Abstract
This paper examines whether and to what extent a firm's performance pricing loans provide an incentive for managers to manipulate earnings more aggressively. We find that firms with a higher slope of the performance pricing schedule have significantly larger discretionary accruals, which is consistent with the prediction of the positive accounting theory (Watts ＆ Zimmerman, 1986, 1990). However, the positive relationship between the slope of performance pricing schedule and discretionary accruals is significantly attenuated in firms borrowing from high reputation banks or banks with a prior lending relationship. These results suggest that bank reputation and prior lending relation serve as an effective monitoring mechanism, which in turn mitigates managers' incentive and ability to manipulate earnings.