Management earnings forecasts and bank loan contracting

• Author: Byron Y. Song,Xinlu Wang,Ray R. Wang,Tien‐Shih Hsieh
• DOI: http://doi.org/10.1111/jbfa.12371
• Published date: 01 May 2019
• Date: 01 May 2019

DOI: 10.1111/jbfa.12371

Management earnings forecasts and bank loan

contracting

Tien-Shih Hsieh1Byron Y. Song2Ray R. Wang2

Xinlu Wang3

1University of Massachusetts-Dartmouth,

Dartmouth, MA, USA

2Hong KongBaptist University, Hong Kong

3Southwestern Universityof Finance and

Economics

Correspondence

RayR. Wang, Hong Kong Baptist University,34

RenfrewRoad, Kowloon Tong,Kowloon, Hong

Kong.

Email:raywang@hkbu.edu.hk

Fundinginformation

Theauthors gratefully acknowledge the financial

supportfrom Hong Kong Baptist University.

Abstract

We find that firms tend to issue management earnings forecasts and

convey good news before bank loan initiation. Issuing firms enjoy

more favorable contracting terms and attract more lenders. Man-

agement forecasts issuance within a nine-month period prior to the

loan activating quarter can lower the subsequent loan spread by

14.06 basis points. Moreover, firms with larger management fore-

cast errors are charged harsher contracting terms and attract fewer

lenders. Our study suggests that firms strategically issue manage-

ment earnings forecasts before entering into debt contracts and

lenders incorporate the information contained in management earn-

ings forecasts into bank loan contracting.

KEYWORDS

bank loan contracting, good news, management earnings forecast,

management forecast errors, voluntary disclosure

1INTRODUCTION

This study provides empirical evidence on the relationship between management earnings forecasts and bank loan

contractingdecisions. Management earnings forecasts are an essential mechanism for firm management to voluntarily

conveyinformation to capital market participants (Patell, 1976; Pownall & Waymire,1989; Waymire, 1984). Prior stud-

ies (Balakrishnan, Billings, Kelly,& Ljungqvist, 2014; Frankel, McNichols, & Wilson, 1995; Shroff, Sun, White, & Zhang,

2013) suggest that management earnings forecasts could help mitigate information asymmetry and decrease the cost

of equity capital in financial markets. However,little work has been done to examine how management earnings fore-

castsaffect creditors’ decision-making processes, except for the work of Shivakumar, Urcan, Vasvari,and Zhang (2011).

Shivakumar et al. (2011) focus on the impact of management earnings forecasts on credit default swap (CDS) spreads

and find that credit spreads increase (decrease) significantly in response to good (bad) news management earnings

forecasts and the reactions are even stronger than those to actual earnings announcements. Our study aims to extend

research in this area by investigating how management earnings forecasts can affect bank loan contractingdecisions.

Specifically,we examine the following two related research questions: (1) whether firms communicate with bank loan

lendersthrough management earnings forecasts before loan borrowing; and (2) whetherlenders value and incorporate

the information provided by management earnings forecasts into loan contractterms.

712 c

2019 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2019;46:712–738.

HSIEH ET AL.713

Around the world, firms access debt marketsmore frequently than equity markets and bank loans are an important

source of corporate financing in debt markets (Bharath, Sunder,& Sunder, 2008; Florou & Kosi, 2015; Graham, Li, &

Qiu, 2008; Qian & Strahan, 2007). According to Thomson Reuters (2017), global syndicated lending reached US$ 4.6

trillion from 9,887 transactions during 2017. Although externalfinancing is undoubtedly essential for firms, the litera-

ture has not provided consistent results in explaininghow external financing activities can affect companies’ voluntary

disclosures. For example, prior studies (Kim, 2016; Lees, 1981; Ruland, Tung, & George, 1990) suggest that external

financing could motivate managers to issue more management forecasts. Frankel et al. (1995), however, find no sig-

nificant evidence showing that firms issue management forecasts more frequently over the nine-month period before

externalfinancing. They suggest that litigation risk could deter the intention to voluntarily increase disclosures prior to

external financing decisions. Similarly,Lang and Lundholm (2000) find no increase in the frequency of forward-looking

information disclosure during the six months preceding seasoned equity offerings (SEOs). These inconsistent findings

motivate us to investigate how companies communicate with lenders before their loan borrowings and how lenders’

decisions could be affected by companies’ voluntary disclosures.

