Earnings Management to Avoid Debt Covenant Violations and Future Performance

Journal Article (Journal Article)

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.

Full Text

Duke Authors

Cited Authors

  • Dyreng, SD; Hillegeist, SA; Penalva, F

Published Date

  • January 1, 2022

Published In

Volume / Issue

  • 31 / 2

Start / End Page

  • 311 - 343

Electronic International Standard Serial Number (EISSN)

  • 1468-4497

International Standard Serial Number (ISSN)

  • 0963-8180

Digital Object Identifier (DOI)

  • 10.1080/09638180.2020.1826337

Citation Source

  • Scopus