The purpose of this paper is to evaluate the extent to which firms manage earnings prior to private debt issuance.
This is an empirical archival research paper using financial statement data and data related to private debt issuance.
The results indicate that, on average, firms engage in income-increasing earnings management in the period prior to a new private debt issuance. In addition, it was found that this income-increasing earnings management is limited to firms which have engaged in income-increasing earnings management to a greater extent in prior years.
This paper provides insight into how managers’ balance competing incentives to use income-increasing earnings management to obtain more favorable lending terms, and to use income-decreasing earnings management to reduce the risk of a future debt covenant violation. The results indicate that firms’ incentive to use income-increasing earnings management dominates. However, reputational concerns significantly constrain firms’ earnings management decisions prior to private debt issuance.
The paper fills a notable void in the literature by investigating firms’ earnings management activity prior to private lending agreements, and thereby provides new insights into both the relation between private debt and accounting quality, and the literature investigating the use of earnings management to avoid debt covenant violations.
