Debt Covenant Violations Research Articles

Creditors’ Role in Shaping Asymmetric Cost Behavior: Evidence from Debt Covenant Violation

ABSTRACT This study uses covenant violations as a quasi-natural experimental setting to examine creditors’ roles in shaping corporate cost behavior. Using a regression discontinuity design, I find that cost stickiness experiences a sharp decline following debt covenant violations when control rights are transferred to creditors. The cost stickiness effect is more substantial for borrowers with lower credit ratings and when creditors possess greater bargaining power. The effect is also more pronounced during industry downturns when borrowers have fewer alternative sources of finance. Results are consistent when I use alternative measures of cost stickiness and alternative research designs. Overall, my evidence indicates that creditors play a monitoring role in firms’ cost behaviors and identifies a specific channel (loan covenants) through which the misalignment of incentives can impact cost asymmetry. JEL Classifications: D24; G32; M41.

Balance Sheet Debt Covenants and Seasoned Equity Offerings

Synopsis The research problem This study examined the effect of having debt contracts that contain balance sheet covenants on the decision to make seasoned equity offerings (SEOs). Motivation Prior studies examined the determinants of equity issuance without considering private debt contracts that contain balance sheet covenants. Generally, firms are not restricted from stock issuance when they have financial debt covenants. This might motivate firms to make SEOs when they are more susceptible to balance sheet debt covenant violations. Making SEOs increases firms’ equity capitals in the short term and, therefore, has the direct effect of improving balance sheet covenants in the current period. This effect motivated this study to examine whether firms are more likely to conduct SEOs when their debt contracts include more-restrictive balance sheet covenants. The test hypothesis The hypothesis of the study is in the null form, which states that balance sheet covenant restrictiveness is unrelated to the probability of conducting SEOs. Target population The target population includes shareholders, debtholders, and firm managers. Adopted methodology Panel data estimation was used, specifically, the fixed effects model. Analyses The empirical analysis was conducted on a unique sample of UK listed firms with private debt covenants that is hand-collected from annual reports. Equity issuance in the sample is based on private placements, which are a common type of SEO in the UK. The restrictiveness of balance sheet-based covenants is defined as the number of balance sheet covenants in a loan contract or the tightness of net worth covenant slack. Findings The results show that balance sheet covenant restrictiveness is positively associated with the probability of conducting SEOs through private placements. The baseline result is robust to the application of a number of the controls often used in the literature, including cash shortage, the use of balance sheet covenants in the previous loan contract, earnings management, and the quality of external governance. It is also robust to excluding the financial crisis period and addressing potential endogeneity concerns using a propensity score-matching procedure. Additionally, further analysis provides some evidence that equity issuance by firms with more-restrictive balance sheet covenants is negatively associated with future operating performance, suggesting that these firms may not efficiently use the raised capital.

Debt Covenant Violation and Real Earnings Management: Evidence From the U.S.

Debt Covenant Violation and Real Earnings Management: Evidence From the U.S.

Bank intervention and firms’ earnings management: evidence from debt covenant violations

Earnings management has long been one of the main concerns in accounting and management literature, and the extent to which corporate governance mechanisms can discipline management behaviour and prevent earnings management has attracted increasing interest among policy makers and academic researchers. Differing from previous corporate governance literature that focuses mainly on the board and auditors, we explore the role of creditors in corporate governance. In particular, we examine the effect of bank intervention on earnings management via the lens of debt covenant violations, where control rights are transferred to creditors (banks). Using a Difference-in-Difference approach, we find that firms reduce both their accruals-based and real earnings management following debt covenant violations. The negative effect on earnings management is more prominent when banks possess greater bargaining and monitoring power and when firms are more financially constrained. By identifying a specific channel through which debt providers influence corporate financial reporting, our findings suggest that creditors can play an important role in governing organisations and disciplining management behaviour.

