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...choice, Fields et al. (2001, 275) state that "the evidence on whether accounting choices are motivated by debt covenant concerns is inconclusive." There are at least three reasons that previous research may underestimate the effects of debt contracting on managers' accounting choices.
First, previous research that does not use the details of firms' actual debt contracts assumes that contract calculations are based on current accounting methods. However, Mohrman (1996) and Beatty, Ramesh, and Weber (2002) document that private debt contract calculations often prohibit firms from changing accounting methods. For these contracts, borrowers cannot use voluntary accounting method changes to avoid covenant violations. Thus, debt contracts give borrowers an incentive to change accounting methods only if the voluntary accounting method changes affect contract calculations.
Second, existing research that focuses exclusively on debt covenants ignores other accounting-based features of debt contracts. Performance pricing is a relatively new feature in bank debt contracts that explicitly makes the interest rate charged on a bank loan a function of the borrower's current creditworthiness. Asquith et al. (2002) document that performance-pricing features typically measure the borrower's creditworthiness using financial ratios such as debt to earnings before interest, taxes, depreciation, and amortization (EBITDA), leverage, or interest coverage. That is, the interest rate charged in the contract does not remain fixed over the length of the loan, but varies inversely with changes in measures of financial performance. Compared to covenants under which accounting information affects loan rates only when the borrower violates a single threshold, performance pricing creates a more continuous and direct link between accounting information and interest rates. Thus, performance pricing likely gives managers additional incentives to make income-increasing accounting method changes. Previous research does not consider whether this feature of debt contracts influences accounting choice.
Third, previous research has focused on borrowers who were either close to violating or had already violated covenants. These studies may underestimate the effect of debt contracting on accounting choice for cases in which borrowers have effectively used accounting changes to provide slack in financial covenants, and thus never come close to covenant violations.
To provide more conclusive evidence that debt contracting concerns affect borrowers' accounting choices, we address these three limitations of prior research. First, our research design incorporates the fact that debt contracts often prohibit borrowers from using voluntary accounting method changes to affect contract calculations. This cross-sectional variation in bank debt provisions allows us to examine whether managers who have chosen to change their accounting methods are more likely to make income-increasing changes when the debt contract allows these changes to affect contract calculations. Second, we consider whether another debt contracting feature--accounting-based performance pricing-increases borrowers' tendencies to make their voluntary accounting method changes income-increasing rather than income-decreasing. Third, rather than restricting our sample to borrowers approaching covenant violations, we study all borrowers who make voluntary accounting changes, and control for their other incentives to change accounting methods. If borrowers effectively use changes in accounting methods to create slack in financial covenants so that they avoid coming close to violating their covenants, then our tests examining all accounting method changes are more powerful than tests employed in previous research that focused solely on borrowers who are close to or had already violated their covenants.
To provide evidence on how debt contracts affect the sign of voluntary changes that borrowing firms make in their accounting methods, we identify a sample of borrowers with material bank debt who have chosen to make accounting changes. We determine whether their contracts have accounting-based restrictive covenants, dividend restrictions, or performance-pricing requirements. Beatty, Ramesh, and Weber (2002) find that borrowers willingly pay higher interest rates to obtain bank debt contracts that allow voluntary accounting changes to affect the calculation of financial terms in those debt contracts. We therefore expect borrowers to make use of this costly flexibility. Consistent with our hypothesis, we find that borrowers who change their accounting methods are more likely to make income-increasing changes if their debt contracts allow the changes to affect contract calculations. This increase in likelihood of an income-increasing accounting change is attenuated when the cost of a covenant violation is lower because all the firm's bank debt is from a single lender, and occurs only for borrowers whose contracts have performance-pricing provisions and dividend restrictions.
Our debt contracting results hold even after we control for other motives that borrowers have for changing accounting methods. Specifically, our results hold even after we control for the fact that incentives arising from executive compensation contracts and incentives to meet earnings benchmarks increase borrowers' propensity to make income-increasing (rather than income-decreasing) changes. We also control for the fact that a borrower with a new Chief Executive Officer (CEO) who reports a large loss before the effect of the accounting method change is more likely to report an income-decreasing accounting change (consistent with new CEOs of poorly performing firms taking "big baths"). Our debt contracting results also hold after controlling for tax incentives.
