The Importance of Accounting Changes-Beatty (SAI-BUN)

Journal of Accounting and Economics 33 (2002) 205227
The importance of accounting changes in debt

contracts: the cost of exibility in covenant
calculations$
Anne Beattya,*, K. Rameshb, Joseph Weberc
a
Smeal College of Business, Pennsylvania State University, 215 Beam Business Adm. Building,
University Park, PA 16802, USA
b
Analysis Group/Economics, Cambridge, MA 02138, USA
c
Sloan School of Management, Massachusetts Institute of Technology, Cambridge, MA 02142, USA
Received 2 May 2000; received in revised form 30 November 2001
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 nd 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 exibility that may help them avoid covenant violations and to avoid duplicate
record-keeping costs. r 2002 Elsevier Science B.V. All rights reserved.
JEL classification: M4; G32
Keywords: Debt contracting; Accounting change; Covenant; Accounting choice
$
We would like to thank Robert Bowen and Angela Davis (the referees), Paul Asquith, Paul Fischer,
Bob Holthausen, S.P. Kothari, Richard Leftwich, Thomas Lys (the editor), Jody Magliolo, Ed Maydew,
Karl Muller, Katherine Schipper, Linda Vincent, and seminar participants at the University of Chicago,
University of Florida and the Pennsylvania State University for helpful comments. Anne Beatty gratefully
acknowledges nancial support from PricewaterhouseCoopers.
*Corresponding author. Tel.: +1-814-863-0707; fax: +1-814-863-8393.
E-mail address: alb16@psu.edu (A. Beatty).
0165-4101/02/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved.
PII: S 0 1 6 5 - 4 1 0 1 ( 0 2 ) 0 0 0 4 6 - 0
206
A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227
1. 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.
Specically, we estimate the amount paid by borrowers to retain the exibility
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 sufciently value the exibility 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 exibility 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 borrowers 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
207
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 nd 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 nd 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 ndings 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 exibility 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 rms ability to make accounting changes when the contracting costs
associated with the change are relatively large. These results are consistent with
Watts and Zimmermans 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.
2. Background
The inclusion of voluntary versus mandatory accounting changes in the
calculation of debt covenant compliance may exert different effects on the
probability of covenant violations. Specically, the inclusion of voluntary accounting changes will reduce the probability of covenant violation but the effect of
including mandatory changes on the probability of covenant violations is uncertain.
However, the inclusion of either type of accounting change in the calculation of
covenant compliance is likely to increase the contracting costs associated with the
contract and affect the rate of interest charged on the loan.
2.1. The effects of voluntary accounting changes on covenant compliance
Although borrowers can use voluntary accounting changes to avoid violating
accounting-based covenants, previous research that examines whether managers use
this discretion nds only limited evidence of this behavior.
Healy and Palepu (1990) examine whether a sample of 126 rms that were close to
violating their dividend covenant restrictions changed their accounting methods.
They nd that these rms do not appear to make accounting changes to circumvent
dividend restrictions, but instead cut their dividends. Healy and Palepu (1990)
208
conclude that three possible explanations account for the lack of evidence supporting
the hypothesis that borrowers change accounting methods to avoid violating debt
covenants. First, they contend that borrowers may want to avoid the reputation
effects of changing accounting methods. Second, they suggest that the borrowers
may not have had sufcient accounting exibility to avoid covenant violations,
although Healy and Palepu think this unlikely to be the case. Third, they argue that
accounting changes may be employed only when managers have no other mechanism
available to avoid covenant violations, which is not the case for covenants that
restrict dividend payments.
If Healy and Palepus rst two arguments explain their lack of ndings, one could
conclude that accounting changes are, at most, of limited importance in the debtcontracting process. In contrast, their third argument would suggest that accounting
changes may not be important in covenants that restrict dividend payments, but may
be important for other covenants where accounting changes are the best mechanism
available to avoid covenant violations.
Sweeney (1994) nds some evidence of the importance of accounting changes
among her sample of 130 borrowers who eventually violate their debt covenants. She
documents a higher incidence of income increasing accounting changes in the year of
default and two subsequent years but not in the years leading up to the default. In
addition, her cross-sectional analysis is inconclusive on whether default rms make
income-increasing accounting changes to offset tightening debt-covenant constraints.
