To Cheat or Not to Cheat

Two different bodies of literature suggest contradictory relations between the likelihood that a firm misreports its financial statement and the use of debt in its capital structure. We test these relations using three different measures of misreporting and find that the results differ depending upon the materiality of misreporting. For relatively less (more) material misreporting, we find the likelihood of misreporting is positively related (unrelated) to bank borrowing. These results suggest that bank monitoring is insufficient to deter or detect misreporting and that bank debt may even provide incentives for managers to misreport, consistent with the “debt covenant hypothesis.”