Leverage, earnings management and audit industry specialization: the case of Palestinian-listed companies

PurposeThis study explores the relationship between leverage and earnings management in the context of Palestinian-listed companies, while also investigating whether audit industry specialization influences this relationship.Design/methodology/approachThe data used in this study are extracted from public financial reports of 39 firms listed on Palestine Stock Exchange (PEX), spread across the service, insurance, industry and investment sectors, for the time period 2011–2022. A model is developed to test 4 hypotheses about the relationships between long-term and short-term debts, and earnings management, and then to examine the influence of audit industry specialization on these relationships.FindingsThe results depict a significant, negative relationship between long-term debt and earnings management. Whereas the association between short-term debt and earnings management is insignificant. Audit industry specialization is proven to have no influence on the relationships between the independent and the dependent variables. Results are robust for firms that changed their accounting policies and using different audit industry specialization proxies.Originality/valueThe association between leverage and earnings management is a significant research topic, given that previous research identifies credit ratings and debt covenant violations as key factors which motivate earnings management. This paper fills a substantial research gap by examining the relationship between the two variables in the context of Palestinian-listed firms, while emphasizing the distinction between long-term and short-term debts. It also highlights key relationships that have been neglected in this particular context, which adds to the body of literature. Furthermore, the research's findings provide a solid information base that is of great interest to accounting and auditing experts and that may be seriously evaluated to support and advance the PEX sector.

Labor unions and debt covenant violations*

This study examines the relationship between labor unions and firms’ decisions to violate debt covenants. We find that firms with high unionization rates are more likely to violate debt covenants than firms with low unionization rates. This relationship is stronger for firms with larger cash reserves. Our analysis also reveals that debt covenant violations lead to a lower probability of a strike. Additionally, we find that high-unionization firms are in better financial condition prior to covenant violations than low-unionization firms. Our study confirms the existing literature by showing that long-term abnormal stock returns after covenant violations are significantly positive. However, our results also show that high-unionization firms experience smaller stock returns compared to low-unionization firms. Furthermore, we provide evidence that high-unionization firms tend to manipulate earnings downward before covenant violations. These findings suggest that firms may strategically violate debt covenants to gain bargaining flexibility and force labor unions to make concessions in subsequent negotiations.

Do creditor control rights impact corporate tax aggressiveness? Evidence from debt covenant violations

AbstractWe examine the effect of bank interventions on corporate tax aggressiveness via the lens of debt covenant violations. Using three identification strategies, we find that bank interventions have a negative effect on corporate tax aggressiveness. This effect is less pronounced for more financially constrained firms, firms with higher shareholder power and firms facing less powerful banks. Covenant‐violating firms compensate their reduced tax aggressiveness by reducing other expenditures, including capital expenditures and cash acquisitions. Our results suggest that creditors perceive aggressive tax activities as risky investment opportunities.

Effect of cash flow risk on corporate failures, and the moderating role of earnings management and abnormal compensation

In this study, we find that United States firms' average cash flow risk (CFR) shows a significantly increasing trend over the past four decades or so. This does not portend well considering the significance of cash flows in maintaining a firm's financial health and going concern status. The CFR also increases dramatically for firms approaching financial distress or bankruptcy, suggesting its important role in predicting a firm's failure. Empirically, we find that CFR has a strong positive effect on a firm's financial distress likelihood. We also find that the association between CFR and financial distress is negatively moderated in firms with high earnings management and abnormal compensation. The results suggest that managers in firms with high CFR are more likely to use heuristics in form of earnings management. Thus, supporting the upper echelons theory related to managers under performance pressure. Meanwhile, consistent with the notion in the agency theory that financial incentives serve as effective monitoring mechanisms, compensation packages can incentivize better risk management practices and decrease the likelihood of a firm's failure. Our findings are also robust to alternative definitions of a firm's failure: financial constraints, presumed debt covenant violation and legal bankruptcy filings.

Do credit market incentives drive classification shifting in emerging markets?

