Effect of SME and Chaebol Loan Contracts on Debt Covenant Hypothesis: Evidence from Korea

Abstract

This study provides an in-depth analysis of the covenant-based hypothesis that focuses on whether and how correlations between debt ratios and earnings management (measured by discretionary accruals) are affected by the size and nature of firms. We performed a pooled ordinary least squares regression using a sample of 10,983 firms listed in Korea from 2002 through 2012. In the Korean financial market, SMEs and firms belonging to chaebols (conglomerates) are markedly different in terms of their bargaining power with financial institutions. The results suggest that SMEs have a larger portion of secured loans and that chaebols can use their credit in the bond market to access alternative sources of financing. Accordingly, neither SMEs nor chaebols are motivated to make income-increasing choices for larger discretionary accruals to relax their debt constraints. In contrast, a large firm with a higher debt ratio is likely to make accounting choices to increase reported earnings, which results in more discretionary accruals. The debt agreements between lenders (financial institutions) and borrowers (firms) have different implications in the Korean financial market depending on a firm’s size and nature.