Bank Financing as an Incentive for Earnings Management in Business Start-ups

By

Nancy Huyghebaert Heidi Vander Bauwhede Marleen Willekens

Katholieke Universiteit Leuven

The authors thank Christof Beuselinck and Marc Deloof for useful comments on an earlier draft of this paper. Corresponding author: Nancy Huyghebaert, Katholieke Universiteit Leuven, Department of Accountancy, Finance and Insurance, Naamsestraat 69, 3000 Leuven, Belgium; tel: 00 32 16 326 737, fax: 00 32 16 326 732, e-mail: nancy.huyghebaert@econ.kuleuven.be

Electronic copy of this paper is available at: http://ssrn.com/abstract=967386

Bank Financing as an Incentive for Earnings Management in Business Start-ups

By

Nancy Huyghebaert Heidi Vander Bauwhede Marleen Willekens

Katholieke Universiteit Leuven

Abstract In this paper, we investigate whether business start-ups in need for external financing manage their earnings in the years prior to obtaining a first bank loan. Newly established firms typically face valuable growth opportunities whereas their external financing sources usually are limited to bank loans and trade credit. Due to lack of track record, information asymmetries between entrepreneurs and potential financiers tend to be large. Business start-ups, as a result, may manage their earnings upwards when applying for a first bank loan, to influence the lending decisions of banks. We use a unique sample of Belgian start-up firms to test this hypothesis. Earnings management behavior is captured through two measures of current accruals: trade accruals and non-cash working capital accruals. Our multivariate analyses indicate that, after controlling for elements that affect the normal level of accruals, business start-ups indeed have significantly increased levels of current accruals and thus earnings in the years preceding a first bank loan. However, we find no evidence that bank lending decisions are actually influenced by this earnings management behavior.

JEL: G21, G32, G33

Electronic copy of this paper is available at: http://ssrn.com/abstract=967386

I. Introduction Newly established firms typically face valuable growth opportunities, which need to be financed. In this paper, we investigate whether earnings management by such firms if any is inspired by the need for external financing. For start-ups in traditional industries, the external financing sources are usually limited and mainly consist of bank loans and trade credit.1 Start-up firms incentives to manage earnings upwards in order to influence the lending decisions of suppliers likely are limited. The evidence in Ng et al. (1999), for example, suggests that suppliers do not actively collect information on a firms creditworthiness before granting trade credit, as the supply of trade credit is largely industry determined and varies little across firms within the same industry. And, as trade credit is generally a short-term financing source, suppliers can react quickly to newly obtained bad information by refusing to roll over the trade credit, which protects them against adverse selection and moral hazard problems. So, suppliers likely base their lending decisions on other considerations than analyzing information included in the annual accounts.2 These ideas are confirmed by Sercu et al. (2003), who report that privately held companies do not seem to target suppliers when managing their earnings. For bank lending, the situation is different and, as a result, banks may carefully screen the financial statements of start-up clients for the following reasons. First, banks do not only lend larger amounts as compared to suppliers, but also extend loans with longer maturities, which makes them more vulnerable to information and incentive problems. Furthermore, when a debtor goes bankrupt, banks being specialists in the evaluation of creditworthiness can be held liable by other creditors, for instance suppliers, for having given a too optimistic signal on the firms credit quality. In the context of newly established firms, failure rates are typically
1

Berger and Udell (1998) discuss the sources of financing firms can access according to their age. Typically, venture capital is only available for firms in specific industries, and in Continental Europe, venture capitalists largely finance firms in the growth rather than the start-up stage. For start-ups in traditional industries, Huyghebaert (2006) and Huyghebaert and Van de Gucht (2007) show more explicitly that bank debt and trade credit are the main financing sources. 2 Wilner (2000), for example, points out the role of the supplier implicit equity stake, i.e. the rents that suppliers can earn on future sales of their product to the client firm to which they extend trade credit. Because of this implicit equity stake, suppliers may be willing to extend credit even to client firms that face potentially high adverse selection and risk shifting problems. Huyghebaert (2006) and Huyghebaert and Van de Gucht (2007) find empirical support for these ideas.

high in the first few years after start-up. Dun & Bradstreet (1994), for instance, document that approximately 50% of all firms that failed in 1993 did so during the first five years of their existence. Later studies report similar statistics (see, for example, Huyghebaert and Van de Gucht, 2004). Such high failure rates likely urge banks to careful lending decisions. Newly created firms have a limited track record and no established relationships with banks, especially in the case of a first loan application. Examining annual accounts when available may then help banks to determine the firms assets that can serve as collateral and its future cash flow generation, to gauge the firms debt capacity. When start-ups are aware (or assume) that a careful financial viability assessment will be done based on company accounts, an incentive is created for them to manage their earnings upwards in the year(s) before receiving a first bank loan. Survival of start-up firms often depends upon obtaining the necessary financial resources to finance assets and operations,3 which creates a further incentive to manage earnings upwards when in need of bank financing. Furthermore, as newly established firms typically have no or few taxable earnings (see, for example, Laitinen, 1994; Huyghebaert, 2006), they have no incentive to manage their earnings downwards. Due to the limited size of most firms, company accounts issued by business start-ups also remain unaudited, which actually provides opportunities for undetected earnings management. In this paper, we examine whether business start-ups manage their earnings upwards in the years before receiving a first bank loan. Given that information asymmetries between startup firms and banks are largest at this point in time and as such firms have not yet built a reputation for servicing their debt well, we expect earnings management to be particularly likely in this case. One way to manage earnings is the use of discretionary accounting accruals to raise reported earnings relative to the actual cash flows.4 In this paper, we focus on earnings

management through current accruals rather than total accruals because management of current

Holtz-Eakin et al. (1994), for example, find that entrepreneurs whose financial constraints are reduced after receiving an (exogenous) inheritance face significantly increased survival chances. 4 Accruals consist of a non-discretionary or normal component that changes with the firms level of operating activities, and a discretionary or abnormal component that is the result of earnings management.

accrual accounts is less visible than management of non-current accrual accounts (see also Guenther, 1994; Teoh et al., 1998a). Current accruals relate to those short-term assets (such as accounts receivable and inventories) and liabilities (such as accounts payable) supporting the day-to-day operations of the firm. Using data on a unique sample of Belgian business start-ups that published annual accounts before receiving a first bank loan, we find that current accruals are significantly higher in the years preceding a first bank loan as compared to the years thereafter, ceteris paribus. These findings are consistent with accruals being managed upwards before obtaining a first bank loan. The results further indicate that firms that are short of cash and with limited tangible assets have significantly higher current accruals, ceteris paribus. We interpret the latter relations as reflecting that more financially constrained business start-ups are more inclined to manage their earnings upwards, ceteris paribus. Indeed, firms that lack cash may highly need the bank financing, but when the amount of assets that can be pledged as collateral is limited, they may expect banks to be less willing to lend. As a supplementary analysis to this paper, we also examine whether start-up accruals, which may at least partly result from earnings management, influence the bank lending decision, but find no corroborative evidence for such a relation. Rather, we document that economic variables shape the banks credit-granting decision in the context of business start-ups. More specifically, start-up firms with significant financing needs resulting from growth opportunities are more likely to obtain bank debt, ceteris paribus. Internal cash generation (current

profitability) also increases the likelihood of bank lending but, consistent with the pecking order model of capital structure, firms with accumulated cash reserves resulting from past profitability are less likely to borrow from banks. Finally, banks tend to lend more eagerly to firms with higher tangible fixed assets whereas firm risk (activity risk nd financial risk) negatively affects the bank lending decision. Overall, our results could reflect that 1) banks carefully examine company accounts before lending, and are not being misled by start-up earnings management

when deciding on granting a loan, nor do banks penalize companies for the information risk resulting from potential earnings management or 2) banks do not attentively scrutinize company accounts in the case of business start-ups. Ravid and Spiegel (1997), for example, argue that the relatively small size of start-up loans and the complexity associated with screening and monitoring of these firms renders such activities cost ineffective from the point of view of banks (see also Huyghebaert and Van de Gucht, 2007). The remainder of this paper is organized as follows. In Section II, we develop our main hypotheses based on prior earnings management studies. Also, we link start-up accrual accounts to subsequent bank lending decisions. empirical models. In Section III, we present our research design and

Section IV reports the results of our empirical analyses on earnings Section V

management by business start-ups in the period around their first bank loan. concludes this paper.

