The Proximity to Debt Covenant Violation and Earnings Management — A Neuroscience Evidence

This study uses a neuroscience experimental approach to evaluate managerial decision-making processes with respect to the proximity of violating debt covenants. The literature on debt covenant violation and earnings management posits that managers have incentives to manage earnings upward in periods prior to or concurrent with default to avoid the significant costs of technical default. This study argues that this behavior could be ascribed to differences in managers’ cognitive functions of evaluating and processing the information in proximity to violating debt covenants. Neuroscience research demonstrates that the ventral striatum (VS) brain regions in the limbic system are responsible for integrating information related to emotion and motivation, facilitating goal-directed motor behaviors, and influencing cognitive function and decision-making. We investigate whether managers’ VS brain activation reacts to this emotion-related information during earnings management decisions. We utilize functional magnetic resonance imaging (fMRI) to conduct an experiment with 52 managers who undergo fMRI scanning while making decisions regarding debt covenant scenarios. We find an inverse relationship between the proximity to debt covenant violations and VS brain activation. The findings provide initial evidence that emotion-related information of proximity to debt covenant violation affects brain activation when managers engage in earnings management.