Financial Accounting Characteristics and Debt Covenants

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1 Financial Accouning Characerisics and Deb Covenans Richard Frankel Washingon Universiy in S. Louis Lubomir Liov Washingon Universiy in S. Louis Firs draf: January 2006 Curren Draf: March 2007 Absrac 1 We examine he relaion beween financial accouning characerisics and accouningbased covenans. We hypohesize ha use of accouning-based covenans is more likely when asymmeric imeliness is higher and accouning discreion is reduced, because he covenans can more efficienly reduce agency coss in hese circumsances. Overall, we find lile associaion beween he use of accouning-based covenans in lending agreemens and hree financial reporing characerisics (1) he magniude of pas discreionary accruals, (2) Basu s (1997) asymmeric imeliness measure, or (3) Ball and Shivakumar s (2006) asymmeric imeliness measure. We also are unable o find a consisenly significan relaion beween hese accouning characerisics and iniialcovenan slack. Our resuls sugges ha he relaion beween he effeciveness of accouning-based and hese characerisics is marginal. 1 We graefully acknowledge financial suppor from he Cener for Research in Economics and Sraegy (CRES) a Washingon Universiy in Sain Louis. We hank Kose John, Joshua Ronen, and he paricipans of he finance brown bag seminar a he Washingon Universiy in S. Louis for useful discussions. We furher hank Sacie Driebusch and Michelle Wang for research assisance. All remaining errors of course are our own. 1

2 I. Inroducion We esimae he relaion beween financial accouning characerisics and firms use of accouning-based covenans in lending agreemens and he amoun of covenan slack in hese agreemens. The financial accouning characerisics sudied are he magniude of prior discreionary accruals and asymmeric imeliness. We find he use of accouning-based covenans is no clearly associaed wih he asymmeric imeliness of earnings wheher asymmeric imeliness is measured according o he echniques of Basu (1997) or Ball and Shivakumar (2006). Neiher is he use of accouning-based covenans significanly associaed wih he absolue value of discreionary accruals. Furhermore, we do no find a consisen relaion beween asymmeric imeliness or absolue discreionary accruals on he one hand and covenan slack on he oher. Research suggess ha accouning-based covenans are effecive a limiing bondholder/sockholder conflics (e.g., Healy and Palepu, 1990, and Bille, King, and Mauer, 2006) and ha he characerisics of accouning-based covenans are consisen wih conracing-efficiency consideraions (e.g., Lefwich, 1983 and Asquih, Beay, Weber, 2005). Researchers also provide evidence ha deb conracing incenives shape financial reporing characerisics (Ball, Kohari, and Robin, 2000 and Bushman and Pioroski, 2005) and ha financial reporing characerisics are relaed o deb pricing (Moerman, 2006, and Bharah e al., 2004). Taken ogeher hese sudies imply ha accouning characerisics have conracing efficiency implicaions because hey aler he effeciveness of bond covenans. We argue ha a reamen is more likely o be used when i is more effecive. Therefore, if a given accouning characerisic (e.g. lower discreionary accruals) increases he efficiency of accouning-based covenans we will be more likely o observe he use of accouning-based covenans when ha characerisic is 2

3 presen. We use his logic o draw inferences from he correlaion beween accouningbased covenan use and a given se of financial reporing characerisics. Deb covenans reduce shareholder moral hazard by providing bondholders wih addiional righs prior o severe financial disress. The level of covenan slack reflecs he rade-off beween he benefis of a proecive rip-wire and he coss of renegoiaion. If unimely and unreliable accouning reduce he abiliy of accouning covenans o funcion as an advanced warning device and lenders reduce slack in an aemp o counerac his deficiency, hen we expec covenan slack o be reduced as accouning becomes less imely and less reliable. Therefore, we examine he relaion beween covenan slack and proxies for hese accouning characerisics. The accouning characerisics we sudy are discreionary accruals and bad news sensiiviy. These characerisics have been associaed wih he imeliness and reliabiliy of financial repors. 2 conracing efficiency. Researchers have aemped o link hese characerisics wih Exising work focuses on he relaion beween hese characerisics and borrowing coss (Ahmed e al., 2002, and Bharah e al, 2004) and covenan violaions (Zhang, 2004). While hese papers look for effecs given conracs are in place, we examine facors associaed wih he ex-ane choice of covenans. 3 Using he Loan Pricing Corporaion s Dealscan daabase, we idenify privaelending agreemens in a given year ha conain accouning-based covenans. Accouning-based covenans include requiremens o mainain a given ineres-coverage raio, curren raio, ne worh, ec. We hen examine he relaion beween prior bad news sensiiviy and discreionary accrual magniude and he use of accouning covenans in he curren period. We hypohesize ha if hese characerisics are 2 For examples of research discussing he relaion beween discreionary accruals and earnings managemen see Dechow, e al., 1995, Guay, Kohari, and Was, 1996, and Subramanyam, Basu, 1997, ies bad news sensiiviy o imeliness. 3 Demerjian s (2007) also uses an ex-ane perspecive. He examines wheher profiable companies wih low earnings volailiy are more likely o use accouning-based covenans. 3

4 associaed wih accouning-covenan efficiency, hey should be relaed o he use of accouning covenans and he amoun of covenan slack. We find ha accouning-based covenans are less likely o be used when he magniude of discreionary accruals is higher in prior years, bu his relaion is no significan. EBITDA-based covenans use an adjused measure of GAAP income as par of he compuaion of he covenan benchmark and his measure will no be as srongly affeced by discreionary accruals such as depreciaion. To provide a more powerful es, we divide accouning-based covenans ino wo caegories, (1) EBITDA-based covenans and (2) balance shee and earnings-based covenans. (hereafer B&E covenans ). However, we do find a significan relaion beween he use of B&E covenans and he magniude of discreionary accruals. To furher invesigae he affec of discreionary accrual magniude on deb covenans, we examine wheher covenan slack is reduced for firms wih large absolue discreionary accruals. We find a marginally significan negaive relaion beween he magniude of discreionary accruals and covenan slack in curren-raio and angible ne worh covenans bu no significan relaion for ne-worh covenans. Overall, hese resuls provide weak evidence supporing he noion ha covenans are ighened o offse increased discreion in he compuaion of numbers in financial repors. We do no find a srong relaion beween bad news sensiiviy and he use of accouning covenans. We use wo measure of bad news sensiiviy: Basu s (1997) reurn-based measure and Ball and Shivakumar s (2006) cash-flow-based measure. We esimae hese measures a he indusry level. The Basu based resuls provide marginally significan evidence ha accouning covenan use increases as accouning becomes imelier, overall, and wih respec o bad news. The sronges resuls are wih respec o use of B&E covenans. The use of hese covenans increases significanly wih boh 4

