The role of financial reporting in contracting

Transcription

1 The role of financial reporting in contracting Lakshmanan Shivakumar* London Business School Regent s Park London, NW1 4SA United Kingdom lshivakumar@london.edu November 30, 2012 * I am grateful for comments from Jayaraman Sudarshan. 1

2 1. Introduction Contracts are at the heart of most business dealings. The need for contracting, in general, arises from three basic human traits self-serving attitudes, disparate goals and time-inconsistent behaviour. Self-serving attitudes cause individual agents to put their personal needs above those of others. Disparate goals are reflected in individuals having different goals and different attitudes towards an object, and time-inconsistent behaviour is reflected in the agents changing their perception of people or objects over time. In the absence of these traits, everyone would work towards a single, noble objective of improving a community s welfare, and there would be little need for contracting. Given this close link between basic human traits and the need for contracting, it is no wonder that the history of written contracts is almost as old as the history of writing itself. The need for contracting is even greater now, as complicated businesses depend on the cooperation of numerous people, including shareholders, debtholders, management, labour, suppliers, customers, and government. In such circumstances, firms face agency problems, which arise when the cooperating parties have different goals, and economic agents act in their own self-interest rather than the interest of their principal. Numerous agency problems are possible in a firm, but I restrict my focus in this talk to those between shareholders and debtholders, and those between shareholders and managers. Agency problems arise between shareholders and debtholders, as the shareholders, seeking to maximize the value of their claims, have incentives to take actions that are detrimental to the debtholders. For instance, subsequent to a borrowing, shareholders have incentives to adopt high-risk projects, as by doing so they enhance their expected payoffs. This is because shareholders retain the upside payoffs from the risky projects, while sharing losses from the projects with lenders (e.g., Jensen and Meckling, 1976). 1 Based on a similar logic, Myers (1977) points out that equityholders have an incentive to underinvest and pass up positive net present value projects when a firm has risky debt outstanding. This occurs because positive net present value projects reduce default probabilities and increase debt value, causing equityholders to share the net benefits from the investments with 1 An alternative way to view this incentive is to realize that equity represents a call option on the firm s assets, and because option value increases with the volatility of the underlying asset, equityholders have an incentive to shift the firm s investments into high-risk projects, to the detriment of debtholders. 2

3 bondholders, while they bear all the investment costs. Alternatively, shareholders can take actions that transfer wealth directly from debtholders to shareholders, such as increasing debt levels in the future, or distributing the firm s cash to shareholders through dividend payments. Such shareholder actions reduce the probability that the lenders will get paid their full dues. Agency problems can also occur between managers and shareholders. Today s complex organizations have evolved through their focus on comparative advantages, not just in their trading activities and operations, but also in their management and financing. Wealthy investors often do not possess the skills needed for identifying investment opportunities, channelling employee talents and utilizing scarce resources effectively, while those with managerial skills often lack the capital needed to establish a successful business. This divergence of people endowed with funds and those with leadership skills has given rise to firms where investors entrust assets and decision-making to managers. This stewardship role of managers gives rise to potential agency problems where managers, acting as the agents of investors, attempt to increase their personal wealth at the expense of their principals (i.e. the firm s owners). Self-serving managers aim to increase returns to their skills through perk consumption, and by concealing information that could help investors unravel opportunistic or inefficient managerial decisions. In this review, I shall focus on the role that financial accounting plays in contracts aimed at mitigating agency problems. 2 Several prior studies have reviewed agency-related issues, both between shareholders and managers and between shareholders and debtholders (e.g., Hermalin and Weisbach, 2003), as well as the broader role of contracting in a firm (e.g., Roberts and Sufi, 2009a). I shall not attempt to review these vast literatures again, but even on this limited topic of the role of financial numbers in contracts that are designed to ameliorate agency problems I am not the first or the only 2 Since, as observed by Coase (1937), corporations can be viewed as a nexus of contracts designed to minimize contracting costs, almost all activities in a firm can be brought under the framework of contracting. For instance, the role of financial reporting for valuation can be seen as aiding an implicit contract between managers and investors to provide timely information for accurate valuation of the firm. Such a wide characterization of contracting would essentially bring the entire academic literature in financial accounting under its purview. So to keep the task at hand to more manageable levels, I have relied on a narrower focus of contracting, namely that aimed at mitigating agency issues within a firm. 3