Banks and other loan lenders are typically viewed as sophisticated investors with privileged access to borrowers’

private information (Beneish & Press, 1993; Campbell & Kracaw,1980; Fama, 1985; Smith, 1993). Thus, management

forecasts might carry little incremental value to lenders in this rich information environment. If that is the case, firms

might not be motivated to issue management earnings forecasts before entering into a loan contract and lenders’

decisions should not be affected by borrowers’ management earnings forecasts. However, Shivakumar et al. (2011)

find that changes in CDS spreads are significantly associated with management earnings forecast news. Anecdotes

also suggest that credit rating agencies changed their outlook on Nokia after the company revised its management

forecasts (Standard & Poor's, 2010). Such evidence indicates that management earnings forecasts before entering a

loan contract could still provide incremental information for creditors to evaluate borrowers’ credit risk. Therefore,

we hypothesize that companies tend to increase the incidence of management earnings forecasts before entering into

a loan contract. Moreover,good news management forecasts could paint a rosy picture of a firm's future performance

and thus alleviate lenders’ concerns about interest payments and principal repayment. Hence, we further hypothesize

that firms tend to conveygood news via management forecasts before entering into a loan contract.

Next, we investigate whether management earnings forecasts affect bank loan terms. Lenders can benefit from

management forecasts in the following two ways. First, the forward-looking information contained in management

forecasts facilitates loan lenders’ evaluation of a potential borrower's credit quality and ability to fulfill its loan obli-

gations, such as periodic interest payments and principal repayment at maturity.Second, the issuance of management

forecasts signals firms’ willingness to conveytimely information to outside parties, including lenders (Graham, Harvey,

& Rajgopal, 2005; Healy & Palepu,2001; Skinner, 1994). Thus, lenders could be less concerned about the availability of

relevant and timely information during the lending period and potential rent extractionby managers and shareholders

(Jensen & Meckling, 1976; Lambert, Leuz, & Verrecchia, 2007). Therefore, we also hypothesize that lenders tend to

grant more favorable loan contract terms to borrowers that issue management earnings forecasts and to borrowers

that conveygood news via management earnings forecasts before entering into a loan contract.

Moreover,the accuracy of historical management earnings forecasts can serve as an indicator of the reliance and

credibility of a firm's information environment (Williams, 1996; Yang, 2012) and could help lenders to assess a firm's

information risk. Giventhe evidence on the effect of information risk on loan contracting (Bharath et al., 2008; Costello

& Wittenberg-Moerman, 2011; Graham et al., 2008; Kim, Song, & Zhang, 2011), we hypothesize that lenders takeinto

account the accuracy of management forecasts when contractingwith a borrower.

Since managementearnings forecasts are endogenouslydetermined, empirical studies about management earnings

forecasts (Kim, 2016; Kim, Shroff, Vyas,& Wittenberg-Moerman, 2018b) often encounter the challenge of the endo-

geneity issue. Toaddress the endogeneity concern that the association between management earnings forecasts and

bank loan contracting could be driven by borrowers’ underlying performance, we adopt a propensity score matching

(PSM) procedure to construct a matched sample to further test our research hypotheses. We also include the inverse

Mills ratio (IMR) to control for potential selection bias (Heckman, 1979) when testing how management forecast prop-

erties (e.g., good news or forecast accuracy)affect bank loan contract terms (Kim, 2016).