5 he asymmeric imeliness and he overall imeliness of earnings. However, covenanslack ess using he Basu-measure do no find a consisenly posiive relaion beween covenan slack and imeliness. In fac, conrary o wha we expec ne-worh covenan slack is declining significanly in asymmeric imeliness. For he Ball and Shivakumarbased measure, we find no significan relaion beween imeliness of accruals and use of accouning-based covenans. Nor do we find a consisenly significan posiive relaion beween covenan slack and imeliness. Our ess are grounded in he noion ha a remedy is more likely o be used when i is more effecive. We also assume accouning-based covenans reduce he incenive conflic beween bondholders and shareholders. Given hese premises, our resuls sugges ha he efficacy of accouning-based covenans is no significanly increased in siuaions where discreionary accruals are limied and where earnings are more asymmerically sensiive o bad news. Our resuls represen a challenge o he argumen ha asymmeric imeliness increases he efficiency of deb conracing. Caveas Low power is a possible explanaion for our lack of findings especially in ligh of he difficulies in measuring accouning discreion and asymmeric imeliness a he firm level. To defend he validiy of hese resuls, we would argue ha our ess are based on over 6,000 firm-level observaions. Moreover, we have used mehods o esimae hese accouning characerisics ha replicae hose used by prior lieraure o produce significan resuls. Finally, as our robusness ess indicae, our resuls hold for a variey of specificaions and esimaion procedures. II. Hypohesis Developmen To provide a framework for undersanding he relaion beween financialaccouning characerisics and accouning-based-bond covenans, we analyze how 5

6 accouning characerisics aler he coss and benefis associaed wih covenans. We assume firms maximize he combined wealh of bondholders and sockholders, i.e., marke value maximizaion (Fama and Miller, 1972). Conflicing bondholdersockholder ineress imply ha sockholders will be emped o deviae from marke value maximizaion and insead maximize he value of shareholders equiy. Expeced deviaions will be refleced in he price of he firm s securiies. Thus, he firm s shareholders have an incenive o assure lenders ha managers will no deviae from marke value maximizaion and o do so a he lowes possible cos (Fama, 1978). Bond covenans are one way o provide his assurance (Myers, 1977, and Smih and Warner, 1979). For example, a minimum-ne-worh covenan can be used o preven he paymen of dividends ha ransfer wealh from bondholders o sockholders (Kalay, 1982). As he value of he firm s asses (V A ) declines relaive o he promised paymen on he firm s deb (P), a dividend of a given amoun resuls in larger ransfer of wealh from bondholders o sockholders. If he deb is abou o maure, and V A < P, every dollar of dividends paid o shareholders reduces he value of deb by a dollar. However, if, a he mauriy of he deb, V A > P, a dividend of V A P can be paid o shareholders wihou affecing he value of he deb. Clearly, he difference beween V A and P is an imporan facor in deermining wheher or no dividend ransfers wealh from bondholders o sockholders. 4 A minimum-ne-worh covenan prevens wealh ransfers by giving bondholders he opion o demand repaymen or renegoiaion of he loan if ne worh falls below a prearranged amoun. By using ne worh as a proxy for V A P he covenan grans addiional righs o bondholders precisely when shareholders/bondholder conflics assume greaer economic significance. In his way, he covenan reduces he agency 4 The variance of V A and he ime remaining unil he mauriy of he deb are also imporan facors. See Galai and Masulis (1976). 6

7 coss arising from deb (Jensen and Meckling, 1976) and increases he value of he firm. Accouning-based covenans ha use oher benchmarks (e.g., earnings before ineres axes and depreciaion o ineres expense, deb o equiy, senior deb o cash flow, and curren asses o curren liabiliies) ac in a similar way o reduce he agency coss of deb. Tha is, hey give bondholders addiional righs when incenive conflics become more severe. However, adding covenans o a lending agreemen leads o incremenal coss. These addiional coss include he cos o negoiae and monior hese covenans. Moreover, when covenan violaion occurs, he lender decides when o exercise he opion o renegoiae and does so o maximize his wealh. The expeced deviaion from marke value maximizaion reduces he ex-ane value of he firm. Aside from hese coss, obaining ouside financing in he presence of significan informaion asymmery beween borrowers and lenders is cosly (Myers, 1984 and Myers and Majluf, 1984). The resuls of El-Gazzar and Pasena, 1990, sugges he adminisraion coss are economically meaningful. They find deb feauring muliple lenders ypically has fewer financial resricions han single lender deb presumably because negoiaion, renegoiaion, and monioring coss are increasing in he number of lenders. Given he coss, accouning-based covenans will no be used if hey do no provide sufficien benefis in he form of reduced agency coss (hereafer agency benefis ). We argue ha accouning characerisics affec he abiliy of covenans o provide agency benefis. A number of facors inhibi he abiliy of financial saemen numbers o provide he basis for covenans ha reduce agency coss. Firs, he firm s accouning sysem can be slow o reflec changes in V A. Moreover, bond values are more sensiive o declines in V A han increases. 5 Therefore, he accouning sysem s imeliness 5 Frankel, 1992 uses an opion pricing framework based on Galai and Masulis, 1976, o illusrae hese poins. 7