4 one to provide a systematic review of the literature. 3 Comprehensive reviews on these topics are contained in Armstrong, Guay and Weber (2010), Bushman and Smith (2001) and Lambert (2001), among others. So, rather than repeat these detailed reviews, I shall attempt to provide some key takeaways from academic literature for accounting practice and regulation. Through this approach, I hope to appeal to both practitioners and academics. My discussions will also extend prior reviews to consider more generally the effects of certain accounting attributes on the relevance of financial reports for contracting. Some of my later discussions will place a greater emphasis of the role of accounting in debt contracts, as compared with the role of accounting in stewardship, not because the latter is in any way less important or less exciting, but rather to reflect my research interests. Research on the role of debt contracting has burgeoned in the last decade, thanks to the availability of datasets on detailed debt covenants, bond prices and credit default spreads for a wide range of firms, covering both public and private debt across many countries. These have helped us gain a significantly better understanding of the role of financial accounting in debt contracts. A major role of accounting numbers is in their use for contracting purposes, a view supported by the evidence in Ball and Shivakumar (2008), who find that earnings announcements convey little new information to market participants, compared with the information available to those participants outside the earnings announcement window. Based on this evidence, Ball and Shivakumar (2008) conclude that the primary economic role of reported earnings cannot be in the provision of timely new information to investors and other capital market participants, and that its role must lie elsewhere, such as in settling debt and compensation contracts (Watts and Zimmerman, 1986), and in disciplining prior information released by managers (Gigler and Hemmer, 1998; Ball, 2001; Ball, Jayaraman and Shivakumar, 2012). Financial accounts play an important role in both formal contracts and implicit contracts. Formal contracts, written using legal parlance, are intended to be enforced through courts of law. These contracts are employed where the likelihood or costs of non-performance in the contracts are 3 Even in discussions of agency problems between shareholders and debtholders, I focus only on studies that are based on the assumption that managers act in shareholders interests. 4

5 particularly high, or where other means of enforcement are unlikely to be effective (Gillan, Hartzell and Parrino, 2009). In contrast, implicit contracts do not aim to create a legally binding agreement between the parties concerned, and are often enforced through the goodwill of the contracting parties, reputational effects, or threats of economic punishment. Formal contracts have the major advantage that they minimize losses in case either party reneges on the contract, and lower the uncertainty in unexpected outcomes. Although implicit contracts might seem far and few between, given the complexity of arrangements between contracting parties in today s world, this does not appear to be the case in reality. For instance, Gillan et al. (2009) find that less than half of the firms in the S&P 500 have a comprehensive written employment agreement with their CEOs. The mechanisms through which accounting numbers matter for formal contracts differ from those for informal contracts. A formal contract often includes clearly stipulated financial accounting measures to define the boundaries of an agent s authority. For instance, at the time of contracting, accounting numbers are used to determine the parameters of the contract, such as interest rates in borrowings and bonus rates in compensation. Formal contracts also use explicitly described accounting numbers to define events that would need renegotiation of the contract, or lead to the imposition of additional constraints on the activities of a contracting party. For instance, debt contracts often impose restrictions on borrowing, investing or dividend payments based on threshold values for accounting ratios, such as leverage ratios, interest coverage ratios, etc. In contrast, although implicit contracts could also rely on specific-definitions of accounting numbers like those incorporated in formal contracts, generally speaking, implicit contracts are more likely to rely on general measures of financial performance. For instance, payment terms in an implicit agreement between a firm and its supplier would obviously depend on the general financial position of the firm, but would not rely on predefined financial covenants, as it is difficult to enforce specific accounting covenants in such contracts. The rest of the paper is organized as follows. The next two sections describe the role of financial accounting in stewardship and in debt contracting respectively. In Sections 4 and 5, I discuss how specific attributes of financial reporting affect the use of accounting numbers in 5

6 contracting. Specifically, Section 4 focuses on the effects of conservatism and Section 5 on the effects of fair-value accounting. Finally, I draw conclusions in Section The role of financial accounting in stewardship Corporate governance represents control mechanisms that ensure that managers act in the interests of their principals, namely the shareholders. These include both internal mechanisms, such as monitoring by the board of directors, incentive alignment through appropriate compensation contracts and non-financial incentive plans, and external mechanisms, such as monitoring by analysts, class action lawyers, regulatory authorities, and reputation effects in the labour market and the market for corporate control. The effectiveness of corporate governance depends on the quality of information available to those monitoring managers as well as on the quality of the information employed in incentive alignment contracts. 2.1 Financial accounting in monitoring by board of directors Since large firms typically have too many shareholders, internal monitoring by all the shareholders would be infeasible, as well as undesirable owing to the potential leakage of proprietary information. This problem is solved through the use of shareholders representatives in the form of the board of directors. The effectiveness with which a board can carry out its role in monitoring the managers, and in inducing them to act in the shareholders interests, depends on firm-specific information available to them. Effective monitoring requires boards to rely on forward-looking information (i.e., share prices) as well as on backward-looking accounting numbers. While stock price changes have the advantage of revealing all of a manager s value creation, they reflect investors expectations, which are potentially noisy and possibly influenced by sentiment. By contrast, earnings provide more precise measures for monitoring CEOs, and being typically backward-looking are more grounded in reality and based on actual outcomes, rather than subjective expectations. Consistent with accounting information playing a role in monitoring CEOs, Engel, Hayes and Wang (2003) find that CEO 6

