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Erschienen in: Review of Accounting Studies 2/2011

01.06.2011

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

verfasst von: William Moser, Kaye Newberry, Andy Puckett

Erschienen in: Review of Accounting Studies | Ausgabe 2/2011

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Abstract

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.

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1
Given this contractual use of accounting numbers, Ball et al. (2008) hypothesize and find evidence of debt markets creating a demand for financial reporting.
 
2
Fields et al. (2001), Dichev and Skinner (2002), and Beatty and Weber (2003) provide discussions of the inconclusive nature of empirical evidence on reporting choices.
 
3
Early versions of the securities relied on limited liability companies (LLCs) as issuing entities but, beginning in 1995, subsidiary trusts emerged as the special purpose entity of choice. Thus “trust preferred stock” came into use as a common descriptor for the entire group of debt-equity securities.
 
4
In addition to the standard (e.g., investment banking) costs that are associated with redeeming TPS, we find eight redeeming firms that paid a call premium to redeem their TPS shares. The average call premium was 101.625%, or $7 million, and ranged from 100.625 to 104.25%.
 
5
“Floating” GAAP refers to the use of current accounting rules to define financial terms, such that the definition of financial terms changes along with subsequent accounting rule changes. Alternatively, “fixed” GAAP refers to the use of the specific GAAP rules that are in place when the contract is signed. Under “fixed” GAAP, the definition of financial terms does not change with subsequent accounting rules changes.
 
6
Several potential advantages of using “floating” GAAP include that it is less costly to monitor and that it imposes fewer restrictions on corporate activities (see Smith and Warner 1979; Holthausen and Leftwich 1983; Watts and Zimmerman 1986).
 
7
This reclassification as quasi-equity was not without some merit given some of the common features of TPS, such as its long maturity term and allowance for deferred interest payments in the event of financial distress.
 
8
El-Gazzar (1993) examines the effects of retroactive capitalization of leases under SFAS13 and finds that reductions in market returns are positively correlated with increased tightness of debt covenants. Frankel et al. (2008) similarly find greater usage of tangible net worth covenants (vs. net worth covenants) after the passage of SFAS 141 and 142 increased the likelihood of net worth covenant violations.
 
9
This finding complements prior evidence that changes in the short-term versus long-term classification of debt on the balance sheet have implications for managing leverage ratios (Gramlich et al. 2001) and for debt-rating downgrades (Gramlich et al. 2006).
 
10
A discussion of these consolidation rule differences is provided in Mills and Newberry (2005). In a typical arrangement, the company creates a trust that issues nonvoting preferred stock and transfers the proceeds to the parent company as a loan. Because the special purpose trust is included in the consolidated financial statements, the inter-company loan is eliminated and the preferred stock is reported on the balance sheet as mezzanine financing.
 
11
We do not expect firms’ tax positions to significantly affect their redemption choices because the corporate tax treatment of trust preferred stock as debt remains the same. We confirm this in sensitivity tests that indicate firms’ tax rates and excess foreign tax credit positions are not associated with their redemption choices.
 
12
Although most firms in our sample cite FAS 150 as the underlying reason for reclassifying their outstanding TPS to the liability section of the balance sheet, some firms cite FASB Interpretation No. 46 (revised December 2003 as FIN46R) requirements to consolidate variable interest entities as the basis for their reclassifications.
 
13
Levi and Segal (2005) find evidence of firms continuing to issue TPS in the post-FAS 150 period, while we find only one firm in our sample of industrial firms issuing TPS after FAS 150. This difference is likely due to the exclusion of regulated firms (financials and utilities) from our sample.
 
14
Prior research explores instances in which lenders make adjustments to GAAP accounting. For example, Beatty et al. (2008) find an association between income escalators in net worth covenants and accounting conservatism, while Li (2009) finds evidence of adjustments for transitory components in contractual definitions of earnings and net assets.
 
15
For example, the Federal Reserve ruled that TPS qualified as Tier 1 equity capital for banks in 1996, and insurance companies are subject to capital adequacy requirements.
 
16
See “Appendix B” for examples of debt covenant agreements that either explicitly exclude or include TPS in the definition of debt in the covenant agreement.
 
17
Kimberly-Clark issued TPS from its Luxembourg-based financing subsidiary. In turn, the Luxembourg-based financing subsidiary loaned 97% of the proceeds from the issuance to Kimberly-Clark at a fixed rate of interest. In its annual report for 2004, Kimberly-Clark Corporation maintained that the foreign financing subsidiary with its fixed interest obligation should not be consolidated in its financial statements. As a result, Kimberly-Clark continued to report its TPS in the mezzanine section of its balance sheet.
 
18
We find two instances where firms negotiated with lenders in response to FAS 150. For example, Dura Automotive negotiated a 2003 amendment to its debt covenant agreement that specifically excluded TPS from the definition of debt. Any measurement error resulting from our failure to find other renegotiated covenant agreements should bias against finding results consistent with our hypotheses.
 
19
Of the 36 firms that do not have Affected Covenants, 17 firms have debt covenant agreements that specifically included or specifically excluded TPS from the definition of debt or interest, 15 firms have debt covenant agreements that do not rely on debt on interest in their measurement (e.g., cash balances, net worth, or dividend restrictions), and the remaining four firms are not subject to financial debt covenants.
 
20
This calculation is in the spirit of Engel et al. (1999) who use estimated tax savings as a gauge of the benefits from issuing TPS to retire traditional preferred stock. Similar to Engel et al. (1999), we use 35% as the marginal tax rate for this purpose.
 
21
Roberts and Sufi (2009) find that renegotiations are highly pro-cyclical and that the terms of the renegotiation are significantly more favorable for the borrower during periods of economic expansion. This finding is particularly relevant for firms in our sample since bank loan renegotiations would have occurred during or immediately following the 2001 recession (the end of the 2001 recession was not determined by the National Bureau of Economic Research until July 17, 2003).
 
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Metadaten
Titel
Bank debt covenants and firms’ responses to FAS 150 liability recognition: evidence from trust preferred stock
verfasst von
William Moser
Kaye Newberry
Andy Puckett
Publikationsdatum
01.06.2011
Verlag
Springer US
Erschienen in
Review of Accounting Studies / Ausgabe 2/2011
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-011-9143-x

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