8 wih respec o bad news can be more criical o he reducion of agency coss han he accouning sysem s imeliness wih respec o good news (Was, 2003). Second, he accouning sysem may no produce numbers ha are sufficienly verifiable and reliable measures of V A. When an accouning number used o assess covenan compliance canno be verified, managers can avoid covenan violaions by disoring he number. A noisy number reduces he likelihood ha a covenan will provide righs o bondholders when necessary. For example, if we assume ha ne worh on he balance shee is unrelaed o V A P, hen a ne-worh covenan is unlikely o gran addiional righs o bondholders when conflicing incenives are more pronounced. In paricular, he covenan will no provide bondholders wih a reliable and fair means of prevening liquidaing dividends. In such a case, he covenan provides lile agency benefi and is unlikely o be used given is coss. We use he magniude of discreionary accruals as a proxy for he verifiabiliy and noise in financial accouning numbers. Accruals are defined as he difference beween ne income and operaing cash flow. Differences beween ne income and cash flow are expeced based on he firm s growh and producion and invesmen decisions. By esimaing a modified version of he Jones model (Jones, 1991, and Dechow, e al., 1995) our inenion is o provide a measure of he magniude of accruals ha are a he discreion of he manager and o produce a proxy for he verifiabiliy and reliabiliy of repored financial accouning numbers and hus heir abiliy o provide agency benefis when used as he basis for covenans. We do no have srong priors on he relaion beween he agency benefis of accouning-based covenans and he magniude of discreionary accruals. On he one hand, accruals can provide imely informaion abou V A ha is incremenal o operaing cash flows in cases where cash flows can be prediced bu have no ye occurred 8

9 (Dechow, 1994, Subramanyam, 1996, Dechow, Kohari, and Was, 1998, and Ball and Shivakumar, 2006). Accruals can couner he negaive serial correlaion in cash flows, which hinders he abiliy of cash flows o measure changes in V A (Dechow and Schrand, 2004). Furhermore, if repored accruals are merely a linear funcion of sales and propery plan and equipmen and herefore (given sales and PP&E) can be compued wihou reference o managers privae informaion, hey would add lile o conracing efficiency beyond operaing cash flows. A formula could subsiue for repored accruals. On he oher hand, research links discreionary accruals o avoidance of covenan violaions (Defond and Jiambalvo, 1994). In addiion, Xie s, 2001, finding ha discreionary accruals have significan explanaory power for fuure reurns suggess cauion when using he correlaion beween accruals and reurns o isolae accrual manipulaion. In sum, efficienly using discreionary accruals o augmen he imeliness and reliabiliy of operaing cash flows as a performance measure implies no relaion beween he magniude of discreionary accruals and he use of accouning-based covenans. Alernaively, if discreionary accruals are used o disor earnings, reducing is reliabiliy as a performance measure, we would expec less use of accouning-based covenans in siuaions where he magniude of discreionary accruals is large. Therefore our firs hypohesis is as follows: H1: The use of accouning-based covenans is negaively relaed o he magniude of discreionary accruals. We also examine he relaion beween measures of earnings imeliness and he use of accouning-based covenans. When earnings are less imely, accouning-based covenans are less effecive in reducing agency coss, because when changes in V A are no immediaely refleced in accouning numbers used o assess covenan compliance, 9

10 covenans do no preven he ransfer of wealh from bondholders o sockholders. For example, if repored ne worh does no reflec economic losses incurred in he curren period, he firm can pay liquidaing dividends wihou violaing is minimum-ne-worh covenan. Similarly, if repored ne worh does no reflec gains generaed by he firm in he curren period, a minimum-ne-worh covenan can reduce firm value by resricing he paymen of dividends, even hough his resricion provides lile benefi o he bondholders. 6 In sum, reduced earnings imeliness, reduces he agency benefis of accouning-based covenans, and we expec ha hey will be used less frequenly. We also es for agency benefis from asymmerically imely recogniion of losses over gains. Was (2003, p. 209) argues ha Conservaism consrains managerial opporunisic behavior and offses managerial biases wih is asymmerical verifiabiliy requiremen. Echoing his senimen, Ball e al. (2000, 2), sae, conservaism as we define i makes leverage and dividends resricions binding more quickly Conservaive accouning hus faciliaes monioring of managers and of deb and oher conracs Conservaism can be defined as requiring a higher sandard of evidence for he recogniion of gains han for losses. As evidence accumulaes, conservaism implies ha losses will end o be recognized in a more imely manner han gains. Guay and Verrecchia, 2006, argue incorporaing difficul-o-verify news is cosly and because bondholders are more concerned abou bad news i may be more efficien o incorporae difficul-o-verify bad news and ignore difficul-o-verify good news. Empirical resuls sugges conservaism is associaed wih increased conracing efficiency (e.g., Ahmed e al., 2002, Zhang, 2004). Thus, our second hypohesis saed in alernaive form is: H2: Condiional on he imely recogniion of good news, he use of accouning-based covenans is posiively relaed o incremenal imeliness in he recogniion of bad news. 6 This argumen assumes dividends policy affecs firm value. 10

11 Iniial covenan slack reflecs a rade-off beween agency coss and renegoiaion coss. To minimize agency coss a firm will reduce covenan slack. Reducing covenan slack allows he lender o renegoiae he erms of he loan prior o significan deerioraion in he credi worhiness of he borrower. As par of his renegoiaion process, he lender can reques updaed financial informaion from he borrower (Dichev and Skinner, 2002). In his way, igher covenans allow he lender o closely monior he financial condiion of he borrower and rapidly gain addiional righs should incenives problems arise. To minimize renegoiaion coss a firm will increase covenan slack. Myers, 1977, noes ha renegoiaion can be muually beneficial o lender and borrower when he ne presen value of an invesmen projec is posiive bu less han he promised paymen on he deb. However, when a covenan is violaed, he lender is graned he opion o renegoiae or collec he loan. His decisions will be based on a desire o maximize his payou raher han he value of he firm. As covenan slack is reduced, ceeris paribus, he probabiliy ha he lender will be given he opion o renegoiae or collec on he loan increases. Thus, he expeced coss of his non-marke value maximizing renegoiaion are increased by reducing slack. More imely and reliable financial repors can subsiue for reduced covenan. For example if accouning-based covenans are used in a lending agreemen and financial saemens are more reliable, he lender will be less concerned ha he borrower is delaying covenans violaions by earnings manipulaion. Therefore, if accouning is more reliable, an accouning-based covenan can achieve a given level of conrol wih more covenan slack. A similar argumen can be made for he imeliness of earnings. Tha is, reducing covenan slack is one way o ensure ha an accouning-based covenan provides early 11

