Clear conscience never fears midnight knocking : the effect of earnings manipulation on the application of paycheck protection program during the Covid-19

Abstract

This paper examines the real consequences of earnings management through the lens of public funds application. Utilizing the Paycheck Protection Program (PPP) during the Covid-19 pandemic as a laboratory, I document that firms with higher earnings management prior to the outbreak of Covid-19 are less likely to apply for the PPP loans, suggesting that firms tend to forgo “low-hanging fruit” funding opportunities to pre-empt potential public outcry over government funds flowing to disreputable firms. I further find that the identified effect is more pronounced for firms receiving greater public attention and when the loans are under tighter scrutiny. Finally, I find that firms with higher earnings management are less likely to repay PPP loans after the Small Business Administration (SBA) called for returning the loans if borrowers cannot make a good-faith certification, probably because returning behaviour may expose firms to heightened public scrutiny. Overall, my findings shed novel light on the role of financial reporting in capital allocation during unexpected challenging times.