MEZCLADO Y AMASADO

2.5.1 The debt covenant hypothesis

Table 2.3, columns (1) to (4) present the RAM regression results for testing the debt covenant hypothesis and AM regression results are in column (5).

[Table 2.3 around here]

Column (1) indicates statistically significantly positive associations between aggregate RAM (A_RAM) and CLOSE_IC and DEFAULT_IC at the 1 percent and 5 percent levels, respectively. The coefficients are also economically significant. This implies that firms close to violation or in technical default of their interest coverage covenants use more RAM than firms far from violation of their interest coverage covenants. I also find similar results for the debt to EBITDA covenant as the coefficients on CLOSE_DTE and DEFAULT_DTE are significantly positive in column (1). Turning to the individual RAM measures, column (2) shows a significant relationship between abnormal production costs (A_PROD) and the dummy variable CLOSE_IC. This suggests that firms close to violation of their interest coverage covenants increase abnormal production more relative to firms far from violation of their interest coverage covenants. Furthermore, I find that firms close to default or in violation reduce discretionary expenses and lower abnormal cash flows more compared to firms far from violation as indicated by the significant coefficients on CLOSE_IC, CLOSE_DTE and DEFAULT_DTE in columns (3) and (4). These results are consistent with

21 _{I also check whether my covenant measure can capture imputed slack without too much noise by comparing}

my covenant slack proxy for dead firms with the one for live firms. I find that dead firms in my sample have tighter covenant slack than live firms as they have significantly smaller covenant medians (means).

the debt covenant hypothesis (Dichev and Skinner 2002; Franz et al. 2014) and indicate that firms close to violation or in technical default engage in RAM to avoid covenant violations.

Column (5) shows a significant relationship between working capital discretionary accruals (A_WCA) and DEFAULT_DTE. This indicates that firms in technical default of their debt to EBITDA covenants employ more AM than firms far from violation of their debt to EBITDA covenants.I, however, do not find such evidence for firms close to violation of their debt to EBITDA covenants or for firms in violation or close to default of their interest coverage covenants. This is probably due to the costly nature of AM under UK GAAP (Peasnell, Pope, and Young 2000; Osma and Young 2009) and after IFRS adoption (Leuz,

Nanda, and Wysocki 2003; Barth et al. 2008). My results are consistent with the findings

that the introduction of tighter and more rigid accounting standards makes RAM an appealing proxy for earnings management (Cohen et al. 2008; Zang 2012).

Overall, the findings suggest that UK firms close to violation or in technical default of their interest coverage (debt to EBITDA) covenants employ RAM and AM more but mainly the former than firms far from violation of their interest coverage (debt to EBITDA) covenants.22 Hence, P1A and P1B are supported.

2.5.2 IFRS adoption and the debt covenant hypothesis

Table 2.4, column (1) presents the RAM regression results for testing the effect of IFRS adoption on the debt covenant hypothesis while the AM regression results are in column (2).

[Table 2.4 around here]

22 _{I also analyze the total use of earnings management for avoiding covenant violations by summing the}

working capital discretionary accruals and the aggregated measure of RAM. The results show that firms close to violation or in technical default use more total earnings management than firms far from violation (see Table 2.16).

Column (1) shows that CLOSE_IC and DEFAULT_IC are significant at the 1 percent levels, showing that firms close to violation or in technical default of their interest coverage covenants use more RAM than firms far from violation of their interest coverage covenants in the pre-IFRS period. Similar results are found for the debt to EBITDA covenant in the pre-IFRS period. As can be seen in column (1), the coefficients on IFRS*CLOSE_DTE and IFRS*DEFAULT_DTE are positive though only the coefficient on the former is significant. The implication is that the use of RAM particularly for firms close to default of their debt to EBITDA covenants increases following IFRS adoption. This confirms the enhanced importance of this cash flow-based debt covenant in the UK, consistent with Chatterjee (2006) and Moir and Sudarsanam (2007). Column (1) further shows that the coefficients on IFRS*CLOSE_IC and IFRS*DEFAULT_IC are negative and insignificant. This implies that IFRS adoption does not alter the use of RAM for firms close to default or in violation of their interest coverage covenants. This is possibly due to the more or less stable use of the interest coverage covenant in UK debt contracting both in the pre- and post-IFRS periods. Finally, the results in column (2) indicate no significant association between A_WCA and the interaction variables. This indicates that IFRS adoption does not change the use of AM for firms close to violation or in technical default of their interest coverage (debt to EBITDA) covenants.

To summarize, my results indicate some evidence that mandatory IFRS adoption increases the use of RAM for firms close to default of their debt to EBITDA covenants while it leaves unchanged the use of these activities for firms close to violation or in technical default of their interest coverage covenants.23 Thus, P2A and P2B are supported.

23

I also find that mandatory IFRS adoption increases the use of total earnings management for firms close to default or in violation of their debt to EBITDA covenants while it leaves unchanged the use of these activities for firms close to violation or in technical default of their interest coverage covenants (see Table 2.17).