Role of Creditors in Monitoring Earnings Quality in India

Abstract

In this study, we examine how debt financing in general and bank borrowings in particular affect the earnings quality in Indian firms. We conduct an empirical analysis taking a sample of 626 Indian non-financial firms from 2003 to 2021. Our sample comes from the Food and Agro-based industry, which is divided into four relatively homogenous groups. On each of the groups, we apply an industry-wise cross-sectional version of modified Jones model (Dechow et al. 1995) for estimating the discretionary accruals, a measure for earnings quality. Testing the hypotheses using industry fixed effects, for four sub-sectors, we found that debt financing is positively associated with discretionary accruals (negatively associated with earnings quality). We interpret this as a sign of discretion applied by opportunistic managers of borrowing firms in order to showcase a good financial position for reducing the cost of covenant violation. Further, age and size of the firms are positively related to earnings quality while leverage has a negative impact, along expected lines.