12 warning of financial difficulies. More imely earnings, in paricular, wih regard o bad news, can provide a subsiue for reduced slack. Therefore, hypoheses hree and four, are as follows: H3: Covenan slack is negaively relaed o he magniude of discreionary accruals. H4: Condiional on imeliness in he recogniion of good news, covenan slack is posiively relaed o he imeliness in he recogniion of bad news. Efficiency is improved if accouning and covenan choices can be made simulaneously. The firm can hereby minimize (1) he coss of reliable financial saemens, (2) renegoiaion coss, (3) he monioring and adminisraive coss of covenans, and (4) agency coss of deb. Therefore, we expec some endogeneiy in he relaion beween accouning characerisics and accouning covenans. The effec of endogeneiy is magnified if deb levels and covenans are joinly deermined. We argue ha regressions of curren covenan characerisics on lagged accouning characerisics are suiable way o reduce endogeneiy. We use lagged accouning characerisics o proxy for pre-deermined values of he independen variables. A significan porion of he reliabiliy and imeliness of a firm s financial saemens is fixed by he firm s prior producion and invesmen decisions. For example, he reliabiliy of he financial repors a grocery sore, which has a shor operaing cycle, is likely o be higher han ha of a consrucion firm which is required o esimae income on is ye-o-be-compleed projecs. Moreover, he porion of a firm s accouning imeliness and reliabiliy ha is fixed by prior producion/invesmen decisions is poenially more relevan o he form of subsequen covenans, because he firm can credibly commi o i. Second, o limi endogeneiy, we also adop a wo-sage leas squares esimaion framework where we rea leverage as endogenous. In he search for valid insrumens we aim o find 12

13 exogenous variables ha are economically relaed o leverage choices bu are uncorrelaed wih he error erm of he second-sage regression relaing he incidence of accouning-based covenans o corporae accouning imeliness and reliabiliy. We insrumen leverage wih he average book leverage of oher companies in he same indusry based on he premises ha (1) similar firms have similar capial srucures and (2) compeiors financing policy decisions impac a company s capial srucure decision hrough compeiive pressure in he underlying produc markes (Brander and Lewis, 1986). III. Daa Our empirical analysis has wo componens. Firs we examine wheher he use of accouning-based covenans is relaed o accouning qualiy. Second we invesigae he relaion beween covenan slack in accouning-based covenans and accouning qualiy. In his secion, we provide a brief descripion of he variables used in our models. Furher deails on he compuaion of each variable can be found in Table Measures for Accouning Qualiy in Conracing We seek o measure wo underlying characerisics when building proxies for accouning qualiy in conracing. The firs is asymmeric imeliness in reflecing economic losses in he accouning saemens. The second is he exen of managerial discreion in recognizing economic evens in financial saemens. To capure asymmeric imeliness, we use he cash flow/accruals regressions of Ball and Shivakumar (2006) and he earnings/reurns model of Basu (1997). To capure he exen of managerial discreion side, we use absolue discreionary accruals, based on he Jones (1991) model. 13

14 Timeliness of loss recogniion (Ball and Shivakumar) Following Ball and Shivakumar (2005, 2006), we esimae a piecewise-linear regression of accruals on cash flows as follows: ACC OCF OCF = α + α D + α + α * D + ε, (1) TA TA TA i, i, i, 0, j 1, j OCFi, < 0 2, j 3, j OCFi, < 0 i, i, 1 i, 1 i, 1 where ACC are accruals, OCF is operaing cash flow, TA is oal asses, D is an indicaor variable equal o one when operaing cash flow is less han zero, i indexes he firm, indexes he year, and j indexes he hree-digi SIC code indusry. The definiions of he variables in he model follow hose of Ball and Shivakumar (2006). 7 We use indusrylevel esimaes o avoid measuremen error arising from insufficien daa a he firm level. 8 Our measure of imeliness of loss recogniion is he coefficienα 3, j. We esimae his regression each year using he prior en years of daa beginning in 1989 and rolling forward unil The esimaes from hese regressions are labeled imeliness of loss recogniion coefficiens for he following fiscal period, e.g. esimaes from he 1980 o 1989 inerval provide he independen variables for our fiscal 1990 bond-covenan regressions. The corresponding indusry loss recogniion measure is assigned o each sample firm. To compue a reliable measure of asymmeric imeliness we require a leas en firms o be presen in he indusry Timeliness of loss recogniion (Basu) We employ anoher measure of imely loss recogniion, esimaed using he marke-based model of Basu (1997). The model relaes earnings o conemporaneous 7 In he robusness secion, we discuss resuls wih esimaes of accruals derived from he balance shee as in Ball and Shivakumar (2005). In he ables below we presen esimaes based on he definiion of accruals as he difference beween he income before exraordinary iems (#123) ne of ne income from operaing aciviies (#308) scaled by he lagged oal asses (#6). 8 We also compue a firm-level measure of imeliness of loss recogniion on a sample ha requires en firm-year observaions. We discuss he resuls using ha measure in he robusness secion. 14

