The Effect of Technical Default Cost on Discretionary Accounting Decisions

In this study, we investigate whether the variation in the expected costs of technical default provides insights into whether managers manipulate earnings in periods prior to technical default as well as in the fiscal year in which avoidance of technical default is unlikely. We argue that managers have private information about the expected costs and consequences of default, and that, prior to default, managers condition their decisions about accounting choice and accounting (accrual) discretion on these expectations. We provide evidence on the endogeneity of two forms of discretion in accounting choices (i.e., choice of accounting methods and discretion in accounting accruals) in the context of testing the debt covenant hypothesis. Controlling for the endogeneity of the two forms or earnings management, we document that both forms of earnings management are associated with a lower cost of technical default and the use of either form of earnings management tends to reduce the use of the other. Our findings also suggest that earnings management is less likely when the expected cost of technical default is low, and that, managers appear to benefit from earnings management as such decisions are associated with a lower default cost for firms that enter technical default.