II. Literature and hypotheses The accounting and finance literature has extensively studied incentives for and constraints on earnings management. Incentives for earnings management, for example, stem from the role of accounting information in specific financial contracts, such as bonus compensation plans or debt covenants, or in assessing firm performance and value. By managing the reported income figure, managers can artificially meet bonus targets, avoid debt covenant violations, or influence the price of a firms stock. Various studies find evidence consistent with these hypotheses (see, for example, Healy (1985) for the bonus plan hypothesis, DeFond and Jiambalvo (1994) and Jaggi and Lee (2002) for the debt covenant hypothesis). The literature has also elaborated on

mechanisms that constrain firms earnings management behavior. The quality of the external auditor (see Francis et al., 1999; Becker et al., 1998), large institutional shareholders (Chung et al., 2002), and investor protection (Leuz et al., 2003) are examples of constraining mechanisms. Some studies have examined earnings management prior to or around a particular event, such as

initial public offerings (Aharony et al., 1993; Friedlan, 1994; Teoh et al., 1998a), seasoned equity offerings (Rangan, 1998; Teoh et al., 1998b), acquisitions (Erickson and Wang 1999; Heron and Lie, 2002) or venture capital financing (Beuselinck et al., 2003). Most of these studies find clear evidence of upward earnings management prior to or around the studied event. Our paper is the first study on earnings management around bank lending decisions. In particular, we examine earnings management by business start-ups around the time of their first bank loan. Typical for newly established ventures is that they are privately held and ownership is not separated from firm management. Hence, these firms have no incentive to manage their earnings to influence stock prices and/or managerial compensation. In addition, there are other relevant differences between start-up and mature firms, relating to tax incentives and factors that constrain earnings management. In contrast to other privately held firms, business start-ups have no incentive to decrease their earnings for tax reasons (see Sercu et al., 2003), for they have only few taxable earnings (e.g., Laitinen, 1994; Huyghebaert, 2006). Furthermore, start-up firms are not subject to the scrutiny of high-quality external auditors or large institutional shareholders. The reason is that newly established enterprises usually do not exceed the size criteria that trigger a mandatory external audit,5 and are not being financed by large institutional investors, but by one or more entrepreneurs. Business start-ups, however, are in constant need for new funds to finance their investment opportunities. Persson (2004), for example, documents that the size of surviving start-up firms has doubled eight years after their establishment (see also Audretsch, 1995). Not surprisingly, start-up survival often depends upon being able to secure sufficient external financing to initiate investment projects (e.g., Holtz-Eakin et al., 1994; Persson, 2004). Besides supplier credit, bank debt is a main source of financing for these firms (e.g., Berger and Udell, 1998; Huyghebaert, 2006; Huyghebaert and Van de Gucht, 2007).

In Belgium, the country from which we draw our sample, companies are required to appoint a statutory auditor if they employ more than one hundred people, or if two of the following size criteria are met: a) total assets exceed 3,125,000; b) turnover exceeds 6,250,000; and c) more than 50 people are employed.

Although banks are generally considered to have inside information about the (mature) firms they lend to, this is less true in a start-up context. Indeed, as these firms have not yet developed a relationship with a house bank and as their track record is short, information asymmetries between entrepreneurs and banks tend to be large. Furthermore, since we look at the period around a first debt grant, the type of firms we study have not yet been able to build a valuable reputation for servicing their debt well, thereby reducing potential agency problems (e.g., Diamond, 1989). These information and incentive problems cannot be ignored given the high failure risk that business start-ups face. Hence, accounting information may be a welcome source to assess the creditworthiness of loan applicants in the context of business start-ups and first-time loans. Since net income is positively related to profitability and solvency (that is, to the extent that earnings are retained within the firm), start-ups have clear incentives to manage their earnings numbers upwards in order to positively affect the lending decision by banks. Prior research on quoted companies shows that earnings contain value-relevant information, in addition to the information contained in cash flows (the main difference between the two measures being accruals) (see, for example, Bowen et al., 1987), that accruals improve the ability of earnings to measure firm performance as measured by stock returns (e.g., Dechow, 1994), and that accrual-based earnings better predict future operating cash flows than current operating cash flows (Dechow et al., 1998). In addition, Subramanyam (1996) reports that the part of accruals that is the result of earnings management (i.e. the discretionary or abnormal accruals6) is priced by the market and predicts future profitability. Based on the arguments above, we test the following hypothesis:

HYPOTHESIS 1:

Earnings management by business start-ups is larger in the years before they raise a first bank loan than in the years afterwards.

The other part of accruals, the normal or non-discretionary part, is the part that changes with the firms level of operating activities (cfr. infra).

Given the role of financial constraints in the context of business start-ups, we expect that especially firms with difficult access to bank loans may have an incentive to manage their earnings upwards. On the one hand, companies that have limited cash available on their balance sheet have no alternative than to raise external financing to embark on investment projects. Consistent with this idea, de Haan and Hinloopen (2003) show that current liquidity is significantly negatively related to the probability of raising bank debt whereas profitability a measure of future liquidity is not significant. On the other hand, business start-ups with few tangible assets may find it difficult to obtain a bank loan, as they have insufficient assets that can be pledged as collateral for this bank debt (see, for example, Degryse and Van Cayseele, 2000; Lopez Iturriaga, 2005).

HYPOTHESIS 2:

Business start-ups that are financially constrained will manage their earnings upwards.

As a supplementary analysis to examining the incentives for earnings management in business start-ups, we also wish to determine whether bank lending decisions are actually influenced by higher reported earnings as a result of higher accruals numbers. Hence, we wish to establish whether firms that report higher accruals, and thus higher earnings, are more likely to obtain a bank loan, and thus may succeed in their attempts to secure bank financing through accruals management. Finding support for such a relation would also mean that banks can be misled by earnings management, at least in the start-up context, where prior banking relationships are lacking and information asymmetries are particularly extensive. For other sources of external financing, in particular equity, the literature has offered some interesting insights regarding the question whether firms can influence investor perceptions, and obtain funds at a lower cost. Friedlan (1994), Dechow et al. (1996), Teoh et al. (1998b) and Rangan (1998), for example, conclude that firms indeed succeed in manipulating their stock price, and increase the proceeds

from initial or seasoned equity offerings. In the long run, however, the market sees through earnings management and stock prices are corrected downwards again. The above discussion results in the following hypothesis:

HYPOTHESIS 3A:

Business start-ups that increase their earnings through the use of accrual accounts are more likely to obtain a bank loan.

Alternatively, banks may be aware that increased levels of accruals could reflect opportunistic earnings management. Indeed, accruals consist of a normal (i.e. non-discretionary) and an abnormal (or discretionary) part. While only the abnormal part reflects opportunistic earnings management, just total accruals are observable in practice. Hence, banks do not know whether high values of accruals are due to some real underlying economic event or caused by opportunistic earnings management. So, they may consider high accruals as an additional risk factor, on top of the firms failure risk, and be reluctant to lend to firms with relatively high accruals. To test whether banks associate high levels of accruals with increased risk, and adjust their credit-granting decisions, we posit the following hypothesis:

HYPOTHESIS 3B: Business start-ups are less likely to obtain a bank loan the higher the level of their accruals accounts.

