Dyreg 2022 Earnings - Management - To - Avoid - Debt - Covena

European Accounting Review
ISSN: (Print) (Online) Journal homepage: https://www.tandfonline.com/loi/rear20
Earnings Management to Avoid Debt Covenant

Violations and Future Performance
Scott D. Dyreng , Stephen A. Hillegeist & Fernando Penalva
To cite this article: Scott D. Dyreng , Stephen A. Hillegeist & Fernando Penalva (2020): Earnings
Management to Avoid Debt Covenant Violations and Future Performance, European Accounting
Review, DOI: 10.1080/09638180.2020.1826337
To link to this article: https://doi.org/10.1080/09638180.2020.1826337
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European Accounting Review, 2020
https://doi.org/10.1080/09638180.2020.1826337
Earnings Management to Avoid Debt

Covenant Violations and Future
Performance
SCOTT D. DYRENG∗ , STEPHEN A. HILLEGEIST∗∗ and

FERNANDO PENALVA †
∗ FuquaSchool of Business, Duke University, Durham, NC, USA; ∗∗ School of Accountancy, Arizona State University,
Tempe, AZ, USA; † IESE Business School, University of Navarra, Barcelona, Spain
(Received: 24 November 2017; accepted: 2 September 2020)
Abstract In this study, we examine the trade-offs between earnings management (both accruals and
real) and covenant violations by examining how they are associated with future accounting and stock mar-
ket performance. We analyze a matched-pair sample of covenant violation firms with non-violation firms
that have a similar risk of a covenant violation. We have three main findings. First, our evidence indi-
cates that covenant violations are costly events for shareholders as lenders appear to use their control
rights in ways that increase the likelihood of loan repayment but impose costs for shareholders. Second,
there is limited evidence indicating covenant-related accrual-earnings management activities impose sig-
nificant costs on shareholders, but we find shareholders are worse off following unsuccessful real earnings
management. Third, our evidence indicates that, on average, shareholders at high violation risk firms are
better off when their firms successfully engage in accruals earnings management to avoid a violation
compared to shareholders at firms that violate a covenant but do not manage earnings. Thus, covenant-
related earnings management may be in the best interests of shareholders and is not necessarily evidence of
shareholder-manager agency conflicts.
Keywords: Earnings management; Debt covenants violations; Future firm performance
1. Introduction
Numerous prior studies have shown that earnings management is the result of shareholder-
manager agency conflicts (e.g. managing earnings to meet bonus thresholds) or managerial
myopia (e.g. managing earnings to meet analyst forecasts) and therefore destroys shareholder
value. Similarly, the Debt Covenant Hypothesis predicts firms will manage earnings in order to
avoid debt covenant violations (Watts & Zimmerman, 1978, 1990). Dichev and Skinner (2002)
and Franz et al. (2014) provide empirical evidence indicating firms engage in both accrual and
real earnings management to avoid covenant violations. But whether or not managing earnings to
avoid debt covenant thresholds is detrimental to shareholder value is less clear. In this study, we
Correspondence Address: Fernando Penalva, IESE Business School, Ave. Pearson 21, 08034 Barcelona, Spain. Email:
penalva@iese.edu
Accepted by Paul Zarowin.
© 2020 European Accounting Association

2 S.D. Dyreng et al.
examine the trade-offs between covenant-related earnings management and covenant violations
by examining how they are associated with future accounting and stock market performance.1
The underlying premise of the Debt Covenant Hypothesis is that covenant violations are costly
to shareholders. Supporting this idea, prior literature finds shareholders experience substantial
direct and indirect costs when firms violate debt covenants (Beneish & Press, 1993; Chava &
Roberts, 2008; Freudenberg et al., 2012; Nini et al., 2009). These costs include higher interest
rates, more numerous and more restrictive covenants, and reduced access to credit. Further-
more, firms that violate covenants significantly reduce their capital expenditures, which can
further reduce firm value (Chava & Roberts, 2008). Accordingly, shareholders can benefit from
covenant-related earnings management if it allows them to avoid the costs of covenant violations.
However, engaging in either accruals or real earnings management to avoid a covenant-
violation also imposes costs on shareholders. Accruals management can result in more costly
scrutiny by auditors and regulators and can increase the likelihood of shareholder litigation. Real
earnings management is also costly since by definition, it results in the firm making sub-optimal
operating and investment decisions. For example, a firm could forego positive NPV projects by
reducing discretionary capital and/or R&D expenditures. Earnings management is also associ-
ated with higher information asymmetry (Abad et al., 2018) as well as a higher cost of debt and
equity capital (Costello & Wittenberg-Moerman*, 2011; Kim & Sohn, 2013; Kim et al., 2020).
Depending on the relative magnitudes of the costs of a covenant violation and covenant-related
earning management, it is possible shareholders are better off when their managers successfully
avoid a covenant violation by engaging in costly earnings management. In other words, it is an
open question whether covenant-related earnings management is in shareholders’ best interests
or is a manifestation of agency conflicts.2
In order to provide evidence on the trade-offs between earnings management and covenant
violations, we examine a large set of firms with initial covenant violations. We expect firms with
a high likelihood of violating a covenant differ across a number important dimensions relative
to firms with a low-likelihood of violating a covenant, and that these differences are associated
with future firm performance. Therefore, we first match each violation firm with comparable non-
violation firm with a similar risk of a covenant violation. We then examine how future accounting
and stock market performance varies across four groups of firms: (1) non-violation firms that do
not manage earnings; (2) non-violation firms that manage earnings; (3) violation firms that do
not manage earnings; and (4) violation firms that manage earnings.
The results of our analyses indicate there are substantial differences in future performance
across the four groups. We first compare the performance of violation and non-violation firms that
did not engage in accruals earnings management.3 We find that relative to similar non-violation
firms, covenant violation firms experience higher growth in return on assets (ROA) and this
growth is mainly driven by cost cutting efforts (and not by any growth in sales). Violation firms
also reduce their capital expenditures by roughly ten percent compared to non-violation firms.4
1 We refer to covenant-related earnings management as earning management whose primary purpose is to reduce the
likelihood of a covenant violation.
2 Prior research indicates managers experience personal costs following covenant violations, for example through
higher forced CEO turnover (Nini et al., 2012; Ozelge & Saunders, 2012). These personal costs potentially exacer-
bate shareholder-manager agency conflicts prior to covenant violations, and hence, induce managers to make decisions
that are detrimental to shareholders.
3 We focus on summarizing the results w.r.t. accruals earnings management in the Introduction. The real earnings
management results are generally similar, but are not identical. We discuss both sets of results in more detail in Section 5.
4 Our results for the accounting-based performance measures and capital expenditures are generally consistent with those
in Nini et al. (2012). In their analyses of the performance effects of covenant violations, they do not condition on earnings
management activities. We discuss how our study differs from theirs below.
Earnings Management to Avoid Debt Covenant Violations and Future Performance 3
In addition, violation firms experience significantly lower abnormal stock returns compared to
non-violation firms (between 6% and 11% depending on the specification). Overall, our evi-
dence is consistent with lenders using their control rights in ways that increase the likelihood
of loan repayment but impose considerable costs for shareholders even when their firms did not
engage in covenant-related accruals earnings management, covenant violation negatively affect
shareholders.
Second, we examine whether successfully engaging in covenant-related earnings management
is costly for shareholders by comparing the performance of non-violation firms who were more
vs. less likely to have managed earnings. Overall, we find limited evidence that shareholders at
non-violation firms are harmed when their firms successfully engage in accruals (or real) earnings
management. Specifically, we find no significant differences in future accounting performance
or in investment activities between non-violation firms depending on their earnings management
activities. While we find some graphical evidence that abnormal returns are roughly five to seven
percent lower for non-violation firms that engage in earnings management, the difference is not
significant in our regression analyses.
Third, we compare the performance of firms that successfully engaged in covenant-related
earnings management (i.e. non-violators) with violation firms that did not manage earnings.
The accruals earnings management results show that there are no significant differences in
future ROA between the two groups. However, the violation firms experience significantly
lower growth in capital expenditures. Furthermore, abnormal returns for violation firms that
did not engage in accruals-earnings management are 9.4% lower compared to non-violation
firms that engaged in covenant-related accruals earnings management.5 Collectively, our evi-
dence indicates that, on average, shareholders at high violation risk firms are better off when
their firms successfully engage in accruals earnings management to avoid a violation com-
pared to shareholders at firms that violate a covenant but do not manage earnings. Furthermore,
shareholders are no worse off when their firms successfully engage in covenant-related real earn-
ings management. Thus, our results are consistent with the idea that covenant-related earnings
management may be in the best interests of shareholders and is not necessarily evidence of
shareholder-manager agency conflicts.
Finally, we find limited evidence that shareholders bear additional costs when their firms
engage in accruals earnings management to avoid a covenant violation but end up violating a
covenant despite these efforts. While future ROA growth is lower when violation firms engage
in accruals earnings management, shareholders do not experience significantly lower abnormal
returns. In contrast, shareholders are worse off following unsuccessful real earnings manage-
ment. This result suggests that lenders impose more stringent conditions on violation firms if
they had engaged in covenant-related real earnings management.
Our analyses contribute to the literature in at least two ways. First, Nini et al. (2012) argue
that bank intervention following covenant violations benefits shareholders because it effec-
tively reduces shareholder-manager agency costs. They find covenant violation firms experience
faster than expected growth in return on assets (mainly through expense reductions) and some-
what mixed evidence of positive abnormal stock returns during the post-violation period. Our
evidence suggests that there are important cross-sectional differences in the effects of bank inter-
vention following covenant violations that depend on firms’ earnings management activities
5 Thecorresponding results for real earnings management show that violation firms that did not engage in real earnings
management experience significantly higher future ROA growth and significantly lower growth in capital expenditures
compared to for non-violation firms that engaged in real earnings management. However, while the non-violation firms
experience lower abnormal returns, the difference in not significant.
during the pre-violation period.6 We find shareholders at non-violation firms who engage in
covenant-related earnings management may be strictly better off (and certainly no worse off)
than shareholders of similar firms that violate a covenant but do not engage in earnings man-
agement. As such, our results are consistent with assumptions underlying the Debt Covenant
Hypothesis – that is, violations are costly for shareholders.
Second, by showing how future performance depends on firms’ earnings management activi-
ties, we add to the literature on the performance consequences of earnings management (Bhojraj
et al., 2009; Cohen & Zarowin, 2010; Gunny, 2010) by examining the performance consequences
of real and accruals earnings management among firms with a high ex ante risk of a covenant
violation. Our results provide only limited evidence that shareholders incur additional costs when
their firms engage in covenant-related earnings management.7
The rest of this paper is as follows. In Section 2, we develop our hypotheses and describe
our research methodology in Section 3. Section 4 describes the sample and presents summary
statistics while Section 5 presents the results. Section 6 concludes the paper.
2. Hypothesis Development
Violating a debt covenant (aka a ‘technical’ default) has traditionally been viewed as a costly
event for firms (Beneish & Press, 1993, 1995; DeFond & Jiambalvo, 1994; Sweeney, 1994).
When a covenant is violated, the creditor has the right to demand an immediate repayment of
balances owed by the borrower, which can exacerbate conflicts of interest between shareholders
and creditors (Jensen, 1986). Cross-default clauses, common in many debt contracts, amplify
this threat as a default on one loan triggers default on other loans. In practice, creditors rarely
enforce the repayment acceleration option but instead use it to strengthen their bargaining posi-
tion as they renegotiate the contract (HassabElnaby, 2006). These renegotiations frequently lead
to costly changes in loan terms, such as higher interest rates, tighter covenants, or new covenants
(Beneish & Press, 1993; Chava & Roberts, 2008; Chen & Wei, 1993; HassabElnaby, 2006; Nini
et al., 2012). Based on announcement period returns, Beneish and Press (1995) estimate that in
aggregate, these costs are about 1.4% of equity value.
In addition, the transfer in control rights often gives creditors substantial control over the
firm’s operations, investments, and capital structure. For example, creditors often force the firm
to appoint creditor-affiliated individuals as independent directors (Ferreira et al., 2018). These
changes are designed to enhance the likelihood the creditors are repaid.8 Following covenant
violations, creditors force firms to reduce their capital expenditures, net debt issuance, the num-
ber of acquisitions, and restrict access to credit lines (Chava & Roberts, 2008; Demiroglu &
James, 2010; Denis & Wang, 2014; Nini et al., 2009, 2012; Roberts & Sufi, 2009; Sufi, 2009).
In addition, credit lines from banks and trade credit from their suppliers (which is an important
source of financing) are reduced following violations (Sufi, 2009; Zhang, 2019). The reduc-
tion in credit further impairs firms’ ability to fund positive net present value projects and take
advantage of available growth opportunities. Collectively, credit rationing following a violation
imposes substantial indirect costs on shareholders in the form of opportunity costs.
6 Given these differences with Nini et al. (2012), we reconcile our results with theirs at the end of Section 5. These results
indicate the differences depend on firms’ earnings management activities during the pre-violation period and are not due
to sample differences based on accounting data and matching requirements.
7 Our results do not provide evidence on the performance consequences of earnings management at either firms with a
low risk of a covenant violation or earnings management made for non-covenant related reasons.
8 Private conversations with several commercial bankers confirm that banks use their loan acceleration and termination
rights to impose operational changes that enhance the likelihood of repayment.

