Earnings Management Around Debt-Covenant Violations - An Empirical Investigation Using A Large Sample of Quarterly Data

Journal of Accounting,
Auditing & Finance

Earnings Management Around XX(X) 1–28
ÓThe Author(s) 2013
Debt-Covenant Violations – An Reprints and permissions:
sagepub.com/journalsPermissions.nav
Empirical Investigation Using DOI: 10.1177/0148558X13505597
jaf.sagepub.com
a Large Sample of Quarterly

Data
Anand Jha1
Abstract
I find that managers manage earnings upward in the quarters preceding a debt-covenant
violation, but downward in the quarter a violation occurs. And they continue to manage
earnings downward while the firm remains in violation. Because this scenario can play out
within a year, the use of yearly data to examine the debt-covenant hypothesis can be pro-
blematic. Further analysis shows that the earnings management around the debt-covenant
violation is also done to improve the manager’s bargaining power in the renegotiation that
follows the violation. Furthermore, I find no evidence of excessive earnings management by
high-debt firms to stave off a violation, but I do find evidence that the Sarbanes–Oxley Act
restrains managers from using accruals to stave off a violation. These results are based on
examining 193,803 firm-quarters, 8,804 firms, and 2,035 new covenant violations spanning
1996 to 2007.
Keywords
debt-covenants, debt-covenant hypothesis, earnings management, discretionary accruals,
bargaining
Introduction
The incentive to manage earnings around a debt-covenant violation originates from the
manager’s compensation contract. This contract is designed to have the lowest possible
agency cost and to address the conflict between the bondholders and the shareholders.
Usually, the firm first chooses the optimal compensation contract based on accounting
numbers to minimize agency costs arising from the separation of ownership (shareholders)
and control (managers). In addition, the managers may have further obligations to maintain
reported values such as the ratio of earnings to total debt above a contractual threshold.
These restrictions, commonly called debt-covenants, are set by the firm’s lenders to reduce
1
Texas A&M International University, Laredo, USA
Corresponding Author:
Anand Jha, Texas A&M International University, 5201 University Blvd., WHTC-217B, Laredo, TX 78041-1900,
USA.
Email: ajha@tamiu.edu
Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

2 Journal of Accounting, Auditing & Finance
the cost of monitoring. These debt-covenants also assuage the lenders’ fear that the manag-
ers might exploit their informational advantage to pursue strategies that are not in the best
interest of the lenders, but are in the best interest of the managers and the shareholders
(Garleanu & Zwiebel, 2009). By design, these debt-covenants are set to function as ‘‘trip-
wires.’’ Should the debtor trip, the lenders can easily tighten their grip before it’s too late.
What makes the earnings management around the debt-covenants an interesting question
is that the managers have some discretion on how to report their earnings. They are given
this discretion partly because it is impossible to write a contract that eliminates such discre-
tion, and partly because it might be optimal for shareholders to allow managers some dis-
cretion (Demski, Patell, & Wolfson, 1984). Consequently, managers manage earnings. The
reasons for the earnings management can be many, but often the reasons are opportunistic.
Although earnings management can be in the best interest of the short-term shareholders, it
is usually not in the best interest of the long-term shareholders because the earnings man-
agement erodes the firm’s long-term value (Hazen, 1991). One of the instances where man-
agers are thought to manage earnings upward is to avoid a debt-covenant violation because
the violation reflects poorly on the competence of the senior management and is, to some
extent, associated with the removal of top management. In the accounting literature this
process of upward earnings management to avoid a violation is termed as the ‘‘debt-cove-
nant hypothesis.’’ But managing earnings upward before a violation might not always be
the best decision. Sometimes, the optimal decision for the managers might be to manage
their earnings downward in the period before a violation. For example, when the managers
know that it is impossible to stave off a violation, they might do so. They could also
manage earnings strategically in a previolation period—either upward or downward,
depending on whether they expect a waiver of the violation or a renegotiation of the debt-
covenant soon after the violation.
Because of data limitations, the precise dynamics of how managers manage earnings in
the previolation periods is not well understood. For example, there is no knowledge on
how the pattern of the earnings management changes for the last few quarters before the
violation. There is no knowledge on the earnings management behavior when the firm
remains in violation. In addition, only sparse knowledge exists on whether the incentives to
manage earnings to avoid a debt-covenant violation are applicable to all sorts of firms. In
fact, even the evidence on the debt-covenant hypothesis, which has been discussed and
tested in many studies for a long time (Watts & Zimmerman, 1990) is conflicted. Some
studies find that firms manipulate earnings upward to avoid violations (DeFond &
Jiambalvo, 1994; Jaggi & Lee, 2002; Sweeney, 1994), and some do not (Deangelo,
Deangelo, & Skinner, 1994; Gopalakrishnan & Sugrue, 1992; Healy & Palepu, 1990).
The aim of this article is to use a large quarterly data set to conduct precise tests to
better understand the dynamics of the earnings management around a debt-covenant
violation.
All of the prior studies that test the debt-covenant hypothesis use a small sample of
yearly data and examine the abnormal use of accruals 1 year prior to and in the year of the
violation. There are two potential problems with this approach. One, as the authors
acknowledge, is their small sample size. These studies use less than 150 violations. This
sample size can severely limit the power of the tests, and therefore their implications.
Another potential concern, which, to my knowledge, has been ignored in the literature on
the debt-covenants hypothesis, is the use of yearly data. True, managers will manage earn-
ings upward to stave off a violation in quarters leading up to a violation; but when they
realize that staving off a violation is impossible, such as in the quarter when a violation is

Jha 3
going to occur, they might manage earnings downward. Thus, using yearly data does not
produce significant results simply because conflicting earnings management in different
quarters within a year might wash out each other’s effect. Using data from 1 year prior to
the violation solves this problem, but creates another problem—these data might not cap-
ture the upward earnings management that can occur in the last few quarters preceding a
violation. For example, if the violation occurs in the fourth quarter of 2000, using data
from 1999 does not capture the earnings management that occurs in the first three quarters
of 2000.
My study addresses both of these concerns. I use a quarterly data set that consists of
12,847 violations of which 2,035 are new covenant violations. I define a violation as new
if there are no violations in the last eight quarters. Such a large quarterly sample is possible
because of the new rules from the Security Exchange Commission (SEC). Effective, begin-
ning with the second quarter of 1996, the SEC mandates that SEC-registered firms file
their quarterly 10-Q and annual 10-K reports electronically, thus creating the possibility to
use a text algorithm to identify the quarters in which a violation occurs. Nini, Smith, and
Sufi (2011) use such an algorithm and compile these data, and have made the data publi-
cally available.
I use their data set and merge it with the quarterly Compustat database. Following the
literature that investigates the debt-covenant hypothesis, I use the discretionary accrual as a
measure for earnings management. I calculate the discretionary accruals for each firm-quar-
ter and examine the earnings management patterns in the eight quarters preceding the viola-
tion, in the quarter the violation occurs, and while the firm remains in violation. I
distinguish between these quarters because, as mentioned earlier, once the violation appears
inevitable, managers might manipulate earnings downward.
Consistent with the debt-covenant hypothesis, I find that managers do indeed manipulate
earnings upward in the last eight quarters preceding a violation. And, as I conjecture, in the
quarter with the violation, they manage earnings downward. Although Deangelo et al.
(1994) hint at this possibility, this finding is an important insight because it has not been
tested before. Furthermore, this finding suggests that using yearly data to examine the debt-
covenant hypothesis can be problematic.
Next, I focus on a question that has not been empirically tested before. A new violation
is often followed by a series of quarters in which the firm remains in violation that some-
times lasts for more than several quarters. I investigate how firms manage earnings in these
quarters. This is an intriguing empirical question; because, as Kim, Lei, and Pevzner
(2011) acknowledge, the motivation to manage earnings could be in either direction during
these quarters. Deangelo et al. (1994) suggest that managers have incentives to manage
earnings downward because this action might improve the bargaining positions of their
firms during the renegotiations that follow defaults. The idea being that when a firm
appears to be in a worse condition, creditors might set less restrictive covenants than they
might otherwise. However, some studies argue that downward earnings management during
a violation can lead to deeper default (Kim et al., 2011) and actually worsen the bargaining
position (DeFond & Jiambalvo, 1993). Therefore, managers might manage earnings
upward. Given the ambiguous nature of the direction, Kim et al. (2011) leave the solution
to future research.
In this study, I reconcile these two conflicting ideas. The common idea in both of these
suggestions is that a manager manages earnings strategically while in violation. A strategic
decision for firms in financial distress is to manage earnings downward because they
expect to renegotiate the terms of the loans. However, because financially healthy firms

hope to get a waiver, the strategic decision is to manage earnings upward. To take into
account these opposing incentives, I make a distinction between firms that are financially
distressed and firms that are financially safe. Consistent with the literature, I find that
financially distressed firms manage earnings downward while in violation. Also consistent
with the literature, I find that financially healthy firms manage earnings upward while in
violation. This detailed insight on how firms manage earnings in violation and when nego-
tiating the terms of new loans are only possible because I use a large quarterly data set.
I also examine whether high-debt firms differ in their earnings management pattern
around the covenant violation. Recent literature on the debt-covenant hypothesis posits that
a high-debt firm is likely to manage earnings to a greater extent to avoid a violation. The
idea being that high-debt firms might gain more benefit from avoiding a violation (Ghosh
& Moon, 2010). I do not find evidence for this conjecture. My finding suggests that high-
debt firms can solicit higher creditor scrutiny, and excessively managing earnings upward
might be costly for these firms. In this respect, my findings are consistent with the litera-
ture that high-debt firms face stronger monitoring and that stronger monitoring can restrain
upward earnings management (Ahn & Choi, 2009).
In addition, I examine how the Sarbanes–Oxley Act of 2002 (SOX) impacts accrual
management behavior around covenant violations. I find that post-SOX, managers do not
use accruals to avoid a violation. This finding is consistent with the idea that those post-
SOX managers shift from accrual management to real earnings management. What is inter-
esting though is that, although firms reduce the use of accruals to manage earnings upward
before a violation, they manage earnings downward while in violation. This finding further
strengthens the argument that most managers benefit by managing earnings downward
during a violation. The finding also implies that earnings management once the violation
occurs is not simply a cover up of earnings management in an earlier period, but a strategy
to improve bargaining positions during renegotiations.
The rest of the article proceeds as follows: The section ‘‘How Does This Study Extend
the Literature’’ describes the related literature and how my study extends this literature.
The ‘‘Regression Model’’ section describes the empirical model I use, and the section
‘‘Data’’ describes the data. The ‘‘Results’’ section describes the results, while the section
‘‘Limitations of the Study and Future Research’’ describes the limitations of the study and
makes suggestions for future research. The final section presents the conclusion.
How Does This Study Extend the Literature?

