The Impact of Financial Covenants in Private Loan Contracts on Classification Shifting

Abstract

This study examines whether firms with private loan contracts that contain debt covenants based on earnings before interest, taxes, depreciation and amortization (EBITDA) are more likely to misclassify core expenses as special items (i.e., classification shift). Misclassifying core expenses as income-decreasing special items allows the firm to increase EBITDA and thereby potentially avoid debt covenant violations. After controlling for the potential endogeneity of having an EBITDA-related covenant, we show that classification shifting is more likely to occur (1) when loan contracts include at least one EBITDA-related covenant, (2) as the number or proportion of EBITDA-related covenants increases, and (3) when the firm is close to technical violation of at least one EBITDA-related covenant. In contrast, we do not find evidence that non-EBITDA-related financial covenants (i.e., balance sheet covenants) impact expense classification shifting. While prior research on classification shifting focuses primarily on equity market incentives (e.g., meeting analysts’ earnings forecasts), our study extends this research to private loan contracts to highlight that creditors also affect classification shifting. Classification appears to be an additional earnings management technique used by managers to avoid debt covenant violations.