Financial covenants in the markets for public and private debt

The public debt contracts surveyed in Whittred and Zimmer (1986) and Stokes and Tay (1988) were issued between 1962 and 1985, and there has been significant macroeconomic, institutional and regulatory change since that time. We analyse a sample of 36 recently issued Australian public debt contracts and document a considerable change in the ‘package’ of financial covenants used in public debt contracts. The covenant package is now less restrictive and the types of covenants used are more heterogenous. We also survey a sample of 41 recent Australian private debt contracts. These contracts contain a greater number, variety and, collectively, more restrictive set of financial covenants than those public debt contracts we survey, supporting theory which suggests that covenant restrictive and renegotiation–flexible contracts are more suited to borrowers contracting with financial intermediaries in private debt markets. We also note differences in accounting rules associated with financial covenants used in these private debt contracts.     

Hedge commitments and agency costs of debt: evidence from interest rate protection covenants and accounting conservatism

We provide large sample evidence that credible hedge commitments reduce the agency costs of debt and that accounting conservatism enhances hedge commitments. We examine 2,338 bank loans entered into by 263 mandatory derivative users that are contractually obligated by interest rate protection covenants, 709 voluntary derivative users, and 1,366 non-users. We show that loan contracts are more likely to include interest rate protection covenants when borrowers are less likely to maintain the hedge position once the financing is completed. We find that borrowers who credibly commit to hedge using these covenants significantly reduce their interest rates. While we do not find an average interest savings for voluntary derivative users, we do find a reduction in their loan rates when they practice conservative financial reporting. Our results suggest that accounting conservatism helps borrowers resolve shareholder-creditor conflicts by committing to maintain their hedge positions after completing debt financing.     

Accounting Conservatism and the Cost of Capital: An International Analysis

This paper examines the role of conditional accounting conservatism in mitigating the cost of equity and debt capital in an international setting. The findings are that firms domiciled in countries with more conservative financial reporting systems have lower cost of equity and debt capital. The paper further explores the cross‐sectional variation of the above relationships, finding that the negative association between conditional conservatism and the cost of equity and debt capital is more pronounced in countries with stronger legal enforcement, suggesting a complementary role between conservatism and legal institutions in capital markets. In addition, the paper finds that conservatism only reduces the cost of debt in countries where accounting‐based covenants are widely used, consistent with the argument that conditional conservatism improves the efficiency of debt contracts via accelerating covenant violations.     

Debt contract strictness and auditor specialization

The conflicts of interest among managers, shareholders and creditors resulting in agency costs, can be mitigated by restricting managers’ adverse behavior, through financial covenants to better align the various stakeholder interests. Thus, debt contract strictness represents an important aspect of agency costs between creditors, shareholders, and management that is not always captured by interest rates. The contract setting provides a unique opportunity to investigate how creditors may rely on auditors to alleviate information uncertainty stemming from reliance on management's financial reporting and thus alleviate the creditor's potential loss of invested capital. After controlling for borrower risks, loan characteristics, and audit factors, we show that auditor industry specialization is significantly associated with a reduction in the strictness of debt contracts, consistent with creditors viewing certain industry expert auditors as effective monitors against financial reporting manipulation aimed at the avoidance of debt covenant triggers that protect creditors against potential loss. Further, we find that the association between loan strictness and auditor specialization is attenuated by stronger corporate governance systems, external monitors, and prior lender relationships.     

Institutional Differences and International Private Debt Markets: A Test Using Mandatory IFRS Adoption

Institutional differences between countries result in additional information risks between borrowers and lenders in cross‐border private loans. This study examines the effect of these information risks on the structure of optimal debt contracts in international (cross‐border) versus domestic private debt markets. Using mandatory IFRS adoption as an indicator for institutional changes that reduced differences between countries, I compare attributes of international versus domestic loans before and after IFRS adoption. I find that, in the pre‐IFRS period, international loans are associated with a higher credit spread, a weaker relationship between the bank and the borrower, a more diffuse loan syndicate, and less reliance on accounting‐based covenants than domestic loans. These results are consistent with incremental information risks in international debt markets that make it more costly for lenders to screen and monitor borrower credit quality, resulting in a more arm's‐length relationship between borrowers and lenders. Many of these associations attenuate after IFRS adoption, suggesting that the pre‐IFRS differences in contract terms are driven by incremental information risks related to institutional differences between countries. My findings imply that incremental information risks result in a different optimal contract in international debt contracts compared to domestic debt contracts.     