The Literature
Recent studies show that the use of debt-covenants to monitor borrowers is ubiquitous.
Roberts and Sufi (2009) find that 96% of the firms contain at least one debt-covenant.
Among the most common and binding type of debt-covenant is that pertaining to the profit-
ability measure such as the coverage ratio (e.g., EBITDA/interest expense). Nini et al.
(2011) find that in each given year about 10% to 20% of the firms report violations to
covenants, and more than 40% were in violation at some point during the period of 1996 to
2008.
A violation of a covenant is a legal default, and the creditor can ask the firm to acceler-
ate payment, can take the firm to court, or can reduce the existing unused line of credit.
Although violation of a covenant rarely results in creditors demanding accelerated payment
or seeking legal actions, it often triggers a wide range of actions. Sufi (2009) finds that

Jha 5
following a covenant violation, the creditor reduces the availability of the unused credit by
about 30%. Nini et al. (2011) find new loans have a shorter maturity and a higher interest-
rate spread compared with those before the violation. A covenant violation also results in a
decline in acquisitions and capital expenditures (Nini et al., 2011) and the flow of debt
(Roberts & Sufi, 2009). A violation can also lead to the replacement of the CEO and senior
management (Baird & Rasmussen, 2006; Nini et al., 2011).
Although increased scrutiny and intrusion by creditors exists following a violation, only
4% of the violators terminate their contract with the existing lenders within two quarters of
the violation (Roberts & Sufi, 2009). This finding suggests that borrowers are forced to tol-
erate the intrusion from creditors because of their influence that results from limiting the
supply of credit and increasing the cost of debt. These new findings are in line with the
prior findings that following a violation, the shareholders wealth declines (Beneish &
Press, 1995).
Given the consequences of a debt-covenant violation, the expectation that managers will
try to stave off a violation if possible is plausible. This idea, as mentioned earlier, is not
new and has been suggested in numerous studies. A large body of empirical studies has
tried to search for the evidence that managers indeed manipulate earnings upward to avoid
a violation, but the results have been conflicting.
Some studies do find that managers manipulate earnings upward to avoid a violation.
DeFond and Jiambalvo (1994) examine the abnormal accruals of 90 firms that violate debt-
covenants and find that the firms manipulate the earnings upward 1 year prior to the year
of the violation. But they find no evidence that managers try to increase earnings in the
year of the violation. Sweeney (1994) examines whether managers change their accounting
methods to delay violations. Using a sample of 130 firms that violated debt-covenants, she
shows that in the years prior to violations, firms that face high default costs make changes
to their accounting procedures to increase earnings.
Other studies find no evidence for earnings management prior to a violation. In a study
of 126 firms, Healy and Palepu (1990) do not find that firms manipulate earnings prior to
debt-covenant violations. Deangelo et al. (1994) examine the accounting choices of 76
troubled companies and find no evidence of earnings management in the years leading up
to the covenant violations. Specifically, they find that managers manage earnings down-
ward in the year prior to the covenant violations. They interpret this finding as the manag-
ers’ accounting choices primarily reflecting acknowledgment of their firms’ financial
troubles.
In contrast to most studies, Dichev and Skinner (2002) use a large sample to provide
evidence for the debt-covenant hypothesis. Specifically, they show that an unusually small
number of firms are just below the covenant threshold set by creditors and an unusually
large number of firms are at or just above the threshold that suggests the firms manipulate
earnings to stay just above the restrictions set by the creditors. However, an alternative
interpretation of this finding, as the authors themselves point out, is that it is not that the
firms manage the earnings to be just above the threshold set by the banks, but rather that
creditors might be setting the threshold just below where the firms are most likely to be at.
They address this concern by showing that staying just above the requirement set by the
creditors is not only common in the period with the violation and right after the violation,
but also long after the violation. This additional result strengthens their arguments that
managers manage earnings to stay above the requirements set by the banks. However, as
Dichev and Skinner (2002) acknowledge, one limitation of their study is that they do not

provide the form that the earnings management takes. Arguably, this omission makes their
evidence on the debt-covenant hypothesis indirect.
There are also some studies that suggest that not all firms manage earnings upward to
avoid a violation. A firm that is severely distressed, knowing that a covenant violation is
impossible to stave off, might not attempt to stave off the violation by managing earnings
upward. Instead, they might manage the earnings downward to acknowledge their financial
difficulty and improve their bargaining position in the renegotiation that follows the viola-
tion. Jaggi and Lee (2002) show, by using yearly data, that before a violation, managers
manage earnings to improve their bargaining positions during renegotiations. Specifically,
they show that financially distressed firms manage earnings downward in the year of viola-
tion because they expect to renegotiate the loans, but the firms that expect to get a waiver
manage earnings upward. However, because they use yearly data and a small sample size,
they focus exclusively on the year of the violation and are unable to conduct tests to under-
stand how managers behave once the violation happens and as the renegotiations continue.
Arguably, the strategy that improves their bargaining position is likely to be more intense
in these two periods.
My Contribution to the Literature

The first contribution of this study is that it provides a large sample based direct evidence
of the debt-covenant hypothesis. Second, and more importantly, I show that the use of
yearly data can be problematic because conflicting earnings management can occur in the
year in which the firm reports a violation.
Third, I examine, for the first time, the earnings management in the quarter of a new
covenant violation, and the series of quarters in which the firm remains in violation follow-
ing a new covenant violation. I find that managers manage earnings strategically to
improve their bargaining position: Financially distressed firms manage earnings downward
because they expect to renegotiate the terms of the loans; financially healthy firms manage
earnings upward during this time because they expect to get a waiver. Because of the data
limitations, prior studies rely on the earnings management in the year of the violation to
make similar arguments. A more precise way to examine whether managers manage earn-
ings to improve their bargaining power is to examine the period when the violation is inevi-
table, such as the quarter in which the violation occurs, and the period in which the firm is
in violation and is in the process of renegotiation. In these quarters, firms know for sure
that the renegotiation will take place. By this time, managers also have a better idea of the
kind of renegotiations they expect—waivers or more restrictive covenant terms. My data
allow me to conduct such a test. Using these precise tests, I show that managers indeed
manage earnings strategically keeping in mind the possible impact on bargaining during
the renegotiation of the terms. And, as expected, they do so with greater intensity.
Fourth, my study also directly tests whether high-debt firms manage earnings exces-
sively before a violation. I find no evidence for this action—contrary to the suggestion
made in Ghosh and Moon (2010), but consistent with idea that high-debt firms are associ-
ated with greater monitoring that in turn is associated with restrained upward earnings man-
agement (Ahn & Choi, 2009).
Fifth, my study shows that after SOX, managers show restraint in manipulating accruals
upward to avoid a violation, which suggests that managers might have shifted to using
more real earnings management after SOX.

Jha 7
Regression Model
To investigate the earnings management around a covenant violation, I use a multivariate
regression framework in which the dependent variable is the discretionary accruals calcu-
lated by using the modified Jones (1991) model,1 which is the most common in the earn-
ings management literature (Cohen & Zarowin, 2010; DeFond & Jiambalvo, 1994;
McGuire, Omer, & Sharp, 2012). I use the signed value of the discretionary accruals.2 The
key research variables are the dummy that captures the quarters before a violation, the
dummy for the quarter with a new violation, and the dummy that captures the series of
quarters with violations.
The empirical model to investigate my question can be summarized by the following
equation:
DISC ACC 5 b0 1 b1 PRE VIOL 1 b2 NEW VIOL 1 b3 CONT VIOL

1 b4 NO VIOL 1 b5 LNMV 1 b6 DEBT 1 b7 ROA 1 b8 Z 1 b9 Q ð1Þ
1 b10 NOA 1 b11 LNANALYST 1 b12 INST OWN 1 h 1 y 1 e:
The following are the definitions of the variables in Equation 1:

DISC_ACC = the discretionary accruals calculated using the modified Jones (1991)
model; PRE_VIOL = a dummy variable that is equal to 1 for quarter t 2 1 and quarter t 2
8 (where t = 0 is the quarter when violation occurs) and 0 otherwise; NEW_VIOL = a
dummy variable that is equal to 1 in the quarter in which there is a new violation and 0
otherwise (a new violation is a violation if there is violation in the quarter, but there has
been no violation for the previous eight quarters); CONT_VIOL = a dummy variable that
is 1 if it is part of series of violations that follows a new violation and 0 otherwise;
NO_VIOL = a dummy variable that is equal to 1 if there are no violations in the last eight
quarters and the following eight quarters and 0 otherwise; LNMV = the natural logarithm
of the market value of the firm; DEBT = the ratio of the total debt to the total assets; ROA
= the ratio of the net income to the total assets; Z = Altman z score; Q = the Tobin’s Q;
NOA= the net operating assets; LNANALYST = the natural logarithm of (1 1 the number
of analysts); INST_OWN = percentage of equity held by institutions; h = firm fixed effect;
y = time (year-quarter) dummies; and e = error term. A more detailed description of the
variables can also be found in the appendix.
My unit of analysis is the firm-quarter. For expositional ease, I have suppressed it. The
control variables consist of the most common firm-level control variables used to examine
the determinant of the signed value of the discretionary accruals. In addition to the controls
common in the discretionary accruals literature (Grullon, Kanatas, & Weston, 2010;
McGuire et al., 2012), I also add the firm fixed effect and therefore control for all time
invariant variables that might affect the earnings management such as the firm location or
any other firm characteristics that do not change over time. In addition, I also add dummies
for each quarter to control for possible macroeconomic issues. The possibility exists that in
certain quarters of certain years, there are greater incentives to manipulate earnings.
Furthermore, I cluster the standard errors at the firm level to adjust for the error terms of a
firm that can be correlated over time.
To understand how earnings management incentives differ between distressed firms and
nondistressed firms, between high-debt and low-debt firms, and pre-SOX and post-SOX
periods, I follow the procedure outlined by Wooldridge (2009) and construct additional
indicator variables that capture the interaction between the relevant variables and add to

the main model summarized in Equation 1. A more detailed description of the interaction
variables and the model used for these additional tests is in the ‘‘Results’’ section.
Data
Sample Selection
My sample consists of 193,803 firm-quarters and 8,804 firms that span from the second
quarter of 1996 to the fourth quarter of 2007. They represent the intersection of nonfinan-
cial and nonutilities firms that have the violation data, the nonmissing data to calculate the
discretionary accruals, and the nonmissing data for the control variables used in the main
regression model.
The sample selection is as follows. I start with all nonfinancial and nonutilities firms
available on Amir Sufi’s website and used in the article by Nini et al. (2011).3 This data
set provides the calendar date of the quarterly filing and an indicator variable that shows
whether the firm reports a violation of a covenant. Describing the process of identifying
whether the firm violated a covenant or not, Nini et al. (2011) write,
We employ a text-search algorithm to search the actual filings for reports of violations. Our
algorithm first locates the word ‘‘covenant’’ in the filing, and then conditional on finding the
word ‘‘covenant,’’ it searches for the following five terms within seven lines surrounding the
initial hit: ‘‘waiv,’’ ‘‘viol,’’ ‘‘in default,’’ ‘‘modif,’’ and ‘‘not in compliance’’ . . . this algo-
rithm, after correcting for false positives, captures 90 percent of actual violations in a random
sample of 1,000 violators for which we manually read the entire filing.
I remove the firms belonging to the financial and the utilities industries because these
industries are highly regulated by the government and the incentives to manage earnings
can be affected by regulatory concerns. This exclusion is common in the earnings manage-
ment literature. This data set consists of 236,219 observations.
I then remove the observations that do not have the firm-level data available to calculate
the discretionary accruals. I require that at least 15 observations be available to run indus-
try-quarter regressions. I am left with 217,218 observations. I use this data set to calculate
three measures of the discretionary accruals.4 The appendix provides a detailed description
of the calculation for the dependent variable. Next, I remove the firm-quarters that have
missing values for the control variables in the regression analysis. I remove three observa-
tions because the LNMV is missing, 3,885 because the DEBT is missing, 4,981 because
the Z is missing, 11,118 because the Q is missing, and 3,428 because the NOA missing. To
mitigate the effect of outliers, I winsorize all of the continuous variables at the 1st and the
99th percentile.
Summary Statistics
Table 1 presents the summary statistics for the sample. The mean for the DISC_ACC is
20.003, and the standard deviation is 0.166. These numbers are similar to prior studies on
earnings management. About 1% of the firm-quarters represent a new violation. To be pre-
cise, there are 2,035 new violations. For 1,012 of these new violations, the firm does not
stay in violation in the following quarter. For the rest of the new violations, there are a
series of violations that last for a median of three quarters with a maximum of 13 quarters.

