We examine the relation between firms’ real earnings management decisions and the level of slack in their net worth debt covenants. 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 tighter slack. Also, within the sub-sample of loan-years with tighter slack, we find that real earnings management is higher for borrowers that experienced increases in bankruptcy risk in the previous year. Finally, we find that firms that manage real activities are more likely to violate debt covenant in the future. Our results suggest that firms use real earnings management to avoid costly debt covenant violations, complementing the mixed results in the literature regarding the relation between accrual earnings management and debt covenant violations. Our results are robust to controlling for endogeneity of the tightness of debt covenant slack, modeling the simultaneity in accrual and real earnings management choices, and controlling for performance as a potential driver of both slack tightness and real earnings management.

https://www.researchgate.net/profile/Mikhail_Pevzner/publication/228252871_Debt_Contracting_and_Real_Earnings_Management/links/0a85e533f2f96dba00000000/Debt-Contracting-and-Real-Earnings-Management.pdf