Earnings management through financing activities: Evidence from early debt extinguishments

• Published date: 01 April 2022
• Author: Abhijit Barua,Jung Hoon Kim,Sheng Yi
• Date: 01 April 2022
• DOI: http://doi.org/10.1002/jcaf.22537

Received:  October Accepted:  December 

DOI: ./jcaf.

RESEARCH ARTICLE

Earnings management through financing activities:

Evidence from early debt extinguishments

Abhijit Barua1Jung Hoon Kim2Sheng Yi3

School of Accounting, College of

Business Administration, Florida

International University, Miami, Florida,

USA

Accounting Department, Lam Family

College of Business, San Francisco State

University, San Francisco, California,

USA

Department of Accounting, Finance &

Economics, College of Business and

Public Policy, California State

University-Dominguez Hills, Carson,

California, USA

Correspondence

JungHoon Kim, Accounting Department,

LamFamily College of Business, San Fran-

ciscoState University, San Francisco, CA,

USA.

Email:jhkim@sfsu.edu

Weare grateful for helpful comments pro-

videdby workshop participants in Florida

InternationalUniversity and the  AAA

AnnualMeeting. We are responsible for all

remainingerrors.

Abstract

Weinvestigate whether early debt extinguishments, a financing activity, are used

to manage earnings after the introduction of SFAS No.  in . This stan-

dard changes the reporting rules of gains and losses from early debt extinguish-

ments, which are now included in income from continuing operations. This shift

in reporting rules provides firms with a potential opportunity to manage income

from continuing operations, which is valued more by investors than below the

line items. We hypothesize and find that gains from early debt extinguishments

are positively associated with the magnitude of shortfall from earnings bench-

marks and the propensity to meet or beat earnings benchmarks after the adop-

tion of SFAS . Thus, our findings suggest unintended consequences of the

SFAS No. ,which may have implications for policy makers.

KEYWORDS

earnings benchmarks, earnings management, financing activity, gains from early debt extin-

guishments, SFAS 

1 INTRODUCTION

Survey evidence suggests that managers are more willing

to use real activities than accounting discretion to manage

earnings (Graham et al., ). While a large number

of prior studies on real activity management document

that firms manage operating and/or investing activities

to achieve earnings benchmarks (e.g., Baber et al., ;

Bartov, ; Bushee, ; Cohen et al., ; Dechow

& Shakespeare, ; Roychowdhury, ), there is

scarce evidence that firms manage earnings upward using

financing activities to achieve earnings benchmarks.

To fill this void, we investigate whether firms manage

earnings upward using gains from early debt extinguish-

ments, a financing activity, to avoid losses and earnings

declines.

The introduction of Statement of Financial Accounting

Standards (SFAS)  in  changes the reporting rules

of gains and losses from early debt extinguishments, which

are now usually treated as part of income from continuing

operations (FASB, ). Before the adoption of SFAS

, such gains and losses were reported below the line as

extraordinary items.As the timing and amount of debt

extinguishments are firms’ decisions, the shift in reporting

rules of gains and losses from early debt extinguishments

provides firms with a potential opportunity to manage

their income from continuing operations. In response to

the shift in reporting rules mandated by SFAS, the New

York Stock Exchange (NYSE) expressed concerns that

some companies that would not otherwise be qualified to

list may qualify as gains from early debt extinguishments

are included in pre-tax earnings. On that ground, the

J Corp Account Finance. ;:–. © Wiley Periodicals LLC99wileyonlinelibrary.com/journal/jcaf