Influence of financial situation and earnings management on violation of financial covenants by insolvent companies: Evidence from Brazil

Abstract Purpose: To analyze the influence of financial situation and earnings management on the probability of breaching financial covenants. Originality/value: This study stands out for its innovative approach to analyzing the probability of breaching financial covenants, specifically focusing on insolvent companies. The relevance of our research lies in the recognition that previous studies, such as those by Oliveira et al. (2020), Duarte et al. (2020), and Konraht and Colauto (2021), have underestimated the importance of financial condition as a critical factor in the probability of breaching financial covenants. Therefore, this article seeks to fill this gap and contribute to a more comprehensive understanding of earnings management practices in these companies in financial distress. Design/methodology/approach: The sample consists of 1,369 obser-vations of publicly traded Brazilian companies from 2010 to 2019 in an unbalanced panel to cover the listed companies. The data were downloaded from the Economatica database and retrieved from the explanatory notes. Four models were used to measure firms’ insolvency level, using the Dechow et al. (1995) metric to measure discretionary accruals and applying logistic and linear regressions with year-fixed effect to analyze the results. Findings: The analysis reveals that firms experiencing insolvency are significantly more prone to breach financial covenants both in the present and subsequent periods. Additionally, the data shows that these firms tend to exhibit higher levels of discretionary accruals during years when they do not breach any financial covenants. This suggests that insolvent firms strategically employ accounting practices to reduce the likelihood of covenant violations.