Debt Covenant Violations Research Articles

Firm Exit Through Bankruptcy – The Effect of Accounting Bias on Product Market Competition

We analyze the effect of accounting biases on the profits of firms that compete in a Cournot product market. We find accounting biases strictly decrease firms' profits when the firms are fully equity-financed. However, different results emerge when we introduce debt into the firms' financial structures. Firms must report interim accounting signals, on which their debt covenants are based. We contrast firms' profits under an unbiased accounting system, a conservative accounting system and an aggressive accounting system. Conservative accounting system increases the likelihood of debt covenant violations and firm liquidation. Interestingly, the increased likelihood of could make the borrowing firms better off by turning the surviving firm into a monopolist that captures the entire market share. In addition, conservative accounting bias gives the banks more decision rights in liquidating or re-organizing the firms' operations, thus reducing the excessive liquidation problem. Absent renegotation, conservative accounting system improves the banks' payoffs.

Debt Covenant Violation and Cost of Borrowing: Evidence from Quarterly Bond Issue

Do debt covenant violations increase the cost of borrowing for violating firms? By examining the SEC filing of and bond issue by all US nonfinancial firms from 1996 to 2005, I find that debt covenant violations play an important role in determining the cost of debt for firms. The results indicate that debt covenant violations are important from three aspects: the incidence of violation, the timing of the violation and the frequency of the violation. The results outline these three aspects. First, I find that violating firms on average have a higher cost of borrowing (100 to 107 bps) compared to non-violators. Second, I find that firms which report a violation in the bond-issue quarter have a higher cost of borrowing (30 to 44 bps) compared to firms that did not report a violation and firms that report a debt covenant violation in the quarter preceding the bond-issue report a higher cost of borrowing (88 to 105 bps) compared to non-violators. Third, I find that firms that report exactly one debt covenant violation have a higher cost of borrowing (13-47 bps) than non-violating firms, although the increase is not significant. I also find that firms that report more than one debt covenant violation have a higher cost of borrowing (39-48 bps) than non-violating firms. I conclude that there are significant benefits of not violating a debt covenant and violators are penalized by the creditors for not upholding the contractual restrictions.

Market Timing and Wealth Transfer in Debt Repurchases: The Decision between Tender Offers and Open Market Bond Repurchases

This study investigates how the firm’s objective of the bond repurchase affects its choice of whether to repurchase on the open market or via a tender offer. Unlike tender offers, open market repurchases are not pre-announced and the identity of the buyer is unknown to the seller. We provide evidence that firms are likely to repurchase on the open market when they seek to exploit mispricing of their bonds and when they seek to manage their financial reports, either in order to meet earnings targets or avert debt covenant violations. When firms seek to amend indenture terms they are likely to choose a tender offer over an open market repurchase. We also find that mispricing exploitation is mitigated when the information quality available to bondholders is higher and that insiders take advantage of the likely wealth transfer from bondholders to shareholders achieved in open market repurchases.

Does Shareholder Litigation Affect Financial Reporting Choices?

This paper investigates the effects on financial reporting practices of a court ruling that made it easier for public corporations to defend against class-action litigation filed under securities laws. I find an increase in restatements and discretionary revenues for firms affected by the ruling relative to unaffected firms. Further, within affected firms, these results were concentrated among those most likely to face litigation. I also find a decline in debt covenant violations and an increase in investment levels. These results suggest that the threat of shareholder litigation can discipline managerial reporting practices.

Insightful Insiders? Insider Trading and Stock Return around Debt Covenant Violation Disclosures

This paper examines insider trading around first-time debt covenant violation disclosures in SEC filings, and is interesting from a research and regulatory standpoint for three reasons – delay and infrequency of a first-time disclosure, lack of attention to covenant disclosures by regulators, and a dearth of research. We document net insider selling in the 12 months before a debt covenant violation disclosure and net insider buying up to 12 months after disclosure. This net insider selling leads investors’ negative returns before violation disclosure. Net buying also leads investors’ positive returns after disclosure. We also show that net insider selling in a narrow (one to two month) window around the covenant violation disclosure associates predictably with investors’ price response in that same window.

Creditor Control Rights, Investment and Growth Opportunities

We show that creditors do not just ensure that inefficient investment is not undertaken, but also do not preclude efficient investment. Examining what happens following a debt covenant violation, a situation through which creditors acquire some control rights over the firm, we find that investment declines when the firm has few growth opportunities but it may increase otherwise. The results are robust to the use of different proxies for growth opportunities. The firm’s performance improves but it suffers dividend cuts and increased CEO turnover. The results suggest that creditors consider the benefits of growth opportunities as a source of future cash flows to meet outstanding debt obligations.

