Fair Value Accounting for Liabilities and Own Credit Risk

Transcription

1 Fair Value Accouning for Liabiliies and Own Credi Risk Mary E. Barh Graduae School of Business Sanford Universiy Leslie D. Hodder Kelley School of Business Indiana Universiy Sephen R. Subben Graduae School of Business Sanford Universiy May 2006 This paper has benefied from helpful discussions wih Sephen Cooper and Jim Wahlen. We would also like o hank workshop paricipans a he Bank for Inernaional Selemens, Brigham Young Universiy, Harvard Business School, Hebrew Universiy, The Inerdisciplinary Cener a Herzliya, London Business School, UCLA, Universiy of Tennessee, and Tel Aviv Universiy for insighful commens and suggesions.

2 1. Inroducion Credi risk measures reflec common, priced risk facors ha influence boh deb and equiy reurns. Higher credi risk levels are associaed wih higher expeced equiy reurns (Vassalou and Xing, 2004). Unexpeced increases in credi risk are associaed wih negaive realized equiy reurns (Holhausen and Lefwich (1986). We refer o hese esablished firsorder effecs as direc. The objecive of his sudy is o empirically es wheher changes in equiy value also reflec aenuaing gains and losses associaed wih changes in deb value ha arise from changes in credi risk. Meron (1974) esablishes hese second-order effecs heoreically; however, empirical evidence is lacking. Our research quesion is relevan o he use of fair value accouning for liabiliies, which would include recognizing in income, wha some view as anomalous effecs on equiy value of credi risk changes. In paricular, we es wheher increases (decreases) in credi risk are associaed wih incremenal increases (decreases) in equiy values, afer conrolling for he direc effecs of risk changes on equiy values. Because fair value accouning for liabiliies, if adoped, would apply o all firms, we conduc our ess on a broad sample of primarily solven firms. 1 We also calculae and provide descripive evidence relaing o he effecs on firms financial saemens of recognizing changes in deb value. Changes in credi risk may arise when eiher he value or he risk of he firm s asses changes. 2 Meron (1974) shows ha changes in equiy value occasioned by changes in asse value and changes in asse risk can be characerized ino poenially counervailing direc and 1 For ease of exposiion, we discuss increases in equiy value associaed wih decreases in deb value arising from increases in risk. However, he same argumens, and our empirical ess, also apply o decreases in equiy value associaed wih increases in deb value arising from decreases in risk. We use he erm solven o mean ha he value of he firm s asses exceeds he book value of is deb. 2 Changes in credi risk also can arise from changes in financing risk, i.e., leverage, ha are unrelaed o changes in he value of operaing asses. Our analysis holds he face value of deb consan.

3 indirec effecs. The direc effec of changes in asse value comprises he one-o-one mapping beween asse value and equiy value ha exiss in he absence of deb. The direc effec on equiy value of increases in asse risk is negaive or zero. I is negaive if he risk is sysemaic and decreases asse value; i is zero if he risk is unsysemaic and no priced. The indirec effecs of changes in asse value and asse risk are counervailing and comprise he amoun of any asse value change ha is absorbed by deb holders, plus he change in deb value associaed wih changes in asse risk. Meron (1974) predics ha deb value changes wih asse value, despie he mainained assumpion ha deb has prioriy over equiy. This predicion applies even o solven firms because prioriy a liquidaion of he deb does no imply ha deb holders have firs claim on asse value before liquidaion. Thus, deb holders paricipae in changes in asse value, even when asse value is more han sufficien o liquidae he deb. Meron (1974) also predics ha deb value decreases wih unanicipaed increases in asse risk. Because equiy value equals asse value minus deb value, decreases in deb value resul in increases in equiy value. Therefore, he indirec effec on equiy value of increases in asse risk is posiive. Figure 1 summarizes he direc and indirec effecs of asse value and risk changes on equiy. Figure 1 shows ha deb in he capial srucure aenuaes boh he effecs of asse value changes and risk changes. Alhough here is abundan evidence ha deb and equiy prices respond direcly o changes in credi risk, we empirically es he second-order predicions of he Meron (1974) model because prior sudies do no documen gains (losses) o equiy holders from decreases (increases) in deb values across a broad sample of solven firms. Generalizaion of resuls from exising sudies examining wealh ransfers beween deb and equiy holders is limied by heir 2

4 small sample sizes and selecive conexs. Analyically, Meron (1974) does no consider he effecs of insiuional feaures such as marke inefficiencies or deb covenans, eiher of which could limi equiy holders abiliy o realize pre-liquidaion gains from decreases in deb value in real markes. As well, because Meron (1974) shows ha he indirec effec on equiy value of risk increases decrease wih solvency, he effec migh be negligible for many firms. Thus, ess based on a broad sample of primarily solven firms provide insigh ino he imporance of he effec for mos firms. Undersanding how changes in credi risk affec he values of deb and equiy is criical o he debae abou using fair value accouning for liabiliies. The concepual frameworks of he Financial Accouning Sandards Board (FASB) and he Inernaional Accouning Sandards Board (IASB) provide for income recogniion of gains and losses arising from changes in he recognized amoun of deb. Thus, if deb is recognized a fair value, firms will recognize gains (losses) when he fair value of deb decreases (increases). This is counerinuiive o some and has generaed conroversy relaing o financial reporing for liabiliies. 3 Also, asses and liabiliies are accouned for using differen convenions. To he exen ha recognized decreases in deb value are no offse by recognized decreases in asse value, firms wih deerioraing credi qualiy will recognize ne gains. Concern abou recognizing such gains is he primary reason he European Commission endorsed Inernaional Accouning Sandard (IAS) 39 (IASB, 2003) for use by European firms only afer deleing he opion for firms o use fair value accouning for financial liabiliies. The European Commission did no delee he corresponding opion for financial asses. 3 This effec also runs couner o he radiional financial saemen analysis view ha leverage exacerbaes he effec on equiy reurn of realized reurn on asses (ROA). A realized ROA higher (lower) han he cos of deb, increases (decreases) realized reurn on equiy. However, his obains unambiguously only if he cos of deb is no equal o he oal reurn on deb (ie. he cos of deb excludes changes in he value of deb). 3

5 We focus our sudy on documening empirically he indirec effec on equiy value of increases in risk. Thus, we es he predicion ha he decrease (increase) in equiy value associaed wih an increase (decrease) in risk is miigaed o he exen of deb in he firm s capial srucure, i.e., he firm s leverage. Specifically, our ess focus on he relaion beween annual equiy reurns and he ineracion beween risk changes and leverage. Our proxy for change in risk is change in esimaed bond raing. Bond raings reflec bond raing agencies assessmens of oal credi risk; higher bond raings reflec more risk. Risk changes ineraced wih leverage provides a link beween equiy reurns and deb values. If equiy marke value changes are associaed wih deb value changes, he relaion beween equiy reurns and change in risk will depend on leverage. Holhausen and Lefwich (1986) finds ha equiy reurns are negaively associaed wih bond raing changes; we expec he same relaion. However, we expec ha equiy value also reflecs benefis associaed wih decreases in deb value. Thus, we predic ha he ineracion beween leverage and change in credi risk is posiive. We include earnings, change in earnings, and he level of leverage as conrol variables in our esimaion equaions. We expec equiy reurns o be posiively relaed o earnings and changes in earnings; we do no predic he sign of he associaion wih leverage. Consisen wih our predicions, we find ha he associaion beween change in equiy value and change in risk is significanly less negaive when leverage is higher. Because of poenial nonlineariies, we also esimae he relaion separaely for firms wih credi downgrades and upgrades. We find ha downgraded firms have significan negaive equiy reurns, afer conrolling for leverage, earnings, and changes in earnings. More imporanly for our research quesion, we also find, as prediced, ha reurns are significanly less negaive when leverage is 4

6 higher. As prediced, we find he opposie for upgraded firms alhough heir equiy reurns are incremenally significanly posiive, reurns are significanly less posiive when leverage is higher. We also permi he esimaion relaion o differ depending on wheher he upgrade or downgrade is wihin invesmen grade, beween invesmen grade and non invesmen grade, or wihin non invesmen grade. We find a significan posiive relaion beween reurns and change in credi risk ineraced wih leverage for each group, excep for downgrades wihin invesmen grade. Because change in credi raing reflecs asse value changes as well as asse risk changes, we es separaely wheher changes in equiy cos of capial and changes in expeced fuure cash flows are aenuaed by deb in he capial srucure. This design allows us beer o separae he effecs of risk from he effecs of asse value changes. Consisen wih our primary resuls, we find ha leverage ineraced wih change in risk aenuaes he effecs of asse value changes and of asse risk changes. To provide a more direc link beween changes in equiy value and changes in deb value associaed wih changes in credi risk, we esimae he change in deb value inciden o he change in firm s credi raings and use i in our esimaing equaion in lieu of he risk change and leverage ineracion variable. The change in deb value we calculae resuls from he change in marke ineres rae associaed wih he change in he firm s esimaed bond raing over he mauriy of he firm s deb. Consisen wih our primary findings, we find ha he gain or loss o equiy holders from he calculaed deb value changes is significanly posiively associaed wih equiy reurns. We supplemen our primary analyses by providing descripive evidence on he financial saemen effecs of fair value accouning for deb by using observed sock prices and volailiy 5