7 turnover decisions are correlated with accounting earnings, even after controlling for the impact of poor stock performance. With regards to the use of accounting numbers for monitoring, mandated financial statements that are externally verified through audits are an excellent tool to provide the board of directors with reliable and relevant information. However, board of directors cannot rely on audited financial statements alone, as these are not prepared with sufficient frequency for timely decision-making. Moreover, increasing the frequency of audited financial reports is not feasible, given that auditing is both costly and time-consuming. Thus, board members, especially the non-executive members who in the interests of independent monitoring are not involved in the day-to-day running of the business, have little option other than to rely on voluntary disclosures made by managers. However, in the absence of a credible managerial commitment to be truthful, such disclosures will be uninformative, as managers, driven by their interests to protect personal benefits, would favourably bias the disclosures. In this context, Ball (2001) and Ball et al. (2012) suggest that audited financial reports, even if less timely, can alleviate this problem and allow credible communication of managers private information. They suggest that audited financial statements help outsiders, who include non-executive directors, to evaluate the truthfulness of management s past voluntary disclosures, which then forms the basis upon which the board appraises the credibility of management s subsequent voluntary disclosures. 4 This also removes ex-ante managerial incentives to provide untruthful financial numbers, as they will be aware that their lies will be exposed when audited financial statements are subsequently disclosed. The effectiveness of audited financial statements in playing such a disciplining role, however, depends on whether auditors can independently verify the reported numbers and hence, for the financial reports to be effective in this disciplining role, they need to primarily report verifiable data, which tend to be backward-looking. Carcello, Hermanson, Neal and Riley (2002) provide empirical evidence consistent with the above arguments. Evaluating a sample of Fortune 1000 firms that employ Big-6 auditors, they show 4 Although Ball et al. (2012) focus their arguments and analysis primarily on voluntary disclosures made to outside investors and capital market participants, their arguments apply equally to voluntary disclosures made to outside directors. 7

8 that firms with more independent and higher quality boards have incremental demand for higher audit quality, as reflected in the excess audit fees paid by these firms. This greater level of audit verification allows higher quality boards to obtain credible information in a more timely manner from managers. 2.2 Financial accounting in managerial incentive alignment Accounting numbers are extensively used in top executive compensation contracts, which are often designed to align the incentives for top management with those of shareholders. Based on a survey done in of 177 firms, Murphy (1999) reports that over 90% of the sample firms explicitly include some measure of accounting profits in their annual bonus plans. Likewise, Ittner, Larcker and Rajan (1997) find that almost 99% of firms analysed by them rely on financial measures for annual bonus plans, with earnings per share, net income and operating income being the most common financial measures. These studies establish that accounting measures of performance play a critical role in the board of directors compensation of senior management in firms. This heavy reliance on accounting measures in compensation contracts is driven primarily by an inability to observe managerial effort directly. In an ideal world, where shareholders or directors are able to unambiguously measure and monitor all managerial actions, contracts designed to align managerial interests with those of the shareholders would rely exclusively on managerial effort rather than on the outcome of that effort, as the latter is additionally affected by a variety of factors unrelated to managerial effort. Such a contract would induce managers to focus on expending the right actions. This solution, often referred to in the theoretical literature as the first-best solution, is not feasible in practice, however, as managerial efforts are not entirely observable. Hence, in reality, most incentive alignment contracts are almost always based on realized outcome measures, such as reported earnings. Contracting on outcomes rather than on effort, however, incentivizes managers to take actions that are myopic, focusing on short-term-oriented goals, rather than maximizing long-term shareholder value. Such contracts also induce managers to waste resources on manipulating outcome measurements, such as engaging in earnings management. 8