This collective evidence indicates that covenant violations are costly events for shareholders,
and hence, managers should try to avoid violating covenants. In contrast to this traditional view,
some theoretical studies posit that post-violation creditor interventions can benefit sharehold-
ers (in addition to creditors) by reducing shareholder-manager agency costs (Aghion & Bolton,
1992; Dewatripont & Tirole, 1994; Jensen, 1986; Smith, 1993). Consistent with these arguments,
Nini et al. (2012) find firms experience better operating performance and (mixed evidence of)
positive abnormal returns following a violation.9 However, Nini et al. (2012) do not condition
their analyses on whether and what type of earnings management activities firms may have
engaged in during the pre-violation period. Thus, given that earnings management activities are
costly, there could be substantial cross-sectional variation in post-violation performance. Thus,
by itself, we do not think the positive abnormal returns experienced by violation firms docu-
mented in Nini et al. (2012) necessarily implies that covenant-related earnings management is
against shareholders’ interests.
Given the direct and indirect costs firms experience following a violation and the earnings
management efforts they take to avoid a violation (discussed below), we expect shareholders of
covenant violation firms are worse off compared to shareholders of otherwise similar firms that
do not violate a covenant. Accordingly, we make the following hypothesis:
Hypothesis 1: In the absence of covenant-related earnings management, the future performance of violation firms is
worse than otherwise similar non-violation firms.
Credit agreements typically include covenants based on accounting variables. The Debt
Covenant Hypothesis predicts managers at firms with a high risk of a covenant violation will
engage in earnings management activities in order avoid a covenant violation (Watts & Zim-
merman, 1986). A number of studies have provided evidence consistent with the Debt Covenant
Hypothesis (DeFond & Jiambalvo, 1994; Dichev & Skinner, 2002; Franz et al., 2014). For exam-
ple, Dichev and Skinner (2002) analyze the distributions of financial ratios that are frequently
used in financial covenants. They conclude firms manage their accounting numbers in an effort
to avoid violating a covenant. More recently, Franz et al. (2014) provide more direct evidence
supporting the Debt Covenant Hypothesis. They find firms close to a debt covenant violation
(or in actual violation) engage in both real and accruals earnings management activities to avoid
the violation (or mitigate it more quickly). Collectively, this evidence indicates managers act
as if violations are costly and actively manage earnings to avoid violating accounting-based
covenants.10
Prior evidence indicates that both accruals and real earnings management activities are costly
to shareholders. Accruals earnings management increases scrutiny from auditors and regulators
and can also increase the risk of shareholder litigation (DuCharme et al., 2004; Peng & Röell,
2008). Accruals earnings management can also result in higher cash taxes (Dyreng, 2010; Erick-
son et al., 2004). Prior literature indicates that when accruals management is too costly, firms will
engage in real earnings management activities instead (Cohen et al., 2008; Cohen & Zarowin,
2010; Franz et al., 2014; Gunny, 2010; Zang, 2012). Survey evidence in Graham et al. (2005)
indicates managers may in fact prefer real earnings management to accruals-based earnings
management in order to avoid the additional scrutiny accruals management entails. However,
real earnings management also imposes costs on shareholders because it involves engaging in
sub-optimal operating and investment decisions (Cohen & Zarowin, 2010; Kim & Sohn, 2013).
9 The abnormal returns estimates for violation firms during the post-violation period are consistently positive across the
various specifications they examine. However, whether or not the estimates are significant depends on the specific test
specification and the time period over which returns are computed.
10 An alternative explanation is that if covenant violations are beneficial for shareholders (Nini et al., 2012), then
managers’ efforts to avoid violations are manifestations of agency costs. We discuss this alternative below.
Given the costly nature of earnings management activities, we expect firms which success-
fully avoid a covenant violation through the use of earnings management will perform worse
compared to similar non-violation firms that did not manage earnings. Accordingly, we make the
following hypothesis:
Hypothesis 2: Non-violation firms that engage in earnings management have future performance that is worse than
non-violation firms that did not engage in earnings management.
To the extent that both earnings management activities and covenant violations are costly,
managers at firms with a high risk of violating a covenant are faced with a difficult choice. If
they choose not to manage earnings, then they are more likely to violate a covenant. However, if
they reduce the risk of a violation by managing earnings, they will incur the associated earnings
management costs. This choice is non-trivial because covenant-related earnings management
activities may be insufficient to prevent the violation. In which case, the firm will incur both the
violation costs and the earnings management costs.
Economic theory suggests that shareholders prefer firms engage in covenant-related earnings
management when the expected costs of earnings management are less than the expected net
costs of a covenant violation (i.e. any direct costs of renegotiated loan terms and any indirect
costs associated with foregone investment opportunities less any reduction in agency costs), and
vice-versa. Prior evidence indicates that while some firms engage in covenant-related earnings
management, not all firms do (Dichev & Skinner, 2002; Franz et al., 2014).11 Managers have
private information regarding the expected costs of earnings management and the expected costs
of a covenant violation. Thus, the choice of whether to engage in covenant-related earnings
management will vary across otherwise similar firms, but these choices can all be optimal from
a shareholder perspective. To this end, there is no clear directional prediction between the future
performance of firms that successfully engage in covenant-related earnings management and
violation firms that did not engage in earnings management.
We expect agency conflicts also influence managers’ decision to engage in covenant-related
earnings management. The reason is that managers bear additional private costs when their firms
violate a covenant. First, managers’ private benefits of control are reduced when creditors exert
more direct control over managerial actions. Baird and Rasmussen (2006) find creditors fre-
quently require violation firms to hire turnaround specialists as Chief Restructuring Officers as
a condition of waiving technical defaults. Managers also have less control over their investment
decisions (Chava & Roberts, 2008; Roberts & Sufi, 2009). Second, CEOs of violation firms are
much more likely to be fired, presumably at the instigation of creditors. Nini et al. (2012) and
Ozelge and Saunders (2012) find that the forced CEO turnover rate increases by 60% to 98%
following debt covenant violations. Thus, CEOs have strong incentives to avoid violating a debt
covenant through earnings management even when a violation is less costly for shareholders.
To the extent these agency considerations influence covenant-related earnings management deci-
sions, then shareholders of firms that engaged in earnings management might have been better
off had their firms violated a covenant but abstained from earnings management. If true, the
future performance of non-violation earnings management firms will be relatively worse than
non-earnings management violation firms.
The above discussion indicates that the performance consequences of covenant-related earn-
ings management depends on whether the costs of earnings management outweigh the net costs
of creditor interventions, and to what extent these decisions are influenced by agency conflicts.
11 For example, Sweeney (1994) finds that in the nine cases where a firm could have avoided a covenant violation by
changing inventory flow assumptions, four firms chose not to do so. She speculates that large negative tax consequences
dissuaded them. This evidence suggests firms balance the costs and benefits of covenant-related earnings management.
Ultimately, which group performs better is an empirical question. Accordingly, we make the
following, non-directional hypothesis:
Hypothesis 3: Non-violation firms that engage in earnings management have future performance that is different
from violation firms that did not engage in earnings management.
Prior literature indicates that both violations and earnings management are costly to firms.
Firms that engage in covenant-related earnings management but still end up violating a covenant
incur both types of costs. In addition, the magnitude of violation costs could be higher for firms
that also engaged in covenant-related earnings management if creditors treat such firms more
harshly. For example, creditors could impose harsher loan terms or greater restrictions on firms’
investment decisions if a firm tried to avoid a violation through earnings management. Sup-
porting this idea, HassabElnaby (2006) finds the likelihood that a bank waives a violation is
decreasing with the magnitude of discretionary accruals. Furthermore, when they agree to grant
a waiver, banks impose more costly conditions when discretionary accruals are higher. Thus,
violation costs are higher when firms more actively engaged in earnings management before the
covenant violation. Accordingly, we make the following hypothesis:
Hypothesis 4: Violation firms that engage in earnings management have future performance that is worse than
violation firms that do not engage in earnings management.
3. Research Methodology and Earnings Management Proxies

Our goal is to compare the performance of violation firms with non-violation firms who had a
similar likelihood of covenant violation. Doing so is important as violation firms have substan-
tially higher ex ante probabilities of violating a covenant compared to the average non-violation
firm. Thus, we need to ensure that the non-violation firms have similarly high likelihoods of
violating a covenant. To accomplish this goal, we use a propensity score matching procedure to
ensure that our non-covenant violation firms have a similar violation likelihood as our violation
firms (see Section 4.2 below for details). Thus, both violation and non-violation firms in our
sample have relatively high covenant-related earnings management incentives. This approach
effectively homogenizes the violation and non-violation states by restricting the analysis to oth-
erwise similar firms that only have small differences in the estimated probability of a violation.
This approach helps mitigate concerns that differences in variables associated with the likelihood
of a covenant violation are also associated with differences in future performance.
We use discretionary working capital accruals, DWCA, as our measure of accruals earnings
management because nearly all income statement-based financial covenants are written on earn-
ings before depreciation (Dyreng, 2010). Hence, firms gain little, or perhaps nothing at all,
by managing earnings after depreciation. We use the modified Jones model to estimate quar-
terly cross-sectional regression models at the industry level (two-digit SIC code) where we also
include controls for performance and liquidity to measure discretionary working capital accruals
(Dechow et al., 1995; Hribar & Collins, 2002; Kothari et al., 2005; Louis & Robinson, 2005).
DWCA equals the residuals from these regressions. They capture the portion of income not driven
by economic fundamentals, but rather, at least in part, by managerial discretion. Positive (neg-
ative) values of DWCA indicate income increasing (decreasing) accruals earnings management.
Estimation details are given in Appendix B.
Following Zang (2012) and others, we use two measures of real earnings management activi-
ties: abnormal production costs (AbProd) and abnormal discretionary expenses (AbExp).12 These
12 FollowingZang (2012), we do not examine abnormal cash flows from operations (AbCFO) because real activities
manipulation affects this variable in different directions and the net effect is potentially ambiguous. Furthermore, as
measures have been used in numerous studies of real earnings management, including Cohen
et al. (2008) and Cohen and Zarowin (2010). We performance and liquidity adjust our real
earnings management proxies because both variables affect discretionary expenditures. Positive
abnormal production costs indicate income-increasing real earnings management while nega-
tive abnormal discretionary expenses indicate income-increasing real earnings management. For
ease of interpretation, we multiply the latter values by − 1 so positive values of AbExp reflect
income increasing earnings management. Our real earnings management proxy, RM, is the sum
of AbProd and AbExp. Thus, positive values of RM are associated with income increasing real
earnings management. See Appendix B for estimation details.
We create two indicator variables to capture firms that are more or less likely to have engaged
in earnings management. AEM is an indicator variable equal to one if the value of DWCA is
in the top tercile of the empirical distribution of DWCA, and zero if it is in the bottom tercile.
Similarly, REM is an indicator variable equal to one if the value of RM is in the top tercile of
the empirical distribution of RM, and zero if it is in the bottom tercile. We exclude firms in the
middle tercile to increase the power of our tests (Lys & Sabino, 1992).13
Based on a firm’s violation status and the accruals earnings management indicator variable,
AEM, we create four groups from the set of matched pairs: (1) Non-covenant violation firms
that are less likely to have engaged in accruals earnings management (V = No; AEM = No);
(2) Non-covenant violation firms that are more likely to have engaged in accruals earnings
management (V = No; AEM = Yes); (3) Violation firms that are less likely to have engaged
in accruals earnings management beforehand (V = Yes; AEM = No); and (4) Violation firms
that are more likely to have engaged in accruals earnings management beforehand (V = Yes;
AEM = Yes). We create a similar set of four groups based on a firm’s violation status and the
real earnings management indicator variable, REM. While our earnings management proxies
(DWCA and RM ) are based on standard methods in the literature, they contain measurement
errors because the underlying models to not completely account the effects of operating condi-
tions on non-discretionary accruals or operating decisions. If these measurement errors do not
cause substantial changes in which group an observation is placed, then our research design
reduces the effects of measurement errors on our results.
Within each group, there will be unobserved variation in the non-covenant related incentives
to manage earnings (Graham et al., 2005; Healy & Wahlen, 1999), the costs of earnings man-
agement (Barton & Simko, 2002), and the expected costs of a violation (Beneish & Press, 1993;
Denis & Wang, 2014).14 Our matching procedure ensures violation and non-violation firms are
similar across a number of firm characteristics, including those related to earnings management
incentives, accounting variables used in debt covenants, measures of firm performance, and vari-
ables related to corporate governance practices.15 We expect the matching process reduces any
systematic inter-group differences in earnings management and violation costs that are correlated
with these variables. In this way, our research design will help isolate the effects of covenant
violations and covenant-related earnings management. However, if these non-covenant related
Cohen and Zarowin (2010) discuss in their footnote 8, ‘the same activities that lead to abnormally high production costs
also lead to abnormally low CFO; thus, adding these two amounts leads to double counting.’
13 Results are qualitatively similar if we either use the continuous measures of the earnings management proxies (DWCA
and RM ) or indicator variables that equal one if DWCA (RM ) is positive, and zero otherwise, respectively.
14 For example, firms with pre-existing relationships with their lenders may less willing to damage this relationship by
engaging in covenant-related earnings management. In addition, relationship banks may be less willing to impose costly
penalties on firms following a violation because they do not want to risk jeopardizing the relationship (Dichev & Skinner,
2002).
15 To the extent managers have non-covenant related incentives to manage earnings that are related to performance
and liquidity, then the accruals regression models will at least partially capture discretionary accruals related to these
incentives.
factors vary systematically across our sample partitions and are also associated with our future
performance measures, then our results need to be interpreted accordingly.
We compare the performance of each group over the four quarters following the violation quar-
ter using both accounting and stock return performance metrics. Examining both types of metrics
provides more comprehensive evidence on how earnings management and creditor interventions
following violations are associated with future firm performance. We examine the differences in
future performance between the four groups using the following simple regression:
Performancet, t+4 = Intercept + β1 ∗ Violationt + β2 ∗ EMt + β3 ∗ Violationt ∗ EMt + εt

