The Effect of Technical Default Cost on Discretionary Accounting Decisions

Abstract

This study investigates whether the variation in the expected costs of technical default leads managers to manipulate earnings in periods prior to, as well as in, the year in which avoidance of technical default becomes unlikely. We argue that managers have private information about the expected costs and consequences of default and, prior to default, condition their decisions about accounting choice and discretion on these expectations. We provide evidence on the endogeneity of two forms of discretion in accounting choices in the context of testing the debt covenant hypothesis. We document that both forms of earnings management are associated with a lower cost of technical default. Our findings also suggest earnings management is less likely when the expected cost of technical default is low, and such decisions are associated with a lower default cost for firms that actually enter technical default.

Waiving Technical Default: The Role of Agency Costs and Bank Regulations

“…Managers have incentives to manage earnings upwards in periods prior to or coincident with default, either to delay the onset of default or to improve their bargaining position in the event of debt renegotiation (Defond and Jiambalvo, 1994; and HassabElnaby et al, 2005). For opportunistic accruals to be successful, banks must be either unable or unwilling to completely undo the effects of the accruals (Ahmed et al, 2001; and Sloan, 1996).…”