Debt Covenant Hypothesis Research Articles

The Right Purpose on the Right Covenant: Does the Loan Purpose Affect the Debt Covenant Through the Ṣukūk Rating?

Purpose — This paper aims to determine the influence of the purpose for issuing ṣukūk (operations, financing, and investment/acquisition) on different types of debt covenants (balance sheet, income statement, and collateral-based covenants). It also examines the ability of the ṣukūk rating to mediate the relationship between loan purposes and debt covenants. Design/Methodology/Approach — The research data were 236 ṣukūk that were listed on the Indonesia Stock Exchange (IDX) until December 2020. They were collected through the IDX official website. Logistic regression and the Sobel test were used to test the direct and indirect influences among the variables studied. Findings — The results showed that loan purposes affected the types of debt covenants. Loans for operational purposes seemed to be in accordance with the debt covenant with restrictions on income statement (IS), balance sheet (BS) and collateral. Loans for investment/acquisition were more appropriate to both BS and collateral-based debt covenants, while loans for financing were better suited to BS-based debt covenants. This study also proves that the ṣukūk rating could mediate associations between loan purposes, especially for investment/acquisition, and the types of debt covenants. Practical Implication — This research is useful for ṣukūk investors to consider the investment by looking at the purposes, ratings and ṣukūk covenants. In addition, it is helpful for ṣukūk holders, represented by trustees, in determining debt covenants in the form of ṣukūk with different purposes. Research Implication — The results of this study described how accounting information improved contract efficiency. This research provided important evidence of the association between the structure of debt covenants and loan purposes. It provided empirical evidence of the debt covenant hypothesis in agency theory on the importance of designing debt contracts to reduce monitoring costs. Originality/Value — This study employed the debt covenant on ṣukūk in Indonesia. The use of the ṣukūk rating as an intervening variable between loan purpose and debt covenant has not been studied previously. This study also divided debt covenant into four types by adding the collateral-based debt covenant because ṣukūk are different from other types of debt and require underlying assets in their issuance.

Financial reporting, debt covenants and convertible debts

PurposeThis study proposes an alternative perspective on why firms issue convertible debt, to supplement the largely theoretical motives identified in the existing literature. It hypothesises that the separate presentation of convertible debt into its equity and liability components has economic consequences and advantage that explain why firms issue convertible over non-convertible debt, consistent with the debt covenant hypothesis. The purpose of this paper is to address the proposed perspective and hypothesis.Design/methodology/approachData on convertible debt, gearing (debt assets and debt equity), debt issuance and retirement, etc. were collected for a sample of 1,104 firms listed on Bursa Malaysia. Regression analyses were then used to assess the hypotheses on how gearing affects the use of convertible debt and the impacts of its use on changes in gearing over the financing cycle.FindingsFirms with higher gearing, and possibly those close to violating debt covenants, are more likely to issue convertible than non-convertible debt. In addition, the use of convertible rather than non-convertible debt both reduces the increase in gearing when debts are issued and leads to a larger decrease in gearing during debt retirements via conversion.Practical implicationsThese effects on gearing provide firms with additional financial flexibility and enhance firms' capacity to borrow more from other sources, a lower-debt advantage.Originality/valueThis study demonstrates the informational role of financial reporting in addressing the stewardship emphasis, as part of the decision usefulness objective of financial reporting in the Conceptual Framework for Financial Reporting.