(1)
where ∆Performancet,t+4 is the change in performance over the next four quarters. We use
the following variables to measure accounting performance: (1) return on assets (ROA), sales
(Sales), operating expenses (OpExp), SG&A expenses (SG&A), other expenses (OtherExp), cap-
ital expenditures (CapX ), and R&D expenses (R&D). To analyze stock market performance, we
follow Nini et al. (2012) and use buy-and-hold abnormal returns (BHAR) measured over the
four quarters following the violation quarter for violation firms. Violation is an indicator variable
equal to one if the firm reported a debt covenant violation during quarter t, and zero otherwise.
EM represents alternatively one of our two earnings management variables, AEM and REM.
Appendix A provides variable definitions.
In Equation 1, the Intercept coefficient captures the average future performance of the non-
violation, non-earnings management firms (V = No; EM = No), β 1 the violation, non-earnings
management firms (V = Yes; EM = No), β 2 the non-violation firms that engaged in earnings
management (V = No; EM = Yes), and β 3 of the violation firms that engaged in earnings man-
agement (V = Yes; EM = Yes). In all of the regressions reported in this paper, we use robust
standard errors that are clustered both by firm and year-quarter.
4. Sample Construction and Descriptive Statistics

4.1. Sample
Our sample is obtained from Nini et al. (2012) and comprises initial debt covenant violations
reported in 10-Qs and 10-Ks for all Compustat firms during the 1996–2008 sample period.16
Following Nini et al. (2012), we focus on initial violations (meaning that the firm had no previous
violations over the previous four quarters) because the incentives and ability of firms to engage
in earnings management activities are diminished following a violation. Firms are not required to
report a covenant violation if it has been ‘cured’ by the filing date whereby the lender has agreed
to waive the violation or the lender and firm have renegotiated the agreement. This discretion
results in underreporting so that some violation observations are misclassified as non-violation
observations.17
Non-violation observations come from all available firm-quarter observations with the neces-
sary data from the same 1996–2008 period. We obtain quarterly accounting data for non-financial
firms from Compustat and market data from CRSP. To reduce the effect of influential obser-
vations, we winsorize all continuous variables at the 1st and 99th percentiles. We constrain
the non-violation group to only contain firms that are at least four quarters away from (both
16 The data can be obtained from Amir Sufi’s webpage (http://faculty.chicagobooth.edu/amir.sufi/chronology.html). The
online appendix to Nini et al. (2012) contains the details of this sample’s construction and composition.
17 The presence of hidden violation firms in our non-violation sub-samples will reduce our ability to find significant
differences between the sub-samples. That is, it will bias against rejecting the null for Hypotheses 1 and 3.
before and after) a reported violation. This selection procedure generates a sample of 44,575
firm-quarter observations that have the required data, including 1,514 observations with an ini-
tial covenant violation. Thus, only 3.4% our firm-quarter observations have an initial covenant
violation. Descriptive statistics are provided in the online Supplement.
Table 1 provides the summary statistics for the entire sample where we split up the sample
between violation and pre-matched non-violation firms and whether they engaged in high (low)
levels of earnings management based on whether their level of earnings management was above
(below) the sample median. In Panel A (B), we divide firms into high and low levels of accruals
(real) earnings management. All variable definitions are provided in Appendix A.
The results in Panels A and B show substantial differences between the two groups of firms
regardless of the level of earnings management. In both panels, and both high and low levels of
earnings management, non-violation firms are larger, have more cash, higher current and interest
coverage ratios, and are less leveraged compared to violation firms. The two groups also have
significantly different levels of performance, with non-covenant violation firms having higher
ROA, higher growth options (i.e. lower B/M ratios), and higher sales growth. Violation firms
are also less likely to have a debt rating and a high quality auditor. These differences support
our use of the matched sample design to minimize systematic differences between violation and
non-violation firms that are potentially associated with future firm performance.
4.2. Propensity Score Matching

We use propensity score techniques to obtain a matched sample of violation and non-violation
firms in order to analyze the performance consequences of earnings management and covenant
violations. We first estimate the logit regression model in Equation 2 to estimate the likelihood
of a covenant violation. The sample consists of all violation and non-violation observations with
the required data.
Violation = f (Constant, LnAssets, Debt/Assets, Cash/Assets, Equity, Current Ratio,

Debt/EBITDA, Interest Coverage, ROA, B/M , Sales Growth,
Debt Rating, Top Auditor, Industry, Fiscal Quarter) (2)
where Violation is an indicator variable equal to one if the firm reported an initial covenant vio-
lation during the quarter, and zero otherwise. LnAssets is the natural logarithm of total assets.
Debt/Assets is the ratio of total long-term debt plus long-term debt in current liabilities to total
assets. Cash/Assets is the ratio of cash and cash equivalents to total assets. Equity is total share-
holders’ equity. Current Ratio is the ratio of current assets to current liabilities. Debt/EBITDA is
long-term debt plus long-term debt in current liabilities to earnings before interest, taxes, depre-
ciation, and amortization (EBITDA). Interest Coverage is the interest coverage ratio defined as
EBITDA divided by interest expense. ROA is the return on assets. B/M is the book to market
ratio of assets. Sales Growth is the growth in sales. Debt Rating is an indicator variable equal to
one if the firm has a credit rating, and zero otherwise. Top Auditor is an indicator variable equal
to one if the firm has a top eight auditor, and zero otherwise.18 Industry is a vector of industry
18 We include Debt Rating and Top Auditor in order to capture other corporate governance factors which are likely cor-
related with both the likelihood of a violation, the likelihood of engaging in covenant-related earnings management, and
future performance. We chose not to include additional variables related to corporate governance or executive incentives
because their inclusion would lead to a large reduction in sample size. Violation firms tend to be relatively small, and
hence, are not tracked by many corporate governance data providers. For example, requiring incentive compensation
data from Execucomp results in a roughly 60% decrease in sample size.
Table 1. Summary statistics for the entire sample of violation and non-violation firms
Earnings Management to Avoid Debt Covenant Violations and Future Performance

Panel A: Partitions by Low/High (below/above median) level of accruals earnings management (AEM)
NAME N Mean StdDev P25 P50 P75 N Mean StdDev P25 P50 P75
Yes Violation & Low AEM No Violation & Low AEM
LnAssets 889 5.135 1.610 3.897 4.999 6.231 21,398 6.198 1.862 4.797 6.308 7.526
Debt/Assets 889 0.335 0.206 0.178 0.309 0.458 21,398 0.277 0.192 0.135 0.251 0.381
Cash/Assets 889 0.073 0.104 0.011 0.034 0.088 21,398 0.123 0.162 0.018 0.055 0.162
Equity 889 233.7 726.1 16.5 51.5 167.5 21,398 801.1 1636.8 50.1 213.1 744.7
Current Ratio 889 1.832 1.226 1.066 1.534 2.188 21,398 2.284 1.645 1.279 1.832 2.712
Debt/EBITDA 889 6.628 31.747 –5.070 6.443 19.375 21,398 7.959 17.846 2.078 6.086 12.091
Interest Coverage 889 1.411 27.497 –2.453 1.666 4.702 21,398 16.402 50.418 2.962 7.086 15.800
ROA 889 0.002 0.042 –0.014 0.013 0.027 21,398 0.028 0.037 0.019 0.033 0.047
B/M 889 0.822 0.991 0.378 0.701 1.186 21,398 0.571 0.566 0.277 0.461 0.727
Sales Growth 889 0.017 0.287 –0.147 –0.003 0.146 21,398 0.094 0.238 –0.014 0.075 0.182
Debt Rating 889 0.226 0.419 0 0 0 21,398 0.413 0.492 0 0 1
Top Auditor 889 0.817 0.387 1 1 1 21,398 0.887 0.317 1 1 1
DWCA 889 –0.033 0.034 –0.044 –0.022 –0.010 21,398 –0.021 0.025 –0.027 –0.013 –0.005
RM 889 –0.011 0.102 –0.056 –0.011 0.040 21,398 –0.015 0.087 –0.055 –0.013 0.027
Yes Violation & High AEM No Violation & High AEM
LnAssets 625 5.215 1.546 3.916 5.079 6.377 21,663 6.150 1.805 4.796 6.214 7.423
Debt/Assets 625 0.339 0.192 0.182 0.333 0.461 21,663 0.282 0.191 0.139 0.258 0.388
Cash/Assets 625 0.057 0.085 0.009 0.027 0.065 21,663 0.102 0.148 0.013 0.039 0.125
Equity 625 234.9 751.4 19.3 56.9 193.8 21,663 734.7 1543.9 50.1 194.2 662.9
Current Ratio 625 1.826 1.197 1.103 1.525 2.302 21,663 2.296 1.561 1.334 1.889 2.740
Debt/EBITDA 625 9.450 31.138 1.344 9.748 19.006 21,663 8.015 16.630 2.531 6.174 11.815
Interest Coverage 625 4.218 23.639 0.518 2.477 6.132 21,663 18.848 52.208 3.536 7.890 17.108
ROA 625 0.015 0.033 0.004 0.020 0.033 21,663 0.032 0.034 0.022 0.036 0.050
B/M 625 0.744 0.946 0.354 0.625 1.045 21,663 0.538 0.530 0.263 0.436 0.687
Sales Growth 625 0.094 0.285 –0.055 0.061 0.213 21,663 0.136 0.242 0.013 0.101 0.228
Debt Rating 625 0.250 0.433 0 0 0 21,663 0.400 0.490 0 0 1
Top Auditor 625 0.814 0.389 1 1 1 21,663 0.883 0.321 1 1 1
DWCA 625 0.029 0.029 0.009 0.020 0.039 21,663 0.025 0.028 0.008 0.016 0.032
RM 625 0.003 0.110 –0.050 –0.002 0.051 21,663 –0.010 0.093 –0.055 –0.009 0.034
(Continued)
11
Table 1. Continued.
Panel B: Partitions by Low/High (below/above median) level of real earnings management (REM)
Variable N Mean StdDev P25 P50 P75 N Mean StdDev P25 P50 P75
Yes Violation & Low REM No Violation & Low REM
LnAssets 722 5.106 1.519 3.925 4.926 6.112 21,565 6.238 1.812 4.893 6.298 7.481
Debt/Assets 722 0.331 0.207 0.168 0.307 0.455 21,565 0.277 0.194 0.132 0.249 0.384
Cash/Assets 722 0.073 0.103 0.012 0.034 0.090 21,565 0.111 0.148 0.017 0.049 0.145
Equity 722 220.0 674.6 18.8 54.2 169.9 21,565 826.3 1686.8 56.1 218.9 746.6
Current Ratio 722 1.839 1.166 1.044 1.517 2.332 21,565 2.200 1.494 1.249 1.835 2.677
Debt/EBITDA 722 8.360 29.289 –1.873 6.845 18.660 21,565 7.260 15.646 2.148 5.476 10.718
ROA 722 0.007 0.043 –0.010 0.017 0.032 21,565 0.035 0.036 0.024 0.039 0.054
B/M 722 0.757 0.958 0.340 0.634 1.109 21,565 0.487 0.497 0.230 0.397 0.628
Sales Growth 722 0.041 0.280 –0.107 0.021 0.162 21,565 0.118 0.234 0.005 0.088 0.203
Debt Rating 722 0.219 0.414 0 0 0 21,565 0.416 0.493 0 0 1
Top Auditor 722 0.801 0.400 1 1 1 21,565 0.896 0.305 1 1 1
DWCA 722 –0.010 0.047 –0.030 –0.006 0.013 21,565 0.001 0.034 –0.014 0.001 0.015
RM 722 –0.080 0.074 –0.102 –0.057 –0.031 21,565 –0.075 0.067 –0.098 –0.055 –0.030
Yes Violation & High REM No Violation & High REM
LnAssets 792 5.224 1.640 3.860 5.085 6.407 21,496 6.110 1.853 4.680 6.222 7.468
Debt/Assets 792 0.342 0.194 0.191 0.328 0.467 21,496 0.281 0.188 0.142 0.260 0.385
Cash/Assets 792 0.061 0.090 0.009 0.028 0.066 21,496 0.114 0.163 0.014 0.044 0.141
Equity 792 247.2 788.7 16.4 52.5 191.2 21,496 708.8 1486.7 44.5 186.1 660.1
Current Ratio 792 1.822 1.256 1.122 1.535 2.153 21,496 2.380 1.701 1.361 1.885 2.783
Debt/EBITDA 792 7.276 33.429 –4.278 9.296 19.694 21,496 8.717 18.683 2.525 6.889 13.120
ROA 792 0.008 0.035 –0.006 0.015 0.028 21,496 0.025 0.034 0.017 0.030 0.043
B/M 792 0.820 0.986 0.390 0.681 1.147 21,496 0.623 0.588 0.312 0.501 0.786
Sales Growth 792 0.056 0.295 –0.111 0.022 0.186 21,496 0.112 0.247 –0.009 0.088 0.207
Debt Rating 792 0.251 0.434 0 0 1 21,496 0.396 0.489 0 0 1
Top Auditor 792 0.830 0.376 1 1 1 21,496 0.874 0.331 1 1 1
DWCA 792 –0.005 0.042 –0.026 –0.003 0.016 21,496 0.004 0.036 –0.012 0.002 0.018
RM 792 0.063 0.080 0.009 0.040 0.090 21,496 0.050 0.063 0.008 0.031 0.071
indicator variables based on Barth et al. (1999) and Fiscal Quarter is a vector of indicator vari-
ables based on whether the fiscal quarter is the 1st, 2nd , 3rd , or 4th fiscal quarter. All the variables
are measured at the end of the fiscal quarter.
The results from estimating Equation 2 are reported in Table 2. The model has reasonable
explanatory power (pseudo R2 = 16.2%; area under ROC = 0.801). The results are gener-
ally consistent with our expectations. All of the coefficients for the covenant-related variables
(with the exception of Debt/EBITDA) are highly significant (absolute value of t-statistics range
between 6.08 and 143) and have the expected signs. The three performance variables also have
highly significant coefficients (absolute value of t-statistics range between 16.8 and 261). As
expected, the likelihood of a violation is decreasing in return on assets and sales growth, and is
increasing in the book-to-market ratio. In addition, the two variables included to capture aspects
of firms’ corporate governance, Debt Rating and Top Auditor, have significant coefficients. Firms
with a debt rating are less likely to violation a covenant. In order to have a credit rating, firms
must have publicly issued debt. Such firms are likely to be larger and have stronger incentives
to avoid a violation as renegotiation costs are higher for defaults on public debt compared to
private debt (Bharath et al., 2008). They also are more likely to have effective governance mech-
anisms. Firms with a top eight auditor are more likely to violate a covenant. We expect this
occurs because a high quality auditor inhibits the ability of the firm to manage earnings in order
to violate a covenant.
We match each violation observation with a non-violation observation in the same industry
using the fitted values from the Table 2 results. We use a procedure that is globally optimal
in the sense it minimizes the sum of the absolute distances across all matched pairs within an
industry. In this way, pairs matched first are not necessarily better than pairs matched last. Instead,
all pairs are matched simultaneously to minimize total match distance. This procedure results
in a matched sample consisting of 1,514 violation observations and their corresponding 1,514
matched non-violation observations with each pair having a similar likelihood of a covenant
violation.19 We do not lose any violation firm observations in the matching process.
Univariate statistics for each group of matched firms are provided in Table 3. There are several
things of note. First, the number of observations varies for each performance measure because
of differences in data availability. Second, none of the mean values for the explanatory variables
in Equation 2 (shown in Table 3 below the dashed lines) are significantly different between the
violation and non-violation groups. These results provide confidence that the propensity score
matching procedure has effectively controlled for these differences between the two groups.20
Third, the mean values of each of the performance measures (the ones above the dashed lines)
are significantly different between the violation and non-violation groups. These comparisons
indicate that while violation firms have higher future growth in return on assets compared to
non-violation firms, they also have significantly lower future abnormal returns. In addition, while
future sales growth tends to be higher among the non-violation firms, so are the growth rates in
expense (operating, SG&A and other). Non-violation firms also have higher growth rates for
R&D expenses and capital expenditures.
Table 4 provides the correlation table. Focusing on the correlations with future abnormal
returns, BHAR, the results show that BHAR is essentially uncorrelated with future growth in
19 The evidence in Roberts and Sufi (2009) indicates that firms frequently renegotiate their loan agreements and most
renegotiations take place without a covenant violation. Thus, some of our non-violation non-earnings management firms
may have avoided a violation by renegotiating their loan agreements. To the extent this type of renegotiation is costly,
our ability to find significant differences between the sub-samples will be reduced.
20 We implicitly assume that both groups will experience similar covenant-related earnings management incentives. To
the extent that this assumption is not descriptive, then we expect this measurement error will reduce our ability to find
significant results and our evidence must be interpreted accordingly.
Table 2. Logit regression of the first step of the