III. Design and models In this paper, we examine upward earnings management by business start-ups prior to receiving a first bank loan. We do this by testing whether current accruals are higher in the years before a first bank loan than in other years, ceteris paribus. As in Han and Wang (1998), we do not use a separate model to divide current accruals into a discretionary and a non-discretionary

component, but rather directly control for the factors that explain the non-discretionary or normal part of current accruals and other factors that may confound our analysis. Accruals include a non-discretionary or normal component that changes with the firms level of operating activities, and a discretionary or abnormal component that is the result of earnings management. Firms may, for example, overstate revenues and accounts receivable or understate the write-down for obsolete inventories in an attempt to increase their earnings. While earnings management researchers are particularly interested in this abnormal or discretionary part of current accruals, only total current accruals are observable. Previous

studies therefore have typically used a two-step procedure, which involves first calculating the discretionary or abnormal accruals from the accruals of firms in the same industry and year, and next estimating a model to explain these discretionary or abnormal accruals. However, this procedure is not feasible in a start-up context, where motives and opportunities to manage earnings are largely different as compared to more established firms (see also Section I). Furthermore, in the case of newly established ventures, it is often difficult to identify a comparable firm in the corresponding industry and year. According to Schumpeter (1934), an entrepreneur is an innovator who implements changes within markets, such as introducing new products or products of better quality, uses new methods of production, opens a new market, etc. Hence, an entrepreneurial firm often has no peer company. Finally, in any context (business start-up or not), a two-step procedure introduces unnecessary measurement error in the estimates of discretionary accruals. In particular, when the average comparable firm also manages its earnings, the calculated discretionary accruals of other firms will not be correctly estimated. This reduces the power of subsequent earnings management tests (see, for example, Dechow et al., 1995). Therefore, we investigate earnings management in business start-ups by testing whether current accruals are higher in the years before a first bank loan, after controlling for factors that may explain the non-discretionary or normal part of the accruals and factors that may confound

our analysis. To that end, we estimate the following model using a one-way random effects panel data estimation technique:7, 8

CURXit = 0 + 1 BANKit + 2 CASHit + 3 PPEit + 4 VAit + 5 NOCFit + 6 LAGCURXit + 7 LNAGEit + 8 LNSIZEit + 9 NOCFit + it (1)

where: CURX = CUR1 (trade accruals) or CUR2 (non-cash working capital accruals) BANK = BANKDUM or BANKCAT BANKDUM = Dummy variable that equals one in the year(s) before obtaining the first bank loan and zero otherwise. BANKCAT = Indicator variable that equals one in the year(s) preceding the first bank loan, zero in the year of this bank loan and minus one in the year(s) thereafter. CASH = Net cash and cash equivalents in year (t1) / lagged total assets PPE = Property, plant and equipment in year (t1) / lagged total assets VA = Change in value added from (t1) to t / lagged total assets NOCF = Change in net operating cash flow from (t1) to t / lagged total assets LAGCURX = Lagged current accruals, using definition 1 (trade accruals) or definition 2 (non-cash working capital accruals) LNAGE = Natural log (1 + years since start-up) LNSIZE = Natural log (total assets) in year (t1) NOCF = Net operating cash flow in year (t1) / lagged total assets

The dependent variable in this model is current accruals. Current accruals relate to the short-term assets and liabilities that support a firms day-to-day operations. We prefer to

examine current accruals over total accruals (i.e. the sum of current and non-current accruals, such as, for example, depreciation)9 because the management of current accrual accounts is less

OLS estimation may produce biased and inconsistent results owing to its failure to control for time-invariant firmspecific heterogeneity. This problem will occur when the disturbance term incorporates time-invariant omitted factors that are contemporaneously correlated with the models explanatory variables. Hence, we estimated the models by means of a random effects panel data estimation technique. Alternatively, we estimated the model using OLS, and obtained qualitatively similar results. These results are not reported, but can be obtained from the authors upon request. 8 The Hausman statistic does not reject the random effects specification in favor of a fixed effects model. In addition, conclusions are not affected under a two-way random effects estimation technique. 9 Total accruals can be separated along two dimensions. First, total accruals are the sum of current and non-current accruals. Second, total accruals can also be seen as the sum of normal or non-discretionary accruals and abnormal or discretionary accruals. As total accruals, its current and non-current parts can be further partitioned in a normal (non-discretionary) and abnormal (discretionary) part. Hence, total accruals can then also be seen as the sum of four

10

visible than the management of non-current accrual accounts (see also Guenther, 1994; Teoh et al., 1998a). The level of current accrual accounts such as accounts receivable and inventories is to a certain extent influenced by managements subjective and discretionary estimates. For instance, the provisions for bad debt and for obsolete inventories are to a large extent based on judgment. If done opportunistically, this is difficult to detect and therefore often goes unnoticed. In contrast, management of non-current items, such as a change in the depreciation methods of fixed assets, is more difficult to hide from stakeholders. The reason is that Belgian GAAP requires that any such changes be duly reported and motivated in the notes to the financial statements, also for the small firms in our sample that may file abbreviated accounts. This makes the latter kind of earnings management more prone to observation by stakeholders. An inspection of the notes did not reveal that the start-up companies in our sample changed their depreciation method in the years after start-up. We use two distinct measures for current accruals trade accruals and non-cash working capital accruals to check whether our results are not idiosyncratic to the choice of current accruals measure. Trade accruals are calculated from trade-related accounts, including Non-cash working capital

inventories, accounts receivable and accounts payable accounts.

accruals also include other short-term liabilities, such as taxes and wages payable and social security payments.

Trade accruals (CUR1) = [ inventories + accounts receivable + accrued assets accounts payable accrued liabilities] / lagged total assets Non-cash working capital accruals (CUR2) = [( current assets cash and cash equivalents) ( current liabilities short-term financial debt)] / lagged total assets

(2)

(3)

separate parts: normal current accruals, abnormal current accruals, normal non-current accruals, and abnormal noncurrent accruals.

11

The test variable for the first hypothesis (BANK) can take either of two forms, to let the data decide on the exact specification of earnings management in business start-ups. First, BANKDUM is a dummy variable that equals one in the year(s) before obtaining a first bank loan and zero otherwise. Second, BANKCAT is an indicator variable that equals one in the year(s) preceding the first bank loan, zero in the year of this bank loan, and minus one in the year(s) thereafter. This paper focuses on bank loans instead of bank credit lines; the latter is very shortterm debt in nature and involves smaller amounts of financing, which makes it less subject to information and incentive problems. BANKDUM then captures whether earnings management is higher during the years preceding the first bank loan, compared to all other years. BANKCAT, however, additionally captures whether earnings management is lower or decreases after the bank loan is granted. Since we hypothesize firms to manage their earnings upwards in the years prior to their first bank loan, we expect to find a positive coefficient on both test variables and interpret such coefficients as evidence of upward earnings management before obtaining a first bank loan. We further include our test variables for the second hypothesis, i.e. variables that may capture earnings management incentives in a business start-up context. Firms with less available cash tend to be more financially constrained and thus should be more likely to manage their earnings upwards to obtain bank debt. We include CASH, measured as the ratio of net cash and cash equivalents in the previous year to lagged total assets, to control for this effect and expect a negative coefficient on this variable. Firms with no or only few tangible assets that can be pledged as collateral have less chance to obtain a bank loan, ceteris paribus. Hence, these firms may be more likely to resort to earnings management to influence bank perceptions of their creditworthiness (borrower quality). We proxy the collateral value of assets by the level of prior-year property, plant and equipment (PPE) relative to lagged total assets and expect a negative coefficient on this variable.