7 o inver he Meron (1974) model o obain esimaes firms asse volailiy, asse value, and deb value. 4 As expeced, if only unrecognized changes in deb value are recognized, mos upgrade firms would recognize lower ne income and mos downgrade firms would recognize higher ne income han under curren accouning rules. Ye, for mos firms, he difference is no large enough o change he sign of ne income. Also, our evidence indicaes ha for downgrade firms, asse wrie-downs recognized in accordance wih presen accouning sandards are larger han unrecognized gains from decreases in deb value. These findings call ino quesion concerns abou anomalous income effecs ha are predicaed on he assumpion ha deb value decreases exceed recognized conemporaneous asse value decreases. The paper proceeds as follows. Secion 2 elaboraes on he background, moivaion, and relaed research ha underlie he sudy. Secion 3 describes he basis for our predicion of he relaion beween equiy reurns and change in risk, and he research design we use o es i. Secion 4 presens he primary findings, and secion 5 presens resuls from addiional analysis. Secion 6 presens resuls relaing o he financial saemen effecs of using fair value accouning for deb, and Secion 7 offers concluding remarks. 2. Background, moivaion, and relaed research 2.1. Risk, deb values, and equiy values Deb holders demand compensaion commensurae wih he level of risk hey assume. Thus, changes in credi risk subsequen o deb conracing can affec he value of deb. The value of deb changes when he marke ineres rae commensurae wih he new level of risk differs from he rae deermined a he incepion of he deb. A large body of finance lieraure 4 We validae hese esimaes by esimaing he relaion beween equiy reurns and changes in esimaed asse value and asse volailiy, and he ineracion beween each of hese and leverage. As expeced, we find change in asse value is posiively associaed wih equiy reurns. Consisen wih our primary findings, we also find he relaion 6

8 focuses on explaining changes in deb values, paricularly variaion in observed credi premiums across raded bonds wih differen defaul risk. However, lile of his research addresses empirically he inerrelaion beween deb and equiy value changes. Thus, he empirical validiy of Meron s (1974) predicions of equiy gains from deb value decreases remains largely unexplored. Srucural deb valuaion models are based on Meron s (1974) insigh ha equiy can be viewed as a call opion on he value of underlying asses wih a srike price equal o he face amoun of he ousanding deb. These models specify defaul risk and deb prices as a funcion of operaing risk aribuable o asses, financial risk aribuable o leverage, and he erm of he deb (e.g., Duffee, 1996, 1998; Duffie and Singleon, 1999; Huang and Huang, 2003; see Bohn, 2000, for a review of his lieraure). 5 Relaed o he effecs on deb value of changes in defaul risk, Srong (1990) invesigaes changes in deb value associaed wih changes in bond raing for a sample of 190 firms in Srong (1990) seeks o disinguish changes in deb value associaed wih changes in firm risk from hose associaed wih changes in marke risk, and finds ha boh explain deb value changes. However, his lieraure does no aemp o link deb value changes and equiy value changes. The firs-order effec on equiy value of changes in defaul risk is well-esablished. Holhausen and Lefwich (1986) and Hand, Holhausen, and Lefwich (1992) invesigae changes in equiy value associaed wih announcemens of bond raing changes. These sudies find ha beween equiy reurns and change in asse value (asse volailiy) is significanly less (more) posiive when leverage is higher. 5 We use he erm credi risk o describe unobservable facors ha deermine he risk premium on deb a any poin. Because we assume ha conracual deb cash flows do no change prior o mauriy, declines in deb value mus derive from increases in credi risk. The erms credi risk, defaul risk, firm risk, and oal risk ofen are used inerchangeably in he finance and accouning lieraures ha we cie. For he mos par, hese erms are consisen wih our usage of credi risk. One excepion is erm defaul risk which may be more narrowly consrued. Specifically, alhough all firms have credi risk, some auhors argue ha only firms wih non-zero deb have defaul risk (Dhaliwal, Lee and Fargher, 1991). 7

9 deb and equiy reurns decrease wih bond raing downgrades, consisen wih bond raing downgrade announcemens conveying ne negaive informaion boh o deb and equiy markes. Dichev and Pioroski (2001) finds ha negaive abnormal equiy reurns persis for up o hree years following bond raing downgrades and aribues his persisence o he marke underreacion. However, Vassalou and Xing (2003) shows ha hese fuure abnormal reurns largely disappear afer aking accoun of serial downgrades and he variaion in defaul risk around downgrades. Relaedly, Ederingon and Goh (1998) finds ha analyss decrease earnings forecass following downgrades and aribues his finding o informaion ransfer from deb raing agencies o equiy analyss. Consisen wih credi risk comprising common facors ha influence deb and equiy reurns, Vassalou and Xing (2004) shows ha a large porion of defaul risk is sysemaic and, hus, priced in equiy value. However, none of hese sudies examines he poenial aenuaing effecs of deb value changes on equiy value changes when common facors cause boh o change. A few sudies examine he inerrelaion beween change in deb value and change in equiy value. In a unique insiuional seing, Kliger and Sarig (KS, 2000) examines changes in sock and bond prices inciden o Moody s 1982 adopion of finer raing pariions. KS finds significan decreases in bond prices for firms wih implied downgrades, bu does no consisenly find significan increases for firms wih implied upgrades. The significance of equiy reurns by raing change group depends on he specificaion; KS finds no posiive abnormal equiy reurns o downgrades when basing expeced reurns on a marke model. Hand, Hughes, and Sefcik (HHS, 1990) invesigaes wheher bond holders gain a he expense of sock holders when firms defease deb in subsance, bu no legally, for a sample of 80 defeasances by 68 firms from

10 o For a subsample of hese firms wih announcemen daa, HHS finds significan posiive bond reurns a he announcemen of he defeasances and significan negaive sock reurns. However, he negaive correlaion beween bond reurns and sock reurns is weak. Afer also invesigaing moivaions for he defeasances, HHS concludes ha he negaive announcemen sock reurns are more likely aribuable o informaion effecs han o increases in deb values resuling from decreases in equiy values. Each of hese sudies provides suggesive resuls, however he uniqueness of he seings and small sample sizes limi generalizabiliy. Anoher relaed sream of research examines wheher deb aenuaes he response of equiy o earnings announcemens. 6 Dhaliwal, Lee, and Fargher (1991) show ha firms wih higher leverage have lower earnings response coefficiens (ERC) and posi ha equiy holders in more highly levered firms receive a smaller share of he change in firm value associaed wih unexpeced earnings. Dhaliwal and Reynolds (1994) shows ha ERCs are negaively relaed o defaul risk measured by bond raing level. Dhaliwal, Lee, and Fargher (1991) suggess ha fuure research can enhance he ess relaing o he effecs on equiy value of changes in asse value by using changes in defaul risk proxies, raher han levels. These sudies esablish he effec of risk level on equiy s response o repored GAAP earnings; we examine he effec of leverage on equiy s response o credi risk changes Fair value accouning for deb The FASB has idenified fair value as he mos relevan measuremen aribue for financial insrumens and has indicaed ha recogniion of all financial insrumens a fair value 6 Anoher sream of research links deb value and equiy value by simulaing he poenial magniude of agency coss arising from risk-aking incenives idenified in Meron (1974), for example, Parrino and Weisbach (PW, 1999). Analyic analysis and simulaions such as hose in PW sugges ha he agency coss can be subsanial. However, PW assumes he Meron (1974) model when consrucing simulaed deb value, and, i canno es he model s predicions. Empirically, Odders-Whie and Ready (OR, 2006) finds ha firms wih lower credi raings have higher adverse selecion componens in heir equiy spreads, suggesing ha agency coss are priced in expeced equiy as 9

11 is one of is long-erm goals (FASB, 1999). Fair value measuremen is permied in US and Inernaional GAAP for many financial asses (e.g., Saemen of Financial Accouning Sandard (SFAS) No. 133 and IAS 39). However, fair value measuremen of liabiliies is no widespread. SFAS 133 and IAS 39 require derivaive liabiliies o be recognized a fair value, bu require or permi firms o recognize a hisorical cos oher liabiliies, including long-erm deb. Fair value recogniion of liabiliies, paricularly long-erm deb, is a conroversy currenly facing sandard seers. Many believe ha recogniion of liabiliies a fair value is consisen wih adopion of a fair value measuremen basis for asses. A large body of research suppors he noion ha boh repored income and is volailiy beer reflec marke and oher risks when financial firms recognize financial asses and liabiliies a fair value (see, e.g., Barh, Landsman, and Wahlen, 1995; Hodder, Hopkins, and Wahlen, 2006). However, ohers find he prospec of recognizing changes in deb fair value disurbing. They are paricularly concerned abou financial reporing implicaions if changes in deb value relaed o changes in he firm s own risk are recognized. For example, he European Cenral Bank has called he recogniion of gains associaed wih increases in risk counerinuiive (European Cenral Bank, 2001). The European Commission s endorsemen of IAS 39 for use by European firms eliminaed he fair value recogniion opion for financial liabiliies. The concern sems from he poenial for ne income o reflec poorly changes in he value of he firm s ne asses if decreases in asse values are no recognized concurrenly wih decreases in deb values. For example, if some inangible asses are no recognized, roubled firms could repor ne income well as deb. However, OR does no es he relaion beween changes in deb value and changes in equiy value inciden o unexpeced increases in risk or decreases in asse value. 10

12 from recognized decreases in deb value during periods in which hey experience decreases in equiy value. 7 Lipe (2002) demonsraes how accouning raios migh convey misleadingly posiive signals when a firm approaching bankrupcy uses fair value accouning for liabiliies. Lipe (2002) concludes ha changes in deb value aribuable o changes in credi qualiy should no be recognized. However, he adverse financial saemen effecs of Lipe s (2002) example primarily derive from incomplee recogniion of asses and changes in asse values, no from he pro-forma recogniion of changes in deb value. Balance shee and income saemen recogniion of risk effecs a incepion is no conroversial. Boh he carrying value of deb and recognized ineres expense reflec deb s credi raing when issued. In conras, fair value accouning measures and recognizes conemporaneously he effecs of any changes in risk or marke ineres raes. Barh and Landsman (1995) noes ha recognizing hese changes is appropriae because deb holders have commied o an ineres rae ha is no commensurae wih he ex pos level of risk. Fair value accouning recognizes subsequen ineres expense a he new rae, reflecing he change in he deb holders required compensaion. The promised sream of cash flows is unchanged and, cumulaively, only he characerizaion of income cash flows beween gain or loss and ineres expense changes. Fair value accouning ensures ha periodic ineres expense reflecs he curren cos of borrowing and excludes he benefis (coss) of below-marke (above-marke) borrowing resuling from prior-period deb ransacions. 7 When risk decreases, increases in asse values ofen are no recognized. Ye, if deb is recognized a fair value, increases in deb value would be recognized as losses. When risk increases, he opposie occurs. Recognized asses may be wrien down. However, no all asses are recognized and asse wrie-downs may no be complee or imely. Because deb values are less sensiive o decreases in risk han o increases, he laer problem is more roublesome o regulaors han he former. 11

