EFFECT OF BANK MONITORING ON EARNINGS MANAGEMENT OF THE BORROWING FIRM: AN EMPIRICAL INVESTIGATION

The literature on bank monitoring posits that strong bank monitoring can either increase or decrease the earnings management of the borrowing firm. We test these two competing hypotheses and find that earnings management (measured by the absolute value of the discretionary accruals) is higher when monitoring is strong–unless the firm is close to default. This result suggests that it might not be appropriate to view bank monitoring as always curbing corporate misbehavior. Our findings are based on examining 22,526 financial statements of private and public firms in India between 2001 and 2009.