Earnings management and firm financial motives: A financial investigation of UK listed firms

This study focuses on the investigation of motives for and characteristics of UK firms that engage in earnings management activities. It concentrates particularly on the provision of voluntary accounting disclosures, the violation of debt covenants, management compensation, and on the equity and debt capital needs of firms and their relation with the use of earnings management. The study examines also the earnings management inclination of firms that seek to meet or exceed financial analysts' forecasts. The findings generally indicate that firms with low profitability and high leverage measures are likely to use earnings management. Also, firms that are in equity and debt capital need and are close to debt covenant violation also appear to be inclined to employ earnings management practices. Likewise, firms tend to use earnings management to improve their financial numbers and subsequently reinforce their compensation and meet and/or exceed financial analysts' earnings forecasts. In contrast, the study shows that firms that provide voluntary accounting disclosures appear to be less inclined to make use of earnings management.     

Do IFRS Reconciliations Convey Information? The Effect of Debt Contracting

We examine whether earnings reconciliation from U.K. generally accepted accounting principles (GAAP) to International Financial Reporting Standards (IFRS) convey information. As a result of debt contracting, mandatory accounting changes are expected to affect the likelihood of violating existing covenants based on rolling GAAP, leading to a redistribution of wealth between shareholders and lenders. Consistent with this prediction, we find significant market reactions to IFRS reconciliation announcements. These market reactions are more pronounced among firms that face a greater likelihood and costs of covenant violation and early announcements. While the association between later announcements and weaker market reactions is consistent with contractual implications of technical changes to earnings, which investors quickly learn to predict, it is inconsistent with IFRS forcing all firms in the sample to reveal firm-specific information through accruals. Thus, by showing that mandatory IFRS also affects debt contracting, we expand on existing IFRS research that focuses on how accounting quality and cost of capital are impacted.     

Direct Evidence on the Informational Properties of Earnings in Loan Contracts

Using a sample of firms that disclose the realizations of earnings used for determining covenant compliance in loan contracts, we provide direct evidence on the informational properties of earnings used in the performance covenants included in debt contracts. We find that the earnings measure used in performance covenants does not exhibit asymmetric loss timeliness and has significantly greater cash flow predictive ability than GAAP measures of earnings. We suggest that these results reflect the idea that contracting parties design accounting rules for performance covenants to enhance their efficacy as “tripwires.”     

The Ex‐Ante Monitoring Role of Accounting Covenants in Public Debt

In contrast to what is known about accounting covenants in private debt, little empirical evidence on the role of accounting covenants in public debt exists. Diffuse ownership, arm's length monitoring, and collective action problems are unique to the public debt setting and raise the question of whether these covenants serve their intended role. As such, this study investigates whether including covenants reliant upon accounting inputs influences borrowers’ actions to prevent adverse credit events. Accounting covenants in the public debt setting provide firms with a disciplining mechanism to renegotiate ahead of costly technical default – a stark contrast to the ex‐post renegotiation ‘trip wire’ role covenants play in private debt. In particular, the results show that including accounting covenants in public debt is associated with an increased probability of ex‐ante renegotiation, that is, negotiation through consent solicitations ahead of covenant violation. This ex‐ante renegotiation, in turn, is associated with decreased adverse credit events. Cross‐sectional results support these findings as the ex‐ante renegotiation role of accounting covenants varies with bondholders’ and trustees’ monitoring ability.     

Stock market listing status and real earnings management

This study analyzes real earnings management among privately held versus publicly listed firms. Our first finding is that public firms engage in more earnings management through operating activities. When a clear incentive to manage earnings in a specific direction is present we continue to find that public firms manage their earnings more than private firms. We reason that capital market pressure and ownership characteristics drive our results. Additional analyses reveal that public firms employ more real earnings management as a proportion of the total earnings management strategy. Furthermore, we find that mitigating factors of real earnings management have stronger impact in public firms. This study contributes to literature on non-accrual earnings management and to the broader understanding about the private vis-à-vis public firm reporting and operating behavior. Finally, we contribute by identifying an important societal cost of stock market listing, which is the increase in potentially value-destroying real earnings management.     

The effect of the interest coverage covenants on classification shifting of revenues

ABSTRACT

While prior studies focus on real/accrual-based earnings management and expense misclassification to investigate earnings manipulation in avoiding covenant violations, this paper extends such research in a new direction. In particular, it examines whether firms employ classification shifting of revenues when they are subject to interest coverage EBITDA-based covenants close to their threshold values or limits. This earnings management tool allows firms to increase reported EBITDA by misclassifying non-operating revenues as operating revenues to remain within covenant limits that include EBITDA. Using a sample of 559 UK listed firm-years for the period 2005–2014, it establishes that the use of classification shifting of revenues is high when interest coverage covenants are close to their limits. Further analysis suggests that firms also employ revenue shifting when all their loan covenants are EBITDA-related.     