13 Alhough here is a subsanial lieraure addressing he value-relevance of fair values for equiy prices and reurns, few of hese sudies examine fair values of liabiliies in indusries oher han banking and insurance. Banking indusry sudies consisenly demonsrae he valuerelevance of asse fair values and o a lesser exen, deposi liabiliies and long-erm deb fair values. For example, Barh, Beaver, and Landsman (BBL, 1996) finds ha unrealized gains and losses on bank long-erm deb are significanly associaed wih he difference beween equiy marke value and book value, alhough no in all model specificaions and years. BBL finds no significan associaion beween changes in unrecognized unrealized gains and losses on longerm deb and changes in he difference beween equiy marke value and book value. Eccher, Ramesh, and Thiagarajan (1996) and Nelson (1996) find no associaion beween equiy value and long-erm deb fair value. For a sample of non-financial firms, Simko (1999) finds ha liabiliy fair values are associaed wih equiy values, bu no consisenly across indusries and years. Barh, Landsman, and Rendleman (BLR, 1998) esimaes deb values for a sample of nonfinancial firms and invesigaes he financial saemen effecs of fair value accouning for deb. BLR finds ha financial saemen amouns using fair value accouning for deb are poenially relevan o invesors because financial saemen amouns would be subsanially differen from hose currenly recognized. However, none of hese sudies invesigaes he effecs of changes in credi risk on he value of he firm s deb and equiy. 3. Basis for predicion and research design 3.1. Basis for predicion We expec he effec on equiy value of changes in credi risk o depend on he amoun of deb in he capial srucure. Meron (1974) shows ha changes in equiy value reflec wo counervailing effecs, a direc effec and an indirec effec. The direc effec is a funcion of 12

14 changes in asse value; equiy value decreases as asse value decreases. Changes in asse risk affec asse value only o he exen ha he risk is sysemaic and he change is unanicipaed. As such risk increases, asse value and, hus, equiy value, decreases. Changes in unsysemaic risk have no effec on asse value and, hus, have no direc effec on equiy value. Thus, in he absence of deb, increases in risk have no posiive direc effecs on equiy. The indirec effec of risk on equiy value is a funcion of facors ha affec he value of deb, including leverage, asse value, and asse risk. Holding leverage consan, he indirec effec comprises he amoun of asse value change ha is absorbed by deb holders plus he change in deb value associaed wih changes in asse risk. Meron (1974) predics ha, despie assuming prioriy of deb over equiy, deb value is increasing in asse value, even for solven firms. Specifically, he value of levered equiy is a convex funcion of asse value wih a slope ha approaches one only in he limi. This suggess ha deb value varies wih asse value, hereby miigaing he effec on equiy value of changes in asse value. Meron (1974) also predics ha deb value decreases wih increases in sysemaic and unsysemaic asse risk. Because equiy value equals asse value minus deb value, changes in deb value resul in changes in equiy value, even when asse value is unchanged. The indirec effecs are hose ha some view as counerinuiive. Thus, we es he predicion ha he decrease (increase) in equiy value associaed wih an increase (decrease) in credi risk is miigaed o he exen of deb in he firm s capial srucure Research design: Reurns and risk changes We esimae in Eq. (1) he relaion beween equiy reurns and change in credi risk. RET = β + β ΔCR + β ΔCR DBTA + β DBTA + β EPS + β ΔEPS β NEG + β NEG EPS + β NEG ΔEPS + ε (1) 13

15 RET is annual size-adjused sock reurn, inclusive of dividends. DBTA is he end-of-year raio of book value of long-erm deb o book value of oal asses. EPS is earnings per share before exraordinary iems, deflaed by beginning-of-year sock price. NEG is an indicaor variable ha equals one if EPS is negaive, and zero oherwise. Δ denoes change and denoes year; we omi firm subscrips. We use only accouning-based explanaory variables in equaion (1) o avoid endogeneiy associaed wih changes in marke values. ΔCR is he annual change in our proxy for credi risk, CR, where CR is a caegorical variable ha ranges from 1 denoing low risk o 4 denoing high risk. Thus, ΔCR is posiive (negaive) when credi risk increases (decreases). CR is he firm s bond raing, which we esimae based on he relaion beween acual bond raings for firms wih raed deb and accouning variables. The appendix explains how we follow prior research o do his. We use acual bond raings o develop CR because bond raings reflec he credi agency s assessmen of he firm s risk, where ha assessmen is based on publicly available and privae informaion (Jorion, Liu, and Shi, 2004). For consisency, we use esimaed bond raings o consruc CR for all firms. Using esimaed bond raings permis us o expand our sample beyond firms wih raed deb, hereby enhancing he generalizabiliy of our inferences. Also, bond raings, especially upgrades, are revised wih a lag (e.g., Pinches and Singleon, 1978), which adds noise when observed bond raing changes are used as proxies for changes in risk. 8 8 Our inferences abou he ineracion beween credi risk and leverage are unaffeced by he use of alernaive measures of credi risk changes, including acual bond raing changes. See able 5 and foonoe 24. Hillegeis, Keaing, Cram, and Lundsed (HKCL, 2004) esimaes probabiliy of defaul using asse value and asse risk esimaes obained from invering he Meron (1974) model. Because heir model uses sock prices as inpus, he HKCL probabiliy of defaul esimaes are endogeneous in Eq. (1). Thus, we do no use hem in our ess. In secion 6.2, we presen findings from esimaing a relaion analogous o Eq. (1) using asse value and asse risk esimaes obained from he Meron (1974) model. Our inferences from ha specificaion are he same as hose we obain from Eq. (1). 14

16 For our research quesion, he key variable in Eq. (1) is ΔCR DBTA. Including i in Eq. (1) permis us o esablish a link beween leverage and increases (decreases) in equiy value associaed wih increases (decreases) in credi risk. Credi risk comprises facors giving rise o he risk premium on deb. Prior research (Dhaliwal, Lee and Fargher, 1991) uses leverage o proxy for defaul risk. In our analysis, we include credi risk explicily, and use leverage o measure he quaniy of deb ousanding. Therefore, ΔCR DBTA proxies for he change in deb value inciden o he bond raing change. 9 We predic ha is coefficien, β 2, is posiive because he more deb in he firm s capial srucure, he greaer he change in deb value and he less equiy holders lose when asse value decreases or asse risk increases (he less equiy holders gain when asse value increases or asse risk decreases). Based on prior research (e.g., Holhausen and Lefwich, 1986), we predic β 1 is negaive. We do no predic he sign of β 3 ; we include leverage in Eq. (1) because we inerac i wih DBTA. 10 We include EPS and ΔEPS in Eq. (1) because of he exensive research documening a posiive relaion beween reurns and earnings and change in earnings; we predic β 4 and β 5 are posiive. Including NEG, NEG EPS, and NEG ΔEPS in Eq. (1) permis he relaion o differ for firms wih negaive earnings (Hayn, 1995; Barh, Beaver, and Landsman, 1998); we predic β 7 and β 8 are negaive. Noe ha each conrol variable likely comprises par of he informaion se leading o credi risk changes and can be inerpreed as a proxy for change in asse value or 9 As noed above, we use DBTA as our leverage measure because i is based on he book values of deb and asses and, hus, is largely unaffeced by changes in deb and asse values Consisen wih his, unabulaed findings reveal ha our inferences are unaffeced by using DBTA 1 in place of DBTA in Eq. (1). 10 Reurns may be correlaed wih change in leverage. However, change in DBTA is refleced in ΔCR hrough esimaion of Eq. (A1). Also, unabulaed saisics reveal ha changes in DBTA are close o zero for mos firms he upper (lower) decile of ΔDBTA is 0.09 ( 0.07). Inferences from an unabulaed esimaion of Eq. (1) eliminaing observaions wih he highes and lowes 1% ΔDBTA are he same as hose from he resuls we abulae. 15

17 risk. Thus, including hese variables in Eq. (1) enhances our inerpreaion of ΔCR DBTA as capuring changes in reurns associaed wih changes in deb value. We esimae Eq. (1) pooling all firms wih year and indusry fixed effecs, defining indusries following Barh, Beaver, and Landsman (1998). To miigae he effecs of influenial observaions, we esimae Eq. (1) using Huber-M esimaion, which minimizes a less rapidly increasing funcion of he regression residuals han OLS. 11 Meron (1974) predics ha he sensiiviy of equiy value of asse value changes decreases as asse value increases. Therefore, we also esimae Eq. (1) separaely for firms wih credi upgrades and downgrades. To invesigae he poenial for addiional nonlineariies, we furher pariion firms based on wheher he upgrade or downgrade is wihin invesmen grade, beween invesmen grade and non invesmen grade, or wihin non invesmen grade. This effecively conrols for he iniial bond raing, as well as clienele effecs Daa and findings for relaion beween changes in risk and equiy reurns 4.1. Daa and sample Fair value accouning for liabiliies would apply o all firms, regardless of financial condiion. Thus, we consruc our sample o comprise a broad cross-secion of primarily solven firms. In paricular, we begin wih all firms wih available daa on Compusa for We eliminae firms in he uiliies, financial services, and real esae indusries because heir capial srucures markedly differ from hose of oher firms. To miigae he effecs of ouliers, we eliminae firms for which he absolue value of EPS, EPS 1, or ΔEPS is greaer han Our inferences are unaffeced if we use OLS esimaion. We also obain similar inferences if we base our es saisics on sandard errors ha are clusered by firm, which conrols for heeroskedasiciy and ineremporal firmspecific dependence in regression residuals. 12 Resuls are qualiaively similar when iniial bond raing is used in lieu of invesmen grade. 13 The sample period begins in 1986 because Compusa does no include bond raings before 1985, and wo years are necessary o calculae change in risk. 16