propensity score procedure
Dependent Variable Violation

Intercept –2.122
(177)
LnAssets –0.162
(27.17)
Debt/Assets 1.334
(79.1)
Cash/Assets –4.466
(143)
Equity 0.000
(7.55)
Current Ratio –0.167
(26.1)
Debt/EBITDA 0.00
(0.00)
Interest Coverage –0.002
(6.08)
ROA –12.741
(261)
B/M 0.337
(52.8)
Sales Growth –0.501
(16.8)
Debt Rating –0.341
(15.4)
Top Auditor 0.206
(5.59)
Industry Fixed Effects Yes
QTR Fixed Effects Yes
Observations 44,575
Pseudo R2 0.162
Area under ROC 0.801
The dependent variable of this logit regression is Viola-
tion, which equals one if reported a covenant violation
during the quarter, and zero otherwise. LnAssets is the
natural log of total assets. Debt/Assets equals the ratio
of total long-term debt + long-term debt in current lia-
bilities to total assets. Cash/Assets equals the ratio of
cash and equivalents to total assets. Equity equals total
shareholders’ equity. Current Ratio equals the ratio of
current assets to current liabilities. Debt/EBITDA equals
long-term debt + long-term debt in current liabilities to
EBITDA. Interest Coverage equals the interest coverage
ratio. ROA is return on assets and equals income before
extraordinary items scaled by total assets. B/M is the
book value of assets to market value of assets ratio. Sales
Growth is the sales during quarter t divided by sales during
quarter t-4 minus one. Debt Rating equals one if the firm
has a debt credit rating, and zero otherwise. Top Auditor
equals one if the firm has a top eight auditor, and zero oth-
erwise. See Appendix A for more details. The t-statistics
reported in parentheses below the coefficients are based
on standard errors computed by clustering at the firm
and year-quarter levels. *** (**) (*) represents two-tail
statistical significance at the 1% (5%) (10%) level.
ROA ( − 0.01). In contrast, BHAR is strongly and positively correlated with future sales growth
(0.24) as well as growth in the expense variables – operating expenses, SG&A expenses, and
other expenses (0.19, 0.14, and 0.16, respectively). The correlations with expense growth likely
reflects the very high correlations between sales growth and expense growth (correlations vary
between 0.45 and 0.81). Finally, the correlations between future abnormal returns and the time
t covenant variables are generally close to zero. These economically insignificant correlations
make sense as the future performance implications of these variables should already be priced
by the market before the future returns periods begin.
Table 3. Summary statistics for the matched sample
Violation Firm-Quarters
Variable N MEAN STD P25 P50 P75
∆ROA 1,405 0.011 0.099 –0.007 0.005 0.024
∆Sales 1,372 0.034 0.270 –0.092 0.043 0.159
∆OpExp 1,312 0.013 0.249 –0.110 0.026 0.140
∆SG&A 1,319 0.013 0.225 –0.108 0.013 0.128
∆OtherExp 1,276 0.019 0.269 –0.115 0.031 0.146
∆R&D 610 –0.025 0.207 –0.082 0.000 0.060
∆CAPEX 1,389 –0.013 0.729 –0.398 –0.034 0.354
BHAR 1,473 –0.055 0.589 –0.461 –0.154 0.195
LnAssets 1,514 5.168 1.584 3.913 5.021 6.281
Debt/Assets 1,514 0.337 0.200 0.180 0.319 0.460
Cash/Assets 1,514 0.067 0.097 0.010 0.031 0.077
Equity 1,514 234.2 736.4 17.9 53.0 180.5
Current Ratio 1,514 1.830 1.213 1.078 1.531 2.230
Debt/EBITDA 1,514 7.793 31.517 –2.782 8.146 19.075
Interest Coverage 1,514 2.570 26.002 –1.326 2.021 5.315
ROA 1,514 0.007 0.039 –0.008 0.016 0.030
BM 1,514 0.790 0.973 0.364 0.662 1.123
SG 1,514 0.049 0.288 –0.108 0.021 0.177
Debt Rating 1,514 0.236 0.425 0 0 0
Top Auditor 1,514 0.816 0.388 1 1 1
DWCA 1,514 0.007 0.079 –0.030 0.004 0.041
RM 1,514 –0.009 0.373 –0.181 –0.017 0.166
Non-Violation Firm-Quarters
∆ROA 1,431 0.003*** 0.227 –0.008 0.002 0.014
∆Sales 1,409 0.071*** 0.264 –0.055 0.063 0.184
∆OpExp 1,348 0.050*** 0.228 –0.062 0.049 0.160
∆SG&A 1,354 0.041*** 0.207 –0.068 0.040 0.146
∆OtherExp 1,308 0.052*** 0.255 –0.066 0.050 0.164
∆R&D 603 –0.009*** 0.189 –0.063 0.000 0.062
∆CAPEX 1,318 0.001*** 0.451 –0.224 0.011 0.240
BHAR 1,429 0.094*** 0.675 –0.287 0.032 0.415
LnAssets 1,514 5.139 1.698 3.676 5.041 6.462
Debt/Assets 1,514 0.335 0.212 0.174 0.307 0.469
Cash/Assets 1,514 0.072 0.108 0.010 0.030 0.086
Equity 1,514 253.1 747.3 15.3 53.9 205.6
Current Ratio 1,514 1.870 1.228 1.106 1.586 2.307
Debt/EBITDA 1,514 7.604 25.433 –0.260 7.256 14.807
Interest Coverage 1,514 2.507 35.941 –0.465 3.489 8.205
(Continued)
Table 3. Continued.
Non-Violation Firm-Quarters
ROA 1,514 0.009 0.050 –0.004 0.023 0.037
BM 1,514 0.808 0.838 0.319 0.589 1.029
SG 1,514 0.056 0.269 –0.075 0.045 0.174
Debt Rating 1,514 0.213 0.409 0 0 0
Top Auditor 1,514 0.815 0.388 1 1 1
DWCA 1,514 0.005 0.073 –0.028 0.004 0.035
RM 1,514 –0.025 0.356 –0.199 –0.026 0.157
This table provides summary statistics for a sample of covenant violation firm-years and non-covenant violation control
firm-years matched on the basis of a propensity score analysis. The performance measures are presented above the
corresponding dashed line while the variables used in the matching process are presented below the dashed line. ***
(**) (*) represents that the mean value of the control group is significantly different from that of the Violation group
at the 1% (5%) (10%) level. indicates the change in the corresponding variable over the next four quarters. ROA
equals return of assets. Sales equals total revenues. OpExp equals operating expenses. SG&A equals selling, general,
and administrative expenses. OtherExp equals other expenses. R&D equals research and development expenses. CapX
equals capital expenditures. BHAR equals buy-and-hold abnormal returns measured over the following four quarters.
Specifically, BHAR is calculated by compounding the firm’s return less the corresponding return from a portfolio created
based on size and book to market over the twelve months following the month of violation. LnAssets is the natural log
of total assets. Debt/Assets equals the ratio of total long-term debt + long-term debt in current liabilities to total assets.
Cash/Assets equals the ratio of cash and equivalents to total assets. Equity equals total shareholders’ equity. Current Ratio
equals the ratio of current assets to current liabilities. Debt/EBITDA equals long-term debt + long-term debt in current
liabilities to EBITDA. Interest Coverage equals the interest coverage ratio. ROA is return on assets and equals income
before extraordinary items scaled by total assets. BM is the book value of assets to market value of assets ratio. Sales
Growth is the sales during quarter t divided by sales during quarter t-4 minus one. Debt Rating equals one if the firm has
a debt credit rating, and zero otherwise. Top Auditor equals one if the firm has a top eight auditor, and zero otherwise.
DWCA is discretionary working capital accruals. RM is real earnings management. See Appendix B for more details.
5. Covenant Violations, Earnings Management, and Post-violation Performance

In order to provide evidence on our hypotheses, we estimate Equation 1. In our first (second)
specification, we use AEM (REM ) as our accrual earnings management proxy. Recall that AEM
(REM) is an indicator variable that equals one if DWCA (RM ) is in the top tercile of its distri-
bution and zero if it is in the bottom tercile. Firms in the middle tercile are excluded from the
regression. The results when AEM (REM ) is the proxy for earnings management are presented
in Table 5 (6). We focus our discussion on the AEM results in Table 5 and reserve our discussion
of the REM results in Table 6 to cases in which the two sets of results differ.
The evidence in Dyreng et al. (2011) and Franz et al. (2014) indicates firms engage in both real
and accruals-based earnings management activities in order to avoid violating debt covenants.
Both types of activities are likely to be costly to firms. In addition, firms experience costs when
they violate debt covenants in the form of higher interest rates, additional covenants, and reduced
access to credit, among other things. Despite these violation costs, Nini et al. (2012) suggest bank
intervention following covenant violations is actually beneficial to firms as it reduces agency
costs associated with entrenched managers. As discussed previously, a key difference is that they
do not condition on firms’ earnings management activities.
We first compare the future performance of non-violation firms that did not engage in
covenant-related accruals earnings management [V = No; AEM = No] with similar viola-
tion firms that did not engage in covenant-related accruals earnings management [V = Yes;
21
AEM = No]. We focus on firms that did not engage in earnings management to isolate the
effect of the covenant violation on performance. In Table 5, the future performance of [V = No;
Table 4. Correlation matrix