Corporate Debt Financing and Earnings Quality

Abstract: Our study establishes linkages between two extensively researched areas, debt financing and the quality of earnings. Debt can have a ‘positive influence’on earnings quality because managers are likely to use their accounting discretion to provide private information about the firms’ future prospects to lower financing costs. For high debt, it can also have a ‘negative influence’ on earnings quality as managers use accruals aggressively to manage earnings to avoid covenant violations. Using accruals quality as a proxy for earnings quality, we document a non‐monotonic (curvilinear) relation between debt and earnings quality. The relationship is positive at low levels of debt and negative at high debt levels with an inflection point around 41%. Our results suggest that firms that rely heavily on debt financing might be willing to bear higher costs of borrowing from lower earnings quality because the benefits from avoiding potential debt covenant violations exceed the higher borrowing costs.

The Cost of Private Debt Covenant Violation

This study quantifies costs that firms are willing to incur to avoid violation of private debt covenants. The results indicate that as firms approach covenant violation they engage in income-increasing earnings management, which increases their tax liability. By estimating the extent of income-increasing activities and the additional tax costs incurred, this study arrives at a lower-bound estimate of the cost of violating private debt covenants. The mean (median) firm with relatively tight debt covenants increases its current tax liability by an amount equivalent to increasing the cost of debt financing by between 12.92 (10.72) and 22.72 (12.81) basis points (where firms with relatively loose debt covenants serve as the baseline). The magnitude of this estimate indicates that the expected costs of covenant violation are meaningful. Combined with recent evidence that private debt covenant violations occur frequently (Dichev and Skinner, 2002; Roberts and Sufi, 2009b), this implies debt covenants and expected violations are economically important.

Control Rights and Capital Structure: An Empirical Investigation

ABSTRACTWe show that incentive conflicts between firms and their creditors have a large impact on corporate debt policy. Net debt issuing activity experiences a sharp and persistent decline following debt covenant violations, when creditors use their acceleration and termination rights to increase interest rates and reduce the availability of credit. The effect of creditor actions on debt policy is strongest when the borrower's alternative sources of finance are costly. In addition, despite the less favorable terms offered by existing creditors, borrowers rarely switch lenders following a violation.

Earnings management and firm financial motives: A financial investigation of UK listed firms

This study focuses on the investigation of motives for and characteristics of UK firms that engage in earnings management activities. It concentrates particularly on the provision of voluntary accounting disclosures, the violation of debt covenants, management compensation, and on the equity and debt capital needs of firms and their relation with the use of earnings management. The study examines also the earnings management inclination of firms that seek to meet or exceed financial analysts' forecasts. The findings generally indicate that firms with low profitability and high leverage measures are likely to use earnings management. Also, firms that are in equity and debt capital need and are close to debt covenant violation also appear to be inclined to employ earnings management practices. Likewise, firms tend to use earnings management to improve their financial numbers and subsequently reinforce their compensation and meet and/or exceed financial analysts' earnings forecasts. In contrast, the study shows that firms that provide voluntary accounting disclosures appear to be less inclined to make use of earnings management.

Precision in Accounting Information, Financial Leverage and the Value of Equity

Abstract: Using an equity valuation model characterized by periodic imperfect accounting information, we examine how financial leverage affects a firm's accounting quality choice (i.e., precision). We find that the existence of financial leverage motivates firms with average to good performance to prepare accounting information with a high degree of precision. However, we conclude that when a firm is performing poorly it has an incentive to reduce accounting precision in order to lower the likelihood of both a debt covenant violation and the detection of accounting bias.

Control Rights and Capital Structure: An Empirical Investigation

We show that incentive conflicts between firms and their creditors have a large impact on corporate debt policy. Net debt issuing activity experiences a sharp and persistent decline following debt covenant violations, when creditors use their acceleration and termination rights to increase interest rates and reduce the availability of credit. The effect of creditor actions on debt policy is strongest when the borrower's alternative sources of finance are costly. In addition, despite the less favorable terms offered by existing creditors, borrowers rarely switch lenders following a violation.

Waiving Technical Default: The Role of Agency Costs and Bank Regulations

Abstract: This paper examines whether the characteristics of banks and borrowers are associated with banks' decisions to waive violations of debt covenants. The findings suggest that banks possess sufficient private information about firms, and they use this information in their waiver decisions. Banks' decisions to waive violations vary with the borrowers' agency costs, debt features, the banks' characteristics and regulatory circumstances, and the bank‐firm business relationship. There is no evidence that syndicated loans, bank structure, and adverse economic conditions are significant determinants of the waiver decision. Research findings offer valuable insight into the theoretical and practical implications of debt covenants and agency costs.

Earnings Management Response to Debt Covenant Violations and Debt Restructuring

The study investigates whether the choice of income-increasing or income-decreasing discretionary accruals is related to the severity of financial distress and whether this choice is also influenced by the creditors' waivers of debt covenant violations. Financially distressed firms experiencing debt covenant violations and/or debt restructuring during the 1989–96 period are used to evaluate the management's choice of discretionary accruals. Discretionary accruals are calculated based on four different accrual models. The results show that managers of financial distressed firms use income-increasing discretionary accruals if they are able to obtain waivers for debt covenant violations, and use income-decreasing discretionary accruals if debt restructuring takes place or debts are renegotiated because waivers are denied. These findings thus provide support to the expectation that the choice of income-increasing or -decreasing discretionary accruals is influenced by the severity of financial distress. They also provide an explanation for divergence in the results of earlier studies on the use of income-increasing or -decreasing discretionary accruals by financially distressed firms.

