Do Lenders Care about the Earnings Smoothness of Their Borrowers’ Customers?
Dr. Zheng WANG
Assistant Professor of Accounting
Department of Accountancy
City University of Hong Kong
Firms rely on their major customers for revenues and profits. As a result, a firm’s ability to repay its borrowings is closely related to its major customers’ profitability and the collectability of its trade receivables outstanding from customers. To lenders, a borrower should have lower credit risk if its customers portray better profit stability. Therefore, when a firm’s customers engage in income smoothing to report more stable earnings, it may have a favorable effect on the firm’s cost of debt. In this study, we show that customers’ income smoothing can result in better loan terms for their suppliers, including lower loan rates, a lower likelihood of having collateral requirements and fewer restrictive covenants. Further investigation shows that these associations between the income smoothing of a firm’s major customers and its loan contracting terms are mainly driven by the subsample of firms that borrow from the same banks as their customers. We also find that customers’ income smoothing has a stronger favorable effect on a firm’s loan contracting terms if the firm has longer relationships with its customers, and if customers are mainly located in highly concentrated industries, relatively smaller and have lower CEO equity incentives.