The effect of auditor litigation risk on clients' access to bank debt: Evidence from a quasi-experiment

We exploit staggered state-level shocks to third-party auditor legal liability in the U.S. to test whether auditor litigation risk affects client companies' access to private debt markets. We find that an exogenous increase in auditor litigation risk leads to an increase in both clients' likelihood of receiving bank loans and the average amount of the bank loans that clients receive. In support of our proposed mechanism that auditor litigation risk leads to improvements in clients' audit and financial reporting quality, we find that these same shocks lead to a reduction in accruals, an increase in going-concern opinions, a decrease in restatements, and an improvement in accruals' ability to predict future cash flows. We also find that increased auditor litigation risk leads to an increase in the contractibility of clients’ accounting numbers, as proxied by the use of debt covenants, and a decrease in the cost of borrowing.     

ARE FIRM‐ AND COUNTRY‐SPECIFIC GOVERNANCE SUBSTITUTES? EVIDENCE FROM FINANCIAL CONTRACTS IN EMERGING MARKETS

We investigate how borrowers’ corporate governance influences bank loan contracting terms in emerging markets and how this relation varies across countries with different country‐level governance. We find that borrowers with stronger corporate governance obtain favorable contracting terms with respect to loan amount, maturity, collateral requirements, and spread. Firm‐level and country‐level corporate governance are substitutes in writing and enforcing financial contracts. We also find that the distinctiveness of borrowers’ characteristics affect the relation between firm‐level corporate governance and loan contracting terms. Our findings are robust, irrespective of types of regression methods and specifications.     

U.S. Audit partner identification and auditor reporting

After a lengthy and protracted debate, the Public Company Accounting Oversight Board (PCAOB) adopted new rules requiring disclosure of the engagement partner’s name and information about other accounting firms on the new PCAOB Form AP, Auditor Reporting of Certain Audit Participants. We investigate the impact of this regulation on auditor behavior in the context of the auditor’s going concern report modification propensity. We document an increase in the propensity to issue a going concern report modification in the disclosure regime, accompanied by a corresponding increase in the Type I (‘false positives’) error rate. Thus, an unintended consequence of Rule 3211 is the potential reduction in the audit report's informativeness. Conceivably, a more significant repercussion is that going concern modifications can hasten bankruptcy for firms since financial institutions may be reluctant to lend money to firms with modified audit reports. An unjustified increase in the going concern modification rate as evinced in our paper may make U.S. capital markets potentially less attractive to young, upstart, albeit financially-distressed, companies.     

Conservative financial reporting, debt covenants, and the agency costs of debt

Considerable research has documented the role of debt covenants and conservative financial accounting in addressing agency conflicts between lenders and borrowers. Beatty, A., Weber, J., and Yu, J. [2008. Conservatism and debt. Journal of Accounting and Economics, forthcoming] document interesting, but mixed, findings on the relation between debt covenants and conservative accounting, and the extent to which the two contracting mechanisms act as substitutes or complements. In this paper, I discuss the economic roles of financial reporting, debt covenants, and conservatism within the debt contracting environment, and attempt to fit BWY's findings within this context.     

