Impact of Proximity to Debt Covenant Violation on Earnings Management

Franz, Diana R.; Hassabelnaby, Hassan R.; Lobo, Gerald J.

doi:10.2139/ssrn.2195351

Cited by 9 publications

(18 citation statements)

References 69 publications

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“…Whereas prior studies typically included only the variable of interest in the second-step regression (as in equation (2)), recent studies tend to include numerous control variables in the second-step regression (as in equation (3)). Figure 2 shows that of the 66 applications listed in table 1, 60 use second-step control variables, and of these studies 47 include 5 There are five studies (Kim, Park, and Wier [2012]; Franz, Hassabelnaby, and Lobo [2014]; Kim, Mauldin, and Patro [2014]; Ali and Zhang, [2015]; Chan et al [2015]) that appear twice in Table 1 because they use the two-step procedure in two different settings or applications. For example, Kim, Park, and Wier [2012] use the two-step procedure with both accruals and real activities.…”

Section: Use Of the Two-step Procedures In Accounting Researchmentioning

confidence: 99%

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Incorrect Inferences When Using Residuals as Dependent Variables

Chen

Hribar

Melessa

2018

J of Accounting Research

521

298

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We analyze a procedure common in empirical accounting and finance research where researchers use ordinary least squares to decompose a dependent variable into its predicted and residual components and use the residuals as the dependent variable in a second regression. This two‐step procedure is used to examine determinants of constructs such as discretionary accruals, real activities management, discretionary book‐tax differences, and abnormal investment. We show that the typical implementation of this procedure generates biased coefficients and standard errors that can lead to incorrect inferences, with both Type I and Type II errors. We further show that the magnitude of the bias in coefficients and standard errors is a function of the correlations between model regressors. We illustrate the potential magnitude of the bias in accounting research in four commonly used settings. Our results indicate significant bias in many of these settings. We offer three solutions to avoid the bias.

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Section: Use Of the Two-step Procedures In Accounting Researchmentioning

confidence: 99%

“…There are five studies (Kim, Park, and Wier []; Franz, Hassabelnaby, and Lobo []; Kim, Mauldin, and Patro []; Ali and Zhang, []; Chan et al. []) that appear twice in Table because they use the two‐step procedure in two different settings or applications.…”

mentioning

confidence: 99%

Incorrect Inferences When Using Residuals as Dependent Variables

Chen

Hribar

Melessa

2018

J of Accounting Research

521

298

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“…If income smoothing results in earnings metrics that obscure the borrower's economic performance, then the reserves generated from income smoothing in prior periods may facilitate managers' ability to delay recognizing material economic losses when credit risk increases. If so, then income smoothing will decrease the effectiveness of covenants to allocate control rights when credit risk increases, leading to a reduction in the debt contracting usefulness of earnings‐based covenants (DeFond and Jiambalvo ; Dichev and Skinner ; Franz et al ; Sweeney ).…”

Section: Background and Hypothesis Developmentmentioning

confidence: 99%

“…Similar to Zhang (), we include total assets ( Size ), leverage ( Leverage ), growth opportunities ( MTB ), profitability ( ROA ), realized growth ( Sales Growth ), default risk ( Z‐Score ), and tangible assets ( Tangible ). We control for earnings management ( Abnormal Accruals, Real EM ), as prior research provides evidence that borrowers will engage in earnings management prior to debt covenant violation (Defond and Jiambalvo ; Franz et al ) . We control for potential agency conflicts.…”

Section: Income Smoothing and Ex Post Covenant Compliancementioning

confidence: 99%

Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting

Demerjian

Donovan

Lewis-Western

2020

Contemporary Accting Res

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We investigate whether income smoothing affects the usefulness of earnings for contracting through the monitoring role of earnings‐based debt covenants. First, we examine initial contract design and predict that income smoothing will increase (decrease) the use of earnings‐based covenants if income smoothing improves (reduces) the usefulness of earnings to monitor borrowers. We find that private debt contracts to borrowers with greater income smoothing are more likely to include earnings‐based covenants. A structural model that explores the cause of this relationship provides evidence that smoothing improves the ability of earnings to reflect credit risk. Second, we examine technical default following contract inception. We find that income smoothing is associated with a lower likelihood of spurious technical default (when the borrower's economic performance has not declined but the loan nevertheless enters technical default). In contrast, we find no association between income smoothing and performance technical default (when the borrower's economic performance has declined). Collectively, this evidence is consistent with income smoothing improving the effectiveness of earnings‐based information in monitoring borrowers.

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“…(Note 1) Examples of earnings management techniques include the over/understatement of loan loss provisions, the deferment of fees, and "big bath" or "cookie jar reserve" techniques. Managers use these techniques to meet analyst earnings expectations (Bartov, Givoly, & Hayn 2002;Doyle, Jennings, & Soliman 2013), hide poor firm performance (Rangan 1998;Teoh, Welch, & Wong 1998;Roychowdhury 2006), draw down assets, and avoid debt covenant violations (Watts & Zimmerman 1986;Healy & Papelu 1990;Defond & Jiambalvo 1994;Franz, HassabElnaby, and Lobo 2014).…”

Section: Introductionmentioning

confidence: 99%

Earnings Management, Earnings Surprises, and Distressed Firms

Howe¹,

Houston²

2015

AFR

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We examine the propensity of distressed firms to manage earnings and the impact of their earnings management on investor response to earnings. We find that distressed firms manage earnings upward and downward more than other firms. Distressed firms manage earnings upward significantly more than non-distressed firms after negative earnings surprises. Investor response to earnings surprises is smaller in magnitude for distressed firms. Investor response to positive earnings surprises of distressed firms is larger in magnitude than the response to negative earnings surprises. The change in bankruptcy probability after a negative earnings surprise is greater for distressed firms. Distressed firms have less post-announcement earnings drift. The results suggest that earnings management by distressed firms lowers earnings quality and weakens investor response. Our evidence has implications for investors, analysts, and compensation and audit committees.

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Impact of Proximity to Debt Covenant Violation on Earnings Management

Cited by 9 publications

References 69 publications

Incorrect Inferences When Using Residuals as Dependent Variables

Incorrect Inferences When Using Residuals as Dependent Variables

Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting

Earnings Management, Earnings Surprises, and Distressed Firms

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