15 sock reurns, which serve as a proxy for economic gains and losses. Following Basu (1997), we esimae he regression of accouning income on sock reurns: EP. β β β β * + ξ i, i, i, i,, i = 0, j + 1, j DR < 0 + 2, j R + 3, j DR < 0 R i, (2) where EP is earnings o price, R is annual reurns, and D is an indicaor variable equal o one when reurns are negaive. 9 The incremenal imeliness of earnings loss recogniion is measured by β 3, j. We esimae he above regression over he prior en years by hreedigi SIC code indusry, indexed by j. 10 We use β 2, j o esimae imely gain recogniion Absolue abnormal accruals We use he Jones (1991) model o esimae discreionary accruals: ACC TA S i, PPEi, γ + γ 2, j, + γ 3, j, + ζ TA TA i, 1 = 1, j, i, 1 TAi, 1 i, 1 i, 1 i, j., (3) where S is he change in annual sales and PPE is propery plan and equipmen. We perform he above regression over he prior en-years. We esimae he regression for each indusry (defined as hree-digi SIC code), indexed by j for fiscal years 1990 hrough We rerieve he coefficien esimaes and hen obain firm-level discreionary accruals (DA) as follows (Dechow, Sloan, and Sweeney, 1995): ACC TA i, i, 1 = 1 i, i, i, ˆ γ ˆ ˆ ˆ 0, j, + γ 1, j, + γ 2, j, + γ, where (4) 3, j, TAi, 1 TAi, 1 TAi, 1 TAi, 1 S RC PPE DA i, ACC ACC TA i, i, =. (5) TA i, 1 i, Deb faciliy daa We collec daa on he characerisics of he loan faciliies for Compusa firms from Dealscan, a daase creaed by Loan Pricing Corporaion (LPC). This daabase 9 We use adjused reurns and earnings in our main esimaion of he Basu s model. In he robusness secion we discuss he resul of he similar regressions using raw reurns. 10 In he robusness secion we discuss esimaes from firm-level regressions. These firm-level esimaes are resriced o firms wih a leas en firm-year observaions 15

16 includes iems such as bond covenan ype, mauriy srucure, size, coss (such as all-in drawn spreads, upfron and uilizaion fees, ec), credi raing, number of lenders, and issue dae for all he loan faciliies. Dealscan idenifies each credi faciliy by company name and icker. We hand mach hese faciliies o he firms in Compusa hus creaing a comprehensive daase of loan faciliies daing back o We develop our main resuls wih he sample of as Dealscan s coverage of covenans embedded in smaller size bank loans prior o 1993 is sparse Covenan Indicaors LPC Dealscan provides indicaors for he presence of weny-four bond covenans. A subse of hese covenans is described in he appendix. 12 As he exac naure of individual covenans can be quie inricae, a valid coninuous measure, reflecing he deails of each covenan is unrealisic. We herefore resric our measure o be an indicaor variable represening he presence of a leas one covenan from a se of covenans in he loan conrac, as described below. The LPC daase is organized a he loan faciliy level. Because he analysis in his paper is a he firm level, our covenan indicaor variables are se o one if a firm has one faciliy in a given fiscal year of he given covenan ype. To focus on he use of accouning-based covenans, we disinguish beween hose covenans whose violaion depends on aaining a specific accouning-based benchmark from hose ha do no. We denoe he former as accouning-based covenans and he laer as oher covenans. Oher covenans include sweeps and he requiremen ha he loan be secured. These covenans generally have no explici accouning-based 11 Dichev and Skinner (2002) limi heir sample o pos-1994 sample due o biases in reporing covenans in LPC prior o ha year. 12 In he appendix we lis he eigheen mos common covenans. In addiion o hese, here are he following (in brackes rae of occurrence as a percen of all covenans): maximum loan value (0.05%), percen excess cash flow (0.21%), percen ne income (1.07%), required lenders (35.6%), erm changes (32.3%), collaeral release (18.95%), invesmen baske (0.64%). We differ from Bradley and Robers (2004) because we seek o classify covenans according o heir use of accouning informaion. 16

17 componen. For example deb issuance sweeps require repaymen of principle from a porion of he proceeds of he new deb issuance. Our hypoheses concern he presence of accouning-based covenans. We do no develop specific predicions wih regard o he relaion beween he presence of non-accouning based covenans and accouning qualiy. Insead as par of our robusness ess we include indicaors for he presence of oher covenans in our model, in he even ha such covenans ac as correlaed omied variables and hereby affec our inferences on he relaion beween accouning-based covenans and accouning qualiy. We discuss hese resuls as par of our robusness checks. Accouning-based-covenan indicaor. Our goal in developing an accouning covenan indicaor is o provide a measure for wheher or no he violaion of he firm s bond covenans depends on financial accouning oucomes. Covenans of his ype include coverage raios, leverage raios, curren raios and ne worh-based benchmarks. We disinguish beween covenans whose benchmark depends on earnings or balance shee measures ( E&B covenans defined in I.B of he appendix) from hose whose benchmark depends on an approximaion of operaing cash flow (EBITDA-based covenans defined I.A in he appendix). EBITDA-based-covenan benchmarks depend on curren accrual choices such as receivables and accrued liabiliies. However, hey are immune o depreciaion and amorizaion choices. Creaing separae caegories for hese covenan ypes allows us o examine wheher accouning qualiy is less criical when lenders and borrowers employ cash-flow-based covenans Covenan-Slack Measures We compue covenan slack for curren-raio, ne-worh, and angible-ne-worh covenans following he mehod of Dichev and Skinner (2002). For example, for each faciliy, f, he curren-raio-covenan-slack measure is compued as 17

