The effects of firm-initiated clawback provisions on bank loan contracting

Although firm-initiated clawbacks reduce accounting manipulation, they also induce managers to engage in suboptimal activities (e.g., reduce research and development (R&D) expenses) to achieve earnings targets. To assess the effectiveness of clawback provisions, we examine their impact from debtholders' point of view. We find that banks use more financial covenants and performance pricing provisions in the loan contracts and decrease interest rates after firms initiate clawbacks. Moreover, we also find that loan maturity increases and loan collateral decreases subsequent to clawback adoption. Taken together, our findings indicate that firm-initiated clawback provisions enhance financial reporting quality, thereby reducing the information uncertainty that financing providers face.     

Loan collateral and financial reporting conservatism: Chinese evidence

We examine the relation between the use of collateral and financial reporting conservatism for a sample of Chinese firms. In the absence of flexibility in risk pricing through interest rates and strong contract enforcement in China, we find that lenders reduce collateral requirements from more conservative borrowers and that this negative relation is significantly moderated by borrowers’ poor credit quality and low asset tangibility. Our finding that conservatism can result in a tangible benefit in the form of lower collateral requirements indicates that lenders value financial reporting conservatism. However, the benefit from financial reporting conservatism is muted as lenders become more concerned about borrowers’ default risk or ability to pledge tangible assets as collateral against loans.     

Accounting quality,bank monitoring,and performance pricing loans

We provide new evidence on the determinants of performance pricing provisions in bank loan contracts. We find that firms that are easier to monitor, such as those with better accounting quality, lower information opacity, or a stronger relationship with the lender are more likely to have performance pricing loans. The use of performance pricing is less likely after financial restatement events. Furthermore, we find that the likelihood of using accounting-based (as opposed to credit-rating-based) pricing provisions increases as the firm’s accounting quality increases, and as the strength of the prior lending relation increases. Our results are robust to alternative measures of accounting quality, information opacity, and bank monitoring, and suggest that monitoring costs have a significant impact on the design of debt contracts.     

CORPORATE BOARDS AND BANK LOAN CONTRACTING

We investigate the role of corporate boards in bank loan contracting. We find that when corporate boards are more independent, both price and nonprice loan terms (e.g., interest rates, collateral, covenants, and performance‐pricing provisions) are more favorable, and syndicated loans comprise more lenders. In addition, board size, audit committee structure, and other board characteristics influence bank loan prices. However, they do not consistently affect all nonprice loan terms except for audit committee independence. Our study provides strong evidence that banks recognize the benefits of board monitoring in mitigating information risk ex ante and controlling agency risk ex post, and they reward higher quality boards with more favorable loan contract terms.     

The effect of borrowers' accounting conservatism on lenders' loan loss provisions: Evidence from China's banking industry

This paper investigates how borrowers' accounting conservatism affects lenders' loan loss provisions in the Chinese banking context. We predict that when borrowers' financial statements are more conservative, lenders receive borrowers' bad news in a timelier manner and set aside more loan loss provisions. The empirical results confirm that borrowers' accounting conservatism is positively associated with lenders' loan loss provisions, as the former affects the latter via its impact on loan classification, and this positive association is more pronounced when information asymmetry is higher. In heterogeneity tests, we find that this positive association is stronger for non-state-owned, listed, and less prudent lenders and also varies across debt contract characteristics. Collectively, the results of this study offer insights into how lenders accrue loan losses when borrowers' financial reporting is more conservative.     

The Impact of Disclosures of Internal Control Weaknesses and Remediations on Investors' Perceptions of Earnings Quality

We hypothesize and find that firms making SOX‐mandated disclosures of material weaknesses in internal control over financial reporting (ICOFR) exhibit lower investor‐perceived earnings quality (IPEQ) than nondisclosers. We measure IPEQ using e‐loading, a market‐returns–based representation of earnings quality developed by Ecker, Francis, Kim, Olsson, and Schipper (2006). Firms do not exhibit decreases in IPEQ after initially disclosing material weaknesses. This is consistent with investors having anticipated ICOFR strength based on observable firm characteristics. However, firms exhibit increases in IPEQ after receiving their first clean audit reports that confirm the remediation of previously disclosed weaknesses. This indicates that, although investors do not find initial weakness disclosures to be incrementally informative, SOX motivates firms to remediate weak controls and provides a venue for credible remediation disclosures, thus enhancing investors' perception of financial reporting reliability. These findings are consistent with the existence of regulatory benefits associated with SOX's internal control disclosure and audit requirements.     

Financial Statements as Monitoring Mechanisms: Evidence from Small Commercial Loans

Using a data set that records banks’ ongoing requests of information from small commercial borrowers, we examine when banks use financial statements to monitor borrowers after loan origination. We find that banks request financial statements for half the loans and this variation is related to borrower credit risk, relationship length, collateral, and the provision of business tax returns, but in complex ways. The relation between borrower risk and financial statement requests has an inverted U‐shape; and tax returns can be both substitutes and complements to financial statements, conditional on borrower characteristics and the degree of bank–borrower information asymmetry. Frequent financial reporting is used to monitor collateral, but only for non–real estate loans and only when the collateral is easily accessible to lenders. Collectively, our results provide novel evidence of a fundamental information demand for financial reporting in monitoring small commercial borrowers and a specific channel through which banks fulfill their role as delegated monitors.     