9 But why are accounting numbers employed so often in incentive alignment contracts? This question arises because, at first glance, it appears that stock prices should be the most appropriate and a sufficient performance measure for alleviating agency problems between shareholders and managers. Stock prices are arguably more relevant than accounting numbers for decision-making by shareholders, whose wealth depends directly on the traded prices. Moreover, share prices are less susceptible to manipulation by senior management. Also, since managerial actions typically affect a firm s performance over multiple periods, compensating managers on share prices rather than on current earnings allows for managerial incentives to be aligned over a longer term, and mitigates concerns over myopic decisions by managers. In the absence of longer-term incentives, managers may avoid undertaking positive NPV projects whose payoffs are expected to arise beyond their tenure with the firm or sell profitable projects early in order to recognize the value created from the project as realized gains in current-period earnings. (Dutta and Riechelstein, 2003, 2005). 5 Partly motivated by these arguments, the use of stock-based compensation has surged in recent times. Bushman and Smith (2001) note that: over the last three decades, the total sensitivity of executive wealth to changes in shareholder wealth has become dominated by executives stock and stock option portfolios, as opposed to cash compensation or other components of executives pay packages... In addition, cash compensation itself appears to have become a less important component of the overall pay performance sensitivities of top executives. In spite of these good reasons to rely almost exclusively on stock-based performance measures, empirically, accounting measures are also employed by firms in executive compensation contracts, which suggests that accounting-based compensation plans must offer certain advantages over stock-based plans. First, compensating based on share prices may not be an attractive option in the case of closely held companies, where existing shareholders may prefer to restrict ownership. Second, share prices can be affected by temporary liquidity or sentiment effects, and it would be inefficient to compensate managers based on temporary price fluctuations. Consistent with this view, Jayaraman and Milbourn (2012) document that stock liquidity influences the composition of CEO annual pay, with both the proportion of equity-based compensation and CEOs pay-for-performance 5 Compensating based on share prices runs the risks that managers may not be interested in actually delivering performance, because share prices reflect the effects of managerial plans on an anticipated basis, rather than reflecting the value created upon implementation of the manager s plans. This concern could be addressed by boards simply imposing vesting restrictions on share awards. 9

10 sensitivity with respect to stock prices increasing in the liquidity of the stock. Third, while stock prices aggregate information about a firm for valuation purposes, this aggregation is not the optimal one for compensation contracts. As Paul (1992) points out, in the context of valuation, share market investors are concerned more with predicting future payoffs, and weigh each signal they receive about a firm say, signals about the profitability of the different projects that the firm undertakes depending on how much of the uncertainty about the firm s future profits it resolves. However, for compensation contracts, the optimal weighting of the various profit signals is based on how accurately each signal reflects the managers unobservable effort in that project. In fact, Paul (1992) shows analytically that, if stock market investors observe information about all projects in a firm with equal precision, then stock compensation contracts would assign the greatest weight to projects that are the noisiest indicators of managerial effort, as signals from these projects contribute the most to share price variations in this case. Lastly, stock-based compensation can subject managers to additional risk by making their compensation a function of industry-specific and economy-wide shocks that are beyond their control (Paul, 1992). Thus both share-based compensation and accounting-measuresbased compensation have a role to play in mitigating incentive conflicts between managers and shareholders. 2.3 Financial accounting in external control mechanisms An important mechanism of external governance is the market for takeovers or corporate control. Even in takeover markets, financial reports play a vital role, as financial statements are a key source of information for making takeover-related decisions. Many important takeover decisions, including identifying a target, estimating synergies and other benefits, are often based on publicly available financial information about the target. The role of financial statements is likely to be even more important in acquisition deals where the target is either unwilling or unable to provide reliable inside information, as would typically occur if a takeover is intended to remove inefficient management of the target. Consistent with the importance of financial reports in corporate control markets, Raman, Shivakumar and Tamayo (2012) find that firms with more transparent financial statements are more likely to be taken over through hostile methods, indicating that the corporate 10

11 control market works more effectively when financial reporting is of a higher quality. They also show that bid premiums paid at takeovers, which indicate the expected value creation in the takeover, are greater for targets with poorer reporting quality. 2.4 Stewardship role of accounting and earnings management incentives Given the substantial evidence that boards rely on accounting numbers to monitor and compensate managers, researchers have studied whether such reliance on accounting numbers for stewardship causes managers to indulge in earnings management. Beginning with Healy (1985), several studies have found that managers opportunistically select accounting methods and estimates to increase their compensation. As Healy (1985) notes, typical executive compensation contracts include an upper and lower bound for earnings, outside which earnings are not eligible for bonus, and this compensation structure incentivizes managers to choose discretionary accruals that maximize not just the current period s bonus, but also the expected value of the next period s bonus. So, when premanaged earnings are anticipated to be between the upper and lower bounds, managers will choose income-increasing accrual estimates, and at other times they generally under-report earnings to boost future periods earnings and bonuses. Healy (1985) provides evidence consistent with such behaviour. Using alternative research methods and data, Holthausen, Larker and Sloan (1995) continue to find support for the Healy hypothesis at the upper bound, but not at the lower bound. They explain the differences in results from Healy (1985) as arising from changes in the structure of compensation contracts during their more recent sample. Specifically, they point out that bonus plans during their sample period from the 1980s and early 1990s were primarily individualized bonus plans, with each executive s bonus having a direct link to the firm s financial performance, whereas the compensation schemes during Healy s sample period of 1930 to 1980 consisted primarily of funding formulae that determined bonus pools available for allocation across eligible executives. Further supportive evidence on compensation-related earnings management is provided in recent research by Burns and Kedia (2006) and Efendi, Srivastava and Swanson (2007), who show that executives equity incentives increase the probability of accounting restatements. 11