18 curren raio covenan-curren raio f, 1 ln, f, (6) Where he curren raio f,-1 is compued based on he firm s end of year -1 financial saemens daa aken from COMPUSTAT, and covenan-curren raio f, is he covenancurren-raio benchmark for a loan faciliy originaed in year obained from Dealscan. We hen value weigh his measure across all faciliies wih a curren raio covenan in year. Value weighing is based on he loan amoun. Compuaion of ne-worhcovenan slack and angible-ne-worh-covenan slack for each firm year is done in a similar way Firm-Characerisic-Conrol Variables Maliz (1986) and Begley (1994) find ha highly levered firms are more likely o include resricive covenans in public deb issues. We hus conrol for he leverage of he company in our regressions. Book leverage is defined as shareholders equiy o oal asses a he end of he fiscal year. Shareholders equiy includes he deferred ax liabiliy and converible deb bu excludes preferred sock. 14 This approach follows Fama and French (1997). In our wo-sage leas squares esimaion we insrumen firm leverage by he average leverage of oher firms in he same hree-digi-sic code, o reduce endogeneiy associaed wih his variable. We include a measure of firm age, because Baker and Wurgler (2002) find ha i is relaed o leverage. We define firm age as he difference beween he curren fiscal year and he year when he firm has firs appeared on he CRSP apes. Leverage and he naure of covenans are also relaed o asse angibiliy (Smih and Warner, 1979 and Smih and Was, 1992). We define asse angibiliy as plan, propery, and equipmen divided by oal asses and include i as an independen variable. We also include he firm s marke-o-book raio as a proxy for he 13 Compusa daa definiions are in Table Please see Table 1 for deails. 18

19 imporance of growh opions. Kahan and Yermack (1998) and Nash, Neer, Poulsen (2003) examine he relaion beween a firm s growh opporuniies and he choice of covenans in public deb. Boh sudies find ha high growh firms are less likely o include resricive covenans, suggesing ha he benefis of fuure flexibiliy ouweigh he agency benefi of including covenans. Begley (1994) finds ha he firm s risk of financial disress is negaively relaed o he use of covenans. We conrol for he risk of financial disress in four differen ways. Firs, we conrol for he long-erm credi raing, assigned o he company by Sandard & Poor s. Second, we conrol for he volailiy of daily reurns from he prior fiscal year because of he relaion beween volailiy and defaul risk (Hillegeis e al., 2004). Third, we include a measure of curren profiabiliy. I is defined as EBITDA (Compusa iem #13) divided by oal asses as of he curren fiscal year. Finally, we conrol for firm size. IV. Empirical Resuls 4.1. Univariae Resuls Table 2 and Table 3 presen univariae resuls. Our analysis excludes financial companies and regulaed uiliies, as he deb financing paerns of hese firms differs subsanially from oher companies. We sar wih he LPC Dealscan se of loans mached o Compusa. Upon compleing he mach, we aggregae our daa a he firmyear level. The merged sample conains a oal of 12,393 firm-years for some 4,539 companies for he period 1994 hrough We hen impose he requiremens of availabiliy of all experimenal and conrol variables, including unsigned discreionary accruals and asymmeric imeliness measures. Tha leaves 6,161 firm-year observaions, 19

20 represening 2,530 firms. The laer represen 24% of he oal corporae book asses for non-financial and non-regulaed companies in Compusa as of In Table 2 we abulae key variables for he enire sample and he sample of firms wih accouning covenans. These abulaions show ha firms wih accouning covenans have lower marke-o-book raios, are less profiable, have on average 551 million US$ less in oal asses (exp(6.795)-exp(5.836)), are on average seven years younger, have lower Alman (1968) Z score, have more volaile sock reurns, are less likely o have Sandard & Poor s long-erm credi raings (33% of he sample populaions vs. 47% oherwise), are less likely o have a credi rank aached o heir bank loan faciliy, have a greaer number of faciliies exended per year, have deb faciliies priced a abou 55 basis poins higher han oherwise, issue significanly higher amoun of deb as a share of heir oal asses, ha are more ofen secured (63.6% of he sample populaion versus 19.8% oherwise). Overall firms whose deb has accouning covenans appear o be more volaile companies wih greaer defaul risk, and less angible asses. Resuls in Table 2 also show ha hose firms whose deb conains accouning covenans, have differen asymmeric imeliness of loss and gain recogniion. However, he resuls are conradicory and hus he inerpreaion is unclear. For example, based on he Ball and Shivakumar (2006) measure, firms wih accouning-based covenans have higher magniude of he α 3 coefficien (i.e. are more asymmerically imely in recognizing heir losses). This resul suggess ha asymmeric imeliness aids he efficacy of accouning-based covenans. This paern is no corroboraed when one 15 We sar wih 57,275 loan faciliies in LPC Dealscan beween , represening 35,000 unique firm-years and 18,373 unique firms. We nex exclude any firms ha are in he financial indusry (SIC code header 6) or in regulaed indusry (SIC code headers 48 and 49). Tha resuls ino a oal of 42,490 faciliies, or 25,552 firm-years, or 13,771 firms, indicaive of he large number of faciliies exended o a small number of financial and regulaed firms. We hand mach he residual companies o Compusa CUSIP idenifiers based on he names and he provided ickers (if available) in he LPC Dealscan daabase. Such hand-maching is required as ofenimes he provided ickers change hrough ime or for a subse of he companies no icker is provided. Upon maching o COMPUSTAT, we obain a oal of 21,489 faciliies, represening a oal of 12,393 firm-year pairs ha correspond o a oal of 4,539 firms, as idenified by heir CUSIP. Our daase is subsanially larger han ohers. For example, Bharah e al (2004) obain a daase of 7,334 faciliies for some 3,081 firms over , a period largely overlapping wih ours. 20

