EARNINGS MANAGEMENT TO AVOID DEBT COVENANT VIOLATIONS: EVIDENCE FROM BRAZIL
DOI:
https://doi.org/10.22561/cvr.v32i2.5971Keywords:
financial covenants, earnings management, debt covenant violations, bondsAbstract
Debt covenant violations implies several negative economic consequences for company. Consequently, the risk of breaching covenants tends to incentive companies to adopt accounting strategies to avoid this situation. International studies show that managers can use alternative accounting strategies to avoid covenant violations, including changes in accounting policies, earnings management or real earnings management. This research analyzes the relation between the proximity to debt covenant violation and the earnings management using discretionary accruals, with the purpose to test whether Brazilian companies use discretionary accruals to avoid covenant violations. We used panel data analyses with 1223 quarterly observations, corresponding to 100 companies listed on the Brazilian Stock Exchange that issued bonds among 2010-2016. The financial covenants analyzed consisted in the following financial indicators: Net Debt/EBITDA and Net Debt/Book value of Equity. We find evidence that managers use discretionary accruals to increase earnings and, thereby, to avoid debt covenant violations as they become closer to threshold. Our contribution to literature is to identify that Brazilian companies use implicit accounting choices as an alternative to changes in explicit accounting policies, such as disclosed in companies’ Notes, to try to avoid covenant violations. This research opens the way for further testing of this relationship in Brazil, since the results signaling a possible managers’ preference to use discretionary accruals rather than explicit changes in accounting policies to avoid covenant violation.
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