18 (Eason and Harris, 1991) and firms wih RET in he exreme 1 percenile of he observaions (Kohari and Zimmerman, 1995; Collins, Maydew, and Weiss, 1997; Fama and French, 1998; Barh, Beaver, Hand, and Landsman, 1999; among ohers). To miigae undue effecs of very small firms, we also eliminae firms wih oal asses or sales less han $10 million, or share price less han $1. 14 The final sample comprises 50,297 firm-year observaions, of which 11,799 have Compusa bond raings. Daa limiaions reduce he sample size for some addiional analyses. We obain all daa from Compusa, excep for sock marke daa, which we obain from CRSP. The bond raings on Compusa are Sandard & Poors Issuer Credi Raing. 15 RET is each firm s size-adjused annual buy-and-hold reurn, compued as he firm s reurn compounded over welve monhs minus he corresponding compounded size decile reurn associaed wih he firm s marke value of equiy a he beginning of he year Descripive saisics Table 1 presens descripive saisics for he variables in Eq. (1). Panel A presens disribuional saisics, panel B presens correlaions beween he variables, and panel C presens he indusry composiion of he sample. Panel A reveals ha sample firms have negaive (posiive) mean and median RET (EPS and ΔEPS). Alhough he median risk change, ΔCR, is zero, he mean is posiive, indicaing ha, on average, risk increases. Table 1, panel A, also shows ha he mean long-erm deb-o-oal asse raio, DBTA, is 19% and ha 25% of he sample firms have negaive EPS. 14 Our inferences are unaffeced if we include all firms in our ess. 15 Beginning Sepember 1, 1998, Sandard & Poor (S&P) bond raings reflec he firm s overall crediworhiness, apar from is abiliy o repay individual obligaions. I focuses on he firm s capaciy and willingness o mee is financial commimens of more han one year as hey come due. Prior o his dae, he raing is he firm s senior deb raing. I is an assessmen of he crediworhiness wih respec o long-erm deb no subordinae o any oher long-erm deb. Typically, he raing is for he firm s highes senior issue. If a firm does no have senior deb, i is an implied senior raing. Our inferences are he same before and afer his change. 16 Consisen wih Fama and French (1992) and Jegadeesh (1992), our inferences are unaffeced by using beaadjused reurns. However, using bea-adjused reurns noiceably reduces our sample size. 17

19 Panel B of able 1 reveals ha RET is negaively correlaed wih ΔCR (Pearson correlaion is 0.20 and Spearman correlaion is 0.21), which is consisen wih prior research and wih ΔCR reflecing changes in asse value. As expeced based on prior research, RET is posiively relaed o EPS and ΔEPS. RET is negaively relaed o DBTA. Oher correlaions in panel B also are consisen wih expecaions. For example, he correlaions beween EPS and ΔEPS are posiive, and hose beween ΔCR and EPS and ΔEPS are negaive. The negaive associaion beween ΔCR and EPS (ΔEPS) is equivalen o a posiive associaion beween changes in asse value and EPS (ΔEPS), which is consisen wih curren earnings reflecing a leas a porion of asse value changes. The correlaions beween ΔCR and DBTA are significanly posiive, consisen wih downgrade firms having higher leverage. 17 NEG is negaively correlaed wih RET, EPS, and ΔEPS, and posiively correlaed wih ΔCR and DBTA. All abulaed correlaions oher han he Spearman correlaion beween EPS and DBTA are significanly differen from zero. However, we base our inferences on he mulivariae relaions in Eq. (1) and focus on he ineracion beween ΔCR and DBTA. Table 1, panel C, reveals ha Durable Manufacurers is he mos represened indusry, comprising 29.37% of he sample. Reail and Compuers are he second and hird mos represened, comprising 14.54% and 14.33% of he sample. These percenages reflec he indusry composiion of he Compusa populaion. Unabulaed saisics reveal ha he indusry composiion of firms wih raed deb is similar o ha in panel C Primary findings Table 2 presens regression summary saisics from esimaing Eq. (1). As prediced, i reveals ha he relaion beween change in risk and equiy reurns is less negaive for firms wih 17 We use he erm significance o denoe saisical significance a less han he 0.05 level, based on a one-sided es 18

20 more leverage. In paricular, he firs se of columns in panel A reveals ha he coefficien on ΔCR DBTA is significanly posiive (coef. = 0.17, = 9.21). This indicaes ha changes in deb value are opposiely associaed wih changes in equiy value. In paricular, when risk increases, equiy value increases by an amoun ha depends on he exen of deb in he capial srucure. Also as prediced, he coefficien on ΔCR is significanly negaive (coef. = 0.10, = 18.74), hose on EPS and ΔEPS are significanly posiive (coefs. = 1.90 and 0.42, = and 25.91), and hose on NEG, NEG EPS, and NEG ΔEPS are significanly negaive (coefs. = 0.12, 1.81, and 0.27, = 23.90, 57.68, and 12.69). To compare he magniudes of he effecs of risk changes and leverage, he second se of columns in panel A presens summary saisics from esimaing a version of Eq. (1) using a ranked DBTA variable. The DBTA variable is he decile rank of DBTA, scaled o be beween zero and one. Specifically, we place firms in porfolios 0 o 9 wih porfolio 9 comprising firms wih he larges DBTA, and divide hese porfolio ranks by nine. This permis us o inerpre β 1 as he magniude of he relaion beween change in risk and equiy reurns for firms wih lowes DBTA. The sum of β 1 and β 2 is he magniude for firms wih highes DBTA. Resuls of he rank regression in he second se of columns in panel A are consisen wih predicions and hose in he firs se of columns. Mos imporanly, he coefficien on ΔCR DBTA is 0.10 and is significanly differen from zero ( = 9.04). Of noe is ha he sum of β 1 and β 2 is 0.02 ( ), which significanly differs from zero. This indicaes ha for highly levered firms, he increase in equiy value associaed wih a decrease in deb value offses mos bu no all of he decrease in equiy value resuling from a decrease in asse value. when we have signed predicions and a wo-sided es oherwise. 19

21 Our primary findings are based on pooled esimaes of Eq. (1) wih year and indusry fixed effecs, and he relaions could exhibi differences across years and indusries ha are no capured by mean effecs. However, unabulaed findings reveal ha his is no he case. Separae-year esimaion resuls in coefficiens on ΔCR DBTA ha are posiive in all 18 years; he Z1 and Z2 saisics are 9.75 and Separae-indusry esimaion resuls in coefficiens on ΔCR DBTA ha are posiive in all 11 indusries; he Z1 and Z2 saisics are 7.00 and All oher resuls are consisen wih hose in able To invesigae wheher our findings differ for firms wih credi upgrades and downgrades, we esimae Eq. (1) permiing he coefficiens on ΔCR and ΔCR DBTA o vary wih he sign of he risk change. Consisen wih he findings in able 2, panel A, he findings in he firs se of columns in able 2, panel B, reveal ha ΔCR is significanly negaively relaed o RET for credi downgrades, DN ΔCR, and upgrades, UP ΔCR, (coef. = 0.08; = for downgrades; coef. = 0.13; = for upgrades). Thus, downgrades (upgrades) have significan negaive (posiive) incremenal reurns. More imporanly for our research quesion, he firs se of columns in panel B also reveals ha he relaion beween credi downgrades (upgrades) and reurns is less negaive (posiive) for firms wih more leverage. In paricular, he coefficien on ΔCR DBTA is significanly posiive for firms wih credi downgrades, DN ΔCR DBTA, and upgrades, UP ΔCR DBTA, (coef. = 0.15; = 6.40 for downgrades; coef. = 0.18; = 4.98 for 18 Z1 equals ( 1 G ) 1 ( k ( k 2) ), where G is he number of groups, j is he -saisic on he G j = j j j esimaed coefficien for firm j, and k j is he degrees of freedom for firm j. Z2 equals (mean ) / (sd deviaion / ( G 1) ) (see Whie, 1980; Bernard, 1987). 19 Our inferences also are unchanged when we measure leverage as he raio of oal liabiliies o asses raher han as he raio of long-erm deb o asses and when we eliminae observaions wih negaive book value of equiy. Our abulaed findings include firms wih zero deb because hese firms have credi risk associaed wih heir asse value and asse risk. However, our inferences are unchanged when we eliminae firms wih zero deb. 20

22 upgrades). Unabulaed findings based on he ranked DBTA specificaion reveal he same inferences. 20 Findings from esimaing Eq. (1) furher pariioning firms based on he ype of risk change are in he second se of columns in able 2, panel B. As he appendix noes, bond raing groups 1, 2, 3, and 4 comprise firms wih raings of AAA o A, BBB+ o BBB, BB+ o BB, B+ o D, respecively. The firs wo groups comprise invesmen grade deb; he second wo comprise non invesmen grade. In able 2, panel B, DN INV equals one for firms ha are downgraded from he highes credi group, CR = 1, o he second highes, CR = 2, and zero oherwise. Thus, firms wih DN INV = 1 are downgraded wihin invesmen grade. DN ACR equals one for firms ha are downgraded from group 1 or 2 o group 3 or 4, and zero oherwise. Thus, firms wih DN ACR = 1 are downgraded from invesmen grade o non invesmen grade. DN NINV equals one for firms ha are downgraded from group 3 o group 4, and zero oherwise. Thus, firms wih DN NINV = 1 are downgraded wihin non invesmen grade. UP INV, UP ACR, and UP NINV are analogously defined. UP INV = 1 for firms are hose ha are upgraded wihin invesmen grade, UP ACR = 1 for firms are hose ha are upgraded from non invesmen grade o invesmen grade, and UP NINV = 1 for firms are hose ha are upgraded, wihin non invesmen grade. The second se of columns in able 2, panel B, reveals ha our inferences exend o almos all levels of credi risk change. The coefficiens on ΔCR DBTA ineraced wih DN ACR, DN NINV, UP INV, UP ACR, and UP NINV are significanly posiive, as prediced ( ranges from 1.66 o 5.27). The coefficien on DN INV ΔCR DBTA is posiive, as prediced, bu no significanly so ( = 0.39). These findings indicae ha all levels of risk changes, excep downgrades wihin 20 Tha he abulaed coefficien for downgrades (0.15) is smaller han ha for upgrades (0.18) appears inconsisen wih predicions from Meron (1974). However, he unabulaed coefficien for downgrades from he ranked DBTA specificaion, 0.10, is larger han for upgrades,