Contracting Cost Determinants of Changes in Income Tax Accounting Method

This study examines why firms in New Zealand change income tax accounting methods from comprehensive to partial tax allocation. New Zealand provides a unique institutional setting to test this phenomenon because it allows companies to use either comprehensive or partial tax allocation, a situation not permitted in other major accounting jurisdictions such as the U.S., Canada, and Australia. I hypothesize the change from the comprehensive to the partial tax allocation method is made for efficient contracting reasons to maximize firm value. Specifically, I argue that if firms experience growth in investments in depreciable assets and continue to use comprehensive tax allocation, an unintended and potentially ever growing liability that has no cash outflow implications is reported on the balance sheet. Overstatement of this liability could result in inadvertent adverse consequences such as perceived increased risk, leading to higher borrowing costs and debt covenant violation. As a result, these firms change to partial tax allocation, because it is seen as a more efficient accounting procedure in these circumstances. In general, I find support for the efficient contracting argument - that is, the change to partial is related to the extent of investment in depreciable assets. However, debt-related opportunistic incentives cannot be ruled out totally.

Initial Technical Violations of Debt Covenants and Changes in Firm Risk

The purpose of this paper is to investigate whether initial technical debt covenant violations are associated with significant increases in the equity risk of violating firms. Our results indicate that first‐time violations are associated with significant increases in both systematic and unsystematic risk. The increase in systematic risk is attributable primarily to rising levels of financial leverage as opposed to changes in the underlying asset beta. We also find that the change in unsystematic risk experienced by first‐time debt covenant violators is a significant predictor of future exchange delisting, even after controlling for other factors typically associated with increasing financial distress.

Incentives and Penalties Related to Earnings Overstatements that Violate GAAP

This paper investigates the incentives and the penalties related to earnings overstatements primarily in firms that are subject to accounting enforcement actions by the Securities and Exchange Commission (SEC). I find (1) that managers in treatment firms are more likely to sell their holdings and exercise stock appreciation rights in the period when earnings are overstated than are managers in control firms, and (2) that the sales occur at inflated prices. I do not find evidence that earnings overstatement in these firms is motivated by concerns about debt covenant violations or the cost of external financing. The evidence suggests that the monitoring of managers' trading behavior can be informative about the likelihood of earnings overstatement. Many economists believe that insider trading is an efficient method of compensating managers for their efforts. These economists argue that reputation losses would preclude managers from making profitable trades before periods of poor corporate performance. Consequently, this paper also investigates the employment and monetary penalties imposed on managers after the earnings overstatement is publicly discovered. This evidence reveals that (1) managers' employment losses subsequent to discovery are similar in firms that do and do not overstate earnings and (2) that the SEC is not likely to impose trading sanctions on managers in firms with earnings overstatement unless the managers sell their own shares as part of a firm security offering. The evidence suggests that neither employment or SEC-imposed monetary losses are effective in preventing the managers in these firms with extreme earnings overstatements from selling their stake in their firms in the face of declining performance.

The Determinants of Managerial Accounting Policy Choice: Further Evidence for the UK

This paper combines an accruals-based measure of accounting discretion with a multivariate modelling framework as a means of generating more appropriately specified tests of the determinants of managerial accounting policy choice. Findings suggest that smoothing considerations account for the majority of cross-sectional variation in the degree of accounting discretion. Evidence is also presented that managers employ accounting choices to (i) signal expected future cash flow performance and (ii) reduce the probability of debt covenant violation, as captured by the leverage ratio. However, the strength of the relation between leverage and accounting policy choice is shown to vary across the sample period, possibly reflecting changes in the probability of debt contract violation for the average sample firm over time. Limited evidence is also presented which suggests that the magnitude of the association between discretionary accruals activity and leverage, ownership, and smoothing may be conditional on prior-period accrual activity.

Debt-covenant violations and managers' accounting responses

This paper examines accounting changes, costs of default, and accounting-based covenants violated by 130 firms reporting violations in annual reports. I find that managers of firms approaching default respond with income-increasing accounting changes and that the default costs imposed by lenders and the accounting flexibility available to managers are important determinants of managers' accounting responses. I also document that private lending agreements are the first violated, that net worth and working capital restrictions are the most frequently violated restrictions, and that in 52 percent of the cases lenders require concessions from borrowers to resolve default.

Debt covenant violation and manipulation of accruals

This paper examines the abnormal accruals of a sample of 94 firms that reported debt covenant violations in annual reports. We expect debt covenant restrictions to influence accounting choices in the year preceding and the year of violation. Time-series and cross-sectional models are used to estimate ‘normal’ accruals. In the year prior to violation, both models indicate that ‘abnormal’ total and working capital accruals are significantly positive. In the year of violation, there is evidence of positive abnormal working capital accruals after controlling for management changes and auditor going concern qualifications.