The Relation Between Incentives to Avoid Debt-Covenant Default and Insider Trading Messod D. Beneish, Eric Press and Mark E. Vargus * This Draft: April 23, 2001 COMMENTS WELCOME PLEASE DO NOT QUOTE WITHOUT PERMISSION Abstract: We use a sample of firms that experience technical default to investigate whether an observable managerial action, managers’ trading, is useful in (1) determining the existence of pre-default earnings management, and (2) in assessing whether specific contract modifications in renegotiated debt agreements are costly. We find income-increasing accruals and unexpected accruals in the year preceding the year of default of magnitudes sufficient to forestall default. We show, however, that the significant income-increasing accruals and unexpected accruals occur only in firms in which managers engage in abnormal insider selling. Our evidence suggests that by managing earnings to delay the onset of default, managers sell their equity-contingent wealth at higher prices. Finally, our evidence implies that renegotiated debt provisions—such as additional covenants and restricted borrowing—are costly for firms with greater investment opportunities prior to default. * Indiana University, Kelley School of Business; Temple University, Fox School of Business; and University of Southern California, Leventhal School of Accounting, respectively. We have benefited from helpful comments and discussions with Steve Balsam, Morris Danielson, Mark DeFond, Jagan Krishnan, Jayanthi Krishnan, Jerry Salamon, and workshop participants at the University of Southern California, and Temple University. We also thank CDA/Investnet for data used in this study. Any remaining errors are our own.