23 invesmen grade, are significanly relaed o equiy value changes associaed wih deb value changes Addiional analyses 5.1. Esimaes of changes in long-erm deb fair values based on changes in ineres raes The findings in able 2 reveal ha he relaion beween reurns and credi risk changes depends on leverage. To invesigae wheher he effec associaed wih leverage is aribuable o decreases in deb value raher han oher effecs, we calculae he gain or loss on he firm s deb aribuable o a change in he firm s risk. This analysis also permis us o es our relaion wihou relying direcly on esimaed bond raings. We hen evaluae he relaion beween his calculaed gain or loss and equiy reurn. We esimae he deb gain or loss aribuable o he change in risk using Eq. (2). GL _ ACC = DEBT (1 ΔR) + DEBT6 (1 ΔR) (2) = 1 DEBT is deb mauring in each of he nex five years and DEBT6 + is deb mauring in six years and beyond. We obain deb mauriies from financial saemen foonoes. ΔR is he ineres rae change indicaed by he firm s change in risk. Tha is, ΔR = (1 + R beg )/ (1 + R end ) where R beg (R end ) is he ineres rae associaed wih he firm s risk, CR, a he beginning (end) of he year. The ineres rae we associae wih each risk group is he average ineres rae for ha group s associaed bond raing over he sample period. Using he average avoids inroducing ino our analysis confounding emporal effecs. The average also helps insulae GL_ACC from effecs 21 When we limi he sample o firms wihou raed deb, our inferences are he same as hose for he full sample using esimaed bond raings. When we use acual bond raings for firms wih raed deb and esimaed bond raings for firms wihou raed deb, our inferences are he same, excep ha he coefficiens on UP INV ΔCR DBTA and UP ACR ΔCR DBTA are no significanly differen from zero ( = 0.65 and 0.21). The insignificance of hese coefficiens is consisen wih lags in acual bond raing upgrades. 22

24 associaed wih changes in marke ineres raes beween he beginning and end of he year. Thus, GL_ACC reflecs primarily he effecs of changes in he firm s risk. For comparison, we calculae he deb gain or loss implied by he parameers esimaed in Eq. (1). The marke-implied gain or loss on long-erm deb, GL_MKT, is equal o 0.17 ΔCR DBTA. We use 0.17 because i is he esimae of β 2 in able 2, panel A. GL_ACC and GL_MKT are per share, deflaed by beginning of year sock price. Table 3 presens descripive saisics and resuls. Panel A reveals ha he means (sandard deviaions) of GL_ACC and GL_MKT are 0.00 and 0.00 (0.07 and 0.04). Panel B reveals ha GL_ACC and GL_MKT are significanly posiively correlaed. The Spearman correlaion is 0.99, alhough he Pearson correlaion is 0.25, which is consisen wih uncorrelaed esimaion error in one or boh of he variables. Consisen wih his, correlaions beween GL_ACC and RET and beween GL_MKT and RET are similar. Table 3, panel C, presens summary saisics from esimaing Eq. (1) wih GL_ACC insead of ΔCR DBTA. Inferences are he same as hose we obain from able 2. In paricular, he amoun we calculae for gain or loss on deb aribuable o changes in credi risk aenuaes he gain or loss refleced in ΔCR. The coefficien on GL_ACC is 0.25, wih a -saisic of All oher resuls are similar o hose in able Changes in operaing risk and asse value Credi risk increases wih oal equiy risk, which prior research separaes ino operaing risk and financing risk (see, e.g., Beaver, Keler, and Scholes, 1970). Operaing risk derives from he sysemaic risk of operaing asses. Financing risk resuls from leverage. As explained in secion 3.1, he exisence of deb can miigae he negaive effecs on equiy value of decreases 23

25 in asse value if deb holders absorb some of he asse value decrease. Beyond his loss sharing, increases in operaing risk may resul in a wealh ransfer from deb holders o equiy holders. To invesigae he effec of wealh ransfers aribuable o increases in operaing asse risk, we esimae Eq. (3). To invesigae he effec from loss sharing aribuable o decreases in operaing asse values, we esimae Eq. (4). Δ (3) * ECC = β 0 + β1δcr + β 2ΔCR DBTA + β3dbta + β 4Δr + ε 3 * FR β 0 + β1δcr + β 2ΔCR DBTA + β3dbta + β 4Δr + ε 4 = (4) Eq. (3) relaes change in equiy cos of capial, ΔECC, and credi risk change, ΔCR, and he ineracion beween leverage and risk change, ΔCR DBTA. We predic β 1 is posiive; changes in credi risk are posiively associaed wih changes in equiy cos of capial. We expec β 2 is negaive o he exen deb miigaes he effec on equiy value of increases in operaing risk. Eq. (4) is he same relaion wih analys earnings forecas revisions, FR, as he dependen variable. FR is a proxy for he change in expeced cash flows inciden o he credi risk change. We predic β 1 is negaive; changes in risk are negaively associaed wih analyss forecas revisions. In Eq. (4), ΔCR DBTA capures he exen o which deb holders share in unrealized gains and losses in asse value. We expec β 2 is posiive o he exen deb in he capial srucure miigaes he effec on equiy value of decreases in asse value. Leverage, DBTA, and changes in he risk-free ineres rae, Δr, are conrol variables. Because we aim o consider separaely risk and cash flow effecs associaed wih risk changes, ΔECC* (FR*) is he residual from a regression of ΔECC (FR) on FR (ΔECC). 22 We esimae equiy cos of capial following Claus and Thomas (2001), Gebhard, Lee, and Swaminahan (2001), Gode and Mohanram (2003), and Eason (2004). Each sudy s 24

26 esimae is based on he residual income model, afer specifying a relaion beween equiy cos of capial, equiy marke value, equiy book value, and forecased earnings and dividends. We use he assumpions in Dhaliwal, Heizman, and Li (2005). Following Hail and Leuz (2004) and Dhaliwal, Heizman, and Li (2005), ECC is he mean of hese four cos of equiy esimaes. 23 To miigae he effecs of error associaed wih esimaing ECC, we eliminae observaions for which ECC < 0% or ECC > 50%. FR is he consensus one-year-ahead forecas of annual earnings per share in June of year, minus he consensus wo-year-ahead forecas of annual earnings per share in June of year 1. We exclude observaions in he exreme 1% of he FR disribuion. Table 4 presens he findings. Panel A presens descripive saisics and reveals ha he mean and median change in equiy cos of capial, ΔECC, and change in he risk-free ineres rae, Δr, are The mean (median) revision o analyss earnings forecas, FR, is 0.26 ( 0.09), which is consisen wih analyss walking down heir forecass over ime (Richardson, Teoh, and Wysocki, 2004). The disribuional saisics for ΔCR and DBTA are similar o hose in able 1, panel A. Panel B reveals ha ΔECC and FR are significanly negaively correlaed, which indicaes ha increases in expeced earnings are associaed wih decreases in equiy cos of capial, parially moivaing our use of ΔECC* and FR* as he dependen variables. Panel B also reveals ha ΔECC (FR) is significanly posiively (negaively) correlaed wih ΔCR. These correlaions indicae ha increases in equiy cos of capial and decreases in expeced earnings are associaed wih increases in risk. Panels C and D presen regression summary saisics from Eqs. (3) and (4). Panel C reveals ha, as expeced, changes in equiy cos of capial no associaed wih changes in analys forecas revisions, ΔECC*, are significanly posiively associaed wih changes in risk, ΔCR ( = 22 Our inferences are unaffeced when we use ΔECC and FR as he dependen variables. 25

27 15.92). More imporanly for our research quesion, panel C also reveals ha he relaion is less posiive for firms wih more leverage; he coefficien on ΔCR DBTA is significanly negaive ( = 2.53). Similarly, panel D reveals ha, also as expeced, analys earnings forecas revisions no associaed wih changes in equiy cos of capial, FR*, are significanly negaively associaed wih changes in risk, ΔCR ( = 17.79). More imporanly, i also reveals ha he relaion is less negaive for firms wih more leverage; he coefficien on ΔCR DBTA is significanly posiive ( = 4.84). All oher inferences are he same as in able 2. These findings indicae ha our able 2 findings are aribuable o changes in risk, as capured by ΔECC, as well as changes in expeced fuure cash flows, as capured by FR Deb covenans Deb holders may proec he value of heir deb from increases in risk by including covenans in deb conracs. Doing so should miigae he effecs on deb value and, hus, on equiy value of increases in risk (Core and Schrand, 1999). To invesigae his possibiliy, we esimae Eq. (1) including ΔBR and ΔBR DBTA ineraced wih an indicaor variable, COV, ha equals one if more han one-half of he firm s deb issues have covenans, and zero oherwise. We obain deb covenan daa from he Fixed Income Securiies Daabase. The mean of COV for our sample is Because COV is available only for firms wih raed deb, we use acual bond raings, BR, in his analysis. However, his resuls in a subsanially smaller sample han ha used in our primary analysis. We predic a negaive coefficien on ΔBR DBTA COV. We do no predic he sign of he coefficien on ΔBR COV. Table 5 presens he findings. As 23 Inferences based on each cos of capial measure are consisen wih hose from he resuls we abulae. 26