Jha 9
Table 1. Summary Statistics.
Variables N M SD Median p25 p75

DISC_ACC 193,803 20.003 0.166 0.001 20.037 0.040
PRE_VIOL 193,803 0.082 0.274 0 0 0
NEW_VIOL 193,803 0.011 0.102 0 0 0
CONT_VIOL 193,803 0.010 0.098 0 0 0
NO_VIOL 193,803 0.249 0.433 0 0 0
LNMV 193,803 4.370 2.332 4.346 2.738 5.995
DEBT 193,803 0.782 1.691 0.466 0.260 0.688
ROA 193,803 20.093 0.367 0.002 20.055 0.018
Z 193,803 0.193 29.856 1.900 0.261 4.725
Q 193,803 4.030 9.784 1.658 1.119 2.977
NOA 193,803 0.446 1.912 0.142 20.187 0.420
LNANALYST 193,803 0.740 0.972 0 0 1.386
INST_OWN 193,803 18.761 27.731 0.939 0 30.203
Note. This table reports the summary statistics of the variables used in the main model. DISC_ACC is the discre-
tionary accruals calculated by using the modified Jones (1991) model. PRE_VIOL is a dummy variable that is equal
to 1 for quarter t 2 1 and quarter t 2 8 (where t = 0 is the quarter when a new violation occurs) and 0 other-
wise; NEW_VIOL is a dummy variable that is equal to 1 in the quarter in which there is a new violation and 0 oth-
erwise (A new violation is a violation where there has been no violation for the previous eight quarters);
CONT_VIOL is a dummy variable that is 1 if it is part of series of violations that follows a new violation and 0 oth-
erwise; NO_VIOL is a dummy variable that is equal to 1 if there is no violation for the last eight quarters or no
violation in the next eight quarters and 0 otherwise; LNMV is the natural logarithm of market value of the firm;
DEBT is the ratio of total debt to total assets; ROA is the ratio of net income to total assets; Z is the Altman’s z
score; Q is the Tobin’s Q; NOA is the net operating assets scaled by assets; LNANALYST is the natural logarithm
of (1 1 number of analysts); and INST_OWN is the percentage of equity held by institutions.
The number of quarters that represent the previolation period is by design 8 times more
than the number of quarters that represent the new violation period.
Correlations
Table 2 presents the Pearson correlations among the variables I use in the main regression
model. The PRE_VIOL is positively correlated with the DISC_ACC and is significant at
1% that suggests the managers manipulate earnings upward in the eight quarters preceding
a violation. The NEW_VIOL and the CONT_VIOL are negatively correlated with the
DISC_ACC and significant at 1%, which suggests that in the quarter where there is a new
violation firms manage earnings downward and continue to manage earnings downward in
the series of quarters that follow the violation.
Results
Confidence Interval Plots
I start by plotting the mean and the confidence interval of the discretionary accruals for the
quarters around a new violation. Figure 1 presents this plot. Notice from the plot that the
firms tend to manipulate earnings upward in quarters leading up to a violation, and then
manage earnings downward during the violation. In Figure 1, t = 0 is the quarter when a
new violation occurs;21 to 28 are quarters preceding a violation where 21 means one

10
Table 2. Correlations.
[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13]
[1] DISC_ACC 1.000
[2] PRE_VIOL .015 1.000
(0.00)
[3] NEW_VIOL 2.011 2.031 1.000
(0.00) (0.00)
[4] CONT_VIOL 2.011 2.030 2.010 1.000
(0.00) (0.00) (0.00)
[5] NO_VIOL .009 2.172 2.059 2.057 1.000
(0.00) (0.00) (0.00) (0.00)
[6] LNMV 2.008 2.006 2.014 2.039 .143 1.000
(0.00) (0.05) (0.00) (0.00) (0.00)
[7] DEBT 2.116 2.036 2.010 2.004 2.031 2.280 1.000
(0.00) (0.00) (0.00) (0.99) (0.00) (0.00)
[8] ROA .365 .057 .007 .008 .026 .269 2.672 1.000
(0.00) (0.00) (0.01) (0.00) (0.00) (0.00) (0.00)
[9] Z .082 .018 .001 2.002 .023 .309 2.781 .607 1.000
(0.00) (0.00) (.581) (.455) (0.00) (0.00) (0.00) (0.00)
[10] Q 2.082 2.059 2.025 2.024 2.001 2.123 .689 2.691 2.505 1.000
(0.00) (0.00) (0.00) (0.00) (.538) (0.00) (0.00) (0.00) (0.00)
[11] NOA 2.057 2.019 2.002 .000 2.027 2.272 .708 2.519 2.604 .532 1.000
(0.00) (0.00) (.362) (.871) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00)
[12] LNANALYST 2.006 2.022 2.014 2.029 .135 .702 2.152 .190 .151 2.112 2.159 1.000
(0.15) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00)

[13] INST_OWN 2.006 2.018 2.002 2.013 .043 .526 2.130 .167 .122 2.113 2.135 .634 1.000
(0.01) (0.00) (.36) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00)
Note. This table reports the Pearson correlation of the variables used in the main regression. The p values are in the brackets. DISC_ACC is the discretionary accruals calculated
by using the modified Jones (1991) model. PRE_VIOL is a dummy variable that is equal to 1 for quarter t 2 1 and quarter t 2 8 (where t = 0 is the quarter when a new violation
occurs) and 0 otherwise; NEW_VIOL is a dummy variable that is equal to 1 in the quarter in which there is a new violation and 0 otherwise (A new violation is a violation
where there has been no violation for the previous eight quarters); CONT_VIOL is a dummy variable that is 1 if it is part of series of violations that follows a new violation and
0 otherwise; NO_VIOL is a dummy variable that is equal to 1 if there is no violation for the last eight quarters or no violation in the next eight quarters and 1 otherwise;
LNMV is the natural logarithm of market value of the firm; DEBT is the ratio of total debt to total assets; ROA is the ratio of net income to total assets; Z is the Altman’s z
score; Q is the Tobin’s Q; NOA is the net operating assets scaled by assets; LNANALYST is the natural logarithm of (1 1 number of analysts); and INST_OWN is the percent-
age of equity held by institution.
Jha 11
.01
0
DISC_ACC
-.01
-.02
-.03
-8 -7 -6-5 -4 -3 -2 -1 0 1 2 3 4
Quarters, t=0 is the quarter of a new violation
95% confidence intervals
Figure 1. Confidence interval plots of discretionary accruals around a new violation. This figure
plots the mean and the 95% confidence interval of the DISC_ACC. Zero is the quarter when a new
violation occurs; 21 to 28 are quarters preceding the violation where 21 means one quarter before
violation, and 28 means eight quarters before a new violation; 1 to 4 captures the quarters once the
firm emerges from a violation, where 1 means the quarter right after the firm is no longer in violation,
and 4 is the fourth quarter after the firm emerges.
quarter before a violation, and 28 means eight quarters before a violation. Similarly, 1 to 4
captures the quarters once the firm emerges from a violation where 1 means the quarter
right after the firm is no longer in violation, and 4 is the fourth quarter after the firm
emerges. The highest that firms remain in violation in my sample is thirteen quarters. I con-
sider a firm to have emerged out of the default stage only after the series of quarters when
the firm remains in violation has ended.
From Figure 1, I know that the earnings management to stave off a violation can occur
as early as eight quarters before an actual violation, but once the violation appears inevita-
ble the managers are no longer interested in managing the earnings upward. What is strik-
ing is that during the quarter of violation, the average downward earnings management
appears quite stark.5 The figure supports the view that once the violation appears inevitable,
managers manage earnings downward.
Main Regression Results: Earnings Management Around Covenant Violation

The findings of the regression analysis are in line with those for the correlations and the
confidence interval plots. Table 3 reports the regression coefficients. Column 1 reports the
results of a base model where the only firm-level control included is the LNMV. The
PRE_VIOL, the NEW_VIOL, and the CONT_VIOL are significant at 1%. Column 2
of Table 3 reports the regression coefficient for the main model that is specified in
Equation 1. The coefficient for the PRE_VIOL, the NEW_VIOL, and the CONT_VIOL are

Table 3. Main Results: Earnings Management Around Covenant Violation.
(1) (2) (3) (4) (5) (6)

