Earnings Management to Avoid Debt Covenant Violations and Future Performance

Accounting Research Network, 2020

63 Pages Posted: 26 Oct 2020

See all articles by Scott Dyreng

Scott Dyreng

Duke University - Accounting

Stephen A. Hillegeist

Arizona State University (ASU) - W. P. Carey School of Business, School of Accountancy

Fernando Penalva

IESE Business School - University of Navarra; European Corporate Governance Institute (ECGI)

Date Written: September 6, 2020

Abstract

In this study, we examine the trade-offs between earnings management (both accruals and real) and covenant violations by examining how they are associated with future accounting and stock market performance. We analyze a matched-pair sample of covenant violation firms with non-violation firms that have a similar risk of a covenant violation. We have three main findings. First, our evidence indicates that covenant violations are costly events for shareholders as lenders appear to use their control rights in ways that increase the likelihood of loan repayment but impose costs for shareholders. Second, there is limited evidence indicating covenant-related accrual-earnings management activities impose significant costs on shareholders, but we find shareholders are worse off following unsuccessful real earnings management. Third, our evidence indicates that, on average, shareholders at high violation risk firms are better off when their firms successfully engage in accruals earnings management to avoid a violation compared to shareholders at firms that violate a covenant but do not manage earnings. Thus, covenant-related earnings management may be in the best interests of shareholders and is not necessarily evidence of shareholder-manager agency conflicts.

Keywords: earnings management; debt covenants violations; future firm performance

JEL Classification: M41, G10

Suggested Citation

Dyreng, Scott and Hillegeist, Stephen A. and Penalva, Fernando, Earnings Management to Avoid Debt Covenant Violations and Future Performance (September 6, 2020). Accounting Research Network, 2020, Available at SSRN: https://ssrn.com/abstract=3687741 or http://dx.doi.org/10.2139/ssrn.3687741

Scott Dyreng

Duke University - Accounting ( email )

Box 90120, Fuqua School of Business
Durham, NC 27708-0120
United States

Stephen A. Hillegeist

Arizona State University (ASU) - W. P. Carey School of Business, School of Accountancy ( email )

Tempe, AZ 85287-3706
United States
480-965-6614 (Phone)

Fernando Penalva (Contact Author)

IESE Business School - University of Navarra ( email )

Ave. Pearson 21
Barcelona, Barcelona 08034
Spain
932534200 (Phone)
932534343 (Fax)

HOME PAGE: http://www.iese.edu

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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