28 prediced, ΔBR DBTA COV s coefficien is significanly negaive ( = 2.24). This indicaes ha covenans in deb conracs miigae he effec on equiy value of changes in risk Financial saemen effecs of deb fair value recogniion 6.1. Esimaing asse and deb values and asse volailiy Meron (1974) provides a mechanism for decomposing equiy value ino he values of asses and liabiliies. This permis us o esimae he financial saemen effecs of recognizing deb fair value. Specifically, given observed equiy value and hisorical sock volailiy, we inver he Meron (1974) model o obain esimaes of asse value and is volailiy. Equiy value is fiscal year end share price imes he number of shares ousanding. Following Hillegeis, Keaing, Cram, and Lundsed (HKCL; 2004), we esimae he volailiy of equiy using daily sock reurns, and require a leas 80% of he reurns o be non-missing in he esimaion period. Our esimaion procedure follows HKCL, excep ha we esimae he remaining erm of he deb, raher han assuming i equals one year. Compusa provides he amoun of deb due in each of he nex 1 hrough 5 years. Thus, we calculae he weighed average remaining erm of he firm s deb by summing he percenage of oal deb ousanding in each mauriy caegory imes he number of years in ha caegory. We assume ha he firm s remaining long-erm deb is due in he 10h year. The Meron (1974) model assumes zero-coupon deb. Thus, if here are amouns due before mauriy, we increase he amouns due by he amoun of ne ineres paid in year, as repored in he saemen of cash flows. We also differ from HKCL in ha we focus on long-erm deb raher han oal liabiliies, and we include in asses all oher liabiliies. We define he fair value of deb as he esimaed value of he firm s asses minus is marke value of 24 Unabulaed saisics reveal COV and DBTA are significanly posiively correlaed, alhough he correlaion is small, To conrol for his, in an unabulaed analysis we use COV* in place of COV, where COV* is he residual from a regression of COV on DBTA. Our inferences relaing o covenans are unaffeced. 27

29 equiy. For he risk-free rae, we use he annual one-year Treasury rae published on To miigae he effecs of esimaion errors, we eliminae he op and boom 1% of observaions of each variable, excep for he remaining erm of he deb, he riskfree ineres rae, and DBTA. These daa requiremens resul in a sample of 19,133 observaions. Panel A of able 6 presens descripive saisics for inpus o and oupus from he Meron (1974) model. The mean (median) raio of marke value of equiy, MVE, o book value of equiy, BVE, is 2.10 (1.65), consisen wih sample firms having unrecognized ne asses. The average remaining mauriy on long-erm deb is 4.89 years, he average risk-free ineres rae over he sample period is 5%, and he average volailiy of equiy reurns is 49%. Consisen wih leverage increasing he volailiy of equiy, our calculaed volailiy of asse value, σ V, is 38%. We calculae a mean (median) raio of fair value of asses o book value of asses (MVA/BVA) of 1.74 (1.43). The mean (median) raio of fair value of deb, MVD, o book value of deb, BVD is 1.17 (1.10). Unabulaed saisics confirm ha our sample comprises primarily solven firms. In paricular, for only 1.6% of he sample firms is he value of asses less han he book value of deb Inernal validiy check of model esimaes Before urning o esimaes of he financial saemen effecs of recognizing changes in deb values, we invesigae he inernal validiy of our model esimaes. We do his by esimaing a version of Eq. (1) in which we include he change in asse value and change in asse volailiy, boh esimaed using he Meron model, in lieu of credi raing change and earnings. Recall ha Eq. (1) includes credi raing change and earnings as proxies for changes in asse value and risk. We inerac boh variables wih leverage. If validly implemened, he model resuls in he equiy value effecs of changes in asse value and asse risk being moderaed by he exen of deb in he 28

30 capial srucure. We primarily view his as an inernal validiy check because he firm s sock price and volailiy are inpus o he model hus, he dependen variable is used indirecly o esimae he explanaory variables. Table 6, panel B, presens he findings, which are consisen wih our primary resuls. I reveals ha equiy reurns are posiively and significanly associaed wih change in asse value, ΔMVA, ( = 70.79). Because we include direcly he change in asse value, which reflecs changes in sysemaic risk, he coefficien on change in asse risk should reflec only he effecs of change in unsysemaic risk and, hus, be zero. Oherwise, i should be negaive. Consisen wih his, he coefficien is no significanly differen from zero ( = 0.73). More imporanly for our research quesion, consisen wih he Meron (1974) model and he able 2 findings, he effec on equiy reurns of increases in asse value (asse risk) is less (more) posiive when leverage is higher. In paricular, he coefficien (-saisic) on ΔMVA DBTA is 0.35 ( 24.68) and ha on Δσ V DBTA is 0.43 (4.01) Esimaes of financial saemen effecs As noed in secion 2, opponens of fair value deb recogniion are concerned ha ne income would become less reflecive of he ne change in he economic value of he firm s ne asses. To invesigae his possibiliy, able 7 presens descripive saisics relaing o various forms of repored ne income, NI, and unrecognized changes in esimaed asse and deb values, ΔUA and ΔUD. All variables are deflaed by beginning of year MVE. Because of he esimaion error likely inheren in ΔUA and ΔUD, hese saisics should be inerpreed wih cauion. Noneheless, hey provide some indicaion of he poenial financial saemen effecs of recognizing changes in deb values. 29

31 Table 7 presens saisics separaely for firms wih credi upgrades, no change in credi sanding, and credi downgrades. Relaing o firms wih upgrades, able 7 reveals ha, on average, hese firms have posiive ne income in year and year 1, and posiive change in ne income from year 1 o year. The means for NI, NI 1, and ΔNI are 0.10, 0.02, and I also reveals ha he change in unrecognized asses, ΔUA, is posiive for mos of hese firms. On average, ΔUD is posiive, As a resul, had hese firms recognized ΔUD, heir ne income would have been lower. On average, NI ΔUD also is posiive; he mean (median) is 0.09 (0.08). Thus, mos upgrade firms would have posiive ne income even if he increase in he value of heir deb were recognized. Unabulaed saisics reveal ha whereas NI is posiive for 95% of upgrade firms, NI ΔUD is posiive for 80%. Thus, recognizing ΔUD would resul in approximaely 15% more upgrade firms reporing negaive raher han posiive ne income. Relaing o downgrade firms, able 7 reveals saisics ha generally are of he opposie sign o hose for upgrade firms. In paricular, alhough hese firms have posiive ne income in year 1, hey have negaive ne income in year caused by a negaive change in ne income from year 1 o year. The means for NI, NI 1, and ΔNI are 0.05, 0.05, and I also reveals ha for mos of hese firms change in unrecognized asses, ΔUA, is negaive. On average, ΔUD is negaive; he mean (median) is 0.04 ( 0.07). Thus, had hese firms recognized ΔUD, heir ne income would have been higher. However, unabulaed saisics reveal ha boh he mean and median NI ΔUD are insignificanly differen from zero. Thus, he difference is no large enough o urn losses ino profis in mos cases. Unabulaed saisics reveal ha whereas NI is negaive for 55% of downgrade firms, NI ΔUD is negaive for 45%. Thus, recognizing ΔUD would resul in approximaely 10% more downgrade firms reporing posiive raher han negaive ne income. 30

32 Table 7 also presens saisics for ΔNI ΔUD. This is a proxy for he effec on ne income of he firm s change in year circumsances, including changes in asses and liabiliies. This is paricularly relevan for downgrade firms because asse impairmen wrie-downs are required, bu asse wrie-ups generally are no permied. When assessing he effec on ne income of recognizing he change in unrecognized deb, one would like o compare i o he amoun of asse impairmens, which is no available o us. Under he assumpion ha NI 1 is a good proxy for income before he firm s downurn, ΔNI is a proxy for asse wrie-downs recognized in year. For downgrade firms, he mean (median) ΔNI ΔUD is 0.06 ( 0.05). These saisics indicae ha for mos downgrade firms, recognized asse wrie-downs are larger han unrecognized decreases in deb values. Thus, alhough downgrade firms would recognize higher ne income if deb value changes were recognized, for mos firms he ne effec of decreases in recognized asse value and increases in deb value is negaive. Also conribuing o he concern abou poenial anomalous income saemen effecs arising from fair value accouning for deb is he fac ha no all concurren asse value changes are recognized. The saisics in able 7 indicae ha for mos upgrade (downgrade) firms he ne change in unrecognized asse and liabiliy values, ΔUA ΔUD, is posiive (negaive). Table 7 also reveals ha for all firms ΔUA ΔUD is greaer in magniude han ΔNI ΔUD. These saisics are consisen wih he exisence of unrecognized asses for all groups of firms and, hus, changes in he values of hose asses, increases or decreases, no recognized. Relaing o firms wih no change in bond raing, he saisics in able 7 are as expeced. Tha is, he mean (median) change in ne income, ΔNI, and change in unrecognized deb value, ΔUD, are small, 0.00 (0.01) and 0.01 (0.00). Thus, recognizing unrecognized changes in deb value have lile effec on ne income for hese firms. 31

33 7. Conclusion This sudy ess wheher equiy value reflecs gains and losses associaed wih changes in he value of deb, consisen wih predicions of Meron (1974). This no only conribues o he exan deb and equiy valuaion lieraure, bu also is criical o he debae abou using fair value accouning for liabiliies. Because increases in credi risk resul in decreases in deb value, a firm suffering from deerioraing credi qualiy would recognize gains wih respec o is ousanding deb. This oucome is counerinuiive o some and has generaed considerable conroversy relaing o fair value accouning for liabiliies. Consisen wih prior research, we find ha equiy reurns are significanly negaively relaed o increases in credi risk as refleced in change in esimaed bond raings. More imporanly for our research quesion, we find ha he relaion beween risk changes and equiy reurns is significanly less negaive when leverage is higher. We also find ha equiy reurns for firms wih downgrades are significanly less negaive when leverage is higher; we find he opposie for firms wih upgrades. Our findings hold for all risk groups, excep for firms downgraded wihin invesmen grade. Thus, equiy increases associaed wih increases in risk are eviden for a broad cross-secion of firms, including quie solven firms. To provide a more direc link beween changes in deb values and changes in equiy values, we calculae he change in deb value arising from he change in marke ineres rae associaed wih he change in he firm s risk, and use his esimae of he change in deb value in our esimaing equaion in lieu of he risk change and leverage ineracion variable. Consisen wih our primary findings, we find ha he calculaed deb gain or loss is incremenally significanly posiively associaed wih reurns. We also provide evidence ha he effec we 32