Dependent variable = DISC_ACC
# Violations . 0
PRE_VIOL 0.007*** 0.005*** 0.007*** 0.005***
(.000) (.000) (.000) (.000)
NEW_VIOL 20.012*** 20.008*** 20.009*** 20.005*
(.000) (.001) (.000) (.060)
CONT_VIOL 20.019*** 20.013*** 20.015*** 20.010***
(.000) (.000) (.000) (.000)
NO_VIOL 0.001 0.001 0.001 0.000 0.000 0.002
(.393) (.592) (.383) (.853) (.876) (.340)
LNMV 20.011*** 20.008*** 20.008*** 20.007*** 20.008*** 20.002
(.000) (.000) (.000) (.000) (.000) (.103)
DEBT 20.003 20.003 20.003 20.003 20.005
(.124) (.125) (.124) (.124) (.220)
ROA 0.358*** 0.358*** 0.358*** 0.358*** 0.386***
(.000) (.000) (.000) (.000) (.000)
Z 20.001*** 20.001*** 20.001*** 20.001*** 20.001***
(.000) (.000) (.000) (.000) (.000)
Q 0.004*** 0.004*** 0.004*** 0.004*** 0.004***
(.000) (.000) (.000) (.000) (.000)
NOA 0.007*** 0.007*** 0.007*** 0.007*** 0.013***
(.000) (.000) (.000) (.000) (.000)
LNANALYST 0.001* 0.001* 0.001* 0.001* 0.001
(.094) (.094) (.068) (.071) (.165)
INST 0.000 0.000 0.000 0.000 20.000
(.637) (.651) (.645) (.646) (.380)
Firm fixed effect X X X X X X
Time fixed effect X X X X X X
Observations 193,803 193,803 193,803 193,803 193,803 85,866
R2 .175 .229 .229 .229 .229 .228
Number of firms 8,804 8,804 8,804 8,804 8,804 3,322
Note. This table reports the results of the main regression analysis. DISC_ACC is the discretionary accruals calcu-
lated by using the modified Jones (1991) model. PRE_VIOL is a dummy variable that is equal to 1 for quarter t 2 1
and quarter t 2 8 (where t = 0 is the quarter when a new violation occurs) and 0 otherwise; NEW_VIOL is a
dummy variable that is equal to 1 in the quarter in which there is a new violation and 0 otherwise (A new violation
is a violation where there has been no violation for the previous eight quarters); CONT_VIOL is a dummy variable
that is 1 if it is part of series of violations that follows a new violation and 0 otherwise; NO_VIOL is a dummy vari-
able that is equal to 1 if there is no violation for the last eight quarters or no violation in the next eight quarters
and 0 otherwise; LNMV is the natural logarithm of market value of the firm; DEBT is the ratio of total debt to
total assets; ROA is the ratio of net income to total assets; Z is the Altman’s z score; Q is the Tobin’s Q; NOA is
the net operating assets scaled by assets; LNANALYST is the natural logarithm of (1 1 number of analysts); and
INST_OWN is the percentage of equity held by institutions. The p values based on clustered standard error at the
firm level are reported in the parentheses.
The ***, **, * denote significances at the 1%, 5%, and 10% levels, respectively.
0.005, 20.008, and 20.013 respectively. Each of these coefficients is significant at 1%.
Respectively, the sign of these coefficients shows that managers manage earnings upward
in the eight quarters preceding a new violation, downward in the quarter with a violation,
and downward while the firm remains in violation. These results are also economically

Jha 13
nontrivial. For example, the magnitude of the PRE_VIOL in the main model suggests that
the increase in the earnings management in the quarter leading up to the violation is equiv-
alent to 12.7% of the change that occurs when the Q changes by one standard deviation
(0.005 / (0.004 3 9.784)) and 26.8% of the change that occurs if the LNMV changes by
one standard deviation (0.005 / (20.008 3 2.332)). The impact of the NEW_VIOL and the
CONT_VIOL are even stronger.
Columns 3, 4, and 5 report the results when only one of the key research variables is
used. The signs of the coefficient and its magnitude and significance are similar to that
reported in column 2 (Main Model). Column 6 reports the results when only those firms
that have reported at least one violation are used. The idea being that this sample might be
more homogeneous, and therefore a more meaningful comparison can be made between the
treatment and the control groups. Although the sample size reduces by more than 50%, the
key research variables of the PRE_VIOL, the NEW_VIOL, and the CONT_VIOL retain
their significance.
The coefficients for the control variables are similar to those reported in the literature.
For example, I find that the signed value of the discretionary accruals is negatively associ-
ated with firm size and the debt ratio, but positively to the return on assets (Grullon et al.,
2010; McGuire et al., 2012). The coefficient for the NON_VIOL is not significant, as
expected.
Additional Analysis and Results

Is earnings management done to improve the bargaining position?
The literature suggests that managers might manage earnings to improve their bargaining
position. For example, firms that are in a sound financial condition expect their covenant
violations to be waived, and these firms have an incentive to manage earnings upward pre-
violation, in the quarter with a violation, and while in violation. However, firms that are
severely distressed financially know that a violation is inevitable and do not expect to get a
waiver, but rather expect to renegotiate the terms of the loans. Therefore, these firms have
an incentive to manage earnings downward previolation, in the quarter with a violation,
and while in violation. The idea being that by portraying a poor financial situation, manag-
ers might get concessions on the stringency of the new covenant requirements. I find results
consistent with this idea.
This finding is based on a test for which I first calculate the Altman z score following
Roberts (2012). I then construct the following two indicator variables: the DISTRESS that
equals 1 if the Altman z score is in the lowest 25th percentile and 0 otherwise; and the
SAFE that equals 1 if the Altman z score is above the 75th percentile and 0 otherwise.
Therefore, the variable DISTRESS categorizes the firms that are financially distressed and
have a higher chance of bankruptcy, while the SAFE categorizes the firms that are in
sound financial condition and have a very low probability of bankruptcy. I implicitly
assume that the DISTRESS with a value of 1 represents situations where firms expect to
renegotiate the loans; and when the SAFE equals 1, it represents the situations where the
firms expect to get a waiver.
To empirically test if financially distressed firms manage earnings differently compared
with firms not financially distressed around covenant violation, I interact the DISTRESS
with the PRE_VIOL, the NEW_VIOL, and the CONT_VIOL. Following the econometric
technique outlined for interacting two indicator variables in Wooldridge (2009), I construct

four mutually exclusive indicator variables for each of the research variables. For example,
to examine how financially distressed firms versus firms not financially distressed manage
earnings before a violation, I construct the PRE_VIOL_DISTRESS, an indicator variable
that equals 1 when the firm-quarter represents one of the eight quarters before the violation
and where the firm is also in distress and 0 otherwise; the PRE_VIOL_NODISTRESS, an
indicator variable that equals 1 when the firm-quarter represents one of the eight quarters
before the violation and when the firm is not in distress and 0 otherwise; the
NOPRE_VIOL_DISTRESS, an indicator variable that equals 1 if the firm-quarter does not
represent one of the eight quarters before a violation and where the firm is in distress and 0
otherwise; and the NOPRE_VIOL_NODISTRESS, an indicator variable that equals 1 if the
firm-quarter does not represent one of the eight quarters before a violation and where the
firm is not in distress and 0 otherwise.
Except for the NOPRE_VIOL_NODISTRESS, I include the other three in the regression
analysis, the results of which are reported in column 1 of Table 4. The coefficient for the
PRE_VIOL_DISTRESS and the PRE_VIOL_NODISTRESS therefore capture the respec-
tive magnitude and direction with respect to the NOPRE_VIOL_NODISTRESS—the indi-
cator variable that is excluded. The coefficient for the PRE_VIOL_DISTRESS is negative
and significant at 1%. This significance shows that compared with firms that are not
severely distressed and are not in the previolation period, distressed firms during the pre-
violation period are significantly more likely to manage earnings downward. In contrast to
the coefficient for the PRE_VIOL_DISTRESS, the coefficient for the
PRE_VIOL_NODISTRESS is positive and significant at 1%. This result suggests that
while firms that are financially distressed manage earnings downward before a violation,
firms that are not distressed manage earnings upward as predicted by the debt-covenant
hypothesis. A more important test is a F test that shows these two coefficients are signifi-
cantly different at 1%. The p value of this test is also reported in column 1 of Table 4.
I repeat the analogous tests for the other two research variables: the NEW_VIOL and
the CONT_VIOL. The results are reported in columns 2 and 3, respectively. These results
show that distressed firms and nondistressed firms manage earnings downward in the quar-
ter with a violation and while in violation. The coefficient for the NEW_VIOL_DISTRESS
(20.028), the NEW_VIOL_NODISTRESS (20.005), the CONT_VIOL_DISTRESS
(20.036), and the CONT_VIOL_NODISTRESS (20.005) are negative and significant.
What is noteworthy is that the distressed firms manage earnings downward in the quarter
with a violation and while they remain in violation with a magnitude that is 7 times more
than the nondistressed firms—and these differences are statistically significant.
An argument can be made that I should find upward earnings management for nondis-
tressed firms in the quarter with a violation and while in violation because nondistressed
firms benefit by managing earnings upward. But, my definition of distressed firms is that
the Altman z score is in the lowest 25th percentile to be considered distressed. Therefore,
those firms that I define as nondistressed are unlikely to also have some firms that expect
to renegotiate their loans and thus are likely to manage earnings downward. To alleviate
this concern, I construct the variable SAFE. As mentioned earlier, this variable is likely to
have firms that are in very good financial condition and that expect to get waivers. For
these firms, I expect to find that firms manage earnings upward in the quarter with a viola-
tion, and while they remain in violation. Consistent with this idea, I do find that these
SAFE firms are likely to manage earnings upward while they remain in violation—the
coefficient for the CONT_VIOL_SAFE in column 6 is 0.015 and significant at 1%. It is
also significantly larger than the CONT_VIOL_NOSAFE, which has a negative and

Jha 15
Table 4. Is Earnings Management Done to Improve Bargaining Positions?
(1) (2) (3) (4) (5) (6)

PRE_VIOL_DISTRESS 20.010***
(.008)
PRE_VIOL_NODISTRESS 0.006***
(.000)
NOPRE_VIOL_DISTRESS 20.012***
(.000)
NEW_VIOL_DISTRESS 20.028***
(.000)
NEW_VIOL_NODISTRESS 20.005*
(.057)
NONEW_VIOL_DISTRESS 20.012***
(.000)
CONT_VIOL_DISTRESS 20.036***
(.000)
CONT_VIOL_NODISTRESS 20.005**
(.047)
NOCONT_VIOL_DISTRESS 20.012***
(.000)
PRE_VIOL_SAFE 0.011***
(.000)
PRE_VIOL_NOSAFE 0.006***
(.000)
NOPRE_VIOL_SAFE 0.005***
(.000)
NEW_VIOL_SAFE 20.007
(.361)
NEW_VIOL_NOSAFE 20.007***
(.005)
NONEW_VIOL_SAFE 0.006***
(.000)
CONT_VIOL_SAFE 0.015**
(.018)
CONT_VIOL_NOSAFE 20.014***
(.000)
NOCONT_VIOL_SAFE 0.005***
(.000)
PRE_VIOL 0.005*** 0.005*** 0.006*** 0.006***
(.000) (.000) (.000) (.000)
NEW_VIOL 20.008*** 20.008*** 20.008*** 20.008***
(.002) (.002) (.002) (.002)
CONT_VIOL 20.013*** 20.013*** 20.013*** 20.013***
(.000) (.000) (.000) (.000)
NO_VIOL 0.001 0.001 0.001 0.001 0.001 0.001
(.632) (.632) (.629) (.574) (.574) (.572)
LNMV 20.009*** 20.009*** 20.009*** 20.008*** 20.008*** 20.008***
(.000) (.000) (.000) (.000) (.000) (.000)
DEBT 20.003 20.003 20.003 20.003 20.003 20.003
(.121) (.120) (.121) (.107) (.107) (.108)
(continued)

Table 4. (continued)
(1) (2) (3) (4) (5) (6)
ROA 0.357*** 0.357*** 0.357*** 0.358*** 0.358*** 0.358***