Top management incentives and financial flexibility: The case of make‐whole call provisions

Consistent with the premise that make‐whole call provisions enhance value‐creating financial flexibility, we find that higher sensitivity of managerial wealth to stock price (delta) increases the likelihood that corporate bonds contain make‐whole provisions. Building on the results of related research, post‐issue financial performance of make‐whole callable bond issuers increases in delta. In line with prior findings that demonstrate financial flexibility can be costly to bondholders, we find that managerial equity incentives impact the incremental effect of make‐whole provisions on the pricing of corporate debt securities. Consistent with the flexibility explanation, we also find that the market response as measured by abnormal trading volume to the issuance of make‐whole callable debt varies in equity incentives. Overall, our results suggest that managerial incentives play a role in the choice, pricing, and market response to make‐whole options in corporate debt securities.     

Finding diamonds in the rough: Analysts’ selective following of loss‐reporting firms

Investors face greater difficulty valuing loss‐reporting than profit‐reporting firms: losses may be due to very different reasons (e.g., poor operating performance or investments in intangibles, and financial accounting information is of more limited use for valuing loss‐making firms than profit‐making firms. Because of increased uncertainty about loss firms’ future financial and business viability, we hypothesize that financial analysts will be more selective when choosing to follow loss firms than profit firms, with the result that “abnormal” analyst following will be more informative to investors regarding the future performance of loss firms than profit firms. Consistent with this prediction, we find that abnormal analyst coverage is useful for predicting firms’ future prospects, and is more strongly associated with future performance (stock returns and ROA) for loss firms than for profit firms. The market, however, does not seem to use this useful information when pricing loss firms: for loss firms a portfolio investment strategy based upon abnormal analyst following can generate positive excess returns over 1‐ to 3‐year holding periods. These results are stronger for persistent‐loss firms than for occasional‐loss firms. We conclude that abnormal analyst following contains useful information about firms’ future prospects, and even more so for loss firms than for profit firms.     

Financial Reporting Quality,Structural Problems and the Informativeness of Mandated Disclosures on Internal Controls

Even before firms report internal control weaknesses under the Sarbanes–Oxley Act (SOX), they are characterized by structural problems, are prone to internal control weaknesses, and have low financial reporting quality. If the stock market incorporates much of this information during the pre‐disclosure years, investors are less surprised when firms subsequently report internal control weaknesses under SOX. We find that for the pre‐disclosure period, firms reporting internal control weaknesses under SOX, (1) had structural problems, (2) were prone to internal control problems, and (3) had low financial reporting quality. Further, we provide direct evidence that stock prices during pre‐disclosure years incorporate much of the information about structural problems, the likelihood of internal control weaknesses, and low reporting quality. Finally, we find that many of these value‐relevant factors are not related to announcement period returns when firms eventually disclose such problems under SOX and that limited new information about structural problems is generated around this date. Our results provide a compelling explanation for the muted stock price reaction around the mandatory disclosure date.     

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.     

The effect of voluntary clawback adoption on non-GAAP reporting

We examine the effect of voluntary adoption of clawback provisions on non-GAAP earnings disclosures. Prior literature documents that voluntary clawback adoption improves financial reporting quality by increasing the costs of misstating GAAP earnings. However, managers may respond to perceptions of reduced discretion over GAAP reporting by increasing their reliance on non-GAAP earnings disclosures. Using a propensity score matched sample, we find that non-GAAP earnings disclosure frequency increases and non-GAAP exclusion quality decreases after clawback adoption, consistent with a more opportunistic use of non-GAAP reporting. Additional cross-sectional tests help support this interpretation.     

Does it pay to remediate? An analysis of the internal and external benefits of remediation

We examine the internal and external benefits associated with the remediation, or correction, of material weaknesses in internal controls over financial reporting. We document that firms that remediate material weaknesses exhibit higher performance and reporting quality than firms that never reported any weaknesses. These results suggest that the remediation of material weaknesses, an indication of an improved internal control system, is associated with internal benefits. Moreover, we find that remediating firms experience significantly lower audit fees and betas (i.e. external costs) than non-material weakness firms. However, these lower external costs are contingent on a firm's level of performance and information quality. These results suggest that remediation offers firms a chance to re-examine and correct their internal controls and this leads to better performance and information quality. Furthermore, external stakeholders are not necessarily swayed by remediation alone but need to observe tangible evidence of the corrected internal control system before reassessing a firm's risk downward.     

Capital Versus Performance Covenants in Debt Contracts

Building on contract theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debt holder–shareholder interests. Performance covenants serve as trip wires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on the capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting‐based covenants can improve contracting efficiency in two different ways.     