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21)
(1) ∆ROA 1.00

(2) ∆Sales 0.04 1.00
(3) ∆OpExp − 0.10 0.81 1.00
(4) ∆SG&A − 0.16 0.45 0.71 1.00
(5) ∆OtherExp − 0.01 0.79 0.89 0.41 1.00
(6) ∆R&D − 0.05 0.19 0.30 0.38 0.18 1.00
(7) ∆CAPEX 0.04 0.21 0.23 0.20 0.18 0.14 1.00
(8) BHAR − 0.01 0.24 0.19 0.14 0.16 0.06 0.12 1.00
(9) LnAssets − 0.02 − 0.01 0.05 0.13 0.00 0.05 0.01 0.03 1.00
(10) Debt/Assets − 0.05 − 0.03 − 0.02 0.00 − 0.03 0.01 − 0.08 0.02 0.19 1.00
(11) Cash/Assets 0.03 0.04 − 0.03 − 0.02 − 0.01 − 0.02 0.05 0.02 − 0.10 − 0.16 1.00
(12) Equity − 0.01 0.01 0.04 0.06 0.00 0.07 0.03 0.00 0.52 − 0.04 − 0.01 1.00
(13) Current Ratio 0.02 − 0.04 − 0.04 0.00 − 0.04 0.02 0.06 − 0.07 − 0.04 − 0.22 0.37 − 0.04 1.00
(14) Debt/EBITDA − 0.04 − 0.02 0.07 0.08 0.04 − 0.01 0.02 − 0.01 0.19 0.16 − 0.10 0.05 − 0.04 1.00
(15) Inter. coverage − 0.03 0.02 0.16 0.20 0.09 0.11 0.00 0.05 0.22 − 0.01 − 0.13 0.12 0.00 0.05 1.00
(16) ROA − 0.03 − 0.02 0.22 0.29 0.10 0.15 0.04 0.08 0.40 0.04 − 0.32 0.13 − 0.04 0.23 0.49 1.00
(17) BM 0.00 − 0.10 − 0.11 − 0.10 − 0.09 − 0.08 − 0.06 0.10 − 0.04 − 0.15 − 0.19 − 0.04 0.09 0.02 − 0.02 0.07 1.00
(18) SG − 0.15 0.03 0.19 0.25 0.09 0.14 0.11 0.00 0.08 0.04 0.00 0.04 − 0.05 0.03 0.11 0.20 − 0.16 1.00
(19) Debt Rating − 0.01 − 0.01 0.03 0.09 − 0.01 0.02 − 0.01 0.02 0.62 0.29 − 0.11 0.36 − 0.10 0.13 0.06 0.20 − 0.11 0.03 1.00
(20) Top Auditor 0.03 − 0.04 − 0.01 0.00 0.00 − 0.05 0.04 0.03 0.35 0.05 − 0.02 0.12 0.03 0.06 0.00 0.15 0.02 0.05 0.20 1.00
(21) DWCA 0.02 0.00 0.07 0.09 0.06 0.02 − 0.02 − 0.07 0.06 0.07 − 0.14 0.02 0.06 0.05 0.09 0.15 − 0.07 0.25 0.03 0.09 1.00
(22) RM 0.02 0.00 0.04 0.09 − 0.01 0.05 0.04 − 0.03 0.12 0.05 − 0.17 0.03 0.01 0.03 0.03 0.09 0.10 0.02 0.08 − 0.04 0.07
Pearson correlations for the sample of covenant violation firm-years and non-covenant violation control firm-years matched on the basis of the propensity score analysis. indicates
the change in the corresponding variable over the next four quarters. ROA equals return of assets. Sales equals total revenues. OpExp equals operating expenses. SG&A equals selling,
general, and administrative expenses. OtherExp equals other expenses. R&D equals research and development expenses. CapX equals capital expenditures. BHAR equals buy-and-hold
abnormal returns measured over the following four quarters. Specifically, BHAR is calculated by compounding the firm’s return less the corresponding return from a portfolio created
based on size and book to market over the twelve months following the month of violation. LnAssets is the natural log of total assets. Debt/Assets equals the ratio of total long-term
debt + long-term debt in current liabilities to total assets. Cash/Assets equals the ratio of cash and equivalents to total assets. Equity equals total shareholders’ equity. Current Ratio
equals the ratio of current assets to current liabilities. Debt/EBITDA equals long-term debt + long-term debt in current liabilities to EBITDA. Inter. Coverage equals the interest coverage
ratio. ROA is return on assets and equals income before extraordinary items scaled by total assets. BM is the book value of assets to market value of assets ratio. Sales Growth is the
sales during quarter t divided by sales during quarter t-4 minus one. Debt Rating equals one if the firm has a debt credit rating, and zero otherwise. Top Auditor equals one if the firm has
a top eight auditor, and zero otherwise. See Appendix A for more details. DWCA is discretionary working capital accruals. RM is real earnings management. See Appendix B for more
details.
17
Table 5. Association between covenant violations, accruals earnings management, and future operating performance
(A) (B) (C) (D) (E) (F) (G) (H)

ROA Sales OpExp SG&A OtherExp R&D CapX BHAR
Dep Variable % % % % % % % %
Intercept –0.324 5.464*** 3.223** 2.679** 2.182 –0.668 –0.891 5.593*
(–0.36) (3.56) (2.61) (2.33) (1.58) (–0.51) (–0.38) (1.81)
Violation 2.530** –2.707 –4.490** –2.609 –2.518 –2.750 –9.450*** –11.755***
(2.62) (–1.40) (–2.38) (–1.67) (–1.25) (–1.43) (–3.05) (–3.10)
AEM 1.600 1.387 2.442 2.014 4.137** 0.175 1.229 –2.355
(1.17) (0.74) (1.47) (1.46) (2.16) (0.09) (0.37) (–0.59)
Violation*AEM –4.021** –2.343 0.044 –0.288 –2.245 1.273 –0.925 1.023
(–2.54) (–1.01) (0.02) (–0.15) (–0.94) (0.43) (–0.22) (0.22)
Observations 1,888 1,843 1,763 1,777 1,708 859 1,722 1,964
Adj. R2 0.001 0.004 0.009 0.004 0.006 –0.000 0.010 0.007
No Violation/No AEM –0.324 5.464*** 3.223** 2.679** 2.182 –0.668 –0.891 5.593*
(–0.36) (3.56) (2.61) (2.33) (1.58) (–0.51) (–0.38) (1.81)
Yes Violation/No AEM 2.207*** 2.757 –1.267 0.070 –0.336 –3.418** –10.340*** –6.163*
(4.14) (1.50) (–0.66) (0.05) (–0.17) (–2.61) (–3.89) (–1.67)
No Violation/Yes AEM 1.276 6.851*** 5.665*** 4.694*** 6.320*** –0.493 0.338 3.238
(1.56) (4.91) (4.44) (4.25) (4.17) (–0.31) (0.15) (0.68)
Yes Violation/Yes EM –0.214 1.801 1.219 1.796 1.556 –1.970* –10.037*** –7.495**
(–0.55) (1.21) (0.98) (1.40) (1.03) (–1.71) (–4.19) (–2.01)
The table presents the results of future accounting and market performance measures. Violation is an indicator variable equal to one if the firm violates a covenant, and
zero otherwise. AEM is an indicator variable equal to one if the value of DWCA is in the top tercile of the distribution, and zero if DWCA is in the bottom tercile of the
distribution. Observations in the middle tercile of the distribution are excluded from the regression. The dependent variables are as follows: indicates the percentage
change in the corresponding variable over the next four quarters. ROA equals return of assets. Sales equals total revenues. OpExp equals operating expenses. SG&A equals
selling, general, and administrative expenses. OtherExp equals other expenses. R&D equals research and development expenses. CapX equals capital expenditures. BHAR
equals buy-and-hold abnormal returns measured over the following four quarters. Specifically, BHAR is calculated by compounding the firm’s return less the corresponding
return from a portfolio created based on size and book to market over the twelve months following the month of violation. Reported t-statistics based on robust standard
errors are provided in parentheses below the corresponding coefficients. F-tests and significance levels refer to F-tests regarding the whether the sum of the corresponding
coefficients is different from zero. The t-statistics reported in parentheses below the coefficients are based on standard errors computed by clustering at the firm and
year-quarter levels. *** (**) (*) represents two-tail significance at the 1% (5%) (10%) level.
Table 6. Association between covenant violations, real earnings management, and future operating performance

