This study investigates whether the variation in the expected costs of technical default leads managers to manipulate earnings in periods prior to, as well as in, the year in which avoidance of technical default becomes unlikely. We argue that managers have private information about the expected costs and consequences of default and, prior to default, condition their decisions about accounting choice and discretion on these expectations. We provide evidence on the endogeneity of two forms of discretion in accounting choices in the context of testing the debt covenant hypothesis. We document that both forms of earnings management are associated with a lower cost of technical default. Our findings also suggest earnings management is less likely when the expected cost of technical default is low, and such decisions are associated with a lower default cost for firms that actually enter technical default.

There are currently no statutory remedies for the double taxation of a taxpayer or transaction, only a judicial doctrine known as equitable recoupment. Equitable recoupment can be used by either a taxpayer or the government to avoid unjust enrichment caused by enforcement of the statute of limitations. It involves a single transaction subject to two different legal theories of taxation, a claim barred by the statute of limitations, and a sufficient identity of interest between the taxpayers. Until recently, equitable recoupment could be raised in District Court and the Court of Federal Claims, but the jurisdiction of the Tax Court in such matters was uncertain. The enactment of a new tax provision in 2006 allows taxpayers to avoid having to sue for a refund and enables them to seek relief in Tax Court. This is particularly helpful for taxpayers who do not have the resources to pay a tax and then file a claim for refund, especially in light of the new enforcement efforts on the part of the IRS. This article provides a judicial history of equitable recoupment, an explanation of the recent statutory change, and a discussion of the implications for taxpayers and tax practitioners.