01 level for a two-tailed test.


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 CORPORATE DEBT FINANCING AND EARNINGS QUALITY 557

Residuals is also non-monotonic. In the last regression when we include all control
variables, the coefficients on DE and DE2 are −0.002 (t-statistic = −3.97) and 0.001
(t-statistic = 3.15), respectively, indicating that earnings quality first increases and then
decreases with higher debt-to-equity ratio.

6. CONCLUSIONS
Our study investigates the association between private debt financing and the quality
of earnings. We posit that the relationship between private debt and earnings quality
is positive when debt is low. Since private lenders rely on high quality information
to assess the creditworthiness of borrowers, they are likely to demand better quality
earnings. Thus, increased monitoring from capital market participants is expected to
lead to accounting accruals (a key component of earnings) that are more informative
about future cash flows. Firms also benefit from reporting informative earnings from
a lower cost of debt.
In contrast, we hypothesize that the relationship between private debt and earnings
quality is negative when debt is sufficiently high. Contracting theory suggests that
private debt holders impose stringent accounting-based contractual constraints to limit
expropriation of wealth by managers. The stringency of the covenants is expected
to increase with debt. Therefore, for high debt, there is a trade-off between benefits
from reporting high quality earnings and benefits from avoiding covenant breaches.
Managers are more likely to use the latitude in accounting choices to manage earnings
around covenant limits because the costs of violating debt covenants are large for high
debt. The use of accounting discretion to avoid covenant violations lowers earnings
quality because accruals are noisy predictors of future performance.
Our measure of earnings quality is based on the accruals quality metric developed
by Dechow and Dichev (2002), modified by McNichols (2002), and implemented by
Francis et al. (2005). Using accruals quality as a proxy for earnings quality, we find that
earnings quality first increases and then declines across increasing levels of debt with
an inflection point around 41%.
We conduct a number of additional analyses. First, we use a piecewise linear
specification instead of including debt and a squared-term of debt in the same
regression to test for non-linearity. Further, since debt is likely to be an endogenous
variable, earnings quality and debt might be jointly determined. Therefore, we also use
a two-stage least squares model to jointly estimate the relation between earnings quality
and debt. Third, because accounting covenants are also based on interest coverage
ratio, we use a variation of the interest coverage ratio (interest expense to revenues) as
an alternative income statement based measure of debt financing. Finally, we deflate
debt by equity as an alternative balance sheet measure of debt. We find that our results
remain unchanged for these additional analyses.
Our results suggest that the positive relationship between debt and earnings quality
is descriptive for the most part of debt (almost 80% of the sample). However, the
reverse is true when debt is high. We conjecture that while creditors are generally
effective monitors of financial reporting, they are not as effective when debt is high.
This is because mangers’ immediate concern is to avoid costly debt covenant violations
rather than report earnings that are more informative about future cash flows. Our
study provides a first step towards understanding the complex relation between debt
financing and the quality of financial reporting.


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558 GHOSH AND MOON

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