(A) (B) (C) (D) (E) (F) (G) (H)
ROA Sales OpExp SG&A OtherExp R&D CapX BHAR
Dep Variable % % % % % % % %
Intercept –0.047 5.628*** 4.165*** 2.536** 5.269*** –1.267 1.672 4.691
(–0.03) (4.54) (3.47) (2.37) (4.65) (–1.02) (0.91) (1.39)
Violation 1.993 –2.039 –3.795** –3.395** –2.704* –3.073* –10.307*** –5.917*
(1.25) (–1.26) (–2.40) (–2.22) (–1.72) (–1.80) (–3.19) (–1.83)
REM 0.337 0.934 1.152 2.701 –0.789 2.071 –3.390 –2.598
(0.21) (0.64) (0.80) (1.56) (–0.53) (1.33) (–1.09) (–0.66)
Violation*REM –1.438 –1.248 1.105 0.751 –0.015 1.965 3.646 –8.114*
(–0.88) (–0.55) (0.54) (0.37) (–0.01) (0.93) (0.79) (–1.82)
Observations 1,888 1,853 1,762 1,766 1,697 853 1,735 1,967
Adj. R2 –0.000 0.001 0.004 0.008 0.001 0.006 0.008 0.010
No Violation/No REM –0.047 5.628*** 4.165*** 2.536** 5.269*** –1.267 1.672 4.691
(–0.03) (4.54) (3.47) (2.37) (4.65) (–1.02) (0.91) (1.39)
Yes Violation/No REM 1.946*** 3.589** 0.370 –0.859 2.565 –4.340*** –8.635*** –1.226
(3.43) (2.65) (0.24) (–0.65) (1.67) (–3.16) (–3.54) (–0.37)
No Violation/Yes REM 0.318 6.562*** 5.317*** 5.236*** 4.480*** 0.804 –1.719 2.092
(0.78) (4.71) (4.58) (4.03) (3.38) (0.76) (–0.68) (0.50)
Yes Violation/Yes REM 0.873*** 3.274** 2.627* 2.592** 1.761 –0.304 –8.380*** –11.938***
(2.78) (2.11) (1.97) (2.31) (1.17) (–0.25) (–3.12) (–3.30)
The table presents the results of future accounting and market performance measures. Violation is an indicator variable equal to one if the firm violates a covenant, and zero
otherwise. REM is an indicator variable equal to one if the value of RM is in the top tercile of the distribution, and zero if RM is in the bottom tercile of the distribution.
Observations in the middle tercile of the distribution are excluded from the regression. The dependent variables are as follows: indicates the percentage change in
the corresponding variable over the next four quarters. ROA equals return of assets. Sales equals total revenues. OpExp equals operating expenses. SG&A equals selling,
general, and administrative expenses. OtherExp equals other expenses. R&D equals research and development expenses. CapX equals capital expenditures. BHAR equals
buy-and-hold abnormal returns measured over the following four quarters. Specifically, BHAR is calculated by compounding the firm’s return less the corresponding
return from a portfolio created based on size and book to market over the twelve months following the month of violation. Reported t-statistics based on robust standard
errors are provided in parentheses below the corresponding coefficients. F-tests and significance levels refer to F-tests regarding the whether the sum of the corresponding
coefficients is different from zero. The t-statistics reported in parentheses below the coefficients are based on standard errors computed by clustering at the firm and
year-quarter levels. *** (**) (*) represents two-tail significance at the 1% (5%) (10%) level.
19
AEM = No] firms is captured by the intercept while the incremental performance of [V = Yes;
AEM = No] firms is captured by the Violation coefficient.
The results in Column A show that the average percentage change in future ROA for [V = No;
AEM = No] firms is small in magnitude (–0.324) and is not significantly different from zero
(t-statistic = –0.36). The results for the constituent parts of ROA are shown in Columns B –
E. They show that while [V = No; AEM = No] firms experience significant growth in sales
(5.464%; t-statistic = 3.56), they also experience significant growth in operating and SG&A
expenses (t-statistics = 2.61 and 2.33, respectively). Thus, the increases in expenses offset the
increase in sales, with the net effect of no change in ROA. Furthermore, we find insignificant
changes in R&D or capital expenditures. Thus, firms do not appear to reduce their level of
investments when the ex ante risk of a covenant violation is high.
The results for [V = Yes; AEM = No] firms shows that these firms experience significantly
higher ROA growth compared to [V = Yes; AEM = No] firms. Specifically, the Violation
coefficient is positive (2.530) and significant (t-statistic = 2.62). Furthermore, the sum of the
Intercept and Violation coefficients is positive (2.207).22 The faster growth in ROA for [V = Yes;
AEM = No] firms likely reflect the influence of bank monitoring on expense management and
investment choices, consistent with Nini et al. (2012). The results Columns B – E indicate that
[V = Yes; AEM = No] firms achieve the higher ROA growth through cost-cutting efforts rather
than through sales growth. While the Violation coefficient is insignificant when ∆Sales is the
dependent variable, it is significantly negative (t-statistic = –2.38) in the ∆OpExp regression.
The magnitude of the coefficient indicates that [V = Yes; AEM = No] firms reduce their oper-
ating expenses by almost 4.5% relative to [V = No; AEM = No] firms.23 The coefficients on
∆SG&A and ∆OthExp are also negative, but are insignificant (t-statistics = –1.67 and –1.25,
respectively).
The prior literature indicates that lenders cause violation firms to significantly reduce their
investments (Chava & Roberts, 2008; Denis & Wang, 2014; Nini et al., 2012; Roberts & Sufi,
2009). Consistent with these results, we find capital expenditures are reduced by roughly 10% for
[V = Yes; AEM = No] firms, both on an absolute basis (–10.340%) and relative to [V = No;
AEM = No] firms (–9.450%). While the relative decrease in R&D expenditures is insignificant
(t-statistic = –1.43), the absolute level of R&D decreases at [V = Yes; AEM = No] firms by
3.418%, which is significant at the 5% level.
In summary, these results indicate that for firms that do not engage in covenant-related accruals
earnings management, lenders use their control rights in ways that cause firms to cut operating
expenses and reduce their investments following a covenant violation. However, by themselves,
it is difficult to determine whether these changes represent a net benefit or cost to shareholders.
For example, the reductions in operating costs and investments could reflect a decrease in agency
costs that are curbed by more intense monitoring by lenders. In contrast, these changes could
represent opportunity costs as lenders force firms to change operations in ways that enhance the
firm’s ability to repay its lenders at the expense of future growth opportunities. Thus, we examine
stock market performance to distinguish between these two explanations.
22 The bottom four rows of Table 5 (and 6) provide the sum of the corresponding coefficients from the regression results
to obtain the absolute effect for each group of firms. Significance levels are based on F-tests on whether the sum is
different from zero. Thus, the absolute 2.207 percent increase in ROA for [V = Yes; AEM = No] firms is significantly
different from zero at the 1% level.
23 The results in Table 6 where REM is the proxy for earnings management are generally similar to those in Table 5.
There are two main exceptions. First, in the ∆ROA regression, the Violation coefficient is positive but not significant
(t-statistic = 1.25) despite significant decreases in all four measures of expenditures. Second, in the BHAR regression,
the Intercept continues to be positive (4.691) but is no longer significant (t-statistic = 1.39).
Figure 1. Buy-and-hold returns (BHAR) depending on covenant violations and accrual earnings management (AEM ).
The figure represents buy and hold portfolios, hypothetically formed at month 0, then followed forward or backward in
event-time. Returns are adjusted for delisting values available in CRSP. The proceeds after the delisting are assumed to
be reinvested in the corresponding risk adjusted portfolio, such that abnormal returns are zero.
Figure 1 (2) graphs the monthly abnormal returns starting from 12 months before the violation
month until 12 months afterwards for groups of firms based on AEM (REM). The dotted line
shows the abnormal returns for [V = No; AEM = No] firms are about 15% 12 months after the
violation month. In contrast, abnormal returns for [V = Yes; AEM = No] firms (gray dashed
line) are small and slightly negative after 12 months. The results in Figure 2 for REM are similar.
Thus, the graphical evidence indicates shareholders of violation firms experience worse stock
price performance compared to non-violation firms that have a similar violation probability.
Column H in Table 5 (6) provides the corresponding regression results. During the 12 months
following the pseudo-violation month, [V = No; AEM = No] firms experience average posi-
tive abnormal returns of 5.593% (t-statistic = 1.81). In contrast, [V = Yes; AEM = No] firms
experience abnormal returns that are 11.755% lower than for [V = No; AEM = No] firms (t-
statistic = –3.10).24 Thus, our results indicate that among firms with a high ex ante risk of
a covenant violation that do not engage in covenant-related accruals earnings management,
covenant violations represent a negative event for shareholders. As such, these results provide
support for Hypothesis 1 (but are inconsistent with the results in Nini et al., 2012).
Next, we compare the future performance of non-violation firms based on whether they engage
in covenant-related earnings management or not. Consistent with much of the earnings man-
agement literature, we expect engaging in earnings management is costly and firms who do so
experience poorer future performance. The results in Table 5 show that all but one of the AEM
coefficients are insignificant. The one exception is when OthExp is the dependent variable. In this
24 The REM results in Table 6 are similar but somewhat weaker. Specifically, the absolute magnitudes of Intercept and
Violation coefficients are smaller (4.619 vs. 5.593 and -5.917 vs. -11.755, respectively) and only the Violation coefficient
is significant (t-statistic = -1.83).
Figure 2. Buy-and-hold returns(BHAR) depending on covenant violations and real earnings management (REM ). The
figure represents buy and hold portfolios, hypothetically formed at month 0, then followed forward or backward in
event-time. Returns are adjusted for delisting values available in CRSP. The proceeds after the delisting are assumed to
be reinvested in the corresponding risk adjusted portfolio, such that abnormal returns are zero.
case, the AEM coefficient is positive and significant (t-statistic = 2.16). It is possible that this
coefficient is picking up the effects of the reversal of accruals during the post violation period.
Thus, we find limited evidence that in the absence of a violation, engaging in covenant-related
accruals earnings management is associated with significantly worse operating performance for
non-violation firms.
Figure 1 shows the monthly abnormal returns for [V = No; AEM = Yes] firms are similar to,
but generally slightly lower than for [V = No; AEM = No] firms until months 11 and 12, when
the gap slightly widens. Thus, while [V = No; AEM = No] firms experience positive abnormal
returns of roughly 15% after 12 months, abnormal returns for [V = No; AEM = Yes] firms is
only about 11% after 12 months in Figure 1. In Table 5, the corresponding regression results
show that while the AEM coefficient is negative, it is not significant (t-statistic = –0.59).25 In
addition, the absolute abnormal returns experienced by [V = No; AEM = Yes] firms is insignif-
icantly positive (3.238% = 5.593–2.355, t-statistic of F-test = 0.68). In contrast, [V = No;
AEM = No] firms experience positive abnormal returns (5.593%, t-statistic = 1.81) over the
first 12 months following the pseudo-violation month. In summary, there is limited evidence that
shareholders at [V = No; AEM = Yes] firms are harmed by covenant-related accruals earnings
management.
25 One possible explanation for the lack of significance in the BHAR regression is that any negative effects of AEM have
already been incorporated in stock prices prior to the violation month. Consistent with this explanation, Figure 1 shows
that [V = No; AEM = Yes] firms experience some modest deterioration in performance starting seven months prior to
the violation.
The tenor of the REM results in Table 6 (and Figure 2) is similar to that in Table 5 (and
Figure 1).26 Figure 2 shows that abnormal returns for [V = No; REM = Yes] firms is about
9% after 12 months, which is less than the roughly 15% returns experienced by [V = No;
REM = No] firms after 12 months. However, the corresponding regression results in Table 6
show that while the REM coefficient is negative, it is insignificant (t-statistic = –0.66). Thus,
there is limited evidence that shareholders at [V = No; REM = Yes] firms are harmed by
covenant-related real earnings management. In summary, while the evidence in Figures 1 and
2 provide some evidence in support of Hypothesis 2, the differences in future stock market
performance are not significant in the regressions reported in Tables 5 and 6.
Given the conflicting arguments, Hypothesis 3 does not make a directional prediction regard-
ing the performance of [V = No; EM = Yes] firms compared to [V = Yes; EM = No] firms.
We examine this hypothesis by comparing the sum of the Intercept and AEM (REM ) coefficients
with the sum of the Intercept and Violation coefficients, respectively (tabulated in the lower half
of Table 5 (6)). In comparing the two groups of firms, we focus on the two summary measures of
performance, ROA and BHAR, as well as the difference in capital expenditure growth, ∆CapX.
The difference in future ROA is relatively small (0.930% = 2.207–1.276) and an F-test fails to
reject the null hypothesis that the difference is insignificant (untabulated p-value = 0.257). Thus,
despite the differences in operations in terms of sales and expense growth, the net result is no
significant difference in ROA growth. In contrast, the difference in capital expenditure growth
is large in absolute magnitude (–10.678% = –10.340–0.338) and the difference is highly sig-
nificant (untabulated p-value = 0.004). The difference in future investment behavior suggests
that outcomes for shareholders may be different depending on how lenders influence firms’
investment decisions. Consistent with this expectation, the difference in twelve-month abnormal
returns is large in absolute magnitude (–9.401% = –6.163–3.238) and significant (untabulated
p-value = 0.057). The graphs in Figure 1 provide evidence consistent with the regression results.
The corresponding results for [V = No; REM = Yes] firms compared to [V = Yes;
REM = No] firms indicate that [V = No; REM = Yes] firms experience significantly higher
growth in ROA (difference = 1.628%; p-value = 0.032) but significantly lower growth in cap-
ital expenditures (difference = –6.916%; p-value = 0.031). These results are consistent with
banks forcing violation firms to change their operations in ways that increase the likelihood
of debt repayment. The results also show that while [V = No; REM = Yes] firms experience
higher abnormal returns compared to [V = Yes; REM = No] firms (3.318%), this difference is
not significant (p-value = 0.413).
Collectively, our evidence indicates that on average, shareholders at high violation risk firms
are significantly better off when their firms successfully engage in covenant-related accruals
earnings management compared to shareholders at firms that violate a covenant but do not engage
in covenant-related accruals earnings management.27 Thus, our results provide a very differ-
ent interpretation of the effects of lender intervention following covenant violations. Consistent
26 We find no significant relative or absolute difference in future ROA growth for [V = No; REM = Yes] firms compared
to [V = No; REM = No] firms. These findings are in contrast to the results in Gunny (2010). She provides evidence
that firms engaging in REM to just meet earnings benchmarks have relatively better subsequent accounting performance
(ROA) than firms that do not engage in REM and miss or just meet the benchmarks. We note that our respective settings
(covenant violations vs. benchmark beating) are very different and likely to have different implications for REM.
27 When managers decide whether or not to engage in covenant-related earnings management, they will take the expected
violation costs into account. Thus, our results may suffer from an endogeneity bias. Thus, firms are more likely to engage
in earnings management when the expected costs of a violation are relatively high, and vice-versa, choose not to engage
in earnings management when expected violation costs are relatively low. In which case, our results underestimate the
differences between the two groups of firms. However, without good instrumental variables or a compelling source of
exogenous variation, we are unable to address this issue directly. Thus, our results must be interpreted accordingly.
with Nini et al. (2012), our evidence indicates lender intervention is associated with signifi-
cant cost cutting and reductions in capital expenditures. However, these changes appear to cause
shareholders to incur opportunity costs from foregone growth opportunities and positive NPV
investments. In essence, lenders appear to impose actions on violation firms that increase the
likelihood of repayment at the expense of shareholder value. Such lender-initiated actions and
consequences are consistent with their incentives and ability to intervene in the firm’s operations
following a covenant violation. Thus, our results are consistent with the idea that covenant-
related accruals earnings management may be in the best interests of shareholders and hence, is
not necessarily a manifestation of shareholder-manager agency conflicts (as implicitly assumed
in the Debt Covenant Hypothesis literature).
In contrast, the results for covenant-related real earnings management are more balanced.
While banks appear to take similar actions with violation firms, the consequences for share-
holders are not significantly different as for firms that successfully engaged in covenant-related
real earnings management. One interpretation is that real earnings management imposes more
costs on shareholders compared to accruals earnings management and/or its use reflects greater
amounts of unsolved agency conflicts at firms that engaged in real earnings management. For
either type of earnings management, our evidence indicates that shareholders are not worse off
when their firms successfully engage in covenant-related earnings management.
Hypothesis 4 predicts that there is an incremental decline in future performance associated
with earnings management following a covenant violation because lenders may impose more
costly restrictions on firms under these circumstances. To provide evidence on this hypothesis,
we examine the Violation*EM interaction coefficients. The results in Tables 5 and 6 provide lim-
ited evidence in support of Hypothesis 4. In Table 5, the interaction coefficient is negative and
significant in the ROA regression (–4.021%; t-statistic = –2.54). However, none of the other
interaction coefficients in Table 5 are significant, including in the capital expenditures regres-
sion. Similarly, none of the Violition*REM coefficients in the accounting variable regressions
(Columns A – G) are significant in Table 6. Thus, lenders do not appear to impose additional or
more stringent investment restrictions on violation firms when they engaged in accruals or real
earnings management.
The graphs in Figures 1 and 2 show that [V = Yes; EM = Yes] firms have abnormal returns
of roughly –5% to –7% during the 12 months following a covenant violation while [V = Yes;
EM = No] firms have abnormal returns of roughly –1%. However, the Violation*AEM coef-
ficient is insignificant in Table 5 (t-statistic = 0.22). Thus, there is only limited evidence that
shareholders bear additional costs following a violation if their firm had engaged in covenant-
related accruals earnings management. In contrast, the Violation*REM coefficient is negative
( − 8.114) significant (t-statistic = –1.82) in Table 6 when BHAR is the dependent variable.
Overall, absolute returns are almost –12% for [V = Yes; REM = Yes] firms. Thus, our evi-
dence indicates that shareholders bear significantly higher costs when their firms unsuccessfully
engage in real earnings management to avoid a covenant violation.
Reconciliation with Nini et al. (2012)

