DO INSIDERS WHO PLEDGE THEIR SHARES MANIPULATE REPORTED EARNINGS

Abstract

In January 2009, the Securities Exchange Board of India (SEBI) issued a new regulation that made it mandatory for Indian firms to report the number of shares pledged by their promoters to borrow loans. We take advantage of these quarterly disclosures on share pledges to examine whether and how pledging motivates promoters to manage accruals and discretionary expenses. Our results suggest that pledging reduces the likelihood of accruals-based earnings management. Potential monitoring by lenders deters earnings management by pledging promoters despite the strong incentive to manage earnings upward. However, when we distinguish between first-time and continuing pledgers we find that the former record positive discretionary accruals, while continuing pledgers record significant negative discretionary accruals. In the first year of the pledge, the incentive to manage accruals upward is sufficiently important that it dominates any deterrence caused by monitoring by lenders. Alternatively, lender monitoring of pledgers is low in that year. After the first year, either the first year’s earnings management reverses and / or the deterring effect of lender monitoring becomes strong enough that firms record negative discretionary accruals. Our examination of discretionary expenses indicates that pledging is associated with lower levels of R&D spending, but is unrelated to advertising costs. Further, the negative association between R&D spending and pledging does not depend on whether the promoters are pledging for the first time or continuing to pledge. The contrasting results for discretionary accruals and R&D are consistent with promoters viewing real management activities such as cutting R&D as being subject to less scrutiny by lenders, auditors, and regulators.

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