Debt Covenant Violation and Earnings Management: A Neuroscience Approach and Future Directions – A Research Note

Abstract

Decision-making rationality is said to be bounded by managers’ cognitive capabilities. Recent studies indicate that accounting functions evolved to augment the cognitively bounded human brain in handling complex economic exchanges. The neuroscience discipline indicates that human brains have the ability to implement ‘automatic’ processes of positive versus negative emotional stimuli to make rational decisions. Neuroscientific evidence shows that the activations in the ventral striatum decrease with negative emotional information/motives and increase with positive emotional information/motives. We, hence, argue that our understanding of decision making rationality in financial and managerial decisions could be enhanced by using a functional neuroimaging approach.

Decision making rationality has been focal in debt covenant violation and earnings management research. The contracting theory predicts a relationship between managers’ decisions and the proximity of violating debt covenants. However, no prior research has investigated brain activities associated with evaluation of debt covenant violation and earnings management. Meanwhile, in another strand of research, there is extensive prior literature concerning consequences of managers’ decisions and use of accounting information in relation to their evaluative style, i.e. supervisory style. We argue that the relationship between proximity to debt covenants violation and earnings management and earnings management incentives is contingent upon managers’ supervisory style. However, no previous research has examined the impact of supervisory style on earnings management in the context of proximity to debt covenants violation and other earnings management incentives.

In this research note, we argue here that neuroaccounting could be relied on to examine the relationship between proximity to debt covenants and earnings management, contingent upon managers’ supervisory style, by capturing brain activities. The adoption of a neuroscience functional neuroimaging approach in this field shall contribute to the understanding of managers’ behaviors and provide implications for research. The goal of this research note is to provide a new avenue for future research in this field.

Keywords: Debt Covenant Violation, Earnings Management, Neuroscience

JEL Classification: M41