As discussed above, our future abnormal results for violation firms differ from those reported
in Nini et al. (2012) despite our use of their sample in our analyses. Our future performance
analyses differ from theirs in two main respects. First, our violation sample differs from theirs
because we additionally require violation firms to have the required accounting data to calculate
the earnings management variables and only include violation firms that have a matching non-
violation firm. Second, we do not analyze the performance of all violation firms together. Instead,
we separately analyze the tercile of violation firms that were most (least) likely to have engaged
in covenant-related earnings management; we exclude the middle tercile of firms. Thus, we are
essentially analyzing cross-sectional differences in the future performance of violation firms due
to this second difference.
Before reconciling our abnormal returns results with theirs, we first replicate the analyses in
Table 10, Panel B of Nini et al. (2012) in order to rule out the possibility of any methodological
issues or errors in our analyses.28 Nini et al. (2012) calculate the cumulative abnormal returns
(CARs) of violation firms in event time. They find in the event month (month 0), the mean CAR
is negative (–0.0221) and significant at the 1% level. For event months [ + 1, + 3] ([ + 1, + 6]),
the mean CAR is close to zero and is insignificant. For event months [ + 1, + 12] ([ + 1, + 24]),
the mean CAR is 0.0032 (0.0046) and is significant at the 5% (1%) level.
The results from our replication and reconciliation of their Table 10 Panel B analyses are
presented in Table 7. In Panel A, we replicate their analyses using a sample that consists of all
violation firms that have the required stock market data. The results in Panel A show the magni-
tudes and significance levels are very similar to those reported in Nini et al. (2012). Specifically,
abnormal returns are significantly negative during the event month, insignificant over the next
three (six) months, and significantly positive over the next 12 (24) months.29 Thus, there do not
appear to be any methodological issues or errors in our analyses that are causing the differences
in results.
In Panel B, the sample is limited to the violation firms from Panel A that meet two addi-
tional data requirements. First, they have the required accounting data to calculate the accounting
variables used in this study. Second, we were able to match the violation firm to a comparable
non-violation firm. The results are presented in Panel B.30 The pattern of results is very similar
to those in Table 10, Panel B in Nini et al. (2012). Abnormal returns are significantly negative
during the event month, insignificant over the next three (six) months, and significantly posi-
tive over the next 12 (24) months. In addition, the magnitudes and significance levels are also
similar with two exceptions: the magnitudes of the mean CARs over months [ + 1, + 12] and
[ + 1, + 24] in our Table 7, Panel B are somewhat larger (0.0050 and 0.0059, respectively) than
their counterparts in Nini et al. (2012) (0.0032 and 0.0046, respectively). Thus, our requirement
that violation firms have the required accounting data and a matched non-violation firm does not
cause the differences in results.
Third, we replicate their analyses using the same sample of violation firms we use in our
Tables 5 and 6 analyses. Specifically, we first separate the matched-sample of violation firms
into high and low terciles based on the distribution of the earnings management variables (i.e.
where AEM or REM = 1 or 0, respectively). Thus, we exclude one-third of violation firms in
the Panel B analyses in the analyses reported in Panels C and D.
The results for when we split the sample based on the amount of accruals earnings management
are presented in Panel C. The results show that abnormal returns during the violation month are
28 We focus on the analyses in Table 10 Panel B because they most clearly show violation firms experience positive
abnormal returns during the post-violation period. In contrast, the results in their Table 11 show insignificant abnormal
returns for violation firms following violations. As discussed in Nini et al. (2012), these tests are of relatively low power.
Nini et al. (2012) also examine abnormal returns during months [ + 1, + 60] and find the mean CAR is not significantly
different from zero. Given that we only examine returns through month + 24, we do not replicate their analysis over this
extended time period.
29 In addition, we replicate Figure 8 in Nini et al. (2012), which shows monthly abnormal returns in event time for the full
sample of violation firms that have the required stock market date between months (-12, + 24). The results are presented
in Figure A3 in the online Supplement which is similar to the corresponding Figure 8 in Nini et al. (2012).
30 We also perform additional analyses where we limit the sample of violation firms used in Panel A to those firms that
had the required accounting data in Compustat (i.e., we do not require a match with a comparable non-violation firm. The
untabulated results are quantitatively very similar to those reported in Panel B both in terms of coefficient magnitudes
and significance levels.
Table 7. Reconciliation with Nini et al. (2012), Table 10 Panel B
Event months [0] [ + 1, + 3] [ + 1, + 6] [ + 1, + 12] [ + 1, + 24]

Panel A: Replication with the full violation sample (no additional data requirements)
Mean CAR –0.0293 –0.0006 0.0001 0.0026 0.0055
t-stat (–7.62)*** (–0.22) (0.08) (1.93)* (5.75)***
Robust t-stat [–3.44]*** [–0.09] [0.03] [0.69] [2.40]**
Panel B: Replication with all matched violation firms with required accounting data
Mean CAR –0.0239 –0.0001 0.0029 0.0050 0.0059
t-stat (–3.86)*** (–0.04) (1.09) (2.54)** (4.11)***
Robust t-stat [–2.58]** [–0.02] [0.62] [1.45] [2.34]**
Panel C: Replication based on the top (AEM = 1) and bottom (AEM = 0) terciles of accruals earning management
[0] [0] [ + 1, + 3] [ + 1, + 3] AEM = 0 AEM = 1 AEM = 0 AEM = 1 AEM = 0 AEM = 1
Event months AEM = 0 AEM = 1 AEM = 0 AEM = 1 [ + 1, + 6] [ + 1, + 6] [ + 1, + 12] [ + 1, + 12] [ + 1, + 24] [ + 1, + 24]
Mean CAR –0.0167 –0.0470 –0.0043 –0.0104 –0.0040 –0.0048 –0.0031 –0.0013 –0.0018 0.0011
t-stat (–1.77)* (–5.74)*** (–0.80) (–2.09)** (–1.07) (–1.36) (–1.13) (–0.53) (–0.95) (0.62)
Robust t-stat [–1.19] [–5.82]*** [–0.62] [–1.37] [–0.79] [–0.83] [–0.83] [–0.32] [–0.71] [0.33]
Panel D: Replication based on the top (REM = 1) and bottom (REM = 0) terciles of real earning management
[0] [0] [ + 1, + 3] [ + 1, + 3] [ + 1, + 6] [ + 1, + 6] [ + 1, + 12] [ + 1, + 12] [ + 1, + 24] [ + 1, + 24]
Event months REM = 0 REM = 1 REM = 0 REM = 1 REM = 0 REM = 1 REM = 0 REM = 1 REM = 0 REM = 1
Mean CAR –0.0282 –0.0262 0.0086 –0.0145 0.0052 –0.0086 0.0062 –0.0064 0.0048 –0.0057
t-stat (–3.18)*** (–3.03)*** (1.58) (–3.04)*** (1.40) (–2.44)** (2.34)** (–2.56)** (2.56)** (–3.12)***
Robust t-stat [–2.51]** [–2.51]** [1.26] [–2.32]** [1.17] [–1.80]* [1.87]* [–2.10]** [1.85]* [–1.87]*
This table reports event-time estimates of the mean cumulative abnormal returns (CAR) of new covenant violation firms by estimating the event-study monthly abnormal returns of
stocks following the report of a new covenant violation in an SEC 10-K or 10-Q filing. The sample of new violation firms comes from Nini et al. (2012). In Panel A, the sample consists
of all violation firms that have the required stock market data required to estimate the abnormal returns. In Panel B, the sample is limited to violation firms that meet two additional
data requirements. First, they have the required accounting data to calculate the accounting variables used in this study. Second, we able to match the violation firm to a comparable
non-violation firm. In Panel C, the sample for AEM = 0 (AEM = 1) firms consists of the top (bottom) tercile of violation firms in Panel B based on the distribution of DWCA. In
Panel D, the sample for REM = 0 (REM = 1) firms consists of the top (bottom) tercile of violation firms in Panel B based on the distribution of RM. Thus, in Panel C (D), we omit
the middle tercile of violation firms in Panel B based on the distribution of DWCA (RM ). Abnormal returns are measured on a monthly basis calculated as the firm’s return less the
corresponding return from a portfolio created based on size and book to market. Standard error estimates based on cross-sectional averages of firm-level standard are in parentheses,
and time-series clustering-robust standard errors are in brackets. . *** (**) (*) represents two-tail significance at the 1% (5%) (10%) level.
negative and significant for both AEM and non-AEM firms (although only at the 10% level for
non-AEM firms). The absolute magnitude for [AEM = 1] firms is almost twice as large as for
[AEM = 0] firms (–0.0470 vs. –0.0167). For all of the post-violation periods, abnormal returns
are insignificant for [AEM = 0] firms and [AEM = 1] firms.31 These results are consistent with
the regression results in Table 5 – specifically, the insignificant coefficient on Violation*AEM
when BHAR is the dependent variable. However, they differ from the results in Panel B, where
abnormal returns were positive and significant over months [ + 1, + 12] and [ + 1, + 24]. The
only difference between these two sets of results is that the sample in Panel C excludes firms in
the middle tercile of DWCA distribution. Therefore, it is these firms that are driving the positive
post-violation returns in Panel B, and presumably in Nini et al. (2012) as well.
The corresponding results for the sample splits based on real earnings management are pre-
sented in Panel D. The results for [REM = 0] firms show a similar pattern as in Panels A and B
(and hence, in Nini et al. (2012)). Specifically, abnormal returns are significantly negative during
the event month, insignificant over the next three (six) months, and significantly positive over the
next 12 (24) months. In addition, abnormal returns for [REM = 1] firms are also significantly
negative in the violation month. However, in contrast to the results for [REM = 0] firms, abnor-
mal returns are significantly negative over the next three, six, 12, and 24 months for [REM = 1]
firms. These results are consistent with the results in Table 6 – specifically, the significantly nega-
tive coefficient on Violation*REM when BHAR is the dependent variable. However, these results
are in stark contrast to the positive abnormal returns experienced by [REM = 1] firms during the
longer post-violation periods.
In summary, the results in Table 7 indicate that the post-violation abnormal returns results
in Nini et al. (2012) are not generalizable to all firms that violate a debt covenant. Instead,
they show that there is systematic variation in post-violation abnormal returns that is driven by
cross-sectional differences in firms’ pre-violation earnings management activities. These results
provide further evidence that whether shareholders ultimately benefit from a violation or not
depends on whether and which type of earnings management the firm engaged in during the
pre-violation period.
Summary and Conclusions

In this study, we examine the trade-offs between earnings management and covenant violations
by examining how they are associated with future accounting and stock market performance.
This issue is important because the prior literature indicates that violations impose direct and
indirect costs on shareholders and that firms engage in both accrual and real earnings manage-
ment to avoid covenant violations (Dichev & Skinner, 2002; Franz et al., 2014). However, there
is limited evidence on the costs of these covenant-related earnings management activities and
whether or not managing earnings to avoid debt covenant thresholds is detrimental to shareholder
value.
In order to provide evidence on the trade-offs between earnings management and covenant
violations, we analyze a matched-pair sample of covenant violation firms with non-violation
firms that have a similar risk of a covenant violation. We then examine how future accounting
and stock market performance varies across four groups of firms: (1) non-violation firms that do
not manage earnings; (2) non-violation firms that manage earnings; (3) violation firms that do
31 The negative returns for [AEM = 1] firms over months [ + 1, + 3] are insignificantly different from zero based on
the robust t-statistic, but are significant at the 5% level based on the t-statistic.
not manage earnings; and (4) violation firms that manage earnings. We examine both accrual and
real earnings management activities.
The results of our analyses indicate there are substantial differences in future performance
across the four groups. The evidence supports three main conclusions. First, shareholders at
high violation risk firms are better off (and certainly no worse off) when their firms success-
fully engage in covenant-related earnings management compared to shareholders at comparable
firms that violate a covenant but do not engage in covenant-related earnings management. Thus,
covenant-related earnings management may be in the best interest of shareholders and is not
necessarily evidence of shareholder-manager agency conflicts. Second, among comparable firms
that do not engage in covenant-related earnings management, covenant violations are costly for
shareholders. Thus, our evidence is consistent with lenders using their control rights in ways
that increase the likelihood of loan repayment but impose considerable costs for shareholders.
Third, while we do not find evidence that shareholders are harmed when managers engage in suc-
cessful covenant-related earnings management, we find violation costs are significantly higher
when firms have unsuccessfully engaged in covenant-related real earnings management. Thus, it
appears that banks impose more costly changes on violation firms that engaged in real earnings
management during the pre-violation period.
Acknowledgement
We thank Arizona State University, Duke University, IESE, and INSEAD for financial support. Fernando Penalva
acknowledges financial assistance from research projects ECO2016-77579-C3-1-P and PID2019-111143GB-C31 funded
by the Spanish Ministry of Economics, Industry and Competitiveness, and the Ministry of Science and Innovation,
respectively. We thank Daniel Beneish, Stephen Brown, Katherine Drake, Beatriz García Osma, Joachim Gassen, Leslie
Hodder, Helena Isidro (discussant), Andy Leone, Sugata Roychowdhury, Lakshmanan Shivakumar, Jim Whalen, Paul
Zarowin (associate editor), two anonymous reviewers, and seminar participants at Arizona State University, Indiana Uni-
versity, European Accounting Association Annual Congress, American Accounting Association Annual Meeting, and IX
Workshop on Empirical Research in Financial Accounting for their comments and suggestions.
Funding
Fernando Penalva acknowledges financial assistance from research projects ECO2016-77579-C3-1-P and PID2019-
111143GB-C31 funded by Spanish Ministry of Economy, Industry and Competitiveness, and the Ministry of Science
and Innovation, respectively.
Supplemental Data and Research Materials