Our evidence that debt contracting concerns affect borrowers' accounting choices is more conclusive than previous research because we show that borrowers take advantage of the flexibility to make income-increasing accounting method changes that affect contract calculations. In addition, our evidence suggesting that incentives to lower interest rates through performance pricing and incentives to retain dividend payment flexibility appear to affect borrowers' accounting method choices helps address Fields et al.'s (2001) fundamental questions of whether, under what circumstances, and how accounting choice matters.
Section II develops our hypotheses and Section III explains our research design. Section IV describes our sample selection and provides descriptive statistics. We discuss our empirical results in Section V, provide sensitivity analysis in Section VI, and present our conclusions in Section VII.
II. HYPOTHESIS DEVELOPMENT
Fields et al. (2001) discuss three motives for accounting choice: (1) contracting (including debt and management compensation contracts), (2) asset pricing, and (3) influencing external parties (e.g., the Internal Revenue Service [IRS]). This paper focuses on the relation between accounting method changes and debt contracting while controlling for the other incentives for accounting choice, as explained in Section III. Specifically, we examine the extent to which detailed provisions of debt contracts explain the sign of borrowers' voluntary changes in accounting methods. We focus on accounting method changes because Beatty, Ramesh, and Weber (2002) document that borrowers willingly pay higher interest rates to retain the flexibility to make voluntary accounting method changes that affect bank debt contract calculations. We therefore expect borrowers to make use of this costly flexibility by making voluntary accounting method changes to affect contract calculations.
Does Allowing Accounting Changes to Affect Debt Contract Calculations Influence Accounting Choice?
Previous research examining whether debt covenants affect borrowers' decisions to change accounting methods generally assumes that the calculations stipulated in the covenants will be based on current accounting methods. For example, Healy and Palepu (1990) examine whether borrowers close to violating their dividend covenant restrictions, which are typically defined as a percentage of net income or retained earnings, change their accounting methods to increase those limits. Similarly, Sweeney (1994) investigates whether borrowers use accounting changes to avoid violating financial covenants designed to monitor borrowers' performance. However, Mohrman (1996) and Beatty, Ramesh, and Weber (2002) document that debt contract calculations are often based on the accounting rules that the borrower used when the contract originated. For these contracts, the borrower cannot use changes in accounting methods to avoid covenant violations. The cross-sectional variation in the effects of accounting method changes on contract calculations provides a natural setting that allows us to investigate the effects of debt contracting on borrowers' decisions to make accounting method changes.
Our first hypothesis is that borrowers who change accounting methods will be more likely to make income-increasing (rather than income-decreasing) accounting method changes when such changes affect covenant calculations.
Do the Expected Costs of Covenant Violations Influence Accounting Choice?
Watts and Zimmerman (1986, 215-216) argue that costly covenant violations give borrowers an incentive to make income-increasing accounting method changes to create slack in covenants; however, evidence on the actual magnitude of the cost of covenant violations is mixed. On the one hand, Beneish and Press (1993) provide evidence that covenant violations that lenders have not waived as of the financial-reporting date cost the borrower an average 80 basis point increase in the interest rate the lender charges on the loan after renegotiation. Furthermore, Healy and Palepu (1990) find that firms close to contractually imposed dividend limitations generally cut the dividends they pay rather than violate the dividend-restricting covenants or change their accounting methods to circumvent the covenants. These findings suggest that borrowers perceive violating dividend restriction covenants to be more costly than cutting dividends. On the other hand, Dichev and Skinner (2002) report that lenders may commonly waive technical violations prior to the financial reporting date, and they argue that waived covenant violations are unlikely to be very costly to the borrower. These results suggest that the cost of technical covenant violations will be lower the more likely it is for the lender to waive violations.
Our second hypothesis is that borrowers whose bank debt contracts allow voluntary accounting changes to affect contract calculations will be less likely to make income-increasing (rather than income-decreasing) accounting method...
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