12

The first set of control variables that we include are factors associated with the nondiscretionary or normal part of current accruals. First, we include VA the change in value added as compared to the previous year to control for the change in current accruals that is attributable to changes in the firms operating activities, i.e. firm growth.10 Note that the

expected sign on the coefficient for VA is not a priori clear, as the change in value added is associated with both asset (e.g., inventories and accounts receivable) and liability components (e.g., accounts payable) of current accruals. Hence, the net effect of changes in these accounts cannot be predicted (see also Jones (1991), p. 213). As in Dechow (1994), we also include the change in net operating cash flow (NOCF)11 as a second control variable. The rationale is that changes in cash flows contain temporary components that are reversed over time, and the role of accruals is to match cash disbursements and cash receipts that are associated with the same economic event in order to obtain a performance measure that better captures current firm performance (Dechow, 1994).12 Since some accruals also reverse over time, prior-year (i.e. lagged) accruals may contain information with respect to current-year accruals. We therefore also include lagged current accruals (LAGCURX) in the model and expect a negative sign on this variable. All these control variables are scaled by lagged total assets to take potential

heteroscedasticity problems into account (see also Jones, 1991). Finally, we include a number of control variables that may confound our analysis of earnings management in a business start-up context. First, firm age (LNAGE), calculated as the natural logarithm of (1 + years since start-up), is used to control for the level of information
10

Prior studies typically proxy changes in a firms level of operating activities by means of changes in its sales (see, e.g., Jones, 1991; Dechow et al., 1995). Unfortunately, revenue figures are not available for all start-up firms in Belgium. The reason is that enterprises classifying as a small firm are allowed to file abbreviated financial statements, and the latter do not generally include revenues. Yet, these firms have to report value added, which is calculated as sales minus the cost of goods sold. Changes in value added and changes in revenues are likely to capture the same information when the trend in the cost of goods sold follows the trend in revenues. 11 Net operating cash flow is defined as earnings before interest, taxes, depreciation and amortization (EBITDA) minus the change in non-cash working capital. 12 For example, assume that in period t firms sell on cash and on credit. Both types of sales determine the firms operating performance in period t, i.e. the time of sale. However, cash flows from operations of period t only capture the effect of the cash sales, and not of the credit sales. The impact of the credit sales in period t will be reflected in the cash flow from operations in a later period, i.e. in the period when the customer actually pays. By contrast, earnings of period t capture the effect of both cash and credit sales, and is therefore said to better capture current firm performance.

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asymmetries between the start-up firm and its external financiers. Since the level of information asymmetries and hence the likelihood that earnings management goes undetected decreases as firms grow older, we expect to find a negative coefficient on LNAGE (e.g., Richardson, 2000). Consistent with the literature (e.g., Becker et al., 1998, Young 1998), we introduce the natural log of lagged total assets (LNSIZE) to control for the potential effect of firm size on accounting choices. Earlier research has conjectured and found a negative coefficient on this variable, based on the argument that larger firms are more visible. This point has been made in the context of publicly quoted companies, where larger firms invite more analyst coverage. In the case of privately held business start-ups, however, firm size is certainly not a proxy for investor interest. So, we include firm size, but are unsure about its sign. We measure this variable by lagged total assets (instead of this-year total assets) since the latter are influenced by earnings management in the current year. Finally, prior studies have shown that tests of earnings management may be mis-specified for firms with extreme financial performance (e.g., Dechow et al., 1995). We include net cash flow from operations (NOCF) to control for this effect. Given the results reported by Dechow et al. (1995), we expect a negative coefficient on this variable. The model and the predicted direction of the effects are summarized in Table 1. ************** insert Table 1 **************

IV. Data and results IV.A. Sample description To test the theoretical predictions in the previous section, we need financial information from business start-ups as of start-up. Little research has been done on newly established

entrepreneurial firms, simply because the data are not readily available. For the USA, the Federal Reserve Boards National Survey of Small Business Finances (NSSBF) provides financial information on 4,637 privately held firms, but Ang et al. (2000) report that mean firm

14

age in this database is 17.6 years. As a result, NSSBF is not representative for start-up firms. Furthermore, the database does not include panel data (Petersen and Rajan, 1997). We decided to use Belgian start-up data to test our model for the following reasons. Belgium is an interesting environment for research on business start-ups, because all limited liability firms, i.e. corporations except for financial institutions, insurance companies, exchange brokers and hospitals are mandated to file annual accounts with the National Bank as of the moment of start-up. In 2002, nearly 270,000 corporations filed financial statements with the Belgian National Bank, covering more than 75% of GNP. Overall, the accounting principles in Belgium (Belgian GAAP) are to a large extent comparable to those adopted in the AngloSaxon world (see, for instance, Deloof and Jegers, 1999). The first time a Belgian firm registers with the tax authorities, it receives a unique and chronologically accorded Value Added Tax number. This VAT number allowed us to identify newly established firms and their financial statements as of start-up in the database of the National Bank.13 So, the first year of data in our database truly represents the firms start-up year. And another interesting feature is that Belgian business start-ups are required to publish an abstract from their foundation charter in the Government Newspaper (Staatsblad) shortly after start-up. This abstract contains information on the firms ownership at start-up. We identified 652 limited liability firms (corporations) that were founded in 1992 in manufacturing. This industry was selected because of the larger scale of its operations, at least when compared to retailers, wholesalers or service firms. Entrepreneurs in manufacturing

therefore are more likely to lack the personal financial resources to fully finance the firms assets and operations during the first few years after start-up. To be included in the sample, companies had to report their industry code, i.e. the European NACE code, at the four-digit level. All firms in the sample report only one four-digit NACE code and hence are narrowly focused.

13

This database is commercialized by Bureau Van Dijk Electronic Publishing.

15

To make sure that only firms that are true first-time business start-ups were included in the sample, we subsequently removed all firms that were not entrepreneurial start-ups. From the contents in the foundation charter as published in the Government Newspaper, true business start-ups could be distinguished from newly established subsidiaries of existing firms, split-ups, spin-offs, etc. Through follow-up phone calls, we also identified firms that were established through the incorporation of a previously self-employed activity, and removed them from the sample. These screening criteria reduced the sample to 328 true business start-ups, which are examined during 19922002. 48 firms in this sample never borrowed any funds from banks and hence are not the main focus of our study. The reason is that we cannot determine the moment of their first bank loan. We observe a lot of bankruptcies and voluntary liquidations in this small sample (12 companies were liquidated voluntarily and 11 were liquidated following a bankruptcy procedure). Of the remaining firms, 79 raised a first bank loan after having filed their annual accounts with the National Bank. On average, these firms raise their first bank loan after 4.29 years (median of three years). Finally, 201 corporations already raised bank debt in the start-up year. While for the latter 201 firms we can determine the moment of their first bank loan, it is also the case that bank lending decisions were not based upon publicly available annual accounts.14 Hence, we will separate our analyses by first estimating the models on the

subsample of 79 event firms and then testing the robustness of our results when also including the data on the 201 start-ups who got bank financing in the start-up year. Table 2 describes the industry distribution of the 79 event firms, based on their two-digit NACE code. Industries that are highly represented include the paper, printing and publishing industry (21 firms); the food, drink and tobacco industry (10 firms); and the footwear and clothing industry (8 firms). Besides, we also report the industry distribution for the 201 firms that already raised bank debt in the start-up year.

