Credit Default Swaps and Borrowers’ Real Earnings Management: Evidence From Credit Default Swap Initiation

In this study, we examine whether the initiation of credit default swap (CDS) trading alters borrowers’ real earnings management activities. Creditors increase debt supply and loosen loan contracts after CDS initiation, which in turn lessens borrowers’ pressure to resort to real earnings management as a way of lowering the cost of debt and increasing debt capacity. Consistent with this prediction, we find that borrowers reduce myopic real earnings management activities after CDS initiation. Furthermore, we show that this negative association between CDS initiation and real earnings management is more pronounced for borrowers with safer financial status and fewer debt covenants. Our findings remain robust to conducting a parallel trend analysis, employing the propensity score matching and the two-stage instrumental variable methods, using alternative measures of real earnings management, and controlling for accrual-based earnings management. Overall, our study suggests a potential “bright side” of CDS contracts by showing that the introduction of CDS contracts reduces, rather than exacerbates, borrowers’ myopic real earnings management behavior.