By Thomas Bourveau (Hong Kong University of Science and Technology), Derrald Stice (Hong Kong University of Science and Technology), and Rencheng Wang (University of Melbourne)
Little is known about how managers change their voluntary forecasting behavior as a debt covenant violation approaches. We find that management forecasts are more optimistic in the period leading up to a debt covenant violation (“DCV”), based on a sample of firms in the period before they disclose a DCV in their financial statements. Additionally, we find that managers who are most optimistic in their forecasts also take on more risk and increase dividend payouts before violations. Those managers tend to take actions consistent with last-resort efforts to delay the discovery of DCV and opportunistically engage in activities likely to be curtailed by lenders in the event of a covenant violation.
In further analyses, we partition our sample and find that managers are more likely to optimistically bias their earnings forecasts when they have a higher risk of losing control rights in the event of a DCV. Managers are less likely, however, to bias forecasts if lenders have greater ability to detect bias or if managers have higher reputation concerns. Finally, we perform additional analyses to rule out potential reverse causality and omitted variable issues. Overall, our results are consistent with managers changing their disclosure behavior in order to conceal upcoming covenant violations from debtholders and to justify taking actions that are favorable to equity investors and would likely be opposed by debtholders.
The full article is available here.