The Dynamic Relation between Earnings Management and the Violation of Debt Covenants
Posted: 19 Sep 2001
Date Written: July 18, 2001
This study presents evidence consistent with managers using accounting procedures and discretionary accruals as partial substitutes for low-cost violations. Using a sample of 143 firms reporting violations in annual reports, I estimate sets of simultaneous equations that capturers managers' incentives to violate debt covenants rather than to manipulate earnings. These incentives include the probabilities of waiver, temporary waiver, and renegotiation of debt covenant violations. The results indicate a significant negative association between probabilities of waivers and earnings management from one side, and a significant positive association between earnings management and both the anticipation of temporary waiver and contract renegotiaiton from the other side. Thus, it seems that managers' decision to manipulate earnings or to violate covenants vary considerably across firms depending, in part, on the probability of waiver, its type, and the probability of renegotiation. The findings question the ability of the covenant-based hypothesis in providing explanations for managers accounting choices. In addition, the study has crucial implications on earnings management research and users of financial reports concerned with the quality of earnings.
Keywords: Covenant violation; Earnings management; Waiver; Contract renegotiation
JEL Classification: M41, M43, G32
Suggested Citation: Suggested Citation