The economic consequences of IFRS 16 adoption: the role of gearing restriction in debt covenants

PurposeThis study aims to examine the economic consequences of, and managerial behaviour in response to, the introduction of IFRS 16 Leases. It extends the debt covenant hypothesis to explain why firms reduce the use of operating leases with the introduction.Design/methodology/approachThis study develops a model, based on operating leases as an alternative financing source and the determinants of debt policy, to estimate the effects of gearing on operating lease intensity. High gearing is a proxy to probably closer to the violation of, or expected to violate, the gearing restriction in debt covenants given the retrospective capitalisation of operating leases, when IFRS 16 takes effect.FindingsThis study finds that operating lease intensity fell between 2011 (immediately after the first exposure draft leading to IFRS 16) and 2018 (immediately prior to the effective date of IFRS 16). It also finds that gearing affects changes in operating lease intensity over 2011 and 2018, consistent with the debt covenant hypothesis.Research limitations/implicationsThe introduction of IFRS 16 is a natural experiment with unique characteristics (the active lobbying behaviour, ex ante evidence on adverse economic consequences, a prolonged standard-setting period, etc.) valuable for accounting research.Practical implicationsA showcase about the relevance of financial reporting for contracting interests of firms and managers and a good reference for accounting standard setters in considering and managing the economic consequences of proposed accounting standards.Originality/valueThis study adds to the limited research on the consequences of accounting standards and documents the ex-post impact on firm leverage ratios and the behavioural aspects of reporting entities.

Do Borrowers Intentionally Avoid Covenant Violations? A Reexamination of the Debt Covenant Hypothesis

ABSTRACTIn this study, we replicate and extend the Dichev and Skinner [DS: 2002] study on the debt covenant hypothesis (DCH). We start by replicating DS and find results consistent with theirs. We then extend their work by changing three aspects of the research design: histogram bin width, calculation of slack, and statistical test of discontinuity. We find that the inference from DS is generally robust to varying these choices, although sensitive to different bin widths, during their sample period. We extend our analysis to the period 2000–2019 and find that support for DCH remains robust. We do, however, find a lack of support for DCH when examining the most common financial covenant, debt‐to‐EBITDA. These findings suggest a more nuanced perspective on DCH, whereby different types of financial covenants provide different incentives and abilities to avoid technical default.

A Study on Earnings Management of Zero-leverage Firms from the Perspective of Financial Constraints

Purpose: This study verifies the debt covenant hypothesis by exploring the earnings management of zero-leverage firms that are not constrained by debt covenants. Furthermore, this study investigates whether the earnings management of zero-leverage firms varies depending on financial constraints, whether a consecutive zero-leverage period is associated with the level of earnings management, and whether this association varies depending on financial constraints. Design/methodology/approach: Using a sample of 5,669 firm-year data of listed firms in the securities market in South Korea from 2011 to 2019, this study conducts multiple regression analysis to examine the earnings management of zero-leverage firms from the perspective of financial constraints. In the analysis, two types of earnings management behaviors (i.e., accrual-based and real activities earnings management) are considered. Findings: The findings of this study show that zero-leverage firms are less likely to manage earnings than leveraged firms. Moreover, the longer the zero-leverage period, the lower the level of earnings management. However, these findings disappear when the analysis is conducted for firms with financial constraints. They indicate that a zero-leverage policy or a consecutive zero-leverage period is related to earnings management and that this relation varies depending on financial constraints. Research limitations/implications: This study provides insight into the attributes of zero-leverage firms by analyzing their earnings management. The findings of this study provide compelling evidence that zero-leverage firms are not homogeneous and are significantly distinct according to their status with or without financial constraints. Originality/value: This is the first study to test the debt covenant hypothesis by investigating the earnings management of zero-leverage firms. This study also extends the literature by examining the financing decisions that maintain zero leverage for a long period.

Do Borrowers Intentionally Avoid Covenant Violations? A Reexamination of the Debt Covenant Hypothesis

Do Borrowers Intentionally Avoid Covenant Violations? A Reexamination of the Debt Covenant Hypothesis

PENGARUH PENGUNGKAPAN CORPORATE SOCIAL RESPONSIBILITY DAN LEVERAGE TERHADAP AGRESIVITAS PAJAK (STUDI EMPIRIS PADA PERUSAHAAN SEKTOR UTAMA DAN MANUFAKTUR YANG TERDAFTAR DI BURSA EFEK INDONESIA PERIODE 2014-2016)

