Debt covenant slack and real earnings management

We examine the relation between firms’ real earnings management decisions and the slack in their net worth debt covenant. Using private debt covenant data, we find that the overall level of real earnings management is higher when net worth covenant slack is tighter. Moreover, we find that this effect is more pronounced for loan-years with the tightest slack, which is a setting where benefits of managing earnings are greater. Within the sub-sample of loan-years with the tightest slack, we find that real earnings management is higher for borrowers that experienced increases in bankruptcy risk in the previous year. These results suggest that: (1) firms use real earnings management to avoid violations of debt covenants; and (2) that they are more likely to do so when their ability to renegotiate the technical covenant violations is restricted. Our results are largely robust to controlling for endogeneity of the tightness of debt covenant slack. Finally, we find that the positive relation between the tightness of debt covenant slack and real earnings management exists both before and after the adoption of the Sarbanes-Oxley Act.