Supplemental data for this article can be accessed on the Taylor & Francis website, doi:10.1080/09638180.2020.1826337.
An online Supplement with additional information and analyzes can be accessed at the journal’s Taylor and Francis
website.
ORCID
Fernando Penalva http://orcid.org/0000-0002-5206-3754
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Appendices
Appendix A: Variables definitions
All the variables are measured at the end of the fiscal quarter, unless otherwise indicated. We
indicate the corresponding Compustat items between parentheses.
Violation equals one if the firm reported a covenant violation during the quarter, and zero
otherwise.
LnAssets equals the natural logarithm of total assets (Compustat item ATQ).
Debt/Assets equals the ratio of total long-term debt plus long-term debt in current liabilities to
total assets ((DLTTQ + DLQ)/ATQ).
Cash/Assets equals the ratio of cash and equivalents to total assets (CHEQ/ATQ).
Equity equals total shareholders’ equity (ATQ − LTQ).
Current Ratio equals the ratio of current assets to current liabilities (ACTQ/LCTQ).
Debt/EBITDA equals long-term debt plus long-term debt in current liabilities to EBITDA
((DLTTQ + DLCQ)/OIBDPO).
Interest Coverage equals the interest coverage ratio defined as EBITDA divided by interest
expense (OIBDPO/XINTQ).
ROA equals return on assets (OIBDPQ/ATQ).
BM equals the book to market ratio of assets (ATQ/(ATQ − CEQQ + CSHOQ* PRCCQ)).
Sales Growth equals sales growth ((SALEQt /SALEQt−4 ) − 1).
Debt Rating is an indicator variable equal to one if the firm has a credit rating, and zero
otherwise.
Top Auditor is an indicator variable equal to one if the firm has a top eight auditor, and zero
otherwise.
Industry is a vector of industry indicator variables based on (Barth et al., 1999)
Fiscal Quarter is a vector of indicator variables based on whether the fiscal quarter is the 1st,
2nd, 3rd, or 4th fiscal quarter.
ROA equals the change in ROA over the next four quarters (ROAt+4 – ROAt ).
Sales equals total change in revenues scaled assets (SALEQt+4 / ATQt+4 – SALEQt / ATQt ).
OpExp equals change in operating expenses scaled by assets ((SALEQ –OIBDPQ)t+4 /
ATQt+4 – (SALEQ – OIBDPQ)t / ATQt ).
SG&A equals the change in selling, general, and administrative expenses scaled by assets
(XSGAQt+4 /ATQt+4 – XSGAQt /ATQt ).
OtherExp equals other expenses ((SALEQ – OIBDPQ – XSGAQ)t+4 /ATQt+4 – (SALEQ –
OIBDPQ – XSGAQ)t /ATQt ).
R&D equals research and development expenses (XRDQt+4 /ATQt+4 – XRDQt /ATQt ).
CapX equals capital expenditures (CapXQt+4 /ATQt+4 – CapXQt /ATQt ), where CapXQt =
CapXYt – CapXYt−1 if the fiscal quarter is greater than 1; otherwise CapXQt = CapXYt .
BHAR equals buy-and-hold abnormal returns measured over the following four quarters.
Specifically, BHAR is calculated by compounding the firm’s return less the corresponding return
from a portfolio created based on six Fama-French size and book to market groups (intersec-
tion of two size groups and three book to market groups) over the twelve months following the
violation quarter.
AEM Accruals earnings management indicator equal to one if the value of DWCA is in the top
tercile of the distribution, and zero if DWCA is in the bottom tercile of the distribution. Observa-
tions in the middle tercile of the distribution are excluded from the regression. See Appendix 2
for the definition of DWCA.
REM Real earnings management indicator equal to one if the value of RM is in the top tercile
of the distribution, and zero if RM is in the bottom tercile of the distribution. Observations in
the middle tercile of the distribution are excluded from the regression. See Appendix B for the
definition of RM.
Appendix B: Estimation of earnings management proxies

Discretionary working capital accruals (DWCA): Equation A2.1 below is based on the mod-
ified Jones model, as recommended by Dechow et al. (1995). Following Louis and Robinson
(2005), we estimate the model with quarterly data for every non-financial industry classified
by its two-digit SIC code. Thus, our approach partially controls for industry-wide changes in
economic conditions that affect working capital accruals and allows the coefficients to vary
across time (Cohen & Zarowin, 2010). To reduce measurement errors, we use working capi-
tal accruals obtained from the Statement of Cash Flows (Hribar & Collins, 2002). The likelihood
of a covenant violation is negatively associated with firm performance. Firms with poor perfor-
mance likely have incentives to manage earnings upwards that are unrelated to debt covenants. To
address this issue, we follow Kothari et al. (2005) and control for accounting performance (ROA)
in estimating discretionary accruals. This latter adjustment stems from the fact that commonly
used Jones-type discretionary accrual models applied in quarterly settings do not adequately
control for nondiscretionary working capital accruals that naturally occur due to firm growth. In
addition, we also control for liquidity as in our setting it can have a strong influence on man-
agers’ incentives to engage in earnings management. Our performance-adjusted accrual earnings
management measure allows us to isolate the incentive effects of debt covenants.
We estimate discretionary working capital accruals using the following cross-sectional model
estimated for each two-digit SIC-fiscal quarter grouping as follows:
WCAi,t 4
Qj Salesi,t − ARi,t
= kj + k5 + k6 ROAi,t−1 + k7 Cashi,t−1 + εi,t
Assetst−1 j=1
Assets i,t−1 Assetst−1
(A2.1)
where i indexes firms, t indexes fiscal quarters, and WCA represents working capital accruals,
which are defined as WCA = – (CHGAR + CHGINV + CHGAP + CHGTAX + CHGOTH).
The Compustat acronyms inside the parentheses in this expression represent the changes in
accounts receivable, inventories, accounts payable, taxes payable, and other items.32 Asseti,t−1
represents total assets (ATQ) at the beginning of the quarter, Sales is the change in revenues
(SALEQ) from the preceding quarter, and AR is the change in accounts receivable (RECTQ)
from the preceding quarter. ROA is income before extraordinary items (IBQ) divided by total
assets at the beginning of the quarter, and Cash is the cash and cash equivalents (CHEQ) divided
by assets at the beginning of the quarter. Qj is an indicator variable taking the value 1 in quarter j
and 0 otherwise.33 Every fiscal year, we estimate model (1) for each two-digit SIC code industry
with all the necessary Compustat data. In addition, we impose a minimum of 15 observations per
regression and each observation must have total assets in excess of $10 million. The residuals
from the above specification are our proxy for discretionary working capital accruals, DWCAit .
Abnormal production costs (AbProd): Production costs are defined as the sum of costs of
goods sold and the change in inventory during the quarter. Following Roychowdhury (2006),
32 Notice that a positive (negative) value of CHGAR and CHGINV represents a decrease (increase) in accounts receivable
and inventories, while a positive (negative) value of CHGAP, CHGTAX, and CHGOTH represents an increase (decrease)
in accounts payable, taxes payable, and other items. These variables are referred to as RECCHY, INVCHY, APALCHY,
TAXCHY, and AOLOCHY in the current version of Compustat. Like Collins et al. (2017), we recode missing values of
RECCHY, INVCHY, APALCHY, and TAXCHY as zero if there is a non-missing value of AOLOCHY. Conversely, if
AOLOCHY is missing but the other items are not missing, then we recode AOLOCHY as zero. We undo the year-to-date
nature of these quarterly cash flow statement items and compute the quantities for the quarter under consideration.
33 The traditional modified-Jones model for total accruals includes an additional regressor: gross property, plant and
equipment. We drop this term because our dependent variable is working capital accruals, which are not affected by this
item. Our inferences are not affected by this choice.
production costs are modeled as a linear function of contemporaneous sales and of contempora-
neous and lagged changes in sales. To estimate this model, we run the following cross-sectional
regression for each industry/fiscal year:
Prodi,t 4
Qj Salesi,t Salesi,t
= kj + k5 + k6 + k7 ROAi,t−1 + k8 Cashi,t−1 + εi,t
Assetst−1 j=1
Assets i,t−1 Assets t−1 Assets t−1
(A2.2)
Production costs (Prod) are defined as the sum of costs of goods sold (COGSQ) and the change
in inventory (INVTQ) during the quarter. The rest of variables have already been defined above.
The residuals from equation A2.2 are our estimate of abnormal production costs. More positive
values of AbProd are associated with more income increasing real earnings management.
Abnormal discretionary expenses (AbExp): The normal level of discretionary expenses can
be expressed as a linear function of sales. However, modeling discretionary expenses as a func-
tion of current sales creates a mechanical problem if firms manage sales upwards to increase
reported earnings in a certain year, resulting in significantly lower residuals from running a
regression of discretionary expenses on current sales. To address this issue, we model dis-
cretionary expenses as a function of lagged sales and estimate the following model for each
industry/fiscal year to derive the normal level of discretionary expenses:
DisExpi,t 4
Qj Salesi,t−1
= kj + k5 + k6 ROAi,t−1 + k7 CASHi,t−1 + εi,t (A2.3)
Assetst−1 j=1
Assetsi,t−1 Assetst−1
Discretionary expenses (DisExp) are defined as the sum of quarterly SG&A and R&D expenses
(XSGAQ + XRDQ).34 The rest of variables have already been defined above. The residuals of
this model are our estimate of abnormal discretionary expenses. More negative values of AbExp
are associated with more income increasing real earnings management.
One issue with the AbExp measure is how R&D expenses are typically reported in Compustat.
For a large number of firms, we observe missing values for the first three fiscal quarters but a
positive value for the fourth fiscal quarter. We expect these firms are actually incurring R&D
expenses throughout the fiscal year but only report the amounts annually (or Compustat only
records them annually). We are concerned about potential measurement errors if we treat missing
observations as having zero R&D expenses. Therefore, we exclude these observations when
calculating AbExp.35 However, in our analyses where RM is the dependent variable, we include
these observations and assume they have zero R&D expenses. Our inferences are not affected by
this choice.
Real earnings management (RM): Equals the sum of AbProd and AbExp (after multiplying
it by − 1), so that positive values of RM indicate income increasing real earnings management.
34 Roychowdhury (2006) includes advertising expenses as part of discretionary expenses. We exclude advertising because
it is not reported in quarterly Compustat data.

35 Our inferences are unchanged if we include observations with missing values in these analyses.

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European Accounting Review

ISSN: (Print) (Online) Journal homepage: https://www.tandfonline.com/loi/rear20

Earnings Management to Avoid Debt Covenant

Scott D. Dyreng , Stephen A. Hillegeist & Fernando Penalva

To link to this article: https://doi.org/10.1080/09638180.2020.1826337

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Published online: 21 Oct 2020.

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Full Terms & Conditions of access and use can be found at

Earnings Management to Avoid Debt

SCOTT D. DYRENG∗ , STEPHEN A. HILLEGEIST∗∗ and

(Received: 24 November 2017; accepted: 2 September 2020)

Keywords: Earnings management; Debt covenants violations; Future firm performance

© 2020 European Accounting Association

rights to impose operational changes that enhance the likelihood of repayment.

3. Research Methodology and Earnings Management Proxies

Performancet, t+4 = Intercept + β1 ∗ Violationt + β2 ∗ EMt + β3 ∗ Violationt ∗ EMt + εt

4. Sample Construction and Descriptive Statistics

4.2. Propensity Score Matching

Violation = f (Constant, LnAssets, Debt/Assets, Cash/Assets, Equity, Current Ratio,

Earnings Management to Avoid Debt Covenant Violations and Future Performance

Table 2. Logit regression of the first step of the

Dependent Variable Violation

Table 3. Summary statistics for the matched sample

5. Covenant Violations, Earnings Management, and Post-violation Performance

Earnings Management to Avoid Debt Covenant Violations and Future Performance

(1) ∆ROA 1.00

(A) (B) (C) (D) (E) (F) (G) (H)

Earnings Management to Avoid Debt Covenant Violations and Future Performance

Reconciliation with Nini et al. (2012)

Event months [0] [ + 1, + 3] [ + 1, + 6] [ + 1, + 12] [ + 1, + 24]

Summary and Conclusions

Supplemental Data and Research Materials

Appendix B: Estimation of earnings management proxies

it is not reported in quarterly Compustat data.

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