14

We recognize that in their lending decisions, banks may still use information on earnings and cash flows from the financial plan, which has to be submitted as part of the business plan before a corporation can be founded (see, for example, Vanhoutte and Sels, 2005). Yet, the earnings and cash flow information in this financial plan typically is less extensive than the one in a firms (even abbreviated) annual accounts.

16

************** insert Table 2 **************

We collected financial statement data from the first accounting year up to and including 2002, resulting in 691 and 1670 firm-year observations for the 79 event firms and 201 other start-up firms, respectively. By the end of 2002, 15 event firms (18.99%) had discontinued their operations: 10 due to bankruptcy and 5 firms were liquidated voluntarily.15 As a result, the panel data set is unbalanced. Table 3 reports summary statistics for the 79 event firms in the start-up year and compares this information with the sample of 201 enterprises that already raised bank debt in the start-up year, using a non-parametric Wilcoxon test. The average event firm employs two persons in the start-up year and its total assets amount to 299,754 (median of 59,755). Firm start-up size is significantly smaller when compared to the sample of enterprises that already raised bank debt in the start-up year. The 79 event firms also have a significantly higher ratio of cash and marketable securities to total assets (average of 13.36% and median of 10.13%), suggesting a lower need for bank financing in the start-up year, ceteris paribus. Overall, their ratios of inventories and accounts receivable relative to total assets are not significantly different from those of firms that obtained bank debt already in the start-up year. Yet, the event firms have a significantly smaller ratio of tangible fixed assets to total assets (average of 25.39% and median of 15.44%), which suggests a link between the availability of assets that can be pledged as collateral and access to bank loans. Not surprisingly, the event firms indeed have a

significantly smaller debt ratio, but do not differ in terms of trade credit used and profitability, as measured by net operating cash flow to total assets and net income to total assets. ************** insert Table 3 **************
15

These percentages are comparable to those in the subsample of 201 firms that already raised bank debt in the startup year: 39 firms (19.40%) discontinued their operations by the end of 2002, of which 27 because of bankruptcy.

17

IV.B. Earnings management results In Table 4, we report descriptive statistics on the dependent (Panel A) and explanatory (Panel B) variables in our model. These numbers are calculated from the sample of firms that ever raised a bank loan. Given the presence of extreme values in the data, we winsorized the variables at the 595%. In other words, these percentiles replace the corresponding extreme values. From Panel A, it is clear that trade accruals on average represent 3.72% of lagged total assets (median of 1.50%) whereas non-cash working capital accruals average 3.50% (median of 2.00%). The correlation between these two measures of current accruals amounts to 0.7042. Panel B presents descriptive statistics for the test and control variables in our model, which are also winsorized. A Pearson correlation matrix for the explanatory variables is provided in Appendix A. As the maximum correlation coefficient amounts to 0.3087 (NOCF CASH), multicollinearity is unlikely to be a problem in our study. ************** insert Table 4 **************

In Tables 5 and 6, we report the results of our regression analyses. Table 5 relates to the subsample of 79 business start-ups that raised no bank loan in the start-up year, but did so before the age of ten (691 firm-year observations). Besides including the 79 event firms, Table 6 also incorporates the data on the 201 start-ups that actually obtained a first bank loan in the start-up year (i.e. a total of 280 firms and 2361 firm-year observations).16 In each Table, Panel A contains the results when trade accruals (CUR1) is the dependent variable whereas non-cash working capital accruals (CUR2) is the dependent variable in Panel B. Both panels include the results of three models. The first model is the base model, i.e. the model excluding the test

16

As a robustness check, we also did the analyses in Tables 5 and 6 when including the 48 firms that never obtained a bank loan (for these firms, BANKDUM and BANKCAT always equal one). This robustness check assumes that these firms wanted to borrow from banks but were refused. We find that our results are robust under this alternative specification although the models explanatory power is always somewhat lower. These findings are not reported, but can be obtained from the authors upon request.

18

variables BANK, CASH and PPE. The two other models only differ regarding the specification of the test variable for the first hypothesis: Model 2 uses BANKDUM whereas Model 3 uses BANKCAT. From Tables 5 and 6, it is clear that all models are significant and have substantial explanatory power. Although explanatory power cannot be easily compared from one study to another, our results show that, in comparison to earlier earnings management studies, we can explain a relatively large portion of current accruals for first-time business start-ups. Furthermore, in both tables the trade accruals models (Panel A) have higher explanatory power than the non-cash working capital accruals models (Panel B). Table 5 shows that the test variables BANKDUM and BANKCAT have a positive sign, as predicted, and are significant at the 10% level in all model specifications. In Table 6, the coefficient estimates on the test variables for the first hypothesis are also positive and significant, mostly at the 1% level. These results strongly support our hypothesis that business start-ups manage their earnings upwards in the years before obtaining a first bank loan, as the proportion of current accruals is significantly larger in years before than after a first bank loan, controlling for factors that may explain the normal part of current accruals and other factors that may confound our analysis of earnings management in a start-up context. Yet, we find no

corroborative evidence that earnings are managed downwards after obtaining a first bank loan as the explanatory power of the current accruals models is only slightly higher when using the BANKCAT specification of the test variable. Possibly, the reversal in accrual accounts is already captured by including the lagged current accruals variable, which is highly significant in all models. Start-up firms with more cash on their balance sheet have both significantly lower trade accruals and significantly lower non-cash working capital accruals. In addition, companies that have more tangible fixed assets have significantly lower current accruals. These results are consistent with the idea in hypothesis 2 that more financially constrained business start-ups are inclined to manage their earnings upwards, ceteris paribus. Indeed, firms that lack cash may

19

highly need the bank financing but when the amount of assets that can be pledged as collateral is limited, they may expect that banks are less willing to lend. Hence, as indicated by our findings, these firms resort to earnings management in order to influence bank lending behavior. When we include an interaction term between BANKDUM on the one hand and CASH and PPE, respectively, on the other, we find that these interaction variables have a negative but not significant sign (p-values around 0.20). These interaction terms do become significant when removing CASH and PPE from the model, but this alternative specification has lower explanatory power (not reported). In addition, BANKDUM retains its statistically significant positive parameter estimate. Overall, these results suggest that financially constrained business start-ups manage their earnings upwards, and that receiving a first bank loan does not fully eliminate financial constraints. Tables 5 and 6 further show that the variables explaining the non-discretionary or normal current accruals, namely the change in value added, the change in net operating cash flow and lagged current accruals, are highly significant, with signs in the expected directions. This is also the case for most of the other control variables. The only exception is LNAGE, whose positive sign is mostly not significantly different from zero.17 A positive sign on LNAGE, which

becomes significant only in the non-cash working capital accruals model (Panel B of Tables 5 and 6) could indicate that business start-ups are expanding their personnel at a smaller rate than their cash flows as they grow older, such that non-trade current liabilities (wages and social security payments) increase more slowly. Alternatively, as LNAGE is significant only when including BANKCAT, it might be that a decrease in non-cash working capital accruals after the loan is granted happens in a non-linear way. In short, the results on the control variables suggest that we adequately control for the factors known to determine the non-discretionary (or normal) part of current accruals and the factors that may confound our earnings management tests in a

17

When LNAGE is removed from the models in Tables 5 and 6, we find that the results and conclusions on the other variables remain valid.

