Bonus incentives and losses from early debt extinguishment

Abstract

An increasing number of firms repurchase debt and recognize associated accounting losses (rather than gains). However, few studies to date have examined the effect of reporting incentives on debt repurchase decisions. We examine the relation between managers' bonus incentives and the recognition of gains or losses from early debt extinguishment (EDE). Our findings indicate that managers tend to recognize disproportionately more losses from EDE when earnings before gains or losses from EDE (i.e., as-if earnings) exceed the maximum performance level set in annual bonus contracts. These results are consistent with the notion that managers' income-decreasing reporting incentives affect debt repurchases. Further analyses indicate that bonus-driven debt repurchases are associated with increases in future bonus awards, but do not significantly affect shareholder value. Overall, our results suggest that managers' bonus incentives are an important determinant of debt repurchases and the recognition of losses.