PurposeTo report inflated operating performance indicators, such as operating revenue and operating profit, managers vertically reposition revenue and expense items inside the income statement. This study aims to investigate the relationship between credit market incentives and these practices.Design/methodology/approachThis study examined a sample of 1,592 Bombay Stock Exchange-listed companies from 2009 to 2021 and tested them using panel data regression models. The propensity score matching method and different measurements of classification shifting practices are used to validate the results.FindingsThe conclusions drawn from the empirical data show that firms prefer revenue shifting over expense shifting to prevent debt covenant violations. It shows that the firm’s classification-shifting practices are driven by credit market incentives. This finding is consistent with the notion of positive accounting theory that firms engage in classification shifting (earnings management) to avoid violation of debt covenants. Further, the firm’s preference for revenue shifting is in line with the ease-need-advantage-based shifting framework where firms choose the shifting tool based on costs and constraints associated with each tool.Practical implicationsThe finding suggests that if managers heavily rely on revenue shifting to avoid debt covenant violations, the firm may end up breaking these covenants based on its actual operating performance. Managers may use aggressive accounting techniques to prevent covenant violations, which can be a warning indicator of financial difficulties or operational problems. It highlights the necessity for creditors and investors to carefully evaluate a company’s financial stability outside of the financial statements that are publicly disclosed. Authorities should create separate forensic accounting standards for auditors to check revenue items and stop the corporate misfeasance of revenue shifting.Originality/valueThe study is among the earlier attempts to provide empirical evidence on credit market incentives behind classification shifting practices. It is the first study that documents the substitution relationship between classification shifting forms for avoiding violation of debt covenants.

Do Creditor Control Rights Impact Corporate Tax Aggressiveness? Evidence from Debt Covenant Violations

Do Creditor Control Rights Impact Corporate Tax Aggressiveness? Evidence from Debt Covenant Violations

Economic consequences of operating lease recognition

Accounting Standards Update No. 2016–02 (ASU 2016–02) generated considerable debate between managers and standard setters. We find evidence that after issuance of ASU 2016–02, lessee firms decreased their use of long-term operating leases, increased their use of short-term operating leases, and increased their use of capital expenditures. The shift from long-term operating leases to capital expenditures is more pronounced for firms that had greater reporting incentives to use operating leases prior to ASU 2016–02. However, we find no evidence that the change in leasing behavior leads to negative outcomes predicted by managers (i.e., no evidence of a decrease in reported firm performance, a decrease in firm value, increase in firm risk, decrease in credit ratings, increase in debt covenant violations, or decrease in employment). Our study adds to the literature on the real impacts of accounting standards on managers' investment behavior and economic consequences for lessee firms and their stakeholders.

The Impact of IFRS on the Use of Private Debt Covenants: International Evidence

ABSTRACTWe investigate changes to the use of private debt covenants following the mandatory adoption of IFRS globally. Using a difference-in-differences specification, we find a significant decrease in accounting-based debt covenants (mainly balance sheet covenants) in IFRS-adopting countries after IFRS adoption, but not in non-IFRS countries. The post-IFRS decrease in accounting-based debt covenants is greater in countries with low creditor rights or with high depth of credit information sharing. The decreases are greater in countries with high enforcement and/or large differences between IFRS and local GAAP. In contrast, the use of nonaccounting covenants does not change but other loan conditions tighten after IFRS adoption. IFRS also leads to increased technical violations of accounting-based debt covenants. Overall, our findings are consistent with IFRS reducing contractibility.

