Earnings quality and the cost of debt for SMEs under severe information asymmetry

Abstract

The banking system has undergone substantial changes that boosted the relevance of transaction-lending technologies and the role of financial reporting in the bank-firm relationship. Due to the growing emphasis on accounting data, this study investigates the impact of earnings quality on the cost of debt for a sample of SMEs during the global financial crisis. Relying on a sample of Italian non-financial SMEs, empirical findings show a positive relationship between discretionary accruals and the cost of loans, highlighting the negative consequences of low-quality earnings. Further analysis reveals the different impacts that negative and positive abnormal accruals can have on the cost of debt: low values of the former can convey private information and positively affect the response variable, which shows a positive and quadratic relationship with the latter. These findings confirm the increasing importance of hard information in credit markets and point out the significant impact of the quality of the borrowers’ earnings on the cost of debts. However, the distinctiveness of the study from the previous literature relies on evidence that, even during a credit crunch period, financial institutions weigh up the expected return from lending transactions, relying on both the sign and the magnitude of discretionary abnormal accruals as a vehicle to get firms’ private information.