The purpose of this research is to test whether there is influence of Corporate Social Responsibility disclosure and leverage on tax aggressiveness. The theories used in this research are Stakeholder Theory and Debt Covenant Hypothesis from Positive Accounting Theory. The type of this research is quantitative research. The population in this research is all main and manufacturing sector companies listed on the Indonesia Stock Exchange for the period 2014-2016. The total of companies selected as samples are 75 companies with the period research for three years, so the total of samples in this research are 225 samples that have been selected using purposive sampling technique. The data used in this study is secondary data in the form of annual reports of main and manufacturing sector companies listed on the Indonesia Stock Exchange for the period 2014-2016. Data collection technique used is documentation. The data analysis technique used is panel data regression. The results of this research showed that Corporate Social Responsibility disclosure has no influence on tax aggressiveness while leverage has negative and significant influence on tax aggressiveness.

Creditors and dividend policy: Reputation building versus debt covenant

Agency problem between shareholders and creditors can be reduced by two mechanisms namely reputation-building and debt covenant. Prior studies document supporting evidence for both hypotheses with a positive relationship between creditor rights and dividend policy. However, they fail to test reputation-building mechanism and debt covenant mechanism separately. This paper finds that credit information and legal rules supporting moveable assets are promising variables to fill this gap since the two mechanisms provide opposite effects of credit information and legal rules on dividend policy. With a sample of 37,673 observations collected across 39 countries over the period from 2013 to 2015 we find supporting evidence for debt covenant hypothesis and creditor information has a complementary effect on legal rules in determining corporate dividend policy.

The Impact of Going Concern on Financial Reporting Quality: Evidence from Vietnam

The investigation was conducted to contribute empirical evidence of the association between going concern and financial reporting quality of listed firms on the Vietnam stock market. Based on data from 279 companies listed on the HNX and HOSE exchanges in Vietnam for the period 2009-2015, the quantitative research. Results found that the relationship between the going concern and financial reporting quality of listed firms. Research results are significant for investors, regulators to the transparency of financial reporting information.
 Keywords
 Going concern, financial reporting quality, listed firms
 References
 Agrawal, K., & Chatterjee, C. (2015). Earnings management and financial distress: Evidence from India. Global Business Review, 16(5_suppl), 140S-154S.Bergstresser, D., & Philippon, T. (2006). CEO incentives and earnings management. Journal of Financial Economics, 80(3), 511–529.Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24(1), 99–126.Charitou, A., Lambertides, N., & Trigeorgis, L. (2007a). Earnings behaviour of financially distressed firms: The role of institutional ownership. Abacus, 43(3), 271–296.Chen, Y., Chen, C., & Huang, S. (2010). An appraisal of financially distressed companies’ earnings management: Evidence from listed companies in China. Pacific Accounting Review, 22(1), 22–41Dechow, P., & Dichev, I. (2002). The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors. The Accounting Review, 77, 35-59.DeFond, M., & Jiambalvo, J. (1994). Debt covenant violation and manipulation of accruals. Journal of Accounting and Economics, 17(1), 145–176.DeFond, M.L., & Park, C.W. (1997). Smoothing income in anticipation of future earnings. Journal of Accounting and Economics, 23(2), 115–139.Dichev, I., & Skinner, D. (2004). Large sample evidence on the debt covenant hypothesis. Journal of Accounting Research, 40(4), 1091–1123.Đinh Thị Thu T., Nguyễn Vĩnh K. (2016). Tác động của hành vi điều chỉnh thu nhập đến khả năng hoạt động liên tục trong kế toán: Nghiên cứu thực nghiệm cho các doanh nghiệp niêm yết tại Việt Nam, Tạp chí phát triển khoa học và công nghệ, Quí 3, tr.96-108.Đỗ Thị Vân Trang (2015). Các mô hình đánh giá chất lượng báo cáo tài chính, Tạp chí chứng khoán Việt Nam, 200, tr 18-21.Habib, A., Uddin Bhuiyan, B., & Islam, A. (2013). Financial distress, earnings management and market pricing of accruals during the global financial crisis. Managerial Finance, 39(2), 155-180.Jaggi, B., & Lee, P. (2002). Earnings management response to debt covenant violations and debt restructuring. Journal of Accounting, Auditing & Finance, 17(4), 295–324.Kasznik, R., (1999). On the association between voluntary disclosure and earnings management. Journal of accounting research, 37(1), pp.57-81.Lu, J. (1999). An empirical study of earnings management by loss-making listed Chinese companies. KuaijiYanjiu (Accounting Research), (9), 25–35.McNichols, M.F. and Stubben, S.R., (2008). Does earnings management affect firms’ investment decisions?. The accounting review, 83(6), pp.1571-1603.Selahudin, N.F., Zakaria, N.B., & Sanusi, Z.M. (2014). Remodelling the earnings management with the appear- ance of leverage, financial distress and free cash flow: Malaysia and Thailand evidences. Journal of Applied Sciences, 14(21), 2644–2661.Skinner, D.J., & Sloan, R. (2002). Earnings surprises, growth expectations, and stock returns or don’t let an earnings torpedo sink your portfolio. Review of Accounting Studies, 7(2/3), 289–312.Sweeney, A.P., (1994). Debt-covenant violations and managers' accounting responses. Journal of Accounting & Economics, 17(3): 281-308.Trần Thị Thùy Linh, Mai Hoàng Hạnh (2015). Chất lượng báo cáo tài chính và kỳ hạn nợ ảnh hưởng đến hiệu quả hoạt động của doanh nghiệp Việt Nam, Tạp chí phát triển kinh tế, 10, tr.27-50.Trương Thị Thùy Dương (2017). Nâng cao chất lượng báo cáo tài chính công ty đại chúng, Tạp chí tài chính, 1(3), tr.55-56.Uwuigbe, Ranti, Bernard, (2015). Assessment of the effects of firm’s characteristics on earnings management of listed firms in Nigeria, Asian Economic and Financial Review,5(2):218-228.

