| Pub. Date | : October, 2021 |
|---|---|
| Product Name | : The IUP Journal of Accounting Research and Audit Practices |
| Product Type | : Article |
| Product Code | : IJARAP201021 |
| Author Name | : Sager Reddy Adavelli and CMA Srikanth Potharla |
| Availability | : YES |
| Subject/Domain | : Finance |
| Download Format | : PDF Format |
| No. of Pages | : 7 |
Pledging of shares by the promoters induces them to follow earnings management when financial performance is poor, as the fall in reported earnings will have imminent negative impact on stock price. By analyzing the unbalanced panel data of 158 companies for the period of 2012-2018, the study corroborates the debt covenant hypothesis, as the pledge ratio has a significant positive impact on earnings management. The study also evidenced significant negative impact of operating cash flows on the earnings management, which may be attributed to the reason that when operating performance is poor, firms are more induced towards earnings management in order to report better profits.
Issue of debt by corporate entities is usually backed by a covenant, which is a legally
binding term of agreement between issuer of debt securities and debt security holder. The
underlying motive behind imposing covenants is to safeguard the interest of the debt security
holders that can mitigate default by the issuer and its repercussions. The recent past has
evidenced increased number of pledging of shares by the promoters to raise loan. Share
pledging makes the promoters virtual borrowers, exposing them personally to the risk
eliminating from the leverage. Fall in share price due to reporting of subdued performance
subsequent to pledging of shares will entail costlier penalties on the part of the promoters.
They may have to pledge an additional number of shares or else the lenders may liquidate
the pledged shares. In order to avert such adverse situations, the promoters may indulge in
upward earnings management. Against this backdrop, the study hypothesizes that management
is incentivized to increase or maintain the present level of market price of the shares by
managing earnings upwardly, as a fall in share price due to subdued earnings will be costlier
for the borrowers.
Literature Review
The positive accounting theory, proposed by Watts and Zimmerman (1986), is a cornerstone
of research on how the management chooses accounting and auditing policies. One of the