However, the fact that previous ex post studies have found only limited evidence
that borrowers change accounting methods to reduce the probability of covenant
violations may also be partly due to the research approach used. For example, ex
post studies could have limited power to detect the impact of these changes because
they do not control for whether accounting changes have been excluded from the
calculation of covenant compliance. If lenders recognize that voluntary accounting
changes can help borrowers avoid covenant violations, then lenders can avoid this
moral hazard problem by contracting on the accounting principles used to calculate
covenant compliance. A second possible explanation for the lack of results in
previous ex post studies is that they limit their sample to borrowers who have
violated or are close to violating their debt covenants. Sampling on the dependent
variable and excluding rms not at risk of violating their covenants from their
sample, could reduce the likelihood of nding results.
2.2. The effects of mandatory accounting changes on covenant compliance
In contrast to voluntary accounting changes, the inclusion of mandatory
accounting changes creates only limited moral hazard problems because standard
setters impose mandatory changes externally.1 Moral hazard problems arise only to
the extent that borrowers can choose the timing of adoption of a new standard, the
method of recording the accounting change, or, in the case of an elimination of an
1
One exception to this assumption is the inuence that borrowers can have by lobbying for changes in
GAAP.
209
accepted method, can choose among the remaining accepted accounting methods.2
However, mandatory accounting changes will increase contracting costs because
covenants are optimized based on existing rules and may no longer be optimal when
there is a mandated change in accounting methods. Mandatory accounting changes
may either increase or decrease the probability of covenant violations. Therefore,
mandatory accounting changes may prevent or delay legitimate covenant violations
or may cause inadvertent covenant violations that do not reect the probability of
default. Two anecdotal examples illustrate this point.
In 1993, Storage Technology was in danger of violating a no net loss covenant
in its debt contract. By recognizing $40 million in income associated with the
adoption of the new accounting standard for income taxes, the company was able to
comply with the accounting covenant (The Wall Street Journal, 2/4/93, p. B7). In
contrast, Fisher & Porter was required to adopt a mandated accounting standard on
employees vacation salaries, which was partially responsible for their violation of
their debt-to-equity ratio covenant (Dow Jones News Service, 5/3/82).
Stock price tests of the importance of mandatory accounting changes have
documented both positive and negative wealth transfers. Specically, Lys (1984)
documents a negative stock price reaction related to the increase in default risk of
debt arising from the adoption of SFAS 19 requiring the use of full cost accounting
for oil and gas exploration. Espahbodi et al. (1995) document a positive stock price
reaction associated with the adoption of the provision in SFAS 109 that allows the
recognition of deferred tax assets. Parties to a credit agreement can insulate
themselves from any unintended economic consequences attributable to GAAP
changes by contracting ex ante on the set of accounting principles used to measure
compliance with covenants.
2.3. Reduction in contracting costs from excluding voluntary and mandatory
accounting changes
Jensen and Meckling (1976) suggest that covenants are included in debt contracts
as a strategy for restricting managerial opportunism. They argue that by agreeing to
restrict future opportunistic behavior, a borrower can reduce their borrowing costs.
Thus, the borrower faces a trade-off between retaining the possibility of future
opportunistic behavior and obtaining a lower interest rate. Although the lenders
market power will affect the required rate of return, the trade-off between reduced
contracting costs and interest rates should exist regardless of the lenders market
power.3
2
Consistent with this argument, Sweeney (1994) documents that within the sample period she studies
(19771989) 50% of the standards enacted were income-increasing accounting standards.
3
Jensen and Meckling (1976) frame their argument in terms of one lender offering a menu of contracts.
The results also hold if the problem is modeled as a set of lenders with each lender offering a different type
of contract. Some lenders may offer contracts that contain many covenants and lower interest rates, other
lenders may offer contracts that have few or no covenants and higher interest rates. Instead of the
borrower choosing from a menu of contracts, the borrower may choose a lender who offers a preferred
contract type.
210
We contend that restricting a rms ability to make voluntary accounting

changes from the calculation of covenant compliance will similarly reduce
the contracting costs associated with the debt agreement. Smith (1993), Watts
and Zimmerman (1986, 1990), and others have argued that managers can
opportunistically use voluntary accounting changes to shift wealth from lenders to
borrowers. Consistent with Jensen and Meckling (1976), these later studies
suggest that voluntary accounting changes increase the moral hazard and adverse
selection costs associated with the debt, and restrictions on the use of voluntary
accounting changes should result in a reduction of contracting costs and lower
interest rates.