MANAJEMEN LABA PADA PERUSAHAAN YANG MELANGGAR PERJANJIAN UTANG

This research aims to give empirical evidence concerning earnings management in firms violating debt covenant and to test whether earnings management in those firms are larger than that in control firms. Research population is manufacturing company listed at Bursa Efek Indonesia. The sample includes 17 firms violating debt covenant and 22 firms complying debt covenant as control firms. The sampling method is purposive sampling. Method of statistics used is t-test. The statistic test of first hypothesis shows that mean of discretionary accruals at a year before violation is significantly larger than that at the year debt covenant violation. This result supports debt covenant hypothesis. But, mean difference at the year of violation and at a year after violation does not provide the support for the hypothesis. The statistic test of second hypothesis shows that mean of discretionary accruals of firms violating debt covenant at a year before and at the year violation of debt covenant is significantly larger than that of control firms. Thus, we can conclude that violation of debt covenant motivate management to perform earnings management.

Do debt covenant violations serve as a risk factor of ineffective internal control?

We examine whether debt covenant violations serve as an important determinant of material weaknesses in internal control over financial reporting. Motivated by the debt covenant hypothesis, we posit that the probability of ineffective internal control is expected to be significantly higher for firms with debt covenant violations than for firms without the violations. Equivalently, a covenant violation implies an increasingly unseen firm risk related to internal control ineffectiveness: violating firms can previously select inappropriate but undetected accounting techniques more extensively to delay the current covenant violation or exploit opportunistic accounting methods to prevent further debt covenant violations. Consistent with this notion, our empirical evidence indicates that firms violating debt covenants are more likely to have internal control weaknesses. We also uncover that the positive association between the violations and internal control weaknesses is more pronounced for firms that fail to remediate violations by fiscal year-end. Further, the connection between debt covenant violations and ineffective internal control intensifies with the severity of internal control problems. Our results are robust to a variety of controls, alternative measures, different disclosure regimes, and propensity score matching approach. Overall, our results suggest that debt covenant violations can serve as a risk factor of internal control breakdown.

