Earnings management may be used to avoid a technical default of a covenant under a loan agreement. Loan covenants are written into loan agreements in order to protect a lender form various actions that a borrower might undertake. These covenants often require attainment of certain target financial ratios – calculated using reported GAAP numbers. Failing to achieve these minimum target ratios, and hence falling into technical default, can be very costly to a firm. Earnings management to prevent a technical default will likely save a corporation and its shareholders form experiencing a large loss in market value , without necessarily providing any direct personal benefit to the company’s managers. Is earnings management to avoid a loan covenant violation an ethical breach by management?
If a breach looks inevitable, what actions, other than earnings management, could management take?