20

start-up context, thereby supporting the idea that the results on the test variables for our first and second hypotheses indeed stem from discretionary accruals management. ***************** insert Tables 56 *****************

IV.C. Additional analysis: resolution of the bank lending decision As the results in the previous section show that business start-ups manage their earnings upwards in the years prior to receiving a first bank loan, an interesting follow-up question is whether this earnings management affects the lending decisions of banks. That is, do banks actually take the information from current accruals into account when deciding on granting credit to business start-ups and, if so, do they value higher earnings that are the result of increased current accruals or, alternatively, do they consider higher accruals as an additional risk factor? In this section, we expand our analysis by investigating the factors that are related to the bank lending decision in the context of a first loan to business start-ups. In particular, we examine whether higher current accruals in the year(s) before obtaining a bank loan impacts bank lending decisions. In Table 7, we report the results of a multivariate logistic regression analysis using the sample of 127 firms that did not obtain a bank loan in the start-up year; indeed, only for those firms, current accruals may have affected the decision of banks to provide a first loan. We follow these firms from start-up until and including the year of their first bank loan. Alternatively, when these firms never raised a bank loan, we follow them to 2002 or to the year of their liquidation. This results in 623 firm-year observations. The dependent variable

LENDING equals one for the year in which a first bank loan was obtained and zero otherwise. The test variable in this analysis is a measure of current accruals: trade accruals in Panel A, and non-cash working capital accruals in Panel B. Model 1 reports the results when using prior-year current accruals as the test variable. We introduce alternative specifications for the test variable in subsequent models. Model 2 calculates the test variable as a two-year average of current

21

accruals prior to obtaining the bank loan.18 Finally, the test variable in Model 3 is measured as lagged current accruals minus the firm-level time series average of this variable over the sampling period. A number of control variables are included in the model to capture elements that are related to the demand and supply for bank financing (see, for example, de Haan and Hinloopen, 2003; Beyan and Danbolt, 2004; Huyghebaert and Van de Gucht, 2007). Growth opportunities are measured by the average growth rate in total assets of business start-ups in the corresponding four-digit NACE industry during the studied window. As business start-ups have only limited access to external financial resources, we expect a positive coefficient on this variable, reflecting a higher demand for bank financing. Simultaneously, banks may be more willing to lend to start-ups in high-growth industries, to develop a valuable lending relationship. To take into account that firms with access to internal financing have a smaller demand for external (bank) financing, we include net operating cash flow/total assets and net cash and cash equivalents/total assets and expect a negative coefficient on these variables. These control variables are

calculated from the previous-year financial statements. In addition, we control for the fact that firms with more tangible assets (PPE/total assets) likely find it easier to borrow from banks, as they can pledge these assets as collateral. By contrast, banks may be reluctant to lend to highrisk firms (measured by the failure rate of earlier business start-ups in the corresponding fourdigit NACE industry during 19881991). For a given level of activity risk, the start-ups capital structure may further enlarge its bankruptcy risk. Hence, firms with a higher debt ratio (current liabilities/total assets) may find it difficult to borrow from banks. Finally, we control for firm age (natural log (1 + years since start-up)) and firm size (natural log (total assets)). When older and larger firms face less information asymmetries, they may have better access to bank debt. From inspection of Table 7, it is clear that none of the test variables are significantly associated with the bank lending decision. Higher current accruals do not incite banks to lend
18

When two-year historical data are not available, we use one year of historical data to calculate the test variable in order to preserve the sample size.

22

more eagerly nor do they deprive start-up firms access to bank financing. So, this evidence suggests that any start-up earnings management prior to obtaining a bank loan does not affect the banks lending decision. Overall, these results could reflect that 1) banks carefully examine company accounts before lending, but are not being misled by any start-up earnings management when deciding on granting a loan, nor do banks penalize companies for the information risk resulting from potential earnings management or 2) banks do not attentively scrutinize company accounts in the case of business start-ups. Ravid and Spiegel (1997), for example, argue that the relatively small size of start-up loans and the complexity associated with screening and monitoring of these firms renders such activities cost ineffective from the point of view of banks (see also Huyghebaert and Van de Gucht, 2007). Rather, we do find that economic variables drive the bank lending decision in the context of business start-ups. More specifically, start-up firms that face significant financing needs resulting from growth opportunities are more likely to raise and obtain bank debt, ceteris paribus. This relation suggests that banks are interested in developing a long-term relationship with startups in high-growth industries, possibly with the intention of reaping future hold-up or location rents (see, for instance, Degryse and Ongena, 2002, 2005; Huyghebaert and Van de Gucht, 2007). Internal cash generation (current profitability) also increases the likelihood of bank lending but, consistent with the pecking order model of capital structure, firms with accumulated cash reserves resulting from past profitability are less likely to borrow from banks. The latter results are consistent with the findings of de Haan and Hinloopen (2003), for example. Yet, the results in column 1 indicate that banks are less likely to lend to start-up firms with more tangible fixed assets, which is inconsistent with our priors. Huyghebaert and Van de Gucht (2007) also document a negative relation between asset tangibility and the fraction of debt that consists of bank loans for newly established ventures. They argue that banks are more likely to liquidate firms with a high liquidation value following a default on their loans (see also Hart, 1995; Manove et al., 2001). This issue of default and liquidation is relatively important in a start-up

23

context, especially for firms that face high default risk. Hence, risky firms with highly tangible assets may abstain from bank financing in order to reduce the likelihood of premature liquidation following default (see Huyghebaert et al., 2007). To take this argument into account, we reestimated Model 1 after including an interaction term between PPE/total assets and failure risk (Model 1a) and find support for this conjecture. More specifically, the simple term measuring tangible fixed assets has a positive and significant parameter estimate whereas that of the interaction term is significantly negative. This allows us to conclude that banks tend to lend more eagerly to firms with larger tangible fixed assets, but these firms are reluctant to raise bank debt when their ex-ante likelihood of failure is higher, ceteris paribus. The results further indicate that banks are less likely to ever lend to firms in industries with high start-up failure risk. Besides activity risk (industry failure risk), financial risk also significantly negatively affects the bank lending decision. Finally, we find that older firms are less likely to raise a bank loan whereas firm size has a significantly positive impact on the likelihood of borrowing from banks, ceteris paribus. ************** insert Table 7 **************

V. Conclusions This paper investigates earnings management by business start-ups around the time of their first bank loan. We argue that newly established firms have strong incentives to manage their earnings numbers upwards to influence the lending decisions of banks. The reason is that their survival often depends upon obtaining the necessary financial resources to finance assets and operations. As these firms have only a limited track record and as they have not yet developed a relationship with a house bank in the case of a first bank loan application, information asymmetries between entrepreneurs and banks tend to be large. This makes it also difficult for banks to distinguish between higher accruals resulting from some real underlying economic

24

event and higher accruals resulting from earnings management. This holds especially true in the case of current accrual accounts, which relate to the firms day-to-day operations. Using a unique sample of 328 newly established ventures in the manufacturing industry for a period up to ten years after start-up, we test whether current accruals are larger in the years before these firms obtain their first bank loan than in subsequent years. Consistent with this hypothesis, we find that current accruals of business start-ups are indeed significantly higher in the years prior to obtaining their first bank loan, ceteris paribus. This result is robust to two alternative specifications of the current accruals measure: trade accruals and non-cash working capital accruals. In addition, we find that financially constrained business start-ups, i.e. firms that are short of cash and with limited tangible assets, have significantly higher current accruals, ceteris paribus. However, we find no corroborative evidence that bank lending decisions are influenced by higher earnings resulting from higher current accruals. Rather, we document that economic variables shape the banks credit-granting decision in the context of business start-ups. These results could reflect that 1) banks carefully examine company accounts, but are not being misled by start-up earnings management, nor do they penalize the information risk resulting from potential earnings management behavior or 2) banks do not attentively scrutinize company accounts before lending in the case of business start-ups. Our study, however, is unable to discriminate between these two alternative explanations. Overall, the results of our study may be of interest to start-ups firms, banks and regulators. First, to start-ups the results indicate that earnings management is not successful to influence the lending decisions of banks. Rather, the firms growth opportunities, its

profitability, the tangibility of its assets and the risk of its activities and financial structure are important considerations in the bank lending decision Second, to banks they suggest that startup firms are managing their earnings figures when applying for a first bank loan. And third, to regulators our findings suggest that start-up firms use the flexibility available in GAAP. The results further indicate that the market for bank debt is not negatively affected by this potentially

25

opportunistic behavior. Finally, start-up firms that use earnings management are not being deprived from access to bank loans, as they are not penalized for the information risk resulting from potential opportunistic earnings management.

