Impact of Proximity to Debt Covenant Violation on Earnings Management

43 Pages Posted: 1 Jan 2013 Last revised: 17 Feb 2017

See all articles by Diana R. Franz

Diana R. Franz

University of Toledo - College of Business Administration

Hassan R. Hassabelnaby

Northern Kentucky University

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business

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 greater incentives 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 stronger incentives 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 after the Sarbanes-Oxley Act. We also document that the earnings management implications of debt covenant violation are observed primarily for firms with a poor credit rating and for firms that do not meet analyst forecasts.

Keywords: Debt covenant violation, Real earnings management, Accounting earnings management, Technical default

JEL Classification: M41, G32

Suggested Citation

Franz, Diana R and Hassabelnaby, Hassan R. and Lobo, Gerald J., Impact of Proximity to Debt Covenant Violation on Earnings Management. Review of Accounting Studies, Vol. 19, No. 1, 2014, Available at SSRN: https://ssrn.com/abstract=2195351 or http://dx.doi.org/10.2139/ssrn.2195351

Diana R Franz

University of Toledo - College of Business Administration ( email )

2801 W. Bancroft
Accounting Department
Toledo, OH 43606
United States
419-530-4264 (Phone)

Hassan R. Hassabelnaby (Contact Author)

Northern Kentucky University ( email )

Nunn Drive// BC 305D
Highland Heights, KY 41099
United States
859-572-7720 (Phone)

HOME PAGE: http://https://www.nku.edu/academics/cob.html?

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States
713-743-4838 (Phone)
713-743-4828 (Fax)

HOME PAGE: http://www.bauer.uh.edu/acct/acctprofile.asp?search=Gerald%20Lobo

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