34 documen is associaed wih change in asse risk, as refleced in equiy cos of capial, and change in expeced fuure cash flows, as refleced in revisions of analys earnings forecass. Our findings link and empirically documen he exisence of wo counervailing equiy value effecs associaed wih increases in credi risk: (i) decreases in equiy value, presumably arising from decreases in asse value or increases in sysemaic asse risk, and (ii) increases in equiy value aribuable o decreases in deb value, presumably arising from decreases in asse value or increases in sysemaic or unsysemaic asse risk. We also provide descripive evidence on how recogniion of changes in deb value would affec firms financial saemens. We do his by using observed sock prices and volailiy o inver he Meron (1974) model o obain an esimae of each firm s asse and deb value and asse volailiy. As expeced, we find ha mos upgrade firms would recognize higher ne income han hey do under curren accouning rules if all changes in deb and asse value are included in income. Mos downgrade firms would recognize lower ne income. If only unrecognized changes in deb value were recognized, mos upgrade firms would recognize lower ne income and mos downgrade firms would recognize higher ne income. Ye, for mos firms, he difference is no large enough o change he sign of ne income. Also as expeced, we find evidence of changes in value of unrecognized asses. However, for downgrade firms, i appears ha recognized asse wrie-downs are larger han unrecognized gains from decreases in deb value. These findings call ino quesion concerns abou anomalous income effecs, paricularly relaing o he recogniion of gains associaed wih deb value decreases. 33

35 Appendix Risk Esimaion A.1 Esimaion equaion We esimae he relaion beween bond raings and financial saemen variables, using he subsample of firms wih raed deb (Barh, Beaver, and Landsman, 1998; Ashbaugh, Collins, and LaFond, 2004; Larcker, Richardson, and Tuna, 2004). We se CR, our proxy for risk, equal o he prediced value from equaion (A1) for firms wih and wihou raed deb. ΔCR in Eq. (1) is he annual change in CR. BR = a0 + a1ta + a2roa + a3dbta + a4div + a5subdbt + a6neg + υ (A1) BR is bond raing a he end of year, TA is he log of end-of-year oal asses, ROA is income before exraordinary iems divided by oal asses, DIV is an indicaor variable ha equals one if he firm paid a cash dividend in year, and zero oherwise, SUBDBT is an indicaor variable ha equals one if he firm has subordinaed deb in year, and zero oherwise, and NEG is an indicaor variable he equals one if ROA is negaive in year, and zero oherwise. 25 Esimaing Eq. (A1) using annual daa o calculae CR and hen calculaing annual changes in CR for use in our ess miigaes he effecs of bond raings being revised wih a lag (Pinches and Singleon, 1978). 26 We esimae Eq. (A1) wih year and indusry fixed effecs. BR akes on values ranging from 1 o 4, where larger BR corresponds o higher risk. Specifically, groups 1, 2, 3, and 4 25 Ashbaugh, Collins, and LaFond (2004) and Larcker, Richardson, and Tuna (2004) also include in Eq. (A1) ineres coverage and capial inensiy. We do no include hese variables because doing so noiceably reduces our sample size. However, our inferences are unchanged if we include hese variables and conduc our ess using he resuling CR for he reduced sample. Also, Eq. (A1) does no include variables relaed o deb covenans. Thus, our esimaed bond raings migh no capure all aspecs of deb relevan o is value. Implicily, our design assumes ha unraed deb have covenans similar o hose raed deb. To he exen ha his assumpion is no valid, our ess could be biased. The direcion of he bias is no obvious. However, able 5 repors resuls when we conrol for he exisence of covenans. Our inferences are unchanged. 34

36 include firms wih raings of AAA o A, BBB+ o BBB, BB+ o BB, B+ o D, respecively. 27 Because BR akes on values ranging from 1 o 4, we use maximum likelihood esimaion and an ordered probi model. We predic ha α 1, α 2, and α 4 are negaive, and ha α 3, α 5, and α 6 are posiive. We have no predicion for α 0. A.2 Empirical esimaes Table A1, panel A, presens regression summary saisics from esimaing Eq. (A1) for he 11,799 observaions for firms wih raed deb. Consisen wih prior research, bond raings, BR, are significanly negaively relaed o TA, ROA, and DIV, and significanly posiively relaed o DBTA, SUBDBT, and NEG. The pseudo R 2 from he esimaion is 0.65, indicaing ha hese variables explain a subsanial porion of he variaion in bond raings. 28 Table A1, panel B, presens he disribuions of acual bond raing levels and changes and he disribuions of esimaed bond raing levels and changes. I reveals ha he disribuions are similar. However, in bond raing group 1 here are fewer firms wih esimaed raings (10.38%) han wih acual raings (29.48%). The opposie is rue for bond raing group 4, which comprises 39.97% of firms wih esimaed raings, bu only 19.49% of firms wih acual raings. Panel B also reveals ha changes in acual raings are concenraed in he 0, 1, and 1 change groups, whereas changes in esimaed raings are more widely disribued. Disribuional differences beween firms wih and wihou raed deb are no unexpeced because he explanaory variables 26 Our inferences are unchanged if we esimae Eq. (1) using wo-year reurns for our primary resuls and hose based on only firms wih raed deb. 27 Prior sudies pariion group 4 ino wo groups, one for bond raings of B+ o B and one for bond raings CCC+ o D. We combine hese wo groups because he CCC+ o D group has very few observaions; hese wo groups combined have fewer observaions han do he oher hree bond raing groups. 28 Because CR is he esimaed, raher han acual, bond raing, he sandard errors from Eq. (1) are biased downward. To correc for he addiional variance in CR, as a robusness check, we add a componen o he esimaed variance of he parameers esimaed in Eq. (1). We obain he added componen from boosrapping Eq. (A1). Specifically, following Perin and Train (2002, foonoe 11), we repeaedly esimae Eqs. (A1) and (1) wih boosrapped samples. The added componen is he variance in Eq. (1) parameer esimaes obained over he boosrapped samples. Our inferences are unaffeced by using his procedure. 35

37 reflec sysemaic differences beween he wo groups of firms. For example, firms wih raed deb end o have larger oal asses. 29 As an inernal validiy check, we compare acual and esimaed bond raings for firms wih raed deb. Because for hese firms CR is he prediced value for an observaion included when esimaing Eq. (A1), he comparisons should be inerpreed cauiously. However, unabulaed saisics reveal ha he disribuions of acual and esimaed bond raings are similar. For acual raings, he raing groups 1 hrough 4 are 31%, 27%, 24%, and 18% of he observaions; for esimaed raings he percenages are 33%, 26%, 23%, and 17%. The saisics also reveal ha Eq. (A1) correcly predics 62% of acual raings, and resuls in predicion errors of more han one bond raing group only 2% of he ime. 29 Noe ha he validiy of CR as a proxy for credi risk does no depend on consisen levels of he predicion variables beween firms wih and wihou raed deb. Raher, is validiy depends on consisency of he parameers associaed wih he explanaory variables beween he wo groups of firms. Unforunaely, we are unable o deermine his because bond raings are no observable for firms wihou raed deb. However, as able 5 repors, our inferences are unaffeced by esimaing Eq. (1) using only firms wih raed deb. 36

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43 Whie, H A heeroskedasiciy-consisen covariance marix esimaor and a direc es for heeroskedasiciy. Economerica (48):

44 Figure 1: Effecs of Changes in Asse Value and Asse Risk on Realized Equiy Values Change in Asse Value Change in Asse Risk Direc Effecs posiive non-posiive Indirec Effecs* negaive posiive *Indirec effecs exis only in he presence of deb and reflec 1) he exen o which deb holders absorb asse value changes prior o liquidaion and 2) wealh ransfers beween deb and equiy holders ha arise from changes in asse risk. 43

45 Table 1: Summary Saisics for Regression Variables (N = 50,297) Panel A: Descripive Saisics Variable Mean Median Sd. Dev. RET ΔCR DBTA EPS ΔEPS NEG 0.25 Panel B: Pearson (above he diagonal) and Spearman (below he diagonal) Correlaions RET ΔCR DBTA EPS ΔEPS NEG RET ΔCR DBTA EPS ΔEPS NEG

46 Table 1 (coninued): Summary Saisics for Regression Variables (N = 50,297) Panel C: Indusry Composiion of Sample Indusry SIC codes N Percen Mining and consrucion , excep , Food , Texiles, prining, and publishing , Chemicals , and , Pharmaceuicals , Exracive indusries , and , Durable manufacurers , excep , , Compuers , , and , Transporaion , Reail , Services , excep , , RET = size-adjused fiscal-year sock reurn (including dividends), CR = risk group (4 groups, 1 = highes o 4 = lowes), DBTA = long-erm deb o oal asses, EPS = earnings per share before exraordinary iems, deflaed by beginning of year sock price, NEG = indicaor for negaive EPS, Δ denoes annual change. All correlaions in panel B are significanly differen from zero, excep he Spearman correlaion beween EPS and DBTA. Sample of 7,646 Compusa firms from

47 Table 2: Summary Saisics for Reurns Regressions (N = 50,297) RET = β + β ΔCR + β ΔCR DBTA + β DBTA + β EPS + β ΔEPS β NEG + β NEG EPS + β NEG ΔEPS + ε Panel A: Regression Summary Saisics DBTA ranks Pred. Coef. -saisic Coef. -saisic ΔCR ΔCR DBTA DBTA? EPS ΔEPS NEG NEG EPS NEG ΔEPS Adj. R