12 Dechow and Sloan (1991) study whether compensation contracts based on accounting numbers lead to a horizon problem, where CEOs in the few years prior to retirement reduce investment expenditures, particularly R&D, to improve short-term earnings performance, and they provide evidence supporting the existence of this problem. Other studies (e.g., Pourciau, 1993) document that new CEOs, particularly after a non-routine CEO turnover, tend to shift income from their first year to subsequent years to enhance their reputation, in addition to their compensation. These findings raise concerns over the use of accounting numbers in compensation contracts for new CEOs, and for CEOs close to retirement. Given the vast evidence on managerial incentives to manipulate earnings when compensation contracts and monitoring are based on reported earnings, a natural question that arises is: why do these contracts allow managerial accounting discretion? A simple answer is that it is not always feasible to prevent manipulation entirely, without sacrificing the contracting relevance of the accounting numbers. In fact, as long as managerial actions are not fully observable, incentives for manipulation cannot be entirely eliminated, even by replacing accounting numbers in performancebased compensation contracts with non-accounting measures, such as stock market performance. For instance, based on an investigation of stock option grants to CEOs of Fortune 500 companies, Yermack (1997) provides evidence that stock option awards are timed opportunistically to increase managers compensation. Although earnings management to hide bad performance or boost compensation is almost always viewed negatively by owners or shareholders, it need not be so. Arya, Glover and Sunder (1998) show that accounting flexibility could prevent frequent interventions from owners or boards, who, in the absence of earnings management, would over-react to short-term poor performance and either fire CEOs too frequently or start excessive monitoring of a CEO. By granting some accounting discretion to CEOs, the board allows the CEO more room and time to work things out, and thus lowers the potential costs from owners over-reactions to short-term earnings surprises. Moreover, earnings management need not be costly if both owners and managers are characterized by rational expectations. In a rational world, anticipating opportunistic earnings management by CEOs, owners would appropriately adjust downwards the rate at which bonuses are 12

13 offered to CEOs, or adjust other forms of cash compensation awarded to CEOs. This would prevent managers from increasing their overall compensation by opportunistically selecting accounting estimates and methods. Although no evidence exists for such rational adjustments in the context of earnings management around executive compensation, Shivakumar (2000) provides evidence consistent with similar rational responses in an earnings management game between investors and managers around equity offerings The role of financial accounting in debt contracting Borrowing from debt markets represents one of the most frequent types of fund raising for firms. Armstrong et al. (2010) estimate that nearly 95% of all capital raised by firms in 2006 was in the form of debt. Borrowings can occur either through private negotiations with an individual bank or a syndicate of banks, or through an arms length public issue. Although in either case debtholders face significant agency problems, as discussed in Section 1, private lenders have potential access to proprietary information, such as budgets and detailed financial data, which can reduce the weight that private lenders place on financial statements. In contrast, in public bond issues, proprietary information, even if value-relevant to pricing a bond issue, is not revealed to investors. Such information is at best indirectly available for bond pricing, through the reflection of this information in ratings provided by credit rating agencies, which may be privy to some of the proprietary information. This greater ability to share proprietary information in private negotiations suggests that firms with favourable proprietary information are more likely to prefer private loans, such as bank loans. Consistent with this, James (1987) finds that stock markets react positively to announcements of new bank credit agreements. 3.1 Role of accounting at inception of debt contracts 6 Shivakumar (2000) documents that, in a world with managerial discretion over accounting numbers, managers overstate earnings before announcing an equity offering, and subsequently, on the announcement of the equity offering, investors reverse the stock-price effects of the earlier earnings management. 13