Effect of SME and Chaebol Loan Contracts on Debt Covenant Hypothesis: Evidence from Korea

This study provides an in-depth analysis of the covenant-based hypothesis that focuses on whether and how correlations between debt ratios and earnings management (measured by discretionary accruals) are affected by the size and nature of firms. We performed a pooled ordinary least squares regression using a sample of 10,983 firms listed in Korea from 2002 through 2012. In the Korean financial market, SMEs and firms belonging to chaebols (conglomerates) are markedly different in terms of their bargaining power with financial institutions. The results suggest that SMEs have a larger portion of secured loans and that chaebols can use their credit in the bond market to access alternative sources of financing. Accordingly, neither SMEs nor chaebols are motivated to make income-increasing choices for larger discretionary accruals to relax their debt constraints. In contrast, a large firm with a higher debt ratio is likely to make accounting choices to increase reported earnings, which results in more discretionary accruals. The debt agreements between lenders (financial institutions) and borrowers (firms) have different implications in the Korean financial market depending on a firm`s size and nature.

MANAJEMEN LABA PADA PERUSAHAAN YANG MELANGGAR PERJANJIAN UTANG

This research aims to give empirical evidence concerning earnings management in firms violating debt covenant and to test whether earnings management in those firms are larger than that in control firms. Research population is manufacturing company listed at Bursa Efek Indonesia. The sample includes 17 firms violating debt covenant and 22 firms complying debt covenant as control firms. The sampling method is purposive sampling. Method of statistics used is t-test. The statistic test of first hypothesis shows that mean of discretionary accruals at a year before violation is significantly larger than that at the year debt covenant violation. This result supports debt covenant hypothesis. But, mean difference at the year of violation and at a year after violation does not provide the support for the hypothesis. The statistic test of second hypothesis shows that mean of discretionary accruals of firms violating debt covenant at a year before and at the year violation of debt covenant is significantly larger than that of control firms. Thus, we can conclude that violation of debt covenant motivate management to perform earnings management.

Earnings Management of Firms Reporting Long Term Debt: An Alternative Method

This study aims to apply an alternative detection model to prove that the earnings management will be occured when a company has long-term debts as well as the pressure of operating income. Generally, the literature study of earnings management indicates that the detection of earnings management can be grouped into two objectives, 1] to find variables for detecting earnings management (accruals, real activity and classification shifting) and 2] to use some advanced statistical or mathematical models to detect earnings management. This study applies a quantitative approach using secondary data of financial statements. The study was conducted on 50 companies with the largest market capitalization, 50 of the most active companies based on trading volume, 50 of the most active companies based on the value of trade and 50 of the most active companies by frequency trading. All of them are 200 public company (listed in the Indonesia Stock Exchange-ID) based on IDX statistical report 2013. The results of this study are expected to provide a new method to detect earnings management and its application in the context of positive accounting theory (PAT). The results of the study proves that the model is able to detect earnings management by utilizing foreign exchange transaction losses and use these models to support PAT (particularly on debt covenant hypothesis). These results contribute that earnings management can be done by using the foreign exchange gain / loss. However, the limitation of this study is the model has not been able to capture the phenomenon of earnings management if a company does not report any long-term debt nor foreign exchange gain/ loss.

Accruals and real earnings management: testing the debt covenant hypothesis

This paper examines earnings management activities around debt covenant violations. We focus on accruals management and real activities manipulation behaviour of managers in the quarters around the covenant violation. We expect covenant restrictions to influence these activities in the quarters surrounding and the quarter of the violation. The evidence is consistent with managers manipulating earnings using accrual-based and real earnings management activities and provides evidence for the debt covenant hypothesis. Cross-sectional analyses reveal that managers appear to manipulate accruals in successive quarters in order to increase reported earnings. The evidence on the use of real activities suggests that while managers increase reported earnings in the violation quarter, they have limited discretion over the use of real earnings management techniques in the quarters surrounding the violation.