Large–Sample Evidence on the Debt Covenant Hypothesis

We use Dealscan , a database of private corporate lending agreements, to provide large–sample tests of the debt covenant hypothesis. Dealscan offers several advantages over the data available in previous studies, principally larger and more representative samples and the availability of extensive actual covenant detail. These advantages allow us to construct powerful tests in which we find clear support for the debt covenant hypothesis. We also use these data to provide broad evidence on the economic role of debt covenants. We find that private lenders set debt covenants tightly and use them as "trip wires" for borrowers, that technical violations occur relatively often, and that violations are not necessarily associated with financial distress. Finally, since we measure covenant slack directly, we report evidence that the extensively–used leverage variable is a relatively noisy proxy for closeness to covenants.     

Debt Covenants and Accounting Conservatism

Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision-making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers' abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if the accounting system recognizes economic losses in earnings in a timely fashion. Thus, the demand for timely loss recognition should increase with a contract's reliance on covenants. Consistent with this conjecture, I find evidence that reliance on covenants in public debt contracts is positively associated with the degree of timely loss recognition. I also find evidence that the presence of prior private debt mitigates this relationship.     

The Ex‐Ante Monitoring Role of Accounting Covenants in Public Debt

In contrast to what is known about accounting covenants in private debt, little empirical evidence on the role of accounting covenants in public debt exists. Diffuse ownership, arm's length monitoring, and collective action problems are unique to the public debt setting and raise the question of whether these covenants serve their intended role. As such, this study investigates whether including covenants reliant upon accounting inputs influences borrowers’ actions to prevent adverse credit events. Accounting covenants in the public debt setting provide firms with a disciplining mechanism to renegotiate ahead of costly technical default – a stark contrast to the ex‐post renegotiation ‘trip wire’ role covenants play in private debt. In particular, the results show that including accounting covenants in public debt is associated with an increased probability of ex‐ante renegotiation, that is, negotiation through consent solicitations ahead of covenant violation. This ex‐ante renegotiation, in turn, is associated with decreased adverse credit events. Cross‐sectional results support these findings as the ex‐ante renegotiation role of accounting covenants varies with bondholders’ and trustees’ monitoring ability.     

The Influence of Country‐ and Firm‐level Governance on Financial Reporting Quality: Revisiting the Evidence

This paper examines how firm‐level governance and country‐level governance interplay in shaping financial reporting quality. Using IFRS adoption as a source of variation in firms’ reporting discretion, and a large sample of European firms that mandatorily switch to the new set of standards, we find that in countries with low enforcement and weak oversight over financial reporting, only firms with strong board‐level corporate governance mechanisms experience an increase in financial reporting quality, consistent with firm‐ and country‐level governance mechanisms being substitutes. However, in countries with high enforcement and strict oversight over financial reporting, firms with either strong or weak board‐level governance mechanisms experience an increase in financial reporting quality, even if the increase is larger for the former group. Overall, our findings indicate that in the debate about the effects of governance on the quality of financial reporting, it is important to consider both country‐ and firm‐level corporate governance mechanisms.     

Covenants and Collateral as Incentives to Monitor

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.     

Bank debt covenants and firms’ responses to FAS 150 liability recognition: evidence from trust preferred stock

We examine the relation between accounting-based debt contracts and the economic response of firms with trust preferred stock (TPS) to mandated liability recognition under Financial Accounting Standard (FAS) 150. Our results show that firms’ financial covenants significantly affect their choice to redeem versus reclassify their outstanding TPS. Specifically, firms with bank debt covenants that would be adversely impacted by recognizing TPS as a debt liability are 26.88% more likely to redeem their TPS after FAS 150. We also find that firms are significantly more likely to redeem versus reclassify their TPS after FAS 150 if they used the original TPS proceeds to retire existing debt (id est, to enhance their balance sheets). Our findings suggest that when bank debt contracts use “floating” Generally Accepted Accounting Principles (GAAP) to construct financial covenant terms, changes in the underlying GAAP measure significantly influence firms’ economic behavior.     