14 At the inception of a debt contract, financial statements provide key information for the contracting parties to determine the parameters of the contract. This role of financial statements goes beyond a simple valuation role i.e., estimation of an appropriate yield for the debt. Financial statements additionally provide input for determining other features of a debt contract, such as callability, convertibility, repayment schedule, and the need for collateral. The use of accounting numbers in deciding the contract parameters is informal, and involves a significant element of subjectivity. Consistent with the importance of financial reports in setting the borrowing terms, Bharath, Sunder and Sunder (2008) find that borrowers with more opaque financial statements face higher interest rates and more stringent borrowing terms. A similar conclusion on the importance of financial statements in setting interest rates is also derived by Minnis (2011), who studies a sample of US private firms and documents that lenders are likely to offer more attractive interest rates for borrowers who voluntarily get their financial statements audited. 3.2 Role of accounting in debt covenants A more formal role for accounting numbers can be found in debt covenants. Debt covenants are either restrictions placed on a borrowing firm s activities (restrictive covenants) or requirements for the borrowing firm to carry out specific actions (affirmative covenants). Examples of restrictive covenants are those that place restrictions on dividend payments or additional borrowings, while examples of affirmative covenants are those that require firms to regularly submit audited financial statements, or to maintain a certain minimum level of working capital. Smith and Warner (1979) hypothesize that covenants aim to restrict directly managerial actions that are detrimental to bondholders, and to act as tripwires that give lenders an option to renegotiate loan terms following a decline in economic performance. Building on contract theory, Christensen and Nikolaev (2012) classify covenants into two types capital covenants and performance covenants based on the mechanism through with the covenants mitigate agency problems. Capital covenants, viz. leverage covenants, rely only on balance-sheet numbers, and require shareholders to maintain enough capital in a firm so that shareholders stakes in a firm remain sensitive to managerial actions. These covenants are aimed at 14

15 aligning debtholder interests with shareholder interests, and at mitigating the need for debtholders to monitor managers closely. In contrast, performance covenants rely on income statement and cash flow statement numbers, and act as tripwires to facilitate the contingent allocation of control to lenders in states characterized by poor economic performance. Consistent with this classification, Christensen and Nikolaev (2012) find that the use of performance covenants relative to capital covenants is greater for firms facing more financial constraints, as capital covenants can be overly restrictive for such firms, and for firms having more informative accounting information, as performance covenants are more effective in firms whose accounting numbers better reflect credit risk changes. Demerjian (2012) provides an interesting perspective on covenants by linking their role to the resolution of contracting problems that arise from lenders uncertainty about a borrower. Lenders who face uncertainty about a borrower s financial position may be reluctant to lend, which at the extreme could even lead to a potential breakdown of the credit markets. Demerjian (2012) proposes that such a potential breakdown is avoided through the use of covenants, which he suggests are an ex-ante commitment mechanism to renegotiate in the future when additional information about the borrower becomes available. Thus, at a loan inception, lenders and borrowers contract based on limited information, but simultaneously commit to renegotiate later when more information becomes available. This commitment to renegotiate, which occurs through covenant usage, allows information unavailable at loan inception to still be incorporated in a loan contract. The key difference between Demerjian (2012) and prior explanations for covenant usage rests on the timing of problems associated with loan contracts. Earlier studies focus primarily on the resolution of agency problems that occur subsequent to loan inception, and on changes in borrowers economic situation after a loan is granted, whereas Demerjian (2012) studies the resolution of information-related problems at loan inception. While little empirical evidence exists on the relative importance of these two sets of problems i.e., the information-related problem at contracting date, and agency problems and changes in borrowers financial situation occurring subsequent to the contracting date it is likely that covenants are included to address both sets of problems. 7 7 Examining a large sample of private loan agreements, Dichev and Skinner (2002) find that covenant violations are not only common, occurring in approximately 30% of loans, but also occur when borrowers are not in 15

16 Theoretically speaking, higher-quality financial reports, defined as more reliable financial reports, could lead either to an increase or to a decrease in their usage in covenants. A lower-quality financial report could heighten the uncertainty faced by lenders about a borrower s financial condition at loan inception, increasing the demand for covenants, as predicted by Demerjian (2012). However, less reliable accounting numbers could also imply a decrease in their usage for debt contracting, as covenants based on unreliable numbers would weaken their role in mitigating agency problems, or in signalling a decline in the borrower s financial situation. Using the disclosure of material internal control weakness under the Sarbanes-Oxley Act as a proxy for poor financial reporting quality, Costella and Wittenberg-Moerman (2011) find that such weakness in a borrowing firm leads lenders to lower their reliance on accounting numbers in debt covenants. Other studies complement this evidence and document that, for firms with poor reporting quality, lenders address heightened information problems by increasing their reliance on non-accounting covenants for such borrowers. For instance, Graham, Li and Qiu (2008) examine the effect of accounting restatements on a firm s loan covenants and find that additional non-financial covenants and loan securitizations are imposed on restating firms in their subsequent loans. Chava et al. (2010) find that firms with more opaque financial reports, measured using a disclosure index from Standard and Poor s, are more likely to face dividend payout restrictions. Ball, Bushman and Vasvari (2008) investigate whether higher-quality reporting, defined as the ability of a borrowing firm s accounting numbers to capture credit risk deteriorations in a timely fashion, affects the ownership structure and contractual structure of syndicated loan deals. They find that when a borrower s accounting information possesses higher quality, lead arrangers hold a smaller proportion of new loan deals, consistent with the information asymmetry between the lead arranger and other syndicate participants being lower in such situations. Further, when the quality of the borrower s financial reports is high, they find that loans with performance pricing provisions based on serious financial difficulty. Roberts and Sufi (2009b) record that almost 90% of the long-term private debt contracts they study are renegotiated prior to their maturity date. These re-negotiations are often voluntary, and are driven by accrual of new information concerning a borrower s credit quality, and by greater availability of financing options for the borrower. 16

