The Impact Of Debt Covenant On The Choice Of Accrual Earnings Management And Real Earnings Management

According to the modern enterprise theory, the enterprise is composed of a series of covenants. Debt covenant is signed to solve the conflict between shareholders and creditors, and protect the rights of creditors. Debt Covenant Hypothesis predicts that firms with higher debt levels are more likely to manage earnings in order to avoid possible future debt covenant violations (Watts and Zimmerman,1986). Based on Debt Covenant Hypothesis, many scholars studied the governance effects of debt covenant, but all of them concentrated on the accrual earnings management method. In fact, managers may prefer real earnings management to accrual earnings management to avoid debt covenant violations, even though real earnings management is more harmful to the enterprise. As the possibility of debt covenant violations increase, managers have more motivation to decorate accounting information, and at the same time the creditors will carry out more supervision. As a result, accrual earnings management is potentially more costly to managers than real earnings management. This paper studies the impact of debt covenant on the choice of accrual earnings management and real earnings management, in the hope that it can rich the studies on earnings management from a new point of view, and also benefit to perfect creditors governance mechanism.Started with the debt covenant motivation of earnings management, this paper analyzed the changes of earnings management motivation and creditors’ supervision motivation with the increase of the possibility of debt covenant violations, and concluded the impact of debt covenant on the choice of accrual earnings management and real earnings management. System background can exert an influence on the debt covenant’s governance mechanism and effect. On the basis, considering the characteristic of China’s capital market, we analyzed system background such as controller’s characteristic, investor protection and new accounting principle’s impact on the choice of accrual earnings management and real earnings management. Through the empirical analysis, the results indicate that:(1) Accrual earnings management is negatively related with debt levels, and real earnings management is positively related with debt levels.(2) Both state-owned enterprises and non-state-owned enterprises prefer real earnings management to accrual earnings management with higher debt levels.(3) Compared with companies in weak investor protection environment, the negative relation between accrual earnings management and debt levels is strengthened, and the positive relation between real earnings management and debt levels is strengthened in strong investor protection’s companies.(4) the negative relation between accrual earnings management and debt levels is abated, and the positive relation between real earnings management and debt levels is strengthened in companies with the new accounting principle. The results show that creditors can inhibit accrual earnings management, and managers will use more real earnings management in the effect of debt covenant. At the same time, the special capital market environment also effect the choice of accrual earnings management and real earnings management. Based on above conclusions, this paper gives the related suggestions to improve the effectiveness of the creditors’ corporate governance, speed up the equity division reform of state-owned enterprises and improve the corporate governance environment.