Earnings Management in Manager-owned Firms: Are Lenders Fooled?

This paper explores the causes and cost-of-debt consequences of earnings management in manager-owned firms. We identify a unique institutional setting in which the owner-manager has discretion to shift income from salary to dividends at almost no direct cost due to approximate tax neutrality between the two income streams, and hence increase reported earnings. We term this behavior salarydividend earnings management (SDEM, hereafter). We find that the use of SDEM is associated with the magnitude of debt, and that SDEM firms obtain cost of debt benefits. Both of these relations are stronger in magnitude around the zero earnings benchmark, but not around the last year’s earnings benchmark. The findings extend the earnings management and commercial lending literature by documenting opportunistic behavior and caused effects in firms where manager-shareholder agency conflicts are absent.