21 compares he measure of imely loss recogniion based on he marke model of Basu (1997), β 3. Unsigned discreionary accruals are on average higher for firms wih deb ha conain accouning covenans. 16 Given he oher significan differences beween firms whose deb uses accouning covenans and hose ha do no, hese univariae accouning qualiy resuls should be viewed wih cauion. We nex examine he correlaions among he main bond covenan measures. We sar wih Panel A in Table 3, which displays he correlaions among he bond covenan indicaor variables and value-weighed mauriy. All covenans appear o be significanly correlaed among hemselves, suggesing ha covenans are complemens raher han subsiues. Secured deb is seen when accouning covenans are presen in deb agreemens abou 42.1%. Oher covenans (sweeps) are more ofen seen when accouning covenans are presen. The use of EBITDA-based and oher accouning covenans is also highly correlaed a 60.7%. The presence of accouning covenans is no significanly associaed wih he mauriy of deb. The presence of sweeps or evenriggered covenans is associaed wih longer mauriy as indicaed by he 19.5% saisically significan correlaion. According o Panel B of Table 3, more imely loss recogniion (α 3 ) is posiively associaed wih accouning-based covenans. This resul is no corroboraed when we examine imely loss recogniion based on β 3 in Basu s (1997) marke model which is associaed wih reduced use of bond covenans. Conrary o our hypohesis, higher unsigned discreionary accruals (indicaive of low qualiy of accouning reporing) are associaed wih he presence of accouning covenans (saisically significan 6.71% pairwise correlaion). These resuls are consisen wih he Wilcoxon ess in Table All of he above-examined firm characerisics have saisically significanly differen means across he samples of firms wih and wihou accouning covenans in heir deb agreemens, as judged by a Wilcoxon non-parameric es of equaliy of means (significance a 1% level). 21

22 The univariae resuls on he relaion beween unsigned discreionary accruals and he imeliness of loss recogniion measures sugges hese measures are no generally capuring he same underlying consruc. High discreionary accruals are associaed wih high imely loss recogniion based on Ball and Shivakumar s (2006) model measure α 3 which runs couner o our expecaions firms wih beer qualiy of accouning reporing o be more imely in he recogniion of losses (saisically significan posiive correlaion of 7.49%). The pair-wise correlaion beween α 3 and β 3 shows ha hey are saisically significanly negaively correlaed a -9.7%. One way o view hese resuls is ha each of hese measures focuses on a disinc aspec of accouning qualiy or imeliness. We now urn o an examinaion of he cross-correlaions among he main conrol variables (Table 3, panel C). We noe ha signs of all correlaions of book leverage wih oher firm characerisics have he expeced signs based on prior capial srucure sudies. Mos of he correlaions are below 25% and above -25%. However, in some cases he correlaions are ouside of ha range. The correlaion beween reurn volailiy and he logarihm of oal asses is -52.7%, beween oal asses and firm age is 48.7%. As he presence of mulicollineariy among independen variables could lead o biased coefficien esimaes, coefficiens on size, age, and reurn volailiy in subsequen ess should be inerpreed wih cauion Mulivariae Resuls We aggregae he bank loan daa from LPC a he fiscal-year level for each firm. Companies can have a number of faciliies exended in any paricular fiscal year and reaing each as an independen observaion can bias our sandard errors upward. Therefore we proceed wih a firm-year level panel. In Table 4 we examine he relaion beween he propensiy o include accouning covenans and qualiy of accouning reporing (Hypohesis 1). The poenial join deerminaion of accouning raio covenans 22

23 and firm rais raises endogeneiy concerns. To address hese concerns, we underake wo sraegies. Firs, we use firm characerisics from he year prior o he originaion of he deb faciliy. Second, we use a wo-sage leas squares (2SLS) esimaion framework, where we rea leverage as endogenous. We insrumen leverage as he average leverage of oher companies in he same hree-digi SIC code indusry. In Panel A of Table 4 we presen he regression resuls of a wo-sage leas squares probi model using he unsigned discreionary accruals as our main experimenal variable. Because he probi regression specificaion is a non-linear funcion, he able presens esimaes of he marginal impac of each coefficien (i.e. he regression slope), evaluaed a he mean of he covariaes, on he probabiliy of including a covenan. We begin wih he slope on he marke-o-book raio. In all hree specificaions he coefficien, is significan. However i is negaive, which is no consisen wih he finding of boh Bradley and Robers (2004) and Bille e al. (2006). The relaion beween measures ha characerize he financial condiion of a firm such as firm size, angibiliy, profiabiliy on one side and he presence of covenans on he oher is generally as expeced given prior agency heoreic lieraure, (e.g. Myers (1977) and Smih and Warner (1979)) and is consisen wih he empirical lieraure (see Maliz (1986)): younger firms, wih low asse angibiliy, smaller size, or lower credi raing are expeced o have accouning covenans more ofen. We inerpre hese variables as measuring he exen of he poenial conflics beween shareholders and bondholders ineress. For example, as firms have more risk of bankrupcy, he problems of underinvesmen and liquidaing dividends become more pronounced. The posiive coefficien on profiabiliy runs couner o his reasoning given more profiable companies are less likely o face financial disress. As expeced, book leverage is associaed wih higher propensiy o include accouning-based covenans. Firms wih more faciliies in a given year are also 23

24 more likely o employ accouning-based covenans suggesing economies of scale in negoiaing hese provisions, bu also consisen wih more leverage leading o greaer use of covenans. We furher conrol for he credi spread following Bradley and Robers (2004). We define he credi spread as he average difference beween AAA and BAA raed corporae bonds. We find ha his variable is no significan. We now urn o our analysis of he variable of ineres, he impac of unsigneddiscreionary accruals on he likelihood o include accouning covenans. Higher accouning discreion is associaed wih less frequen use of accouning covenans, as evidenced by he negaive coefficien on absolue discreionary accruals in model 1. This coefficien is saisically significan for he EBITDA-based covenans (-0.828, - saisic = -3.66). However, his significance is no corroboraed by he oher specificaions. This resul suggess ha accouning discreion is likely o have more impac on earnings before ineres axes and depreciaion. The economic effec of accouning discreion is imporan: a one percen increase in he unsigned discreionary accruals from heir mean value would lead o a 0.828% decrease in he likelihood of having income-based covenans. 17 We esimae he effecs of asymmeric imeliness in Panel B of Table 4. We presen resuls based on he measures of imeliness of loss recogniion in Basu (1997) and Ball and Shivakumar (2006). For breviy, we do no repor he conrol variable esimaes, which are he similar o hose in Panel A. We firs display he resuls of he model using he imeliness measures from Basu s (1997) model. The resuls are mixed. The esimaes of he coefficien β 3 are posiive in all specificaion bu are saisically significan only in 17 This resul is robus o various specificaions. In furher robusness checks, we include addiional conrol variables, such as loan-specific characerisics (performance pricing dummy) and firm-specific rais (asse mauriy): our resuls remain unchanged. Our findings on hese addiional independen variables are in line wih he prior empirical lieraure. We obain a saisically significan negaive coefficien on Alman-Z as in Bille e al. (2006). Performance pricing or high economy-wide corporae credi spreads are saisically significanly associaed wih higher likelihood of accouning-based covenans, in line wih he findings of Bradley and Robers (2004). 24

