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We use Dealscan, a database of private corporate lending agreements, to provide large–sample tests of the debt covenant hypothesis. Dealscan offers several advantages over the data available in previous studies, principally larger and more representative samples and the availability of extensive actual covenant detail. These advantages allow us to construct powerful tests in which we find clear support for the debt covenant hypothesis. We also use these data to provide broad evidence on the economic role of debt covenants. We find that private lenders set debt covenants tightly and use them as “trip wires” for borrowers, that technical violations occur relatively often, and that violations are not necessarily associated with financial distress. Finally, since we measure covenant slack directly, we report evidence that the extensively–used leverage variable is a relatively noisy proxy for closeness to covenants.

We address the fact that accounting academics often have very different perceptions of earnings management than do practitioners and regulators. Practitioners and regulators often see earnings management as pervasive and problematic—and in need of immediate remedial action. Academics are more sanguine, unwilling to believe that earnings management is actively practiced by most firms or that the earnings management that does exist should necessarily concern investors. We explore the reasons for these different perceptions, and argue that each of these groups may benefit from some rethinking of their views about earnings management.

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