(.000) (.000) (.000) (.000) (.000) (.000)
Z 20.001*** 20.001*** 20.001*** 20.001*** 20.001*** 20.001***
(.000) (.000) (.000) (.000) (.000) (.000)
Q 0.004*** 0.004*** 0.004*** 0.004*** 0.004*** 0.004***
(.000) (.000) (.000) (.000) (.000) (.000)
NOA 0.007*** 0.007*** 0.007*** 0.007*** 0.007*** 0.007***
(.000) (.000) (.000) (.000) (.000) (.000)
LNANALYST 0.001* 0.001* 0.001* 0.001 0.001 0.001
(.084) (.080) (.081) (.114) (.114) (.118)
INST_OWN 0.000 0.000 0.000 0.000 0.000 0.000
(.625) (.632) (.628) (.600) (.600) (.594)
PRE_VIOL_DISTRESS=PRE_ (.000)
VIOL_NODISTRESS
(p value)
NEW_VIOL_DISTRESS=NEW_ (.000)
VIOL_NODISTRESS (p value)
CONT_VIOL_DISTRESS=CONT_ (.000)
VIOL_NODISTRESS (p value)
PRE_VIOL_SAFE=PRE_ (.023)
VIOL_NOSAFE (p value)
NEW_VIOL_SAFE=NEW_ (.990)
CONT_VIOL_SAFE=CONT_ (.000)
Firm fixed effect X X X X X X
Time fixed effect X X X X X X
Observations 193,803 193,803 193,803 193,803 193,803 193,803
R2 .230 .230 .230 .229 .229 .229
Number of firms 8,804 8,804 8,804 8,804 8,804 8,804
Note. This table reports the results of the regression analysis to examine the interaction effect of financially dis-
tressed and financially healthy firms with the key research variables. The dependent variable is DISC_ACC, the dis-
cretionary accruals calculated by using the modified Jones (1991) model. The PRE_VIOL_DISTRESS is an indicator
variable that is equal to 1 if the observation belongs to the last eight quarters preceding a violation, and the
Altman z score is in the lowest 25th percentile and 0 otherwise. The PRE_VIOL_NODISTRESS is an indicator vari-
able that is equal to 1 if the observation belongs to the last eight quarters preceding a violation and the Altman z
score is not in the lowest 25th percentile and 0 otherwise. The NOPRE_VIOL_DISTRESS is an indicator variable
that is equal to 1 if the observation does not belong to the quarters preceding a violation and the Altman z score
is in the lowest 25th percentile and 0 otherwise. The NEW_VIOL_DISTRESS is an indicator variable that is equal
to 1 if the observation belongs to the quarter with a new violation, and the Altman z score is in the lowest 25th
percentile and 0 otherwise. The NEW_VIOL_NODISTRESS is an indicator variable that is equal to 1 if the obser-
vation belongs to the last eight quarters preceding a violation, and the Altman z score is not in the lowest 25th
percentile and 0 otherwise. The NONEW_VIOL_DISTRESS is an indicator variable that is equal to 1 if the obser-
vation does not belong to the quarter with a new violation, and the Altman z score is in the lowest 25th percen-
tile. CONT_VIOL_DISTRESS is an indicator variable that is equal to 1 if the observation represents quarters
following a new violation where the firm is still in violation, and Altman’s z score is in the lowest 25th percentile
and 0 otherwise. The CONT_VIOL_NODISTRESS is an indicator variable that is equal to 1 if the observation rep-
resents quarters following a new violation where the firm is still in violation, and the Altman z score is not in the
lowest 25th percentile and 0 otherwise. The NOCONT_VIOL_DISTRESS is an indicator variable that is equal to 1
if the observation does not represents quarters following a new violation where the firm is still in violation, and
the Altman z score is in the lowest 25th percentile. The PRE_VIOL_SAFE is an indicator variable that is equal to 1
if the observation belongs to the last eight quarters preceding a violation, and the Altman z score is higher than
the 75th percentile and 0 otherwise. The PRE_VIOL_NOSAFE is an indicator variable that is equal to 1 if the

Jha 17
observation belongs to the last eight quarters preceding a violation, and the Altman z score is not higher than the
75th percentile and 0 otherwise. The NOPRE_VIOL_SAFE is an indicator variable that is equal to 1 the observa-
tion does not belong to the last eight quarters preceding a violation, and the Altman z score is in higher than the
75th percentile and 0 otherwise. The NEW_VIOL_SAFE is an indicator variable that is equal to 1 if the observa-
tion belongs to the quarter of new violation, and the Altman z score is in higher than in the 75th percentile and 0
otherwise. The NEW_VIOL_NOSAFE is an indicator variable that is equal to 1 if the observation belongs to the
quarter of a new violation, and the Altman z score is not in the lowest 75th percentile and 0 otherwise. The
NONEW_VIOL_SAFE is an indicator variable that is equal to 1 the observation does not belong to the quarter of
new violation, and the Altman z score is in higher than the 75th percentile. The CONT_VIOL_SAFE is an indicator
variable that is equal to 1 if the observation represents quarters following a new violation where the firm is still in
violation, and the Altman z score is in higher than the 75th percentile and 0 otherwise. The
CONT_VIOL_NOSAFE is an indicator variable that is equal to 1 if the observation represents quarters following a
new violation where the firm is still in violation, and the Altman z score is not in the lowest 75th percentile and 0
otherwise. The NOCONT_VIOL_SAFE is an indicator variable that is equal to 1 if the observation does not repre-
sents quarters following a new violation where the firm is still in violation, and the Altman z score is in higher than
the 75th percentile. PRE_VIOL is a dummy variable that is equal to 1 for quarter t 2 1 and quarter t 2 8 (where t
= 0 is the quarter when a new violation occurs) and 1 otherwise; NEW_VIOL is a dummy variable that is equal to
1 in the quarter in which there is a new violation and 0 otherwise (A new violation is a violation where there has
been no violation for the previous eight quarters); CONT_VIOL is a dummy variable that is 1 if it is part of series
of violations that follows a new violation and 0 otherwise; NO_VIOL is a dummy variable that is equal to 1 if there
is no violation for the last eight quarters or no violation in the next eight quarters and 0 otherwise; LNMV is the
natural logarithm of market value of the firm; DEBT is the ratio of total debt to total assets; ROA is the ratio of
net income to total assets; Z is the Altman’s z score; Q is the Tobin’s Q; NOA is the net operating assets scaled by
assets; LNANALYST is the natural logarithm of (1 1 number of analysts); and INST_OWN is the percentage of
equity held by institutions. The p values based on clustered standard error at the firm level are reported in the
parentheses.
significant coefficient. Furthermore, somewhat consistent is the earnings management beha-

vior in the quarter with a violation. While I do not find that the SAFE firms in the quarter
with the violation manage earnings upward, I do not find the negative coefficient to be sta-
tistically significant either.
And, as expected, I do find that the coefficient for the PRE_VIOL_SAFE is positive and
significantly larger than the PRE_VIOL_NOSAFE, which shows again that firms in good
financial situations are more aggressive in managing earnings upward previolation. Overall,
these results are consistent with the studies that suggest managers manipulate earnings stra-
tegically to strengthen their bargaining position.
Do high-debt firms manage earnings to a greater extent to avoid a violation?

As I mention earlier, studies suggest conflicting arguments on whether high-debt firms
manage earnings excessively to avoid a violation. Ghosh and Moon (2010) argue that when
the proportion of debt is high, the benefits of preventing a violation could be higher than
the cost of poor quality financial reporting, and therefore managers of high-debt firms
might manage earnings upward excessively to avoid a violation.6 In another related study,
Stanley and Sharma (2011) show that firms with more bank debt are more likely to misre-
port, which suggests that the benefits of earnings management could outweigh the cost of a
covenant violation.
However, some studies imply the opposite. A high-debt firm has a strong firm-bank
linkage and therefore strong monitoring from lender firms (Cai, Cheung, & Goyal, 1999;
Morck & Nakamura, 1999). And, recent studies show that when monitoring is strong, man-
agers restrain themselves from managing earnings upward (Ahn & Choi, 2009). This

finding implies that, faced with greater creditor scrutiny, high-debt firms could be reluctant
to manage earnings excessively upward to avoid a violation. Moreover, high-debt firms
have more to lose in terms of the high cost of external financing should the creditors take
into consideration the poor quality of the earnings reported in determining the cost of
financing (Easley & O’Hara, 2004; Feltham, Robb, & Zhang, 2007; Francis, LaFond,
Olsson, & Schipper, 2005; Hasan, Park, & Wu, 2012).
My results are in contrast to the suggestions made by Ghosh and Moon (2010). I do not
find evidence that firms with high debt manage earnings excessively during the previolation
period. Rather, they are consistent with studies that suggest the high-debt ratio is related to
strong monitoring, and strong monitoring in turn is related to less aggressive earnings man-
agement (Ahn & Choi, 2009).
These results are based on the regression analysis that adds the interaction terms of the
high-debt firms with the PRE_VIOL and are reported in column 1 of Table 5. As in the
case of constructing the interaction terms of financial distress and the PRE_VIOL, I first
construct a variable that measures the firm with high debt. Specially, I construct an indica-
tor variable HD that equals 1 if the firm has a debt-to-assets ratio that is greater than the
75th percentile and 0 otherwise. I then construct four mutually exclusive indicator vari-
ables: PRE_VIOL_HD, PRE_VIOL_NOHD, NOREVIOL_HD, and NOPREVIOL_NOHD.
Respectively, these variables equal 1 if the firm is in previolation and has high debt and 0
otherwise; equal 1 if the firm is in the previolation period and has no high debt and 0 other-
wise; equal 1 if the firm is not in previolation and has high debt and 0 otherwise; and equal
1 if the firm is not in previolation and has no high debt and 0 otherwise. Except for the
NOPREVIOL_NOHD, I include all of the other variables in the regression analysis. The
coefficient for the PRE_VIOL_HD therefore gives the impact of the firm-quarters that rep-
resent the previolation period and high-debt firms compared with the firms that are not in
the previolation period and do not have high debt. The coefficient for the
PRE_VIOL_NOHD is not positive and significant. Instead, it is negative and nonsignifi-
cant. This result suggests that high-debt firms do not manage earnings excessively.
Do high-debt firms manage earnings to a greater extent in the quarter of violation and while in
violation?
I also examine how high-debt and low-debt firms differ in earnings management patterns
in the quarter of the violation and while in violation. I find that in the quarter of the viola-
tion, and once in violation, managers of high-debt firms manage earnings downward to a
greater extent. This result is consistent with the idea that a high-debt ratio is associated
with increased creditor scrutiny. Clearly, financially safe firms are better off managing
earnings upward during this time, but managers could find it difficult to do so because of
the higher creditor scrutiny that comes with a higher debt-to-asset ratio. However, high-
debt, financially distressed firms are better off managing earnings downward during these
periods, and they do so excessively. Therefore, the net effect is downward earnings man-
agement. These results are consistent with the studies that suggest the higher credit scrutiny
restrains upward earnings management, but not downward earnings management.
The regression coefficients documenting how high-debt and low-debt firms differ in
earnings management strategy during the quarter of violation and while they remain in vio-
lation are reported in columns 2 and 3 of Table 5, respectively. Notice that the coefficient
for the NEW_VIOL_HD and the NEW_VIOL_NOHD are negative and significant at 1%.
Furthermore, the NEW_VIOL_HD is 2 times larger in magnitude than the
NEW_VIOL_NOHD; and this difference is significant at 1%, which suggests that firms