Capitalising or Expensing Development Costs? – Mixed Methods Evidence on the Determinants and Motives of the Accounting Policy in the context of UK Private Companies

ABSTRACT Following calls for further research, this study evaluates the determinants and motives behind private companies’ decision to capitalise development costs by using mixed methods. While prior literature and expert interviews indicate initially that private firms may be motivated opportunistically, subsequent archival analyses show that development costs are capitalised to meet benchmarks and ameliorate poor profitability. Additionally, interview evidence emphasises that debt covenant violation avoidance and increasing merger and acquisition (M&A) values are important drivers for capitalisation, whereas management compensation schemes do not seem to influence their accounting policy. Moreover, findings imply a negative association between firm size and the capitalisation of development costs. Expert interview evidence indicates that smaller companies are more likely to have financing needs, suggesting that capitalisation is employed to signal future economic benefits to investors. Conversely, the motivation for larger companies which are more likely to expense may be grounded on risk avoidance from future impairments.

CEO overconfidence and debt covenant violations

AbstractWe examine how the level of chief executive officer (CEO) overconfidence might affect a borrowing firm's ex ante covenant intensity and ex post covenant violations. We find that overconfident CEOs are less effective in steering the firm away from unfavorable opportunistic behavior, and hence creditors include more stringent covenant restrictions in the loan contracts of their firms. The interpretational bias and other positive illusions of overconfident CEOs coupled with the more stringent and/or greater number of stringent ex ante covenants lead to a greater likelihood of covenant violation. These results remain robust after accounting for potential endogeneity issues through various techniques. Ex post tests reveal that firms with more confident CEOs are more likely to violate loan covenants after controlling for covenant intensity. We also find that overconfident CEOs can mitigate the incidence of covenant violations, but only among loans to lower rated (non‐investment‐grade) borrowers and revolving lines of credit where benefits of effective monitoring are most pronounced.

Strategic Disclosure and Debt Covenant Violation

ABSTRACT This study examines how managers change their forecasting behavior as a debt covenant violation (DCV) approaches. We find that management forecasts are more optimistic in the quarter before a DCV, and this result is stronger when firms face a higher risk of shifting control rights to lenders in the event of a DCV. Furthermore, we find that managers combine their forecast optimism with actions that are favorable to shareholders but would likely be curtailed by lenders after the DCV. Last, we find managers who are more optimistic in their forecasts are less likely to be replaced after a DCV. Overall, our results are consistent with managers changing their disclosure behavior in an attempt to reduce lenders' awareness of an impending DCV, and thus, buy themselves time to take actions favorable to equity investors.

Does fiduciary duty to creditors reduce debt covenant violation avoidance behavior?

AbstractFinancial reports should provide useful information to shareholders and creditors. Directors, however, normally owe fiduciary duties to equity holders and not creditors. We examine whether this slant in fiduciary duties affects the extent to which firms use financial engineering to circumvent debt covenant violation. By avoiding debt covenant violation, firms prevent creditors from taking actions to reduce bankruptcy risk and recover their investment, and allow the firm to continue operating for the benefit of equity holders. We find that a Delaware court ruling that imposed fiduciary duties toward creditors led to a decrease in financial engineering and debt covenant avoidance in Delaware firms. We also show that board quality lowers financial engineering and debt covenant avoidance by firms only when their directors owe a legal fiduciary duty to creditors. Collectively, our results suggest that unless directors are required to protect creditors’ interest, they are likely to take actions to circumvent debt covenant violations.

The effect of corporate governance and firm-specific characteristics on the incidence of financial restatement