Debt contracting and the goodwill debate

Extant literature offers mixed evidence on the quality of goodwill after the promulgation of SFAS 141/2 (Li and Sloan, 2017; Lee, 2011; Chen et al., 2008). We reconcile these conflicting findings by examining the role of managerial incentives in determining the efficacy of SFAS 141/2 in improving the quality of goodwill reporting. Using the context of debt contracting, we find that the value-relevance of goodwill is higher for firms that include goodwill in debt covenants in the post-SFAS 141/2 period. We also find that in the post-period, firms that include goodwill in their debt contracts appear to take timelier impairments. In addition, debt contracts in these firms also have tighter covenant thresholds, further corroborating the increased value-relevance of goodwill under the current impairment regime. We also document a relatively higher frequency of covenant violation for firms that use goodwill in their debt contract in the post-SFAS 141/2 period. Taken together, our results inform ongoing discussions regarding the accounting for goodwill and provide new insight into understanding of debt contracting and the role of accounting standards therein.     

Real earnings manipulation and future performance: A revisit using quarterly data of firms with debt covenants

We investigate the implications of real earnings manipulation (REM) and reversals of REM on firms’ future operating performance using quarterly data of firms with debt covenants. In the presence of debt covenants, firms are under persistent pressure to deliver financial results that exceed the thresholds of the debt covenant requirements. We find that REM is associated with lower future operating performance. More importantly, the reversals of REM in the following quarter have an incremental positive effect on future performance, which largely offsets the negative effect of REM. These results provide new evidence on REM reversals that differs from the existing literature. Instead of interpreting the reversals as an indication of true REM based on their negative association with future performance documented in Vorst (2016), our results suggest that REM reversals may be indicative of firms rewinding REM subsequently, which reduces the REM damage to firms’ future operations.     

Debt covenants and asset versus equity acquisitions

We examine whether the presence of loan covenants leads firms to choose either an asset or equity acquisitions. Asset acquisitions involve the selective purchase of a target company's assets, and equity acquisitions involve acquisitions of common stocks. We document that firms with loan covenants are more likely to engage in asset acquisitions as opposed to equity acquisitions. Our results are robust to alternative measures of loan covenants and to endogeneity concerns. Furthermore, the association between loan covenants and asset acquisitions is stronger among firms with greater debt covenant intensity, more severe agency problems, and lower profitability. Acquirers facing more intense competition within their industries are also likely to choose asset acquisitions. Our findings suggest that acquirers' incentives to avoid wealth transfer at the expense of debtholders drive the relation between debt covenants and choice of acquisition structure.     

Debt covenants in Japanese loan markets: in comparison with the traditional relationship banking

This study investigates determinants of debt covenants in Japanese loan markets. We focus on a unique monitoring mechanism by Japanese banks and hypothesise that debt covenants substitute for the traditional main bank governance. Consistently, we find that debt covenants are less likely to be used for firms with stronger ties with their main banks. We also document that such use of debt covenants results in borrower’s upward earnings management. Overall, our evidence suggests that, in the Japanese context, debt covenants are used as a substitute for the main bank system yet they alone are an incomplete monitoring mechanism.     

Creditor control rights and resource allocation within firms

We examine the within-firm resource allocation and restructuring outcomes at firms violating debt covenants. Using establishment-level data from the US Census Bureau, we find that covenant violations are followed by reductions in employment, investment, and more frequent establishment closures among violating firms’ noncore business lines and less productive establishments. These changes are concentrated among establishments at which manager-shareholder agency costs are pronounced and when key lenders have industry experience. Our findings suggest that enhanced creditor control reduces managerial agency costs and encourages a more efficient allocation of resources within the boundaries of firms in technical default.     

Do UK firms manage earnings to meet dividend thresholds?

This paper examines earnings management by dividend-paying firms in cases where pre-managed earnings would fall below the expected dividend, and by non-dividend paying firms aiming to avoid reporting losses. We find that within the UK market the likelihood of upward earnings management is significantly greater in the former case than the latter, though both are drivers for earnings management. Large firms are less likely to upwardly manage earnings to reach dividend thresholds, consistent with prior UK evidence on the ability of the largest firms to avoid restrictive debt covenants. We also find that earnings management is more clearly observable through examining working capital discretionary accruals than through examining total discretionary accruals.     

Debt Covenants and Accounting Conservatism

Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision-making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers' abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if the accounting system recognizes economic losses in earnings in a timely fashion. Thus, the demand for timely loss recognition should increase with a contract's reliance on covenants. Consistent with this conjecture, I find evidence that reliance on covenants in public debt contracts is positively associated with the degree of timely loss recognition. I also find evidence that the presence of prior private debt mitigates this relationship.     