Jha 19
Table 5. Do High-Debt Firms Manage Earnings Differently Around a Covenant Violation?
(1) (2) (3)

PRE_VIOL_HD 20.005 (.126)
PRE_VIOL_NOHD 0.004*** (.000)
NO_PRE_VIOL_HD 20.013*** (.000)
NEW_VIOL_HD 20.018*** (.000)
NEW_VIOL_NOHD 20.009*** (.002)
NO_NEW_VIOL_HD 20.012*** (.000)
CONT_VIOL_HD 20.037*** (.000)
CONT_VIOL_NOHD 20.005* (.074)
NOCONT_VIOL_HD 20.012*** (.000)
PRE_VIOL 0.005*** (.000) 0.005*** (.000)
NEW_VIOL 20.008*** (.002) 20.008*** (.002)
CONT_VIOL 20.013*** (.000) 20.013*** (.000)
NO_VIOL 0.000 (.743) 0.000 (.739) 0.000 (.735)
LNMV 20.009*** (.000) 20.009*** (.000) 20.009*** (.000)
DEBT 20.002 (.227) 20.002 (.227) 20.002 (.225)
ROA 0.358*** (.000) 0.358*** (.000) 0.358*** (.000)
Z 20.001*** (.000) 20.001*** (.000) 20.001*** (.000)
Q 0.004*** (.000) 0.004*** (.000) 0.004*** (.000)
NOA 0.007*** (.000) 0.007*** (.000) 0.007*** (.000)
LNANALYST 0.001 (.118) 0.001 (.120) 0.001 (.119)
INST 0.000 (.732) 0.000 (.732) 0.000 (.732)
PRE_VIOL_HD2=PRE_ (.004)
VIOL_NOHD2 (p value)
NEW_VIOL_HD2=NEW_ (.000)
CONT_VIOL_HD2=CONT_ (.000)
Firm fixed effect X X X
Time fixed effect X X X
Observations 193,803 193,803 193,803
R2 .230 .230 .230
Number of firms 8,804 8,804 8,804
Note. This table reports the results of the regression analysis to examine the interaction between the high-debt
firms and the key research variables. The dependent variable is DISC_ACC, the discretionary accruals calculated
by using the modified Jones (1991) model. The PRE_VIOL_HD is an indicator variable that is equal to 1 if the
observation belongs to the last eight quarters preceding a violation, and the debt-to-asset ratio is higher than the
75th percentile and 0 otherwise. The PRE_VIOL_NOHD is an indicator variable that is equal to 1 if the observa-
tion belongs to the last eight quarters preceding a violation, and the debt debt-to-asset ratio is not higher than the
75th percentile and 0 otherwise. The NOPRE_VIOL_HD is an indicator variable that is equal to 1 if the observa-
tion does not belong to the last eight quarters preceding a violation, and the debt debt-to-asset ratio is in higher
than the 75th percentile and zero otherwise. The NEW_VIOL_HD is an indicator variable that is equal to 1 if the
observation belongs to the quarter of new violation, and the debt debt-to-asset ratio is in higher than in the 75th
percentile and 0 otherwise. The NEW_VIOL_NOHD is an indicator variable that is equal to 1 if the observation
belongs to the quarter of a new violation, and the debt debt-to-asset ratio is not in the higher than the 75th per-
centile and 0 otherwise. The NONEW_VIOL_HD is an indicator variable that is equal to 1 the observation does
not belong to the quarter of new violation, and the debt debt-to-asset ratio is higher than the 75th percentile. The
CONT_VIOL_HD is an indicator variable that is equal to 1 if the observation represents quarters following a new
violation where the firm is still in violation, and the debt debt-to-asset ratio is in higher than the 75th percentile
and 0 otherwise. The CONT_VIOL_NOHD is an indicator variable that is equal to 1 if the observation represents

quarters following a new violation where the firm is still in violation, and the debt debt-to-asset ratio is not higher
than the 75th percentile, and 0 otherwise. The NOCONT_VIOL_HD is an indicator variable that is equal to 1 if
the observation does not represents quarters following a new violation where the firm is still in violation, and the
debt-to-asset ratio is in higher than in the 75th percentile. PRE_VIOL is a dummy variable that is equal to 1 for
quarter t 2 1 and quarter t 2 8 (where t = 0 is the quarter when a new violation occurs) and 0 otherwise;
NEW_VIOL is a dummy variable that is equal to 1 in the quarter in which there is a new violation and 0 otherwise
(A new violation is a violation where there has been no violation for the previous eight quarters); CONT_VIOL is
a dummy variable that is 1 if it is part of series of violations that follows a new violation and 0 otherwise;
NO_VIOL is a dummy variable that is equal to 1 if there is no violation for the last eight quarters or no violation
in the next eight quarters and 0 otherwise; LNMV is the natural logarithm of market value of the firm; DEBT is
the ratio of total debt to total assets; ROA is the ratio of net income to total assets; Z is the Altman’s z score; Q
is the Tobin’s Q; NOA is the net operating assets scaled by assets; LNANALYST is the natural logarithm of (1 1
number of analysts); and INST_OWN is the percentage of equity held by institutions. The p values based on clus-
tered standard error at the firm level are reported in the parentheses.
with high debt manage earnings downward to a greater extent. A similar pattern emerges in
analyzing the coefficient for the CONT_VIOL_HD and the CONT_VIOL_NOHD. The
magnitude of the CONT_VIOL_HD is 20.037 while the CONT_VIOL_NOHD is 20.005,
and the difference is significant at 1%.
Does the earnings management pattern around the covenant violation change after SOX?
Research shows that after SOX, managers shift from managing accruals to real earnings
management—that is, the manipulation of sales, production, and discretionary expenses
(Cohen, Dey, & Lys, 2008). My results suggest that SOX might have affected earnings
management done to avoid a covenant violation in a similar way.
I find that post-SOX managers show restraint in managing earnings upward to avoid a
covenant violation. Table 6 presents these results. Column 1 reports the interaction between
SOX with the PRE_VIOL. As in previous interaction tests, I construct four mutually exclu-
sive variables: the PRE_VIOL_PRESOX that equals 1 if the firm is in the previolation and
the pre-SOX periods and 0 otherwise; the PRE_VIOL_POSTSOX that equals 1 if the firm
is in the previolation and post-SOX periods and 0 otherwise; the NOPREVIOL_PRESOX
that equals 1 if the firm is not in the previolation period but in the pre-SOX period and 0
otherwise; and the NOPREVIOL_POSTSOX that equals 1 if the firm is not in the previola-
tion period but in the post-SOX and 0 otherwise. Except for the
NOPRE_VIOL_POSTSOX, I include the other three variables in the regression analysis.
The coefficient for the PRE_VIOL_PRESOX therefore measures the accrual management
in the quarter preceding the violation in the pre-SOX period, compared with the firm-quar-
ters that are not in violation and are from the post-SOX period. The coefficient for the
PRE_VIOL_PRESOX is 0.007 and significant at 1%, but the coefficient for the
PRE_VIOL_POSTSOX is only zero and not significant. Further tests show that the differ-
ence between these two coefficients is significant, which suggests that the accrual manipu-
lation to avoid a violation is reduced drastically after SOX.
I use the same empirical technique to examine how SOX affects the earnings manage-
ment in the quarter with a violation and while in violation. That is, I construct indicator
variables that capture the interaction effect in the same way as I did for the PRE_VIOL, for
NEW_VIOL, and for the CONT_VIOL and report the results in columns 2 and 3, respec-
tively. I find no significant difference in the earnings management behavior in these
periods—in the pre-SOX and the post-SOX periods, firms manipulate earnings downward

Jha 21
Table 6. Did Earnings Management Pattern Around Covenant Violation Change After SOX?
Variables (1) (2) (3)

PRE_VIOL_PRESOX 0.007*** (.000)
PRE_VIOL_POSTSOX 0.000 (.919)
NOPREVIOL_POSTSOX 20.002 (.115)
NEW_VIOL_PRESOX 20.012*** (.000)
NEW_VIOL_POSTSOX 20.006 (.133)
NONEWVIOL_POSTSOX 20.002** (.031)
CONT_VIOL_PRESOX 20.019*** (.000)
CONT_VIOL_POSTSOX 20.011*** (.001)
NOCONT_VIOL_POSTSOX 20.002** (.030)
PRE_VIOL 0.005*** (.000) 0.005*** (.000)
NEW_VIOL 20.008*** (.001) 20.008*** (.001)
CONT_VIOL 20.014*** (.000) 20.014*** (.000)
NO_VIOL 0.001 0.001 0.001
(.548) (.487) (.486)
LNMV 20.008*** (.000) 20.008*** (.000) 20.008*** (.000)
DEBT 20.003 (.120) 20.003 (.120) 20.003 (.120)
ROA 0.358*** (.000) 0.358*** (.000) 0.358*** (.000)
Z 20.001*** (.000) 20.001*** (.000) 20.001*** (.000)
Q 0.004*** (.000) 0.004*** (.000) 0.004*** (.000)
NOA 0.007*** (.000) 0.007*** (.000) 0.007*** (.000)
LNANALYST 0.001** (.032) 0.001** (.031) 0.001** (.031)
INST_OWN 0.000 (.757) 0.000 (.706) 0.000 (.704)
PRE_VIOL_PRESOX=PRE_ (.001)
VIOL_POSTSOX (p value)
NEW_VIOL_PRESOX=NEW_ (.2034)
CONT_VIOL_PRESOX=CONT_ (.120)
Firm fixed effect X X X
Time fixed effect X X X
Observations 193,803 193,803 193,803
R2 .228 .228 .228
Number of firms 8,804 8,804 8,804
Note. This table reports the results of the regression analysis to examine the interaction of the period after the
Sarbanes–Oxley Act with the key research variables. The dependent variable is DISC_ACC, the discretionary
accruals calculated by using the modified Jones (1991) model. The PRE_VIOL_PRESOX is an indicator variable that
is equal to 1 if the observation belongs to the last eight quarters preceding a violation and also belongs before the
year 2002, and 0 otherwise. The PRE_VIOL_POSTSOX is an indicator variable that is equal to 1 if the observation
belongs to the last eight quarters preceding a violation and also belongs to the year 2002 or beyond, and 0 other-
wise. The NOPREVIOL_POSTSOX is an indicator variable that is equal to 1 if the observation does not belong to
the last eight quarters preceding a violation but belongs to the year 2002 or beyond, and 0 otherwise. The
NEW_VIOL_PRESOX is an indicator variable that is equal to 1 if the observation belongs to the quarter of new
violation and also belongs before the year 2002, and 0 otherwise. The NEW_VIOL_POSTSOX is an indicator vari-
able that is equal to 1 if the observation belongs to the quarter of new violation and also belongs to the year 2002
or beyond, and 0 otherwise. The NONEW_VIOL_POSTSOX is an indicator variable that is equal to 1 if the obser-
vation does not belong to the quarter of new violation but belongs to the year 2002 or beyond, and 0 otherwise.
The CONT_VIOL_PRESOX is an indicator variable that is equal to 1 if the observation represents quarters follow-
ing a new violation where the firm is still in violation and also belongs before the year 2002, and 0 otherwise. The
CONT_VIOL_POSTSOX is an indicator variable that is equal to 1 if the observation represents quarters following
a new violation where the firm is still in violation and also belongs to the year 2002 or beyond, and 0 otherwise.