PurposeThis paper aims to examine the effects of corporate governance and firm-specific characteristics on the incidence of financial restatement among Malaysian public listed firms.Design/methodology/approachThe elements of corporate governance consist of board size, board independence, multiple directorships, audit committee expertise, external audit quality and executive compensation. Meanwhile, the firm-specific characteristics consist of firm age, firm performance, firm leverage and firm liquidity. The agency theory has been used to guide the study. This study used a matched-pair sample that consisted of a sample of 49 restatement firms and 98 non-restatement firms between the years 2011 and 2016. Univariate (t-test and Pearson correlation) and multivariate (logistic regression) statistical techniques were used to test the hypotheses.FindingsThe results show that there is a negative and significant relationship between executive compensation and firm performance, and the incidence of financial restatement. In addition, there is a positive and significant relationship between firm leverage and the incidence of financial restatement. However, the other corporate governance and firm-specific characteristic variables included in the study were found to be insignificant with the incidence of financial restatement. This paper provides evidence that some form of corporate governance mechanisms and firm-specific characteristics, particularly executive compensation, firm performance and firm leverage, may influence the direction and magnitude of the incidence of financial restatement. The findings indicate that optimal executive incentives may align management interests with those of shareholders. In addition, greater performance and lower leverage levels minimise firms’ financial pressure and debt covenant violation risk, which may reduce the management tendency to misstate the financial statement, and consequently, minimise the likelihood of financial restatement.Originality/valueThe main value of this paper is the effect of corporate governance and firm-specific characteristics on the likelihood of financial restatement in Malaysia. The findings of this study provide useful insights for regulators to improve and reconsider the current regulations on corporate governance mechanisms.

Stock and Bond Return Comovement as a Different Way to Assess Information Content: The Case of Debt Covenant Violation Disclosures

We propose a supplementary way to assess the information content of a financial statement disclosure based on the comovement of asset returns in different markets in response to information that has price implications for both. The influence of a signal that strongly influences at least two asset markets measures a dimension of information content less clearly reflected in single‐market responses. We apply our method to debt covenant violation (DCV) disclosures. These are the outcome of a debt renegotiation when the covenant promises in a debt agreement to manage the agency costs of debt are broken. We find that stock and bond return comovement is highest one day before DCV disclosure and differs depending on whether the debt covenant is waived or not waived. We find that stock and bond return comovement in the days following a DCV disclosure decreases more for non‐waiver disclosures than for waiver disclosures. This supports the theory that a non‐waiver outcome shifts control rights and bargaining power to the creditors. Consistent with this theory, single‐market tests show that bonds with a non‐waiver disclosure versus a waiver disclosure earn positive excess returns following a DCV disclosure whereas the reverse is true for stocks.

English

The research expands the earnings management (EM) literature for Italian unlisted firms by investigating the drivers of both accrual-based (AEM) and real activity-based (REM) earnings management. According to prior literature, the reliability of financial statements of these firms concerns mainly lenders in assessing borrower creditworthiness, and Tax Offices in calculating corporate tax. We analyse unlisted firms as they represent 99.9% of Italian firms, consistent with most European countries. We estimate models using factors drawn from the literature which potentially influences both AEM and REM, along with some robustness tests. For AEM, ownership concentration is a positive driver, consistent with the entrenchment hypothesis, and firm leverage is a positive driver, suggesting the use of debt covenant violation avoidance strategies. Quality auditor engagement tends to constrain AEM, while size has a negative impact. However, tax drives AEM and profitability has a positive impact. For REM, ownership concentration has no impact, and leverage has a positive impact. The engagement of Big 4 constrains REM. Our expectations are confirmed when the total earnings management variable is used as the dependent.   Key words: Earnings management, accrual-based earnings management, real activity-based earnings management, determinants, unlisted firms, Italy.

KECENDERUNGAN PELANGGARAN PERJANJIAN UTANG PADA PERUSAHAAN KONSTRUKSI DAN PROPERTI DI BEI

The importance of debt covenant violation is to minimize the debtholder default risk. The possibility of debtholder’s default risk may be caused by liquidity problems, low profitability, and bad quality of earnings. Hence, this study aims to proof the tendency of debtholder to violate debt covenants by measuring current ratio volatility, return on assets, and earnings quality as independent variables. By using five companies from construction and property sub-sector that listed on Indonesia Stocks Exchange in 2016- 2018, the data are analyzed with multiple linear regression model for panel data. From this study, we can conclude that the impact of return on assets to debt covenant violation is significantly negative, debtholders with poor financial performance have higher potential to do debt covenant violation. However, there is no evidence that debt covenant violation is affected current ratio volatility and earnings quality.