Impact of proximity to debt covenant violation on earnings management

Diana R. Franz, Hassan R. HassabElnaby () and Gerald J. Lobo
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Diana R. Franz: University of Toledo
Hassan R. HassabElnaby: University of Toledo
Gerald J. Lobo: University of Houston

Review of Accounting Studies, 2014, vol. 19, issue 1, No 14, 473-505

Abstract: Abstract We examine the impact of differential incentives arising from proximity to debt covenant violation on earnings management. We reason that firms with loans close to violation or in technical default of their debt covenants have a stronger incentive to engage in earnings management than firms that are far from violating their debt covenants. We find results consistent with this expectation. Firms close to violation or in technical default of their debt covenants engage in higher levels of accounting earnings management, real earnings management, and total earnings management than far-from-violation firms. In additional analysis, we find that firms with a stronger incentive to avoid covenant violation switched from using more accounting earnings management before the Sarbanes–Oxley Act to using more real earnings management and more total earnings management afterwards. We also document that the earnings management implications of debt covenant violation are observed primarily for firms with poor credit ratings and for firms that do not meet analyst forecasts.

Keywords: Debt covenant violation; Real earnings management; Accounting earnings management; Technical default (search for similar items in EconPapers)
JEL-codes: G32 M41 (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1007/s11142-013-9252-9

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