The NOCONT_VIOL_POSTSOX is an indicator variable that is equal to 1 if the observation does not represents
quarters following a new violation where the firm is still in violation but belongs to the year 2002 or beyond, and 0
otherwise. PRE_VIOL is a dummy variable that is equal to 1 for quarter t 2 1 and quarter t 2 8 (where t = 0 is
the quarter when a new violation occurs) and 0 otherwise; NEW_VIOL is a dummy variable that is equal to 1 in
the quarter in which there is a new violation and 0 otherwise (A new violation is a violation where there has been
no violation for the previous eight quarters); CONT_VIOL is a dummy variable that is 1 if it is part of series of vio-
lations that follows a new violation and 0 otherwise; NO_VIOL is a dummy variable that is equal to 1 if there is no
violation for the last eight quarters or no violation in the next eight quarters and 0 otherwise; LNMV is the natural
logarithm of market value of the firm; DEBT is the ratio of total debt to total assets; ROA is the ratio of net
income to total assets; Z is the Altman’s z score; Q is the Tobin’s Q; NOA is the net operating assets scaled by
assets; LNANALYST is the natural logarithm of (1 1 number of analysts); and INST_OWN is the percentage of
equity held by institutions. The p values based on clustered standard error at the firm level are reported in the
parentheses.
in the quarter with a violation and while in violation. This is consistent with the idea that
after SOX, managers restrain themselves in managing earnings upward, but see no need to
restrain themselves in managing earnings downward.
These results show that even in instances where firms do not manage earnings upward
to avoid a violation (e.g., in the post-SOX period), firms do manage earnings downward in
the quarter with a violation and while in violation. This further demonstrates that postviola-
tion earnings management is strategic and not simply to cover up the upward earnings man-
agement in previolation periods.
Results Are Robust to Using Alternative Measure of Discretionary Accruals

Kothari, Leone, and Wasley (2005) argue that the use of performance-adjusted discretion-
ary accruals, rather than using the modified Jones (1991) model, leads to clearer and more
powerful tests. Following the technique suggested in their study, I construct the
DISC_ACC Prf Adj that adjusts for the performance of the firm when calculating the
accruals. In addition, I also use the method used in Roychowdhury (2006) to calculate the
discretionary accruals and construct the variable DISC_ACC Roy. The appendix provides
the details of the method used to calculate these alternative measures of accrual manage-
ment. All of the results continue to be qualitatively similar.7 In short, the results of this
study are not dependent on the method used to calculate the discretionary accruals.
Limitations of the Study and Future Research

One of the limitations of this study is that I only focus on the accrual management. My
finding that the earnings management around the debt-covenant violations occurs only
during the pre-SOX period raises the possibility that after SOX, managers might have
shifted to real earnings management that is difficult to detect and is favored by managers
when the accrual manipulation becomes costly. The research shows that after SOX, manag-
ers shifted to using real earnings management (Cohen et al., 2008). Unfortunately, because
of the data limitation,8 I am not able to explore further whether managers indeed switched
to real earnings management around the violation in the post-SOX period.
Another limitation of this study is that it does not provide direct evidence that the bar-
gaining power of managers improves because of the downward earnings management when
the firm is financially distressed. An example of providing direct evidence is answering the

Jha 23
following question: can managers successfully influence the watering down of the new
covenant restriction by managing earnings downward while in violation. If they do, then
the conclusion is definitively that downward earnings management does improve bargain-
ing power. Possibly, earnings management while in violation could affect other kinds of
changes that occur after a violation. As mentioned earlier, the research shows that after a
violation, the firm reduces its size, and the cost of borrowing goes up. The possibility
exists that the earnings management around the debt-covenant violations could affect these
changes. However, exactly how earnings management affects the changes is not clear and
is beyond the scope of this study. Therefore, I leave it to future research to examine these
questions.
Conclusion
Starting with the second quarter of 1996, the SEC requires all public firms to file their 10-
Q and the 10-K reports electronically. This requirement makes it possible to use an algo-
rithm to detect the quarter in which firms report a violation. These data have been collected
and made available publically by Nini et al. (2011).
I use this quarterly data set and conduct a large sample study to examine the earnings
management patterns around debt-covenant violations. My study shows that in general
managers manipulate earnings upward in quarters leading up to a violation, but downward
in the quarter with the violation, and while the firm remains in violation. Because of the
data limitation, prior studies have not been able to make such a fine partition to understand
exactly how managers manage earnings around covenant violations. By documenting the
conflicting directions of earnings management that can occur in different quarters in the
year with a violation, my research shows that the use of yearly data to examine the earn-
ings management around covenant violations is problematic.
While the results are consistent with the debt-covenant hypothesis, further analysis
shows that in the previolation periods managers not only think about avoiding a violation;
but also take into consideration the possibility of successfully staving off the violation, and
their bargaining position should they fail to stave off the violation. For example, severely
distressed firms manage earnings downward in previolation quarters.
Once a violation occurs, earnings management done to improve bargaining positions
becomes even starker. I find that the kind of renegotiation that is likely to occur affects the
earnings management strategy: Firms in a good position manage earnings upward while in
violation to project a healthy image when expecting a waiver, while financially distressed
firms manage earnings downward during these quarters. While the earnings management
before a violation has been extensively studied, to my knowledge, the earnings manage-
ment in the quarter with a violation and the period in which firms remain in violation has
not been examined before.
I also address the conflicting, but empirically untested, assertion on how high-debt firms
manage earnings prior to a covenant violation. I find that high-debt firms do not manage
earnings excessively before a violation. Instead, apparently, high debt induces higher cred-
itor scrutiny and restrains upward earnings management.
Furthermore, consistent with the idea that SOX has restrained managers from using accruals
to manage earnings, my results show that after SOX, managers have restrained themselves
from using accruals to manipulate earnings even when it is to avoid a covenant violation.
Overall, by making use of a comprehensive quarterly database on covenant violation,
conducting precise tests, and seeking answers to questions that have been raised but never

examined because of the data limitations, my study reconciles some of the conflicting
results, provides new insights, and generates questions for future research.
Appendix
Dependent Variables
DISC_ACC This variable is the discretionary accruals calculated by using the
modified Jones (1991) model. To calculate the discretionary
accruals, I first calculate the total accruals (TA) by following
Ramanna and Roychowdhury (2010) TA = (ibq 2 oancfy). This
method is consistent with the cash-flow approach as suggested by
Hribar and Collins (2002). I adjust oancfy to equate quarterly data
because oancfy is reported as a year-to-date variable. To make this
adjustment, I replace oancfy with the difference between the current
quarter and the last quarter, except for the first quarter. Following
the steps in the modified Jones (1991) model, I use the following
regression for each industry and quarter first:
TAit 1 DSalesit
5 b0 1 b1
Assetsit1 Assetsit1 Assetsit1
PPEit
1 b2 1 eit :
Assetsit1
The industry classification is based on the two-digit Standard

Industrial Classification (SIC) code, and I require that there be at
least 15 observations in each industry year. The TA is the total
accruals, Assets is the total assets (atq), Sales is the total sales
(sale), and the PPE is the net plant property and equipment
(ppentq). I use the net plant, property and equipment instead of fol-
lowing (Larcker & Zakolyukina, 2012; Ramanna & Roychowdhury,
2010) because gross plant property and equipment is missing for
more than 30% of the data in Compustat. In the second step, I use
the coefficients from the regression in the first step to calculate the
discretionary accruals as follows:
TAit c0 1
b
DISC ACCit 5
Assetsit1 Assetsit1
!
c ðDSalesit DReceivablesit Þ
b
1 1 c2 PPEit
1b
Assetsit1 Assetsit1
Where the Receivables are the total receivables (rectq). Before con-
ducting the regressions, I winsorize all of the continuous variables
at the 1st and the 99th percentile to remove the effect of outliers
Source: Compustat

Jha 25
DISC_ACC Prf Adj This variable follows one of the suggestions made in (Kothari et
al., 2005). The variable is constructed in the same way as the
DISC_ACC except that in the first-stage regression, the return on
assets (ibq/atq) for the year prior is used as an additional regressor.
Source: Compustat
DISC_ACC Roy Following the approach of Roychowdhury (2006), I calculate this
variable as the residual of the following regression:
TAit 1
5 b0 1 b1
Assetsit1 Assetsit1
DSalesit PPEit
1 b2 1 b3 1 eit :
Assetsit1 Assetsit1
All variables used in the regression are the same as those used in
calculating the DISC_ACC.
Source: Compustat
Variables of Interest
PRE_VIOL This variable equals 1 for the last eight quarters before a new viola-
tion and 0 otherwise.
Source: Compustat
NEW_VIOL This variable equals 1 if there is a violation but no violation in the
last eight quarters and 0 otherwise.
Source: Compustat
CONT_VIOL This variable is an indicator variable that equals 1 for the violations
that are part of the series that follows a new violation and 0
otherwise.
Source: Compustat
Control Variables
NO_VIOL This variable is an indicator variable that equals 1 if there is no vio-
lation in the last eight quarters and the next eight quarters.
Source: Compustat
LNMV This variable is the natural logarithm of the market value of the
firm’s equity (prccq 3 cshoq).
Source: Compustat
DEBT This variable is the ratio of the total debt to the total assets (ltq / atq).
Source: Compustat
ROA This variable is the ratio of net income before extraordinary items
to total assets (ibq / atq).
Source: Compustat
Z This variable is the Altman z score calculated as follows: 1.2 3
((actq 2 lctq) / atq) 1 1.4 3 (req / atq) 1 3.3 3 (piq / atq) 1
0.6 3 ((prccq 3 cshoq) / ltq) 1 0.999 3 (saleq / atq)
Source: Compustat
Q This variable is the Tobin’s Q calculated as follows: (prccq 3
cshoq 2 (atq 2 ltq 1 txditcq) 1 atq) / atq
Source: Compustat

