Manager-Debtholder Alignment and Opportunistic Income Smoothing

Abstract

Managers’ risk preferences are typically greater than those of debtholders. Managers have the potential to gain from risky activities, but debtholders share only in the losses. Debtholders recognize their misalignment with managers’ risk preferences and assign a higher cost of borrowing or restrict financing to higher-risk firms. Recent literature, however, suggests that some managers hold large amounts of debt-based compensation (defined benefit pension plans and deferred compensation plans), and these managers’ actions more closely align with the preferences of outside debtholders. I find that managers with low debt compensation (i.e., those with more agency conflict with debtholders) are more likely to use discretionary accruals to opportunistically reduce the volatility of underlying performance. These results are consistent with less debt-aligned managers attempting to hide excessive risk-taking activities from outside debtholders. I also document that such opportunistic smoothing increases with the firm’s reliance on debt financing and debtholders’ reliance on financial statement information. My study provides evidence on the motive behind managers’ discretionary income smoothing behavior based on the notion that insufficient debt-based executive compensation results in misalignment between managers and debtholders.