17 a single performance measure are more likely to rely on accounting numbers rather than on credit ratings to measure performance. 3.3 Role of accounting in contingency pricing Changes in the financial position of a borrower might cause a lender or the borrower to want to change the terms of the original loan contract. For instance, a borrower whose credit quality has improved might want to lower the interest rate on a loan, or a lender might want to increase the interest rate for a borrower with deteriorating credit quality. This often requires renegotiation, which may be costly, particularly if such interest rate adjustments are needed frequently. One way in which some loan covenants allow for interest rates to be sensitive to changes in the borrower s financial position without the need for renegotiation is through the use of a performance-pricing grid, which maps specific measures of the firm s performance in one period to the interest rates charged in the subsequent period. Performance-pricing grids define performance typically using either credit ratings or accounting ratios. Asquith, Beatty and Weber (2005) find that the debt-to-ebitda ratio is the most commonly used performance measure in pricing grids, followed by credit ratings, interest coverage ratio, leverage ratio and fixed-charge coverage ratio, in that order. 3.4 Modifications to GAAP in debt contracting The reliance on accounting numbers in debt contracting creates incentives for the managers of borrowing firms to engage in manipulation of financial numbers. Through such manipulation, managers could aim to either lower the cost of debt or avoid violating debt covenants. To guard against such manipulation, lenders often exclude the consideration of any effects of voluntary accounting changes, and sometimes even of mandatory accounting changes, in the contract calculations, and require the use of a frozen GAAP for the purposes of determining contractual compliance. Such a requirement to use frozen GAAP, however, increases the costs to borrowers wanting to make accounting changes for reasons other than debt contract manipulation, as the borrowers will need to keep different sets of accounting books for each loan that the firm has outstanding. This cost can be relatively large when one considers the fact that several loan contracts, 17

18 staggered across time, might each require the use of a different accounting standard or method. Moreover, maintaining multiple sets of books could create confusion within a firm as to which accounting record is to be used for which purpose, and increase the likelihood of contract-compliance errors. Nonetheless, among the 206 loan agreements that Beatty, Ramesh and Weber (2002) study, they find that over 50% of the agreements require the use of frozen GAAP. They also observe that, when contracts allow accounting flexibility, lenders anticipate that borrowers will use the flexibility opportunistically, and so protect themselves by charging a higher interest rate. 8 They estimate that lenders charge, on average, an incremental interest rate of 84 basis points when voluntary accounting changes are not excluded from calculation of covenants, and 71 basis points when mandatory accounting changes are not so excluded. Li (2010) is among the few authors who directly investigate contractual definitions of accounting-based covenants. Focusing on a large sample of private debt contracts, and specifically on the definitions of net income and net worth employed in these contracts, he shows that debt contracts typically remove transitory earnings items in the definition of net income, but not of net worth. He shows that debt contracts are never written on comprehensive income as an earnings concept, although other accumulated comprehensive income is included in net worth in most contracts. Consistent with transitory items having little predictive ability for a firm s future performance, Li s findings suggest that the inclusion of transitory items in the income statements makes the income statement items less useful for their use in covenants that act as early warnings of a borrower s future inability to service debt. 3.5 Earnings management and debt contracting 8 Consistent with lenders expectations that managers will use accounting flexibility opportunistically, Beatty and Weber (2003) find that firms are more likely to make income-increasing changes when such changes affect contract calculations. 18