The role of audit verification in debt contracting: evidence from covenant violations

We investigate the role of audit verification in the resolution process following debt covenant violations. Using two sets of proxies for demand—audit fees and the independence and diligence of audit committees—we find evidence that covenant violations result in a demand for differentially higher levels of audit verification. Further analyses demonstrate the link between the increased demand for audit verification and the mechanisms designed to control agency costs in debt contracts. We document cross-sectional variations in the observed fee differential with respect to the level of reliance on financial covenants, the type of covenants violated, and waiver decisions. Moreover, we find that the observed audit fee increases are associated with more favorable movements in borrowing costs and the adoption of more conservative investment policies post violation. Our findings suggest that covenant violations increase the demand for audit services to help control contracting costs post violation.     

Growth Opportunities and the Choice of Leverage, Debt Maturity, and Covenants

We investigate the effect of growth opportunities in a firm's investment opportunity set on its joint choice of leverage, debt maturity, and covenants. Using a database that contains detailed debt covenant information, we provide large‐sample evidence of the incidence of covenants in public debt and construct firm‐level indices of bondholder covenant protection. We find that covenant protection is increasing in growth opportunities, debt maturity, and leverage. We also document that the negative relation between leverage and growth opportunities is significantly attenuated by covenant protection, suggesting that covenants can mitigate the agency costs of debt for high growth firms.     

Reversing an impairment loss and earnings management: The role of corporate governance

This paper examines whether the reversal of a previously recognized impairment loss provides an opportunity for earnings management, and whether such behavior is associated with managers' incentives. It also examines whether a corporate-governance mechanism can mitigate this behavior. Since 2005, listed companies in Taiwan have been required to comply with accounting standards, equivalent to International Accounting Standards (IAS) No. 36 “Impairment of Assets,” which allow reversals of asset-impairment losses. Data on a sample of 55 firms that reversed impairment losses between 2005 and the first quarter of 2007 were matched by industry and size with 55 control firms. Empirical results show that firms recognizing more impairment losses are more likely to reverse impairment losses when doing so would avoid an earnings decline in a subsequent period, which is consistent with the “cookie jar” reserve hypothesis. We also show that such behavior is more pronounced for firms with higher debt ratios, consistent with earnings management being associated with the incentive to avoid violation of debt covenants. However, an effective corporate governance mechanism could mitigate such behavior. Our study may contribute to the debate on global convergence with IFRS, especially convergence between IFRS and U.S. GAAP with respect to the “Impairment of Assets,” by providing a rationale for the latter's prohibition of reversals. It may also contribute to the corporate-governance literature by showing the effect of governance mechanisms on deterring earnings management.     

Precision in Accounting Information, Financial Leverage and the Value of Equity

Abstract:  Using an equity valuation model characterized by periodic imperfect accounting information, we examine how financial leverage affects a firm's accounting quality choice (i.e., precision). We find that the existence of financial leverage motivates firms with average to good performance to prepare accounting information with a high degree of precision. However, we conclude that when a firm is performing poorly it has an incentive to reduce accounting precision in order to lower the likelihood of both a debt covenant violation and the detection of accounting bias.     

Large–Sample Evidence on the Debt Covenant Hypothesis

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

Fair Value Accounting and Debt Contracting: Evidence from Adoption of SFAS 159

We examine how fair value accounting affects debt contract design, specifically the use and definition of financial covenants in private loan contracts. Using SFAS 159 adoption as our setting, we find that a small but significant proportion of loans (14.5%) modify covenant definitions to exclude the effects of SFAS 159 fair values. Only a limited number of these modifications exclude assets elected at fair value (less than 7%), while all exclude liabilities elected at fair value. Notably, we document that covenant definition modification is unassociated with ex ante fair value elections. We find that covenant definition modification positively varies with common incentive problems attributed to fair value accounting and negatively varies with benefits attributed to fair value accounting. Our results suggest that fair value accounting is not uniformly detrimental for debt contracting and fair value adjustments are included when they are most likely to improve performance measurement.     

Bank debt covenants and firms’ responses to FAS 150 liability recognition: evidence from trust preferred stock

We examine the relation between accounting-based debt contracts and the economic response of firms with trust preferred stock (TPS) to mandated liability recognition under Financial Accounting Standard (FAS) 150. Our results show that firms’ financial covenants significantly affect their choice to redeem versus reclassify their outstanding TPS. Specifically, firms with bank debt covenants that would be adversely impacted by recognizing TPS as a debt liability are 26.88% more likely to redeem their TPS after FAS 150. We also find that firms are significantly more likely to redeem versus reclassify their TPS after FAS 150 if they used the original TPS proceeds to retire existing debt (id est, to enhance their balance sheets). Our findings suggest that when bank debt contracts use “floating” Generally Accepted Accounting Principles (GAAP) to construct financial covenant terms, changes in the underlying GAAP measure significantly influence firms’ economic behavior.