NOA This variable is the operating assets minus the operating liability
normalized by the total assets. It is calculated as follows: (atq 2
cheq 2 (atq 2 (dlcq 1 dlttq) 2 (pstkq 1 cstkq) 2 mibq)) / atq).
Source: Compustat
LNANALYST This variable is the natural logarithm of one plus the number of
analysts for the latest consensus forecast (numest). If this number is
not available, the number of analysts following is assumed to be
zero. This is at the firm-year level.
Source: I/B/E/S unadjusted summary files.
INST_OWN This variable is the percentage of equity owned by institutions. I
calculate this percentage by using the data from 13f filings avail-
able from Thomas Reuter’s institutions stockholding data. I assume
zero stock owned by the institutions, if the firm does not appear in
the Thomas Reuter’s database as in Yu (2008). This is at the firm-
year level.
Sources: Thomas Reuters
Acknowledgment
I would like to thank Bharath Sarath (editor) for his valuable feedback. I would also like to than
Amir Sufi for making the data on debt-covenant violation publicly available.
Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/
or publication of this article.
Funding
The author(s) received no financial support for the research, authorship, and/or publication of this
article.
Notes
1. The results are robust to using other models to calculate the discretionary accruals and are dis-
cussed in the section titles ‘‘Results Are Robust to Using Alternative Measure of Discretionary
Accruals.’’
2. The use of the absolute value of the discretionary accruals in this case is inappropriate, because
the hypothesis is about the direction in which the managers are expected to manage earnings, not
earnings management in general.
3. Available at http://faculty.chicagobooth.edu/amir.sufi/data.html, this data set provides the firm id
(gvkey), and the calendar date of the quarterly Standard Industrial Classification (SIC) filing,
and an indicator variable that is equal to 1 if the firm reports a covenant violation and 0
otherwise. A detailed description of how this variable is constructed is provided by the appendix
in (Nini et al., 2011). Their sample consist of any U.S. firm (fic = ‘‘USA’’) outside of the
financial industry (SIC outside of 6000 to 6999) and all firm-quarter observations with
nonmissing information on total assets (atq), total sales (saleq), common shares outstanding
(cshoq), closing share price (prccq), and the exact calendar quarter (datacqtr) of the observation.
I remove from these any firm that belongs to the utilities industry (SIC: 6000-6999).

Jha 27
4. Throughout the study I report the results for only the discretionary accruals calculated by using
the modified Jones model. But as robustness tests, I verify that the results hold for alternative
measures of the discretionary accruals as well. The correlations between these measures are
more than 94%.
5. In Figure 1, t = 0 strictly represents only the quarter in which a new violation occurs. It does not
include the quarters in which the firm remains in violation. Therefore, the downward earnings
management captured in the figure is only for the quarter in which a new violation occurs.
6. Their argument is based on the finding that the earnings quality is poor for firms with high debt.
They argue that the reason they find a very high debt-to-asset ratio is associated with poor earn-
ings quality is that high-debt firms have a lot of covenants to meet and they can be managing
their earnings excessively to avoid these violations.
7. For brevity, I do not report these results. They are available on request.
8. The Compustat quarterly does not provide quarterly data for advertising expenses, which is
needed in obtaining the discretionary expense. Without the discretionary expense, it is not possi-
ble to construct a real earnings management index. For example, Cohen et al. (2008) construct
two separate indices for real earnings management, both of which use the discretionary expense
as a component.
References
Ahn, S., & Choi, W. (2009). The role of bank monitoring in corporate governance: Evidence from
borrowers’ earnings management behavior. Journal of Banking & Finance, 33, 425-434.
Baird, D. G., & Rasmussen, R. K. (2006). Private debt and the missing lever of corporate governance.
University of Pennsylvania Law Review, 154, 1209-1251.
Beneish, M. D., & Press, E. (1995). The resolution of technical default. Accounting Review, 70,
337-353.
Cai, J., Cheung, Y. L., & Goyal, V. (1999). Bank monitoring and the maturity structure of Japanese
corporate debt issues. Pacific-Basin Finance Journal, 7, 229-250.
Cohen, D. A., Dey, A., & Lys, T. Z. (2008). Real and accrual-based earnings management in the pre-
and post-Sarbanes–Oxley periods. Accounting Review, 83, 757-787.
Cohen, D. A., & Zarowin, P. (2010). Accrual-based and real earnings management activities around
seasoned equity offerings. Journal of Accounting & Economics, 50, 2-19.
Deangelo, H., Deangelo, L., & Skinner, D. J. (1994). Accounting choice in troubled companies.
Journal of Accounting & Economics, 17, 113-143.
DeFond, M. L., & Jiambalvo, J. (1993). Factors related to auditor-client disagreements over income-
increasing accounting methods. Contemporary Accounting Research, 9, 415-431.
DeFond, M. L., & Jiambalvo, J. (1994). Debt covenant violation and manipulation of accruals.
Demski, J. S., Patell, J. M., & Wolfson, M. A. (1984). Decentralized choice of monitoring systems.
Accounting Review, 59, 16-34.
Dichev, I. D., & Skinner, D. J. (2002). Large-sample evidence on the debt covenant hypothesis.
Journal of Accounting Research, 40, 1091-1123.
Easley, D., & O’Hara, M. (2004). Information and the cost of capital. Journal of Finance, 59,
1553-1583.
Feltham, G., Robb, S., & Zhang, P. (2007). Precision in accounting information, financial leverage
and the value of equity. Journal of Business Finance & Accounting, 34, 1099-1122.
Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2005). The market pricing of accruals quality.
Garleanu, N., & Zwiebel, J. (2009). Design and renegotiation of debt covenants. Review of Financial
Studies, 22, 749-781.
Ghosh, A., & Moon, D. (2010). Corporate debt financing and earnings quality. Journal of Business
Finance & Accounting, 37, 538-559.

Gopalakrishnan, V., & Sugrue, T. F. (1992). Economic consequences of pension policy deliberations
(SFAS No. 87): An empirical assessment of debt-covenant hypothesis. Journal of Business
Finance & Accounting, 19, 751-775.
Grullon, G., Kanatas, G., & Weston, P. J. (2010, September). Religion and corporate (Mis)behavior
(Working paper). Rice University. Retrieved from http://ssrn.com/abstract=1472118
Hasan, I., Park, J. C., & Wu, Q. (2012). The impact of earnings predictability on bank loan contract-
ing. Journal of Business Finance & Accounting, 39, 1068-1101.
Hazen, T. L. (1991). Short-term/Long-term dichotomy and investment theory: Implications for securi-
ties market regulation and for corporate law. The North Carolina Law Review, 70, 137-207.
Healy, P. M., & Palepu, K. G. (1990). Effectiveness of accounting-based dividend covenants. Journal
of Accounting & Economics, 12, 97-123.
Hribar, P., & Collins, D. W. (2002). Errors in estimating accruals: Implications for empirical research.
Jaggi, B., & Lee, P. (2002). Earnings management response to debt covenant violations and debt
restructuring. Journal of Accounting, Auditing & Finance, 17, 295-324.
Jones, J. J. (1991). Earnings management during import relief investigations. Journal of Accounting
Research, 29, 193-228.
Kim, B. H., Lei, L., & Pevzner, M. (2011, November). Debt covenant slack and real earnings man-
agement. Available at http://web-docs.stern.nyu.edu/old_web/emplibrary/DebtCovenantSlackand
Real...pdf
Kothari, S. P., Leone, A. J., & Wasley, C. E. (2005). Performance matched discretionary accrual mea-
sures. Journal of Accounting & Economics, 39, 163-197.
Larcker, D. F., & Zakolyukina, A. A. (2012). Detecting deceptive discussions in conference calls.
McGuire, S. T., Omer, T. C., & Sharp, N. Y. (2012). The impact of religion on financial reporting
irregularities. Accounting Review, 87, 645-673.
Morck, R., & Nakamura, M. (1999). Banks and corporate control in Japan. Journal of Finance, 54,
319-339.
Nini, G., Smith, D. C., & Sufi, A. (2011). Creditor control rights, corporate governance, and firm
value. Available from http://ssrn.com/abstract=1344302
Ramanna, K., & Roychowdhury, S. (2010). Elections and discretionary accruals: Evidence from
2004. Journal of Accounting Research, 48, 445-475.
Roberts, M. (2012). The role of dynamic renegotiation and asymmetric information in financial con-
tracting. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1732364
Roberts, M. R., & Sufi, A. (2009). Control rights and capital structure: An empirical investigation.
Journal of Finance, 64, 1657-1695.
Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of
Accounting & Economics, 42, 335-370.
Stanley, B. W., & Sharma, V. I. (2011). To cheat or not to cheat how bank debt influences the deci-
sion to misreport. Journal of Accounting, Auditing & Finance, 26, 383-414.
Sufi, A. (2009). Bank lines of credit in corporate finance: An empirical analysis. Review of Financial
Studies, 22, 1057-1088.
Sweeney, A. P. (1994). Debt-covenant violations and managers accounting responses. Journal of
Accounting & Economics, 17, 281-308.
Watts, R. L., & Zimmerman, J. L. (1990). Positive accounting theory: A 10 year perspective.
Accounting Review, 65, 131-156.
Wooldridge, J. M. (2009). Introductory econometrics: A modern approach (4th ed.). Mason, OH,
South-Western Cengage Learning.

Earnings Management Around Debt-Covenant Violations - An Empirical Investigation Using A Large Sample of Quarterly Data

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Earnings Management Around Debt-Covenant Violations - An Empirical Investigation Using A Large Sample of Quarterly Data

Uploaded by

Copyright:

Available Formats

Journal of Accounting,

Auditing & Finance

a Large Sample of Quarterly

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

How Does This Study Extend the Literature?

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

My Contribution to the Literature

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

DISC ACC 5 b0 1 b1 PRE VIOL 1 b2 NEW VIOL 1 b3 CONT VIOL

The following are the definitions of the variables in Equation 1:

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Table 1. Summary Statistics.

Variables N M SD Median p25 p75

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Main Regression Results: Earnings Management Around Covenant Violation

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Table 3. Main Results: Earnings Management Around Covenant Violation.

(1) (2) (3) (4) (5) (6)

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Additional Analysis and Results

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Table 4. Is Earnings Management Done to Improve Bargaining Positions?

(1) (2) (3) (4) (5) (6)

Dependent variable = DISC_ACC

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

(1) (2) (3) (4) (5) (6)

ROA 0.357*** 0.357*** 0.357*** 0.358*** 0.358*** 0.358***

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

significant coefficient. Furthermore, somewhat consistent is the earnings management beha-

Do high-debt firms manage earnings to a greater extent to avoid a violation?

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Table 5. Do High-Debt Firms Manage Earnings Differently Around a Covenant Violation?

(1) (2) (3)

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Variables (1) (2) (3)

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Results Are Robust to Using Alternative Measure of Discretionary Accruals

Limitations of the Study and Future Research

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

The industry classification is based on the two-digit Standard

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Declaration of Conflicting Interests

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

Downloaded from jaf.sagepub.com at PENNSYLVANIA STATE UNIV on September 17, 2016

You might also like

ROA 0.357* 0.357* 0.357* 0.358* 0.358* 0.358*