19 Several studies have investigated whether firms make accounting choices to avoid violating debt covenants, as violations of debt covenants are costly. 9 Initial studies evaluating this issue provide little evidence of managers opportunistically using accounting discretion to avoid violating debt covenants. DeAngelo, DeAngelo and Skinner (1994) study a sample of financially distressed firms and find that, among these firms, accruals are insignificantly different between firms with and without binding dividend restriction covenants. Similarly, evaluating a sample of firms close to violating dividend covenant restrictions, Healy and Palepu (1990) find no significant changes in a firm s accounting method surrounding the year of near-violation. They do find, however, an increase in the frequency of dividend cuts and omissions in the year of near-violation. Both DeAngelo et al. (1994) and Healy and Palepu (1990) conclude that accounting choices play an unimportant role in mitigating debt covenant violations. In contrast to the above studies, Defond and Jiambalvo (1994) and Sweeney (1994) study firms that actually defaulted on their debt covenants. Both studies provide evidence that defaulting firms made income-increasing accounting choices in the period leading up to the default. Recent survey-based evidence corroborates this. Based on a survey of over 400 CFOs in the US, Graham, Harvey and Rajgopal (2005) report that firms that are close to violating covenants are more likely than financially healthy listed firms to make accounting choices to avoid violating debt covenants. A common feature of the above archival studies is the relatively small sample sizes employed typically no more than 150 firms. Dichev and Skinner (2002) use a large database of debt issues consisting of over 1,000 firms and over 10,000 loan-quarter observations to examine the earnings management incentives for avoiding debt covenant violations. Additionally, by not restricting their sample to defaulters, they overcome sample selection biases that could have affected inferences in some previous studies. Also, rather than rely on controversial proxies for earnings management, they identify earnings management by evaluating the distribution of covenant slack, which is the difference between the actual realization of a variable and the corresponding covenant threshold for that variable. In the absence of earnings management, covenant slack is expected to be evenly distributed around 9 Roberts and Sufi (2009c) find that covenant violations lead to an increase in interest rates and a decrease in the availability of credit financing to a firm. 19

20 zero. Dichev and Skinner (2002) report unusually fewer observations of covenant slack just below zero and unusually many observations just above zero, providing strong evidence that managers use accounting discretion to avoid violating covenant thresholds. Kim, Lei and Pevzner (2010) provide additional evidence on the methods that managers employ to avoid violating debt covenants. They document that managers prefer real decisions, such as reducing discretionary expenditures or capital investments, over accruals manipulation as a way to avoid violating covenant thresholds. They point out that, unlike accruals manipulation, real earnings management has the advantage for a manager that it does not attract auditor or regulatory scrutiny, as economic decisions aimed at achieving financial reporting objectives cannot be easily distinguished from optimal business decisions. 4. The role of conservative reporting in contracting Ball and Shivakumar (2005) note that financial reports can recognize economic income, which encompasses both current-period cash flow and revisions to the present value of the expected future cash flows of a firm, either in a deferred manner or in a timely manner. Under the deferred approach, the reporting system awaits the realization of cash flows before recognizing these as profits or losses in the income statement. In contrast, under the timely recognition approach, financial reports incorporate economic gains or losses in the income statement as soon as they are incurred, irrespective of when cash is realized. Conservative reporting is the approach under which timely recognition approach is more prevalently employed for recording economic losses, while the deferred approach is more generally used for recording economic gains. Basu (1997) formally defines conservatism as capturing accountants tendency to require a higher degree of verification for recognizing good news than bad news in financial statements. In other words, conservative reporting causes earnings to reflect bad news more quickly than good news. A key focus in this definition is on news that is, conditional on a manager receiving new information about his or her firm s economic profit or loss, conservatism causes economic losses to be recognized more quickly than economic profits. Typical examples of such conservative reporting include the recognition of asset impairment charges and inventory write-downs under the dictum 20

21 lower of cost or market for inventory valuations. In this framework, conservatism refers to the timely recognition of economic losses, but not of economic profits. The focus on arrival of economic news distinguishes Basu s definition from earlier definitions of conservatism, which often muddled up the conditional version of conservatism with unconditional conservatism i.e., understatement of assets and overstatement of liabilities, irrespective of any economic news. From a contracting standpoint, unconditional conservatism merely introduces noise in the financial statements, and does not provide information relevant for decision-making. Moreover, rational agents can undo its effects by altering the thresholds for contracting variables. A classic example of unconditional conservatism is the immediate expensing of research and development expenditures. As compensation committees do not want to dissuade managers from research development expenditures, pay-to-performance contracts typically exclude research and development expenses from earnings measures. Similarly, debt contracts would loosen thresholds, depending on the level of the unconditional conservatism for leverage ratio covenants. Thus unconditional conservatism will have little effect on when the covenants are triggered. In contrast to unconditional conservatism, conditional conservatism affects contracts only when new information about a firm s economic situation is received, and allows covenants to be tripped more quickly upon the arrival of relevant information. This makes conditional conservatism more relevant to contracting and, hence, I focus only on conditional conservatism in this review. Hereafter, I use the terms conservatism, conditional conservatism and timely loss recognition synonymously. Watts (2003) observes that conservatism arises because it is part of the efficient technology employed in the organization of the firm and its contracts with various parties. He suggests that conservatism is a mechanism used to address the moral hazard problems arising from managers of a firm having an informational advantage relative to other parties contracting with the firm. In the next two subsections, I discuss how conservative reporting affects the stewardship and debt-contracting roles of financial reports. 4.1 Conservatism and stewardship role of financial reports 21