less than expected.

These results are consistent With the debt covenant

hypothesis, time they suggest that managers choose accounting policies to
maintain their covenant ratio. so as to meet or exceed the levels required.

This tendency to maintain zero or positive slack is particularly strong for quarter:
leading up to and including a first covenant violation. DS pointed out that the
costs of an initial violation are higher than for subsequent violations, since the
lender will quickly take action to protect its interests, and much of the damage to
manager and firm reputa tion occurs when a Violation first occurs. Consistent
with these higher costs, the evidence suggests that managers work particularly
hard to manage covenant ratios so as to avoid an initial violation. This finding
supports PATs assumption that managers are rational-we would expect
managers to work harder when the costs of failure are higher.

With respect to the political cost hypothesis, much empirical investigation has
been based on firm size-larger firms are more subject to political scrutiny.
However, this meas ure of political cost is complicated by the correlation of size
with other firm characteristics, such as profitability and risk. Also, the bonus plan
and debt covenant hypotheses work in the opposite direction to size in their
accounting policy predictions, so that it is necessary to control for their effects.

These considerations suggest that empirical investigation of the political cost

hypothesis should look at situations where political costs are particularly salient.
One such situation occurs when firms are under pressure from foreign imports.

Jones (1991) studied the actions of firms to lower reported net income during
import relief investigations. The granting of relief to firms that are affected by
foreign competition is, in part, a political decision. Trade legislation allows for the
granting of assistance such as tariff protection to firms in industries that are
unfairly affected by foreign compev tition. In the United States, the International
Trade Commission (ITC) is responsible for investigating whether there is injury.
This investigation will consider economic factors such as sales and profits of
affected firms. However, there is also a considerable political dimension to the
granting of relief, since consumers will end up paying higher prices, and there
may be retaliation by foreign countries. A determination of injury by the ITC goes
initially to the president, who has 60 days to decide whether to grant relief. If
relief is not granted, Congress may step in and override the president.

Thus, it is by no means clear that a deterioration of profitability is sufficient for

relief to be granted. As a result, affected firms have an incentive to choose
accounting policies to lower their reported net income even more, so as to
bolster their case. Of course, this incentive will be known to the lTC, politicians,
and the public. However, as Jones points out, these constituencies may not have
the motivation to adjust for any downward manipulation of earnings. For
example, the effect of higher prices that would follow the granting of relief to an
industry may not be sufficiently great for it to be cost effective for consumers to
lobby against it. Even the ITC may not be fully motivated to adjust for
manipulation of earnings if it was a priori sympathetic to the petitioning firms.
These disincentives to unwind any earnings manipulation are strengthened if it is
difficult to detect.