48 Table 2 (coninued): Summary Saisics for Reurns Regressions (N = 50,297) Panel B: Regression Summary Saisics from Panel A Regression wih Separae Effecs for Downgrades and Upgrades Pred. Coef. -saisic Coef. -saisic DN ΔCR DN INV ΔCR DN ACR ΔCR DN NINV ΔCR DN ΔCR DBTA DN INV ΔCR DBTA DN ACR ΔCR DBTA DN NINV ΔCR DBTA UP ΔCR UP INV ΔCR UP ACR ΔCR UP NINV ΔCR UP ΔCR DBTA UP INV ΔCR DBTA UP ACR ΔCR DBTA UP NINV ΔCR DBTA DBTA? EPS ΔEPS NEG NEG EPS NEG ΔEPS Adj. R RET = size-adjused fiscal-year sock reurn (including dividends), CR = risk group (4 groups, 1 = highes o 4 = lowes), DBTA = raio of long-erm deb o oal asses, DBTA ranks = decile rank of DBTA, scaled beween 0 and 1, EPS = earnings per share before exraordinary iems, deflaed by beginning of year price, NEG = indicaor for negaive ne income before exraordinary iems, DN (UP) = indicaor for credi downgrade (upgrade), DN INV (UP INV ) = indicaor for credi downgrade (upgrade) wihin invesmen grade, 47

49 DN NINV (UP NINV ) = indicaor for credi downgrade (upgrade) wihin non invesmen grade, DN ACR (UP ACR ) = indicaor for credi downgrade (upgrade) across grades, Δ denoes annual change. Huber M-esimaes are presened, wih year and indusry fixed effecs unabulaed. Sample of 7,646 Compusa firms from See able 1 for indusry composiion. 48

50 Table 3: Summary Saisics for Deb Gain Regression (N = 29,758) Panel A: Descripive Saisics Variable Mean Median Sd. Dev. RET GL_ACC GL_MKT Panel B: Pearson (above he diagonal) and Spearman (below he diagonal) Correlaions RET GL_ACC GL_MKT RET GL_ACC GL_MKT Panel C: Regression Summary Saisics from RET = β 0 + β1δcr + β2gl _ ACC + β DBTA + β EPS + β ΔEPS + β NEG + β NEG EPS + β NEG ΔEPS + ε Pred. Coef. -saisic ΔCR GL_ACC DBTA? EPS ΔEPS NEG NEG EPS NEG ΔEPS Adj. R

51 1 GL _ ACC = P 1 5 = 1 DEBT (1 ΔR) + DEBT 6 + (1 ΔR) 10, where R is ineres rae associaed wih he firm s risk group, averaged over 1986 o 2003, DEBT is deb mauring in each of he nex one o five years, and DEBT6 + is deb mauring in six years and beyond. GL_MKT = β ΔCR DBTA, where β = 0.17 from able 2, panel A. GL_ACC and GL_MKT are deflaed by beginning of period marke value. RET = size-adjused fiscal-year sock reurn (including dividends), CR = risk group (4 groups, 1 = highes o 4 = lowes), DBTA = raio of long-erm deb o oal asses, EPS = earnings per share before exraordinary iems, deflaed by beginning of year sock price, NEG = indicaor for negaive ne income before exraordinary iems, Δ denoes annual change. All correlaions in panel B are significanly differen from zero. Huber M-esimaes are presened in panel C, wih year and indusry fixed effecs unabulaed. Sample of 5,669 Compusa firms from

52 Table 4: Summary Saisics for Equiy Cos of Capial and Analys Earnings Forecas Revision Regression Variables (N = 24,036) Panel A: Descripive Saisics Variable Mean Median Sd. Dev. ΔECC FR ΔCR DBTA Δr Panel B: Pearson (above he diagonal) Spearman (below he diagonal) Correlaions ΔECC FR ΔCR DBTA Δr ΔECC FR ΔCR DBTA Δr

53 Table 4 (coninued): Summary Saisics for Equiy Cos of Capial and Analys Earnings Forecas Revision Regression Variables (N = 24,036) Panel C: Regression Summary Saisics from Δ * ECC = β 0 + β1δcr + β 2ΔCR DBTA + β3dbta + β 4Δr + ε 3 Pred. Coef. -saisic ΔCR ΔCR DBTA DBTA? Δr Adj. R Panel D: Regression Summary Saisics from * FR = β 0 + β1δcr + β 2ΔCR DBTA + β3dbta + β 4Δr + ε 4 Pred. Coef. -saisic ΔCR ΔCR DBTA DBTA? Δr Adj. R ECC = he mean of he equiy cos of capial esimaes from he Gebhard e al. (2001), Claus and Thomas (2001), Gode and Mohanram (2003), and Eason (2004) models. We calculae equiy cos of capial a he end of June for each year. CR = risk group (4 groups, 1 = highes o 4 = lowes), FR = revision in analyss consensus earnings per share forecas, from June of prior year o June of curren year, ΔECC* (FR*) = he porion of ΔECC (FR) ha is orhogonal o FR (ΔECC). DBTA = raio of long-erm deb o oal asses, r = he yield on a 10-year Treasury noe, Δ denoes annual change. All correlaions in panel B are significanly differen from zero, excep he Pearson correlaion beween DBTA and Δr and he Spearman correlaion beween ΔCR and Δr. Huber M-esimaes are presened, wih year and indusry fixed effecs unabulaed. Sample of 4,488 Compusa firms from

54 Table 5: Summary Saisics for Reurns Regressions using Firms wih Raed Deb (N = 11,799) Regression Summary Saisics from RET = β + β ΔBR + β ΔBR COV + β ΔBR DBTA + β ΔBR DBTA COV + β DBTA β EPS β ΔEPS 5 + β NEG + β NEG EPS β NEG ΔEPS ε Pred. Coef. -saisic ΔBR ΔBR COV? ΔBR DBTA ΔBR DBTA COV DBTA? EPS ΔEPS NEG NEG EPS NEG ΔEPS Adj. R RET = size-adjused fiscal-year sock reurn (including dividends), BR = bond raing group (4 groups, 1 = highes o 4 = lowes), DBTA = raio of long-erm deb o oal asses, EPS = earnings per share before exraordinary iems, deflaed by beginning of year sock price, NEG = indicaor for negaive ne income before exraordinary iems, COV = indicaor wheher a leas half of he ousanding deb issues have covenans, Δ denoes annual change. Huber M-esimaes are presened, wih year and indusry fixed effecs unabulaed. Sample of 1,888 Compusa firms from

55 Table 6: Summary Saisics using Meron Model Esimaes (N = 19,133) Panel A: Descripive Saisics for Meron Model Esimaion Inpus and Oupus Variable Mean Median Sd. Dev. MVE / BVE MVA / BVA MVD / BVD Term remaining on deb Risk-free ineres rae σ E σ V ΔMVA DBTA Panel B: Regression Summary Saisics from RET = 0 + β1δ MVA + β 2MVA DBTA + β1δσ V + β 2ΔσV DBTA + β3 β DBTA + ε Pred. Coef. -saisic ΔMVA ΔMVA DBTA Δσ V 0/ Δσ V DBTA DBTA? Adj. R RET = size-adjused fiscal-year sock reurn (including dividends), MVE (BVE) is marke value (book value) of equiy, MVA is marke value of asses esimaed using he Meron (1974) model. MVD = MVA MVE, BVA = book value of asses book value of liabiliies oher han long-erm deb, BVD = book value of long-erm deb, σ E is volailiy of equiy values esimaed using monhly sock reurns over a period equal o he erm remaining on deb, σ V is volailiy of asse values esimaed using he Meron (1974) model, DBTA = raio of long-erm deb o oal asses, Δ denoes annual change. ΔMVA is deflaed by MVE 1. Huber M-esimaes are presened, wih year and indusry fixed effecs unabulaed. Sample of 4,000 Compusa firms from

56 Table 7: Summary Saisics using Meron Model Esimaes (N = 19,133) Upgrades (N = 1,344) Mean Q1 Median Q3 NI NI ΔNI ΔUD ΔUA NI ΔUD ΔNI ΔUD ΔUA ΔUD No Change (N = 16,327) Mean Q1 Median Q3 NI NI ΔNI ΔUD ΔUA NI ΔUD ΔNI ΔUD ΔUA ΔUD Downgrades (N = 1,462) Mean Q1 Median Q3 NI NI ΔNI ΔUD ΔUA NI ΔUD ΔNI ΔUD ΔUA ΔUD

57 NI = income before exraordinary iems, unrecognized asses (UA) = marke value of ne asses book value of ne asses, and unrecognized deb (UD) = marke value of long-erm deb book value of longerm deb. The marke values of ne asses and deb are esimaed using he Meron (1974) model. Each is deflaed by beginning of period marke value of equiy. All panel A means and medians are significanly differen from zero, using a -es for means or signed rank es for medians, excep he median ΔNI ΔUD for firms wihou risk changes, and he mean and median NI ΔUD for downgrade firms. Sample of 4,000 Compusa firms from

58 Table A1: Risk Esimaion Panel A: Regression Summary Saisics from BR = a0 + a1ta + a2roa + a3dbta + a4div + a5subdbt + a4 NEG + υ Pred. Coef. -saisic TA ROA DBTA DIV SUBDBT NEG Pseudo R Panel B: Disribuions of Acual and Esimaed Bond Raing Groups Acual Esimaed Bond Raing Group N Percen N Percen AAA o A 1 3, , BBB+ o BBB 2 3, , BB+ o BB 3 3, , B+ o D 4 2, , Acual Esimaed Change in Bond Raing Group N Percen N Percen Upgrades , No change 0 10, , , Downgrades

59 Panel A is based on an ordered probi esimaion using he 11,799 observaions for firms wih raed deb. The model is esimaed wih year and indusry fixed effecs (unabulaed). Esimaed bond raing groups in panel B are prediced values from he panel A regression. BR = bond raing group (4 groups, 1 = highes o 4 = lowes), TA = naural log of oal asses, in $ millions, ROA = reurn on asses; ne income before exraordinary iems divided by oal asses, DBTA = long-erm deb o oal asses, DIV = one if he firm paid a dividend in year and 0 oherwise, SUBDBT = one if he firm has subordinaed deb and 0 oherwise, NEG = 1 if ROA is negaive and 0 oherwise. Sample of Compusa firms from