26

Table 1: Summary of testable predictions

Predicted Sign Test variables: BANKDUM (H1) BANKCAT (H1) CASH (H2) PPE (H2) Control variables: Change in value added from (t1) to t / lagged total assets (VA) Change in net operating cash flow from (t1) to t / lagged total assets (NOCF) Lagged current accruals (LAGCUR) Natural log (1 + years since start-up) (LNAGE) Natural log (total assets) in year (t1) (LNSIZE) Net operating cash flow in year (t1) / lagged total assets (NOCF) +/ +/ + +

BANKDUM = Dummy variable that equals one in the year(s) before obtaining the first bank loan and zero otherwise. BANKCAT = Indicator variable that equals one in the year(s) preceding the first bank loan, zero in the year of this bank loan and minus one in the year(s) thereafter. CASH = Net cash and cash equivalents in year (t1) / lagged total assets PPE = Property, plant and equipment in year (t1) / lagged total assets

27

Table 2: Industry distribution of start-ups

This table displays the industry distribution of the start-up firms, based on their two-digit NACE industry code. All sample firms are incorporated in Belgium and start their operations in the manufacturing industry in 1992. The sample is constructed from the Belgian National Bank database. Based on the foundation charter and follow-up phone calls, only true entrepreneurial start-ups are retained. We make a distinction between the firms that raised a first bank loan after (79 firms) and in (201 firms) the start-up year. We refer to the firms that raised their first bank loan after the start-up year as the event firms.

NACE code

Description

Number of firms in event sample

22 23 24 25 31 32 34 36 37 41/42 43 44 45 46 47 48 49 TOTAL

Production and preliminary processing of metals Extraction of minerals other than metalliferous and energy-producing minerals; peat extraction Manufacture of non-metallic mineral products Chemical industry Manufacture of metal articles (except for mechanical, electrical and instrument engineering and vehicles) Mechanical engineering Electrical engineering Manufacture of other means of transport Instrument engineering Food, drink and tobacco industry Textile industry Leather and leather goods industry (except footwear and clothing) Footwear and clothing industry Timber and wooden furniture industries Manufacture of paper and paper products; printing and publishing Processing of rubber and plastics Other manufacturing industries 2 firms 10 firms 3 firms 3 firms 8 firms 6 firms 21 firms 2 firms 8 firms 79 firms 1 firm 6 firms 1 firms 7 firms 1 firm

Number of firms with bank debt in start-up year 1 firm

7 firms 2 firms 8 firms 7 firms 5 firms 4 firms 10 firms 37 firms 14 firms 1 firm 13 firms 26 firms 56 firms 3 firms 7 firms 201 firms

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Table 3: Characteristics of the start-up firms

This table provides descriptive statistics for the sample of 79 event firms that raised bank debt after the first start-up year and 201 firms that raised bank debt already in the start-up year. All firms are incorporated in Belgium and start their operations in the manufacturing industry in 1992. The sample is constructed from the Belgian National Bank database. Based on the foundation charter and follow-up phone calls, only true entrepreneurial start-ups were retained. The descriptive characteristics are based on the financial statements of the first accounting year. We also report the p-value of a non-parametric Wilcoxon test that compares the two subsamples.

mean FIRM SIZE Number of employees Total assets () ASSET STRUCTURE Cash and cash equivalents/total assets Inventories/total assets Accounts receivable/total assets Property, plant and equipment/total assets FINANCIAL STRUCTURE Total debt and current liabilities/total assets Bank debt/total assets Trade credit/total assets PROFITABILITY Net operating cash flow/total assets Net income/total assets 0.0670 -0.0803 0.5691 0 0.2466 0.1336 0.1068 0.2366 0.2539 2 229,754

N=79 median 1 59,755 0.1013 0.0359 0.1739 0.1544 0.5601 0 0.1804 0.0826 0.0062

std. dev 3.5984 968,889 0.2285 0.1460 0.2126 0.2387 0.3809 0 0.2377 0.5105 0.4617

mean 3.1841 287,085 0.0391 0.1014 0.2159 0.4729 0.8327 0.3150 0.2097 0.1255 -0.0509

N=201 median 2 150,669 0.0379 0.0541 0.1659 0.4727 0.8502 0.2901 0.1823 0.1339 -0.0122

p-value std. dev 4.5849 441,714 0.1498 0.1282 0.1798 0.2264 0.2113 0.2208 0.1686 0.2569 0.1951 0.0006 0.0001 0.0015 0.3773 0.8095 0.0001 0.0001 0.0001 0.6860 0.4812 0.1061

29

Table 4: Descriptive statistics on dependent and explanatory variables

Panel A: Dependent variables mean 0.0372 0.0350 median 0.0150 0.0200 min -0.3059 -0.4215 max 0.5204 0.5898 std. dev 0.1880 0.2200

Trade accruals (CUR1) Non-cash WC accruals (CUR2)

CUR1 = Trade accruals = [ inventories + accounts receivable + accrued assets accounts payable accrued liabilities ] / lagged total assets. CUR2 = Non-cash working capital accruals = [( current assets cash and cash equivalents) ( current liabilities ST financial debt)] / lagged total assets.

Panel B: Explanatory variables mean 0.0549 0.3629 0.0342 -0.3797 0.0263 0.0170 1.7556 8.8623 0.1497 median 0.0319 0.3187 0.0183 -0.3402 0.0144 0.0186 1.7918 8.8345 0.1542 min -0.2840 0 -0.4052 -6.7827 -0.2836 -0.3649 0 6.7788 -0.3821 max 0.5430 0.9667 0.5657 5.2982 0.4000 0.3811 2.3979 13.5944 0.6096 std. dev 0.2211 0.2842 0.2218 2.4687 0.1626 0.1790 0.5377 1.3424 0.2358

CASH PPE VA NOCF LAGCUR1 LAGCUR2 LNAGE LNSIZE NOCF

CASH PPE VA NOCF LAGCURX LNAGE LNSIZE NOCF

= Net cash and cash equivalents in year (t1) / lagged total assets = Property, plant and equipment in year (t1) / lagged total assets = Change in value added from (t1) to t / lagged total assets = Change in net operating cash flow from (t1) to t / lagged total assets = Lagged current accruals = Natural log (1 + years since start-up) = Natural log (total assets) in year (t1) = Net operating cash flow in year (t1) / lagged total assets

30

Table 5: The determinants of current accruals

This table presents one-way random effects regression results explaining trade accruals (Panel A) and non-cash working capital accruals (Panel B). The first model is the base model. The test variable BANKDUM in the second model equals one in the year(s) before obtaining the first bank loan and zero otherwise. The test variable BANKCAT in the third model equals one in the year(s) preceding the first bank loan, zero in the year of this bank loan and minus one in the year(s) afterwards. The sample includes data on 79 event firms that raised bank debt after the first start-up year (691 firm-year observations).

Panel A: Trade accruals Intercept Test variables: BANK

Pred. sign ?

