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Debt Covenant Violation and Earnings Management: A Neuroscience Approach and Future Directions – A Research Note

Advances in Accounting Behavioral Research

ISBN: 978-1-78714-528-3, eISBN: 978-1-78714-527-6

ISSN: 1475-1488

Publication date: 8 September 2017

Abstract

Decision-making rationality is said to be bounded by managers’ cognitive capabilities. Recent studies indicate that accounting functions evolved to augment the cognitively bounded human brain in handling complex economic exchanges. The neuroscience discipline suggests that human brains have the ability to implement “automatic” processes of positive versus negative emotional stimuli to make rational decisions. Neuroscientific evidence shows that the activations in the ventral striatum decrease with negative emotional information/motives and increase with positive emotional information/motives. The authors, hence, argue that our understanding of the decision-making rationality in financial and managerial decisions could be enhanced by using a functional neuroimaging approach.

Decision-making rationality has been focal in debt covenant violation and earnings management research. The contracting theory predicts a relationship between managers’ decisions and the proximity of violating debt covenants. However, no prior research has investigated brain activities associated with the evaluation of debt covenant violation and earnings management. Meanwhile, in another strand of research, there is an extensive prior literature concerning the consequences of managers’ decisions and the use of accounting information in relation to their evaluative style, i.e., supervisory style. The authors argue that the relationship between the proximity to debt covenants violation and earnings management incentives is contingent upon managers’ supervisory style. However, no previous research has examined the impact of the supervisory style on earnings management in the context of the proximity to debt covenants violation and other earnings management incentives.

In this research note, we argue that neuroaccounting could be relied on to examine the relationship between the proximity to debt covenants and earnings management, contingent upon managers’ supervisory style, by capturing brain activities. The adoption of the neuroscience functional neuroimaging approach in this field should contribute to the understanding of managers’ behaviors and provide implications for research and practitioners. The goal of this research note is to provide a new avenue for future research in this field.

Keywords

Acknowledgements

Acknowledgments

We gratefully acknowledge the helpful comments received from Haitham Elsamaloty, Janet Mosebach, Michael Mosebach, Marc Simpson, Xin Wang, and Blerina Zykaj. We also appreciate the very helpful comments from Hong Xie, our neuroscience paid consultant. We would like to acknowledge the financial support received from the Center for Public Policy and Leadership, United Arab Emirates University, UAE (Code #: UAEU31R002-6306-CPPL1-2013) and the technical support provided by the University Hospital, University of Toledo, Toledo, OH, USA.

Citation

HassabElnaby, H.R., Abdel-Maksoud, A. and Said, A. (2017), "Debt Covenant Violation and Earnings Management: A Neuroscience Approach and Future Directions – A Research Note", Advances in Accounting Behavioral Research (Advances in Accounting Behavioural Research, Vol. 20), Emerald Publishing Limited, Bingley, pp. 63-78. https://doi.org/10.1108/S1475-148820170000020003

Publisher

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Emerald Publishing Limited

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