Accounting and Control

Earnings management to avoid debt covenant violations and future performance

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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 mar-ket 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 indi-cates 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 sig-nificant 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.
Bibliographic citation: DYRENG, S., HILLEGEIST, S. A., PEÑALVA, F. (2022). Earnings management to avoid debt covenant violations and future performance. European Accounting Review, 31 (2), 311-343. doi:10.1080/09638180.2020.1826337.

Reference: 10.1080/09638180.2020.1826337 (DOI)
Date: 01/04/2022
Author(s): S. Dyreng; Stephen A. Hillegeist; Fernando Peñalva
Document type: Article in Journal (refereed)
Department: Accounting and Control
Languages: English