Income Smoothing and Debt Covenants: Evidence from Technical Default

Abstract

We examine whether income smoothing affects the frequency of technical default in private loan contracts. We find that income smoothing is associated with a lower frequency of “spurious technical default” when the borrower’s economic performance has not declined, but the loan nevertheless enters technical default. In contrast, we find no association between income smoothing and technical default when the borrower’s creditworthiness declines — “performance technical default.” This evidence is consistent with borrowers smoothing income to reduce noise in earnings, and inconsistent with opportunistic motives. Further, we find evidence that the efficiency-enhancing effect of income smoothing is incorporated into the initial loan terms, as debt contracts to borrowers exhibiting greater income smoothing are more likely to include income statement covenants and have lower interest rates.