The importance of accounting changes in debt contracts: the cost of flexibility in covenant calculations

Abstract

In this paper, we examine how the exclusion of voluntary and mandatory accounting changes from the calculation of covenant compliance affects the interest rate charged on the loan. After controlling for self-selection bias and other factors known to affect loan spreads, we find that the rate charged is 84 basis points lower when voluntary accounting changes are excluded and 71 basis points lower when mandatory accounting changes are excluded. Our results suggest that borrowers are willing to pay substantially higher interest rates to retain accounting flexibility that may help them avoid covenant violations and to avoid duplicate record-keeping costs.

Introduction

Prior research has focused on the importance of accounting changes in debt contracts either by examining whether borrowers change accounting methods to reduce the probability of covenant violations or by examining stock price reactions to mandated accounting changes. Although these ex post studies consider the importance of accounting changes, they examine only one part of the contracting process. In this paper, we assess the ex ante importance of accounting changes in debt contracts by estimating the price borrowers willingly pay to include the effects of accounting changes in the calculations of covenant compliance. Our ex ante approach produces insights not provide by ex post studies of covenant violations. Specifically, we estimate the amount paid by borrowers to retain the flexibility voluntary accounting changes provide and to avoid the duplicate record keeping costs associated with excluding accounting changes from the calculation of covenant compliance.

Watts and Zimmerman (1990) describe the importance of accounting changes in the contracting process. Borrowers can use voluntary accounting changes ex post to avoid covenant violations, which increases the moral hazard and adverse selection costs associated with the contracts. In contrast, standard setters impose mandatory accounting changes externally and, therefore, these changes impose only limited additional moral hazard costs on the contracting parties. Mandatory accounting changes nevertheless impose additional contracting costs because they increase the costs of investigating and resolving inadvertent violations, and they increase the costs associated with delays in covenant violations that predict default.

Jensen and Meckling (1976) hypothesize that lenders ex ante anticipate the moral hazard and adverse selection costs associated with voluntary accounting changes and protect themselves against this possibility. We expect this protection to come in the form of higher interest rates for contracts that allow voluntary accounting changes to affect covenant compliance. Borrowers are willing to pay the higher interest rate if they sufficiently value the flexibility provided by voluntary accounting changes. Similarly, lenders will protect themselves from the increased contracting costs associated with including mandatory changes by charging the borrower a higher interest rate when mandatory accounting changes are included in covenant compliance calculations. Borrowers may be willing to incur the higher interest rate cost if it is less than the expected duplicate record keeping costs associated with excluding mandatory accounting changes.

To provide evidence on whether borrowers are willing to pay higher interest rates to retain accounting flexibility and to avoid duplicate record keeping costs, we examine the effect of excluding accounting changes on the rate charged on the loan. We control for borrower and loan characteristics known to determine loan pricing. We also control for the borrower's choice to exclude accounting changes since the difference in rates charged when these changes are excluded will not capture the treatment effect if a systematic difference exists in the loan rates that would otherwise be charged to the borrower. To control for this potential problem, we use a Heckman (1976) selectivity correction variable derived from the determinants of the choice to exclude accounting changes.

After controlling for other characteristics known to affect loan pricing and the self-selection problem, we find that excluding voluntary accounting changes from the calculation of covenant compliance results in an average reduction in the loan spread over LIBOR of 84 basis points. We also find that excluding mandatory accounting changes from the calculation of covenant compliance results in a reduction of the average loan spread of 71 basis points. These findings indicate that accounting changes are an important consideration in the debt contracting process. They suggest that borrowers are willing to pay substantially higher interest rates to retain accounting flexibility that may help them avoid covenant violations and to avoid duplicate record keeping costs. They also suggest that lenders protect themselves from the effects of accounting changes either by charging a higher rate when accounting changes are included in the calculation of covenant compliance, or by restricting a firm's ability to make accounting changes when the contracting costs associated with the change are relatively large. These results are consistent with Watts and Zimmerman's hypothesis that accounting changes are important in the lending process and that lenders consider the effects of accounting changes before entering into a contract.

Section 2 includes the background for our study. We describe our sample in Section 3. We develop our research design in Section 4. Section 5 provides descriptive statistics. We discuss our empirical results in Section 6, and Section 7 presents our conclusions.