25 models 1 and 2. They are of limied economic significance: for example, based on model 3, one percen increase in he asymmeric imeliness of earnings from is mean value would lead o a 0.14% decrease in he likelihood of having accouning-based covenans. The effec of imely gain recogniion on inclusion of accouning covenans, represened by β 2, is posiive and is significanly relaed o he likelihood of including covenans in models 2 and 3. We noe ha our endogeneiy concerns are subsaniaed only o a limied exen, as he Wald es rejecs he null hypohesis of exogeneiy of book leverage only for model Resuls based upon he Ball and Shivakumar (2006) measure of imeliness are weak. Boh imely gain and loss recogniion are saisically insignifican and economically less imporan deerminans of he propensiy o include accouning-based covenans as compared o he resuls of Basu s (1997) measures. We conclude ha he imeliness of loss recogniion appears o be less imporan deerminan of he inclusion of accouning covenans in deb agreemens. Table 5 displays resuls from an invesigaion of he relaion beween he resriciveness of he bond covenans and he corresponding measures of accouning qualiy. We focus on he curren-raio, ne-worh and angible-ne-worh covenans, because hese raios are mos clearly defined. Two mehodological feaures should be noed. Firs, we conduc our analysis a he firm-year level, as opposed o he faciliy level. One advanage of his approach is ha i miigaes he correlaion in residuals, as faciliy-level observaions for he same company may no be independen. Second, direcly esimaing he relaion beween he disance measures and accouning reporing qualiy would produce inconsisen esimaes as omiing he inverse Mill s raio would lead o specificaion error (Greene, 2002). Therefore, we use a wo-sage Heckman 18 The Wald es of exogeneiy in discree dependen variable models, such as probi, is similar o he Hausman specificaion es in insrumenal variable esimaion. See Greene (2002) and Newey (1987) for furher deails. 25

26 (1979) esimaion framework o conrol for he decision o use an accouning-based covenan. In he firs sage we predic he incidence of an accouning-based covenan using all variables from Table 4. In he second sage, we examine he relaion beween accouning qualiy and covenan slack. The second sage esimaion includes he inverse Mills raio compued in he firs sage as well as marke-o-book, angibiliy, profiabiliy, firm size, reurn volailiy, and credi raing as conrol variables. These conrol variables are consisen wih hose idenified by Beay, Weber, and Yu (2006). In Panel A of Table 5 we sudy he relaion beween he resriciveness of he covenans and he absolue discreionary accruals. The able presens hree differen specificaions. Each has wo columns; he firs one displays he firs-sage esimaes, while he second shows he selecion equaion esimaes (i.e., he second-sage esimaes). Cerain variables in he selecion equaions such as marke-o-book raio, firm size, leverage, sock reurn volailiy and S&P credi raing are negaively associaed wih he presence of curren raio, ne-worh or angible ne worh covenans. They also preserve heir saisical significance in all hree selecion equaions. Profiabiliy is posiively associaed wih he presence of he hree covenans in he selecion equaions in Panel A. Oher variables, such as he corporae credi spread, asse angibiliy, firm age and unsigned discreionary accruals, change signs across selecion equaions in Panel A. We aribue his change o he fac ha hese probi models aemp o predic he presence of a specific ype of accouning covenan, as opposed o he presence of accouning-based covenans in general. Overall he firs-sage models are significan as indicaed by heir chi-squared saisics. The repored chi-squared saisics are from a Wald es of he join significance of all regression coefficiens in he regression. We now urn o analysis of he second-sage equaions in Panel A. For boh curren raio and ne worh covenan slack regressions he inverse Mills raios indicae he 26

27 presence of selecion bias. In all of he models high absolue discreionary accruals are associaed wih lower covenan slack. These associaed are saisically significan excep for he ne-worh covenan. These resuls are consisen wih he argumen ha increased accouning discreion (as measure by absolue discreionary accruals) is associaed wih reduced slack. We now urn o he Panel B, where we sudy he associaion beween covenans slack and imeliness of loss recogniion. We focus our analysis on he main equaions. The inverse Mills raio indicaor is significan in models 1 and 2, for boh measures of imely loss recogniion. Noe ha all models specificaions are significan, as judged by he p-values of heir chi-squared saisics. The measures of imely gain recogniion, β 2 is negaive and significan in he curren-raio covenan slack regressions. The coefficien is negaive, which is opposie o our conjecure ha more imely gain recogniion is associaed wih higher slack. The imely loss recogniion coefficien β 3 is significan in he ne-worh covenan second sage equaion. The coefficien is negaive, indicaing ha more imely loss recogniion is associaed wih lower ne-worh covenan slack. Overall hese resuls do no suppor he belief ha imely recogniion is a subsiue for covenan slack. Our resuls are more consisen when we sudy he relaion beween Ball and Shivakumar (2006) measures of imeliness of losses and gains recogniion in relaion o covenan slack. In all hree models imely gain recogniion is associaed wih higher covenan slack. However his associaion is saisically significan only for curren-raio slack. Similarly, imely loss recogniion is posiively relaed o covenan slack in all models. However, i is saisically significan only for angible-ne worh covenan slack. In sum, we conclude from hese resuls ha he impac of asymmeric imeliness 27

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