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 from 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 from 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?