Timely “Gain Recognition” in Debt Contracting – Evidence from Cost Savings and Synergy Add-backs

Abstract

In this paper, I study the inclusion of cost savings and synergy add-backs (cost-synergy add-backs hereafter) in loan contracts. Such add-backs allow borrowers to add unrealized cost savings and synergy gains into contractual earnings calculations and thus reflect timely gain recognition in debt contracting. I find that the implications of cost-synergy add-backs depend on lender incentives, which vary with loan market segments. In the non-leveraged loan market where banks perform monitoring, lenders include cost-synergy add-backs to enhance earnings informativeness. By contrast, in the leveraged loan market where non-bank lenders tend to reach for yield and banks may lack monitoring incentives, lenders take on hidden risks through cost-synergy add-backs in an overheated market. Taken together, my results suggest that timely gain recognition in the form of cost-synergy add-backs enhances contract efficiency in non-leveraged loans and distorts contract efficiency in leveraged loans.