Accounting Standards and Debt Covenants

The following post comes to us from Peter Demerjian of the Goizueta Business School at Emory University.

In the paper, Accounting Standards and Debt Covenants: Has the “Balance Sheet Approach” Led to a Decline in the Use of Balance Sheet Covenants?, forthcoming in the Journal of Accounting and Economics as published by Elsevier, I examine whether the “balance sheet approach” has led to a decline in the use of balance sheet covenants. Debt contracts, and especially private loan agreements, frequently include accounting-based debt covenants. Many of these covenants require the borrower to maintain a threshold level of some financial ratio or measure. A broad range of financial measures are employed in these financial covenants. Some are written on earnings from the income statement; the borrower may be required to maintain a minimum level of earnings relative to their interest expense (interest coverage) or their total debt (debt-to-earnings). Similarly, covenants are also written on values from the balance sheet; these include covenants requiring a minimum level for the book value of equity (net worth) or a maximum amount of debt in the capital structure (leverage). If the borrower fails to maintain a covenant threshold, the debt enters technical default. In technical default, the creditor has the option to attempt action against the borrower; a common consequence is renegotiation with stricter contract terms.

Over the past 15 years there has been a striking change in the types of financial covenants included in private debt contracts. In 1996, covenants based on balance sheet numbers were used in roughly 80% of private loan agreements. By 2007, this number had fallen to just 30%. This sharp drop has not occurred for all types of covenants; over the same period, covenants written on income statement variables were used steadily in between 70% and 80% of private loans. The evidence suggests that the use of covenants has changed over time, but the change is focused specifically on balance sheet covenants.

In this study, I examine the role accounting standards in explaining this change. US GAAP has traditionally followed the “income statement approach”. That is, the objective of financial reporting was to a produce a bottom-line net income figure that summarizes the performance of the firm. Over time, however, US accounting standard setting has shifted away from the income statement and more towards the “balance sheet approach”. In this approach to standard setting, the determination of net income is no longer the key objective; rather, accounting is focused on reporting the correct values of assets and liabilities. Under the balance sheet approach, accounting features many adjustments to the book values of assets, such as write-downs of fixed assets and goodwill and fair value adjustments of financial assets.

I argue that the move towards the balance sheet approach has made the balance sheet less useful for debt contracting. Specifically, adjustments to asset values under the balance sheet approach are subject to managerial discretion. I expect this discretion makes balance sheet values less reliable, and hence not useful for contracting. For example, the reported value of a fixed asset is reduced when the sum of expected future cash flows is less than the book value on the balance sheet (often the historical cost of the asset). However, the owner of the asset estimates the timing and amount of future cash flows. Similarly, fair valuation of assets affords considerable discretion to the reporting firm, particularly for items subject to Level 2 and 3 valuation. The amount of discretion makes the values unreliable—users of the financial statements have no way to determine the veracity of estimates—and I predict that users will, in turn, avoid writing covenants on asset values with large unreliably components.

I measure borrowers’ exposure to balance sheet-focused accounting standards based on the distribution of adjustments to asset values: these include asset write-downs, restructuring charges, fair value adjustments, and any other reported value changes not directly related to firm operations. I find that firms with higher exposure to the balance sheet approach are less likely to have balance sheet covenants. This finding is robust to a number of alternative explanations for changes in covenant use, including changes in the asset structure of borrowers, increases in competition and consolidation in banking, and changes in the loan market such increased securitization and secondary market trading of loans. Interestingly, there is no association between the extent of balance sheet focus and use of income statement-based covenants. This is because, in practice, income statement covenants are written on operating earnings; the adjustments associated with the balance sheet approach are classified as non-operating, so they do not affect the measure of income used in these covenants.

Accounting standard setting appears to be continuing its move towards the balance sheet approach. Recent standards by the FASB have standardized and expanded the role of fair value estimate for most financial assets and liabilities. In the international arena, IFRS has even wider use of fair value, including fair valuation for some fixed assets. This study provides evidence of one consequence of the move to the balance sheet approach in standard setting. Understanding the costs to debt contracting parties associated with changing accounting standards is a rich avenue for future research.

The full paper is available for download here.

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