TY - JOUR
T1 - Earnings Management to Avoid Debt Covenant Violations and Future Performance
AU - Dyreng, Scott D.
AU - Hillegeist, Stephen A.
AU - Penalva, Fernando
N1 - Funding Information:
Fernando Penalva acknowledges financial assistance from research projects ECO2016-77579-C3-1-P and PID2019-111143GB-C31 funded by Spanish Ministry of Economy, Industry and Competitiveness, and the Ministry of Science and Innovation, respectively. We thank Arizona State University, Duke University, IESE, and INSEAD for financial support. Fernando Penalva acknowledges financial assistance from research projects ECO2016-77579-C3-1-P and PID2019-111143GB-C31 funded by the Spanish Ministry of Economics, Industry and Competitiveness, and the Ministry of Science and Innovation, respectively. We thank Daniel Beneish, Stephen Brown, Katherine Drake, Beatriz Garc?a Osma, Joachim Gassen, Leslie Hodder, Helena Isidro (discussant), Andy Leone, Sugata Roychowdhury, Lakshmanan Shivakumar, Jim Whalen, Paul Zarowin (associate editor), two anonymous reviewers, and seminar participants at Arizona State University, Indiana University, European Accounting Association Annual Congress, American Accounting Association Annual Meeting, and IX Workshop on Empirical Research in Financial Accounting for their comments and suggestions.
Funding Information:
We thank Arizona State University, Duke University, IESE, and INSEAD for financial support. Fernando Penalva acknowledges financial assistance from research projects ECO2016-77579-C3-1-P and PID2019-111143GB-C31 funded by the Spanish Ministry of Economics, Industry and Competitiveness, and the Ministry of Science and Innovation, respectively. We thank Daniel Beneish, Stephen Brown, Katherine Drake, Beatriz García Osma, Joachim Gassen, Leslie Hodder, Helena Isidro (discussant), Andy Leone, Sugata Roychowdhury, Lakshmanan Shivakumar, Jim Whalen, Paul Zarowin (associate editor), two anonymous reviewers, and seminar participants at Arizona State University, Indiana University, European Accounting Association Annual Congress, American Accounting Association Annual Meeting, and IX Workshop on Empirical Research in Financial Accounting for their comments and suggestions.
Publisher Copyright:
© 2020 European Accounting Association.
PY - 2022
Y1 - 2022
N2 - 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.
AB - 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.
KW - Debt covenants violations
KW - Earnings management
KW - Future firm performance
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U2 - 10.1080/09638180.2020.1826337
DO - 10.1080/09638180.2020.1826337
M3 - Article
AN - SCOPUS:85093652464
SN - 0963-8180
VL - 31
SP - 311
EP - 343
JO - European Accounting Review
JF - European Accounting Review
IS - 2
ER -