Firms' Off-Balance Sheet and Hybrid Debt Financing: Evidence from Their Book-Tax Reporting Differences

We match large U.S. corporations' tax returns during 1989–2001 to their financial statements to construct a firm‐level proxy of firms' use of off‐balance sheet and hybrid debt financing. We find that firms with less favorable prior‐period Standard & Poor's (S&P) bond ratings or higher leverage ratios in comparison to their industry report greater amounts of interest expense on their tax returns than to investors and creditors on their financial statements. These between‐firm results are consistent with credit‐constrained firms using more structured financing arrangements. Our within‐firm tests also suggest that firms use more structured financing arrangements when they enter into contractual loan agreements that provide incentives to manage debt ratings. Specifically, we find that after controlling for S&P bond rating and industry‐adjusted leverage, our sample firms report greater amounts of interest expenses for tax than for financial statement purposes when they enter into performance pricing contracts that use senior debt rating covenants to set interest rates. Furthermore, we find that the greatest book‐tax reporting changes occur when firms become closer to violating these debt rating covenants. These latter findings are consistent with firms' contractual debt covenants influencing their use of off‐balance sheet and hybrid debt financing.     

On the value of restrictive covenants: Empirical investigation of public bond issues

Are restrictive covenants effective mechanisms in mitigating agency problems? Is the magnitude of the increase in the cost of debt due to agency problems non-trivial? We tackle these questions using a large dataset of public bonds. Contrary to the view that restrictive covenants in public bond contracts are standard boilerplates that serve little purpose, we find significant benefits in terms of reduction in the cost of debt associated with covenants. Restrictions on investment activities or issuance of higher priority claims reduce the cost of debt by about 35–75 basis points. These findings suggest that investors view bond covenants as important instruments in mitigating agency problems, and an increase in the cost of debt due to agency problems could be substantial. Additionally, we find that high growth firms and firms with low probability of default are less likely to include covenants suggesting that the costs of covenants outweigh benefits for these types of firms.     

Monitoring by Affiliated Bankers on Board of Directors: Evidence from Corporate Financing Outcomes

Using a hand‐collected data set on boards of directors of large US nonfinancial companies, this paper investigates the effects of the presence of a creditor on a company's board. The results suggest that the presence of a creditor: 1) increases the amount of debt in a company's capital structure via an increase in private debt, 2) decreases the sensitivity of debt financing to the amount of tangible assets that a company holds, 3) decreases the cost of borrowing, and 4) reduces the pledge of collateral and financial covenants in debt contracts.     

Structural changes in covenants through the adoption of IFRS in Brazil

This study examines changes in the structure of covenants in debt agreements of companies issuing debentures during the adoption of International Financial Reporting Standards (IFRS) in Brazil. We investigate debt contracts of public and private companies that issued debentures before and after IFRS adoption in Brazil, between the years 2006–2008 and 2011–2014. We develop a database with all covenants from 126 contracts via hand-collected data, with 78 contracts from before IFRS adoption and 48 contracts afterward. We find high increases in covenants after adoption. However, this growth is observed only for restrictive security and non-accounting covenants, excluding clauses with accounting multiples. Our results show that IFRS adoption in Brazil shifted incentives and, as a result, shaped a new structure of debt contracts. Our findings complement and expand previous studies and can be useful to academics, regulators and practitioners by showing that the incentives to use accounting figures and ratios shifted in the credit market after IFRS adoption.     

The Impact of the Change to International Accounting Standards on Debt Covenants: A UK Perspective1

This paper examines the impact on covenants in the debt contracts of companies of the impending change to international accounting standards (IAS). The primary focus of the paper is the UK debt market, but comparisons are drawn with other EU countries that will also be affected by the adoption of IAS. Existing evidence of the nature of debt covenants and the impact of accounting regulation change on such covenants is briefly reviewed. It is argued that the adoption of IAS will have a significant impact both on reported earnings and on balance sheet values. Moreover, it is argued that the adoption of IAS will increase the volatility of earnings. It is further argued that, as a consequence of these effects, there will be a significant impact on debt covenants given the widespread use of rolling GAAP. A number of cases and hypothetical examples are provided to illustrate the impact of the adoption of IAS.