Earnings Management Around Debt-Covenant Violations: An Empirical Investigation Using a Large Sample of Quarterly Data
54 Pages Posted: 26 Aug 2013
Date Written: August 25, 2013
I find that managers manage earnings upward in the quarters preceding a debt-covenant violation, but downward in the quarter a violation occurs. And they continue to manage earnings downward while the firm remains in violation. Because this scenario can play out within a year, the use of yearly data to examine the debt-covenant hypothesis can be problematic. Further analysis shows that the earnings management around the debt-covenant violation is also done to improve the manager’s bargaining power in the renegotiation that follows the violation. Further, I find no evidence of excessive earnings management by high-debt firms to stave off a violation, but I do find evidence that the Sarbanes Oxley Act restrains managers from using accruals to stave off a violation. These results are based on examining 193,803 firm-quarters, 8,804 firms, and 2,035 new covenant violations spanning 1996 to 2007.
Keywords: debt covenants, debt-covenant hypothesis, earnings management, discretionary accruals, bargaining
JEL Classification: G20, G21, M40, M41
Suggested Citation: Suggested Citation