Do Tighter Loan Covenants Signal Improved Future Corporate Results? The Case of Performance Pricing Covenants

Covenants in corporate bonds and loan agreements mitigate agency conflicts between borrowers and lenders and may provide a signal of borrower quality to help resolve information asymmetry. Performance pricing covenants in bank loans specify automatic adjustments to loan spreads based on borrowers’ subsequent performance. Our covenant signaling framework views interest‐decreasing performance pricing as a tight covenant associated with borrowers’ private information on improved future performance accompanied by reduced credit risk. This positive signal is associated with larger positive loan announcement returns and greater improvements in future borrower performance. Further, in addition to signaling value, we find that the spread impact of this class of covenant also depends on its option value and reduction in transaction costs.     

Auditor Independence,Non‐Audit Services,and Restatements: Was the U.S. Government Right?*

Do fees for non‐audit services compromise auditor's independence and result in reduced quality of financial reporting? The Sarbanes‐Oxley Act of 2002 presumes that some fees do and bans these services for audit clients. Also, some registrants voluntarily restrict their audit firms from providing legally permitted non‐audit services. Assuming that restatements of previously issued financial statements reflect low‐quality financial reporting, we investigate detailed fees for restating registrants for 1995 to 2000 and for similar nonrestating registrants. We do not find a statistically significant positive association between fees for either financial information systems design and implementation or internal audit services and restatements, but we do find some such association for unspecified non‐audit services and restatements. We find a significant negative association between tax services fees and restatements, consistent with net benefits from acquiring tax services from a registrant's audit firm. The significant associations are driven primarily by larger registrants.     

Accounting Quality and Loan Pricing: The Effect of Cross-country Differences in Legal Enforcement

This study examines whether the strength of legal enforcement at the country level plays a role in the value-relevance of accounting quality for loan pricing determination, using an international sample of firms reporting under IFRS. The underlying hypothesis is that stronger vs. weaker enforcement should affect the informativeness of financial statements, due to their increased credibility, and thus results in a stronger influence of accounting quality on loan pricing, in case this information is considered more reliable by potential lenders. Evidence indicates that accounting quality is consequential for the determination of loan spread only in combination with the level of legal enforcement, and this only holds for the countries with stronger legal enforcement. This evidence indicates that financial statement quality information is value-relevant and has a significant impact on the determination of loan pricing only if this information is considered to be credible enough by loan providers in a country, and this is the case when legal enforcement is stronger.     

Financial Reporting Quality and Wage Differentials: Evidence from Worker-Level Data

We examine whether financial reporting quality affects worker wages using employer-employee matched data in the United States. We find that low financial reporting quality is associated with a compensating wage differential—that is, a risk premium—using three distinct approaches while controlling for worker characteristics by (1) regressing wages on firm-year–level and firm-level reporting quality, (2) documenting wage changes when workers switch firms, and (3) estimating a structural approach that separates reporting quality from performance-related volatility. We find evidence consistent with two channels: performance pay and turnover risk, where workers bear risks from noise in performance measurement and unemployment, respectively. To mitigate endogeneity concerns, we show that—after the accounting scandals in 2002 and after the announcements of an internal control weakness (ICW)—former Arthur Andersen clients and ICW firms pay wage premiums to employees, with magnitudes between 0.9% and 2.8% of annual wages.     

Financial reporting changes and the internal information environment: Evidence from SFAS 142

Using the adoption of SFAS 142 as an exogenous shock, we examine the effect of changes in financial reporting on firms’ internal information environment. We argue that complying with SFAS 142 induces managers to acquire new information and therefore improves their information sets. Interviews with executives and auditors confirm this argument. Using a difference-in-differences design, we find that firms affected by SFAS 142 (i.e., treatment firms) experience an improvement in management forecast accuracy in the post-SFAS 142 period. The increase is smaller for those with stronger monitoring in the pre-SFAS 142 period and greater for those with a higher likelihood of goodwill impairment. Furthermore, treatment firms with improvements in management forecast accuracy have higher M&A quality, internal capital allocation efficiency, and performance in the post-SFAS142 period. Overall, our findings indicate that changes in external financial reporting can lead to better corporate decisions via their impact on the internal information environment.     

Evidence on the Trade-Off between Risk and Return for IPO and SEO Firms

Do the low long‐run average returns of equity issuers reflect underperformance due to mispricing or the risk characteristics of the issuing firms? We shed new light on this question by examining how institutional lenders price loans of equity issuing firms. Accounting for standard risk factors, we find that equity issuing firms' expected debt return is equivalent to the expected debt return of nonissuing firms, implying that institutional lenders perceive equity issuers to be as risky as similar nonissuing firms. In general, institutional lenders perceive small and high book‐to‐market borrowers as systematically riskier than larger borrowers with low book‐to‐market ratios, consistent with the asset pricing approach in Fama and French (1993) . Finally, we find that firms' expected debt returns decline after equity offerings, consistent with recent theoretical arguments suggesting that firm risk should decline following an equity offering. Overall, our analysis provides novel evidence consistent with risk‐based explanations for the observed equity returns following IPOs and SEOs.