One-way random effects regression results (1) (2) (3) 0.0672 0.0388 0.0442 0.0238* 0.1117*** 0.0460** 0.1241*** 0.0087*** 0.0237** 0.0009 0.0116 0.0749*** 32.20% 0.1438*** 0.0093*** 0.0294** 0.0135 0.0070 0.0662*** 35.38% 0.0194** 0.1137*** 0.0463** 0.1433*** 0.0092*** 0.0309*** 0.0217 0.0074 0.0644*** 35.67%

BANKDUM (H1) BANKCAT (H1)

CASH (H2) PPE (H2) Control variables: Change in value added / total assets Change in net operating CF / total assets Lagged current accruals (LAGCUR1) Natural log (1 + years since start-up) Natural log (total assets) Net operating CF / total assets Buse R-square Panel B: Non-cash WC accruals Intercept Test variables: BANK

+ + +/ +/

Pred. sign ?

One-way random effects regression results (1) (2) (3) 0.0521 0.0767 0.0599 0.0936*** 0.1305*** 0.0960*** 0.0706*** 0.0082*** 0.0198*** 0.0119 0.0068 0.0785*** 21.81% 0.0966*** 0.0087** 0.0263*** 0.0464 0.0040 0.0602*** 28.68% 0.0525*** 0.1401*** 0.1038*** 0.0976*** 0.0087** 0.0273*** 0.0606* 0.0043 0.0592*** 29.22%

BANKDUM (H1) BANKCAT (H1)

CASH (H2) PPE (H2) Control variables: Change in value added / total assets Change in net operating CF / total assets Lagged current accruals (LAGCUR2) Natural log (1 + years since start-up) Natural log (total assets) Net operating CF / total assets Buse R-square

+ + +/ +/

* indicates significance at the 10% level, ** at the 5% level and *** at the 1% level.

31

Table 6: The determinants of current accruals

This table presents one-way random effects regression results explaining trade accruals (Panel A) and non-cash working capital accruals (Panel B). The first model is the base model. The test variable BANKDUM in the second model equals one in the year(s) before obtaining the first bank loan and zero otherwise. The test variable BANKCAT in the third model equals one in the year(s) preceding the first bank loan, zero in the year of this bank loan and minus one in the year(s) afterwards. The sample includes data on 280 firms that raised bank debt in or after the first start-up year (2361 firm-year observations).

Panel A: Trade accruals Intercept Test variables: BANK

Pred. sign ?

One-way random effects regression results (1) (2) (3) 0.0085 0.0232 0.0056 0.0343** 0.0894*** 0.0383*** 0.1326*** 0.0102*** 0.0295*** 0.0006 0.0059 0.0824*** 33.93% 0.1460*** 0.0100*** 0.0369*** 0.0074 0.0040 0.0739*** 35.97% 0.0208*** 0.0908*** 0.0382*** 0.1453*** 0.0099*** 0.0380*** 0.0089 0.0043 0.0730*** 36.09%

BANKDUM (H1) BANKCAT (H1)

CASH (H2) PPE (H2) Control variables: Change in value added / total assets Change in net operating CF / total assets Lagged current accruals (LAGCUR1) Natural log (1 + years since start-up) Natural log (total assets) Net operating CF / total assets Buse R-square Panel B: Non-cash WC accruals Intercept Test variables: BANK

+ + +/ +/

Pred. sign ?

One-way random effects regression results (1) (2) (3) 0.0085 0.0366 0.0252 0.1548*** 0.1674*** 0.0856*** 0.0824*** 0.0092*** 0.0139*** 0.0217 0.0030 0.0822*** 21.61% 0.1088*** 0.0084*** 0.0221*** 0.0376 0.0013 0.0570*** 29.62% 0.0768*** 0.1738*** 0.0899*** 0.1091*** 0.0083*** 0.0224*** 0.0419** 0.0016 0.0571*** 29.76%

BANKDUM (H1) BANKCAT (H1)

CASH (H2) PPE (H2) Control variables: Change in value added / total assets Change in net operating CF / total assets Lagged current accruals (LAGCUR2) Natural log (1 + years since start-up) Natural log (total assets) Net operating CF / total assets Buse R-square

+ + +/ +/

* indicates significance at the 10% level, ** at the 5% level and *** at the 1% level

32

Table 7: The determinants of the bank lending decision

This table presents logit regression results explaining the likelihood of obtaining a first bank loan. The test variable is trade accruals in Panel A and non-cash working capital accruals in Panel B, respectively. Model 1 (and 1a) uses lagged current accruals as the test variable. In Model 2, the test variable is calculated as a two-year average of current accruals prior to obtaining the bank loan. Finally, the test variable in Model 3 is calculated as lagged current accruals minus the firm-level time series average of this variable over the sampling period. The sample includes data on 127 firms that raised no bank debt in the start-up year (623 firm-year observations).

Panel A: Trade accruals Intercept Test variable Growth opportunities Net operating CF / total assets Net cash and equivalents / total assets PPE / total assets PPE / total assets * Failure risk Failure risk Current liabilities / total assets Natural log (1 + years since start-up) Natural log (total assets) Nagelkerke R-square Panel B: Non-cash WC accruals Intercept Test variable Growth opportunities Net operating CF / total assets Net cash and equivalents / total assets PPE / total assets PPE / total assets * Failure risk Failure risk Current liabilities / total assets Natural log (1 + years since start-up) Natural log (total assets) Nagelkerke R-square

Pred. sign ? +/ + + + + Pred. sign ? +/ + + + +

Logit regression results (1) (1a) 0.7138 0.0874 0.2272 0.1998 0.9984*** 0.9581*** 0.7859* 0.6265 1.7924* 1.6398* 2.0954** 1.9701** 2.2257** 0.1065** 0.1095** 1.0345** 1.3531** 1.4094** 1.2029** 0.2183* 0.2552** 22.41% 27.15% Logit regression results (1) (1a) 0.7113 0.1034 0.3496 0.3212 1.0454*** 1.0045*** 0.8170* 0.6415 1.9305* 1.7767* 2.1161** 2.0903** 2.3086** 0.1099** 0.1117** 1.0469** 1.3846** 1.4032** 1.1985** 0.2241* 0.2625** 22.86% 27.57%

(2) 0.0750 0.1178 0.8971*** 0.7423* 1.4493* 2.0804** 2.1517** 0.1102** 1.3333** 1.2017** 0.2428** 26.98% (2) 0.0706 0.0554 0.9140*** 0.7021* 1.5479* 2.0940** 2.1953** 0.1097** 1.3497** 1.1883** 0.2459** 26.94%

(3) 0.3259 0.0585 0.9168*** 0.7613* 1.4672* 2.1781** 2.2062** 0.1129** 1.3551** 1.1648** 0.2568** 27.07% (3) 0.1307 0.0923 0.9350*** 0.6991* 1.5817* 2.1278** 2.2170** 0.1100** 1.3312** 1.1995** 0.2527** 27.02%

* indicates significance at the 10% level, ** at the 5% level and *** at the 1% level.

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Appendix A: Correlation matrix for the explanatory variables

CASH CASH PPE VA NOCF LAGCUR1 LAGCUR2 LNAGE LNSIZE NOCF 1.0000 0.0314 0.0762*** 0.0469** 0.0189 0.0233 0.0643*** 0.1701*** 0.3087*** 1.0000 0.1572*** 0.1039*** 0.0335 0.0465** 0.1156*** 0.0729*** 0.2063*** 1.0000 0.0596*** 0.0519** 0.0795*** 0.1238*** 0.0544** 0.1251*** 1.0000 0.0029 0.0531** 0.0031 0.0010 0.2820*** 1.0000 0.6786*** 0.0478** 0.0389* 0.1624*** 1.0000 0.0027 0.0244 0.1960*** 1.0000 0.1361*** 0.0558** 1.0000 0.0540** 1.0000 PPE VA NOCF LAGCUR1 LAGCUR2 LNAGE LNSIZE NOCF

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