Trade Credit Risk Management: The Role of Executive Risk‐Taking Incentives

• Date: 01 November 2015
• Published date: 01 November 2015
• DOI: http://doi.org/10.1111/jbfa.12130
• Author: Anna Elsilä

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(9) & (10), 1188–1215, November/December 2015, 0306-686X

doi: 10.1111/jbfa.12130

Trade Credit Risk Management: The Role

of Executive Risk-Taking Incentives

ANNA ELSIL¨

A∗

Abstract: In this study we investigate how executive equity incentives affect companies’ risk-

taking behavior in relationships with their customers. We hypothesize and find that executive

risk-taking incentives provided by options are positively related to the degree of trade credit

riskiness measured both as the amount of total trade credit a firm extends to all its customers

and as the amount of trade credit a firm extends to customers with a high probability of default.

We also find that the measures of trade credit riskiness are positively related to the firm’s future

stock return volatility, suggesting that the customer default risk inherent in customer-supplier

trade credit relationships represents an important economic source of the overall supplier-firm

riskiness. The findings of the study provide insights into why firms facing financial difficulties

are not denied trade credit.

Keywords: risk-taking incentives, executive compensation, trade credit

1. INTRODUCTION

Trade credit is an important form of corporate short-term financing. Its usage is

extensive as evidenced by the substantial amounts of accounts receivable and accounts

payable on firms’ balance sheets. For example, according to results reported in various

studies, accounts receivable constitute on average about 17–22% of total assets (Mian

and Smith, 1992; Deloof, 2003; and Atanasova, 2007), whereas the corresponding

figure for accounts payable is of the order of 10% (e.g., Molina and Preve, 2012).

In addition to being a substitute for bank financing, trade credit may perform a

number of non-financial functions, such as resolving information asymmetry about

product quality or serving as a price discrimination tool (Petersen and Rajan, 1997;

and Ng et al., 1999). One drawback of trade credit relationships is that by allowing

customers to delay cash payments, suppliers expose themselves to the risk that some

portion of their receivables may never be collected. Intriguingly, several studies

∗The author is from the University of Oulu, Finland. This paper benefited from discussions with Juha-Pekka

Kallunki, Rachel Hayes, and Henry Jarva. The author would also like to thank an anonymous reviewer, the

editor (Andrew Stark), the seminar participants at the University of Oulu, Stockholm School of Economics,

Copenhagen Business School, Cass Business School, and Aalto University School of Business for many

valuable comments and suggestions. All remaining errors are the author’s own. (Paper received January

2015, revised version accepted August 2015).

Address for correspondence: Anna Elsil¨

a, Assistant Professor, Department of Accounting, University of

Oulu, P.O.Box 4600, FIN-90014 Oulu, Finland.

e-mail: anna.elsila@oulu.fi

C

2015 John Wiley & Sons Ltd 1188

TRADE CREDIT RISK MANAGEMENT 1189

investigating the motives for providing trade credit from a demand-side perspective

by analyzing accounts payable, have documented that the most unprofitable and

financially distressed firms make extensive use of trade credit (Petersen and Rajan,

1997; and Molina and Preve, 2012). Although it has been argued that the explanation

for this finding lies in suppliers’ willingness to ensure future sales (Petersen and Rajan,

1997; Wilner, 2000; and Cu˜

nat, 2007), there is a lack of empirical evidence on what

specific factors motivate some sellers to take greater risks by providing trade credit to

financially distressed customers.

In this study we investigate the factors affecting suppliers’ willingness to pursue

riskier trade credit policies and, more specifically, to extend trade credit to customers

with a high probability of default. Since these policies are directly related to the firm’s

core operating activities and contain information about the uncertainty of future sales

and cash flows, factors affecting their riskiness are important for the stakeholders of

the firm-supplier.

Economic theory suggests that risk-related agency problems can be mitigated by

increasing the convexity of managers’ compensation or, in other words, its sensitivity

to firm riskiness (Guay, 1999). Accordingly, the empirical literature generally provides

support for the prediction that managers with greater payoff convexity make riskier

financing and investing decisions (Coles et al., 2006; Brockman et al., 2010; and

Chava and Purnanandam, 2010). We therefore predict that, in addition to other

firm economic characteristics, supplier firm managers’ risk-taking incentives resulting

from option compensation should represent a determinant of a supplier’s decision

to extend more trade credit, and to extend trade credit to financially distressed

customers.

An empirical analysis is performed using a sample of S&P 1500 companies included

in ExecuComp over the period from 1992 to 2011. To approximate the degree of a

firm’s exposure to customer default risk we rely on estimates of future doubtful debts

reported on the balance sheet and construct two empirical measures of firm’s tendency

to follow riskier trade credit policies by scaling the allowance of doubtful debts by total

sales and by gross trade receivables.1Because extending more trade credit per se also

involves bearing a greater credit risk, we alternatively measure firm’s exposure to the

customer default risk as a ratio of gross accounts receivable to total sales. We first assess

the construct validity of these empirical measures by investigating their relation to the

aggregate riskiness of the firm as reflected in stock return volatility. The results show

that all the three variables are significantly positively associated with a one-year-ahead

stock return volatility after controlling for other determinants of firm riskiness in both

ordinary lease squares (OLS) and firm fixed effects regression specifications.

We next examine the relation between top executive value-increasing incentives

(delta), risk-taking incentives (vega), and the customer default risk in the multivariate

setting, and find that vega is significantly positively related to the measures of the

customer default risk. This result holds both when estimating regressions using OLS

and when controlling for within-firm variation using firm fixed effects. Finally, we

address a potential endogeneity between executive equity incentives and the customer

default risk using both a two-stage least squares (2SLS) estimation procedure and an

exogenous shock to executive equity incentives induced by the passage of Statement

1 We use the terms ‘doubtful debts’, ‘doubtful accounts’, and ‘doubtful receivables’ interchangeably

throughout the text.

C

2015 John Wiley & Sons Ltd