Earnings Management Around Debt-Covenant Violations – An Empirical Investigation Using a Large Sample of Quarterly Data

I find that managers manage earnings upward in the quarters preceding a debt-covenant violation, but downward in the quarter a violation occurs. And they continue to manage earnings downward while the firm remains in violation. Because this scenario can play out within a year, the use of yearly data to examine the debt-covenant hypothesis can be problematic. Further analysis shows that the earnings management around the debt-covenant violation is also done to improve the manager’s bargaining power in the renegotiation that follows the violation. Furthermore, I find no evidence of excessive earnings management by high-debt firms to stave off a violation, but I do find evidence that the Sarbanes–Oxley Act restrains managers from using accruals to stave off a violation. These results are based on examining 193,803 firm-quarters, 8,804 firms, and 2,035 new covenant violations spanning 1996 to 2007.

To Cheat or Not to Cheat

Two different bodies of literature suggest contradictory relations between the likelihood that a firm misreports its financial statement and the use of debt in its capital structure. We test these relations using three different measures of misreporting and find that the results differ depending upon the materiality of misreporting. For relatively less (more) material misreporting, we find the likelihood of misreporting is positively related (unrelated) to bank borrowing. These results suggest that bank monitoring is insufficient to deter or detect misreporting and that bank debt may even provide incentives for managers to misreport, consistent with the “debt covenant hypothesis.”

Where Were the Banks? The Relation between Financial Statement Misreporting and Firms' Bank Debt Use

We compare firms that restate financial statements to firms that do not restate to test the hypotheses that bank monitoring should deter or detect misreporting. For relatively less (more) severe misreporting, we find the likelihood of misreporting is positively related (unrelated) to bank borrowing, and that ex ante changes in bank debt are positive (unrelated) for misreporting firms versus control firms. These results suggest that bank monitoring is insufficient to deter or detect misreporting. Instead, it may provide incentives for managers to engage in relatively less severe misreporting, consistent with the debt covenant hypothesis.

Creditor Protection and Accrual Quality: The Effect of State Laws

State laws vary with respect to protecting a corporation's creditors vis-a-vis its shareholders. In particular, states vary in their limits on payouts which potentially transfer wealth from creditors to shareholders. We hypothesize that states with tighter constraints on payouts generally decrease the opportunity for earnings management leading to better accrual quality. Based on a large sample of corporations covering the period from 1987 to 2004, we find evidence consistent with this hypothesis. We also extend the debt covenant hypothesis to state payout restrictions and find cross-sectional variation within states with tighter constraints. Our findings show that accrual quality suffers as firms approach their payout constraint. Overall, the results suggest that stronger creditor protection laws have an impact on firm financial reporting quality.

The Effect of Technical Default Cost on Discretionary Accounting Decisions

In this study, we investigate whether the variation in the expected costs of technical default provides insights into whether managers manipulate earnings in periods prior to technical default as well as in the fiscal year in which avoidance of technical default is unlikely. We argue that managers have private information about the expected costs and consequences of default, and that, prior to default, managers condition their decisions about accounting choice and accounting (accrual) discretion on these expectations. We provide evidence on the endogeneity of two forms of discretion in accounting choices (i.e., choice of accounting methods and discretion in accounting accruals) in the context of testing the debt covenant hypothesis. Controlling for the endogeneity of the two forms or earnings management, we document that both forms of earnings management are associated with a lower cost of technical default and the use of either form of earnings management tends to reduce the use of the other. Our findings also suggest that earnings management is less likely when the expected cost of technical default is low, and that, managers appear to benefit from earnings management as such decisions are associated with a lower default cost for firms that enter technical default.