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The Effect of Litigation Risk on Earnings Management in the Proximity to Debt Covenant Violation
Název práce v češtině: The Effect of Litigation Risk on Earnings Management in the Proximity to Debt Covenant Violation
Název v anglickém jazyce: The Effect of Litigation Risk on Earnings Management in the Proximity to Debt Covenant Violation
Klíčová slova anglicky: Litigation risk; Real earnings management; Accounting earnings management; Debt covenant violation; Technical default
Akademický rok vypsání: 2017/2018
Typ práce: bakalářská práce
Jazyk práce: angličtina
Ústav: Institut ekonomických studií (23-IES)
Vedoucí / školitel: Jiří Novák, M.Sc., Ph.D.
Řešitel: skrytý - zadáno vedoucím/školitelem
Datum přihlášení: 11.10.2017
Datum zadání: 11.10.2017
Datum a čas obhajoby: 10.09.2018 09:00
Místo konání obhajoby: Opletalova - Opletalova 26, O105, Opletalova - místn. č. 105
Datum odevzdání elektronické podoby:31.07.2018
Datum odevzdání tištěné podoby:31.07.2018
Datum proběhlé obhajoby: 10.09.2018
Oponenti: RNDr. Michal Červinka, Ph.D.
 
 
 
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Seznam odborné literatury
Chung, H., Wynn, J. and Yi, H. (2013). Litigation risk, accounting quality, and investment efficiency. Advances in Accounting, 29(2), pp.180-185.
Kim, Irene. (2015). Directors’ and Officers’ Insurance and Opportunism in Accounting Choice. Accounting & Taxation, v. 7 (1) pp. 51-65, 2015.
Franz, D., HassabElnaby, H. and Lobo, G. (2013). Impact of proximity to debt covenant violation on earnings management. Review of Accounting Studies, 19(1), pp.473-505.
Jones, J. (1991). Earnings Management During Import Relief Investigations. Journal of Accounting Research, 29(2), p.193.
Cohen, D. and Zarowin, P. (2010). Accrual-based and real earnings management activities around seasoned equity offerings. Journal of Accounting and Economics, 50(1), pp.2-19.
Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of Accounting and Economics, 42(3), pp.335-370.
Kothari, S., Leone, A. and Wasley, C. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39(1), pp.163-197.
Předběžná náplň práce v anglickém jazyce
Research question and motivation
Bank loan agreements include covenants to mitigate agency costs faced by the lender. Technical default gives lenders the option of accelerating the loan repayment schedule, restricting the availability of credit, or modifying the cost of capital. According to the covenant-based hypothesis, firms have incentives to meet debt covenants to avoid a technical default. They may use accounting earnings management (AEM), real earnings management (REM) or both to do so. Ultimately, the quality of the financial statements, portraying the economic performance and condition of the companies, is affected by both AEM and REM. It is thus crucial to determine the factors that limit firm’s ability to manage earnings, and one of such factors proposed and investigated in the prior research is litigation risk.

Contribution
I will add to the literature on effects of litigation risk on earnings management by examining litigation risk as a factor affecting the relation between proximity to debt covenant violation and earnings management. I anticipate litigation risk to have a restricting effect on the overall (total) level of earnings management (TEM) for firms close to a violation or in technical default of their debt covenants. Consistent with previous research on relation between proximity to debt covenant violation and earnings management I also expect a trade-off between REM and AEM to avoid violation of debt covenants in the presence of litigation risk.

Hypotheses
1. Litigation risk reduces total earnings management for firms with substantial debt covenant incentives
2. Firms close to a violation or in technical default of their debt covenant are less likely to engage in upward accounting earnings management in the presence of litigation risk.
3. Firms close to a violation or in technical default of their debt covenant are more likely to engage in real earnings management in the presence of litigation risk.

Methodology
Following Chung et. al. (2013) I will use abnormal Directors & Officers (D&O) liability insurance coverage limits to measure expected litigation risk.
I will follow procedure by Roychowdhury (2006) to model abnormal discretionary expenses, abnormal production costs and abnormal cash flow from operations and measure REM as the sum of these three components
To measure AEM, I will follow the procedure in Kothari et. al. (2005). First, I will estimate modified Jones (1991) model discretionary accrual. Then I will match each firm in the experimental sample based on two-digit SIC code, year and closest return on assets, thus extending and adjusting modified Jones model for performance through performance matching.
To evaluate overall changes in earnings management (TEM), I will combine a measure of REM with a measure of AEM.
I will then proceed with hypotheses testing and evaluation of results.

Outline
1. Introduction
2. Related literature and empirical predictions
3. Research design, sample and data
4. Data analysis and empirical results
5. Summary and conclusions
 
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