The Response of Debtholders to the Recognition of Foreign Investor’s Monitoring Power, and Debt Mispricing Associated with the Types of Earnings Management

This study investigates whether: 1) debtholders can detect accrual-based and real earnings management; 2) debtholders recognize the foreign investor’s monitoring power on debt pricing; 3) the mispricing associated with real earnings management can occur in the debt market; 4) the debt mispricing is intensified (alleviated) in firms with greater foreign ownership. The empirical results can be summarized as follows. First, the debtholders incorporate accrual-based earnings management (AEM), but not real earnings management (REM), into debt pricing. Second, foreign ownership is negatively associated with the cost of debt, with the debtholder’s recognition of a foreign investor’s ability to curb earnings management. Third, debt mispricing tends to be found in low AEM and high REM firms and high AEM and low REM firms, owing to a failure of the debt market in pricing REM. Fourth, the decreases (increases) of debt capital costs for firms with low (high) AEM and high (low) REM are intensified (alleviated) with greater foreign ownership. From these results, we can tentatively conclude that the debt market is inefficient due to REM. Hence, we cautiously suggest that debtholders should be prudent in pricing earnings management in firms with greater foreign ownership.