Debt Covenant Slack And Real Earnings Management

Most of traditional research of earnings management focused on discretional accruals, which studies on managers’behavior that using accounting flexibility to manipulate earnings. Whatever, except taking advantage of discretional accruals to influence the distribution of earnings, managers also can manipulate earnings through constructing real business activities, which is called Real Earnings Management (REM).Compared to the systematic accruals earnings management, the study of real earnings management is still in the initial stage, especially in China. Actually, with the implementation of the new accounting standards in China, accounting flexibility is shrinking, accounting supervision is constantly strengthening. These make enterprises difficult to manipulate earnings through accruals earnings management, which making enterprises to seek a new way to manipulate earnings.Based on the research background, this essay focuses on firms’motivation to avoid debt default, and discusses the existence of real earnings management. This study not only enriches the literatures of REM, but also help stakeholders, especially the creditors, have a more comprehensive understanding on REM, bringing new opportunities for games between managers and other stakeholders.According to the existing conclusion on discretional accruals, this paper hypothesizes that in order to avoid covenant violation, firms with tighter debt covenant slack are more likely to manipulate real activities. What’ more, firms are more likely to manipulate real activities when they are closer to the debt covenant threshold. Based on the above hypotheses, we consider the effect of growth uncertainty. Considering the information theory, this paper hypothesizes that firms are very close to the debt covenant threshold, the greater growth uncertainty they are facing, the more likely to manipulate real activities, hoping to signal good prospects about firms’ future development. The empirical results show that listed firms with tighter debt covenant slack are more likely to manipulate real activities, and mainly use cost manipulation and cash flow manipulation. They are more likely to manipulate real activities when they are closer to the debt covenant threshold, and mainly use cash flow manipulation instead. Contrary with our hypothesis, the results show that firms are very close to the debt covenant threshold, when they are facing greater growth uncertainty,they unwilling to manipulate real activities, while they would manipulate earnings through discretional accruals instead. This suggests that enterprises will consider the implementation capacity and the consequences of earnings management to make optimal choice.