Unlike voluntary accounting changes, the exclusion of mandatory accounting
changes will do little to reduce managerial opportunism since there are only
limited moral hazard costs associated with externally imposed mandatory accounting changes. Additional contracting costs do arise, however, from including
mandatory accounting changes in the calculation of covenant compliance.
Leftwich (1983) argues that it is costly for lenders to determine whether
covenant violations that arise after a mandated change are indicative of a
change in loan quality or a false warning. In addition, mandatory accounting
changes may increase contracting costs because they reduce the likelihood
of a violation occurring that predicts default. Thus, we expect that the exclusion
of mandatory accounting changes from the calculation of covenant compliance
should also decrease the contracting costs of the debt and result in a lower
interest rate.
Although excluding mandatory and voluntary accounting changes from the
calculation of covenant compliance reduces contacting costs, it increases a
borrowers record-keeping costs. The increased record-keeping cost includes the
cost of maintaining two sets of accounting records and the costs of hiring an
accounting staff with an idiosyncratic knowledge of and expertise to cope with
potentially outdated accounting methods. The auditor must also have this
knowledge. In addition, Zimmerman (2000) suggests confusion could occur within
a rm over which set of accounting records to use for a particular decision, and that
there is also a potential of increased demand for differing sets of records from the
rms various constituencies.
Cross-sectional variation can occur in the additional costs associated with
maintaining two sets of books, along with variation in the benets associated with
restricting the rms ability to make accounting changes. Thus, the decision to
exclude accounting changes from the calculation of covenant compliance will depend
on the cost savings associated with restricting the rms ability to make accounting
changes and the duplicate record-keeping costs.4
4
For voluntary accounting changes, a borrower could decline to make the accounting change to avoid
the duplicate record-keeping costs. But, there may be other reasons unrelated to the debt contract for a
borrower to make accounting changes and forgoing these changes would also be costly.
211
3. Sample selection and classication of contracts

We obtain our initial sample of credit agreements from the Lexis-Nexis
database of corporate information using a keyword search to identify private loan
agreements entered into during 19941996.5 Then we merged the sample of loan
agreements collected from Lexis-Nexis with the Loan Pricing Corporation database,
which resulted in a sample of 285 loan agreements. After eliminating agreements
without the data required for our analysis, we reduced our sample to 206
agreements.
We assign the loan agreements to one of four categories based on whether
debt covenant compliance includes or excludes voluntary or mandatory accounting
changes. We classify those contracts that state that covenant calculations will be
based on nancial information prepared in accordance with GAAP as including
both voluntary and mandatory accounting changes. Those that state that
covenant calculations are based on GAAP as in effect on the date of the
agreement, but do not require that the methods be applied in accordance with or
in conformity with those used at the date of the agreement or that the principles
be consistently applied, we classify as including voluntary changes but excluding
mandatory changes. We classify contracts stating that covenant calculations
will be based on the principles used at the date of the agreement as excluding
both mandatory and voluntary changes. Finally, contracts that state that, for
purposes of calculating covenant compliance, the borrower is not allowed to
make any changes in accounting principles except for those required by GAAP, we
classify as excluding voluntary accounting changes and including mandatory
changes.6
We summarize the number of agreements in our sample that fall into each of these
four categories in Fig. 1. Of the 206 agreements in our sample, 48 contracts include
both mandatory and voluntary accounting changes when testing for compliance with
debt covenants; 36 agreements include voluntary but exclude mandatory accounting
changes; 114 exclude both types of changes; and only eight contracts exclude
voluntary changes but include mandatory accounting changes. Given an average
loan size of $154 million, this sample represents total borrowings of $31
billion.7
5
By using a keyword search on the documents containing the phrases credit agreements and exhibit
10, we identied the bank debt contracts required to be led as a material contract under the 1934 Act
reporting rules for 10K lings with the SEC. Under Regulation S-K Item 601, the SEC denes materiality
in terms of the size of the contract and whether the contract is made in the ordinary course of business.
Credit agreements prior to 1994 were not available on Lexis-Nexis.
6
We provide examples of the four types of contracts in Appendix A. We provide both the denition of
GAAP, and the section of the agreement that claries how accounting terms are to be used in the
document. See Mohrman (1996) for additional details on how contracts specify the accounting principles
that govern the contract.
7
Our sample does include some borrowers with multiple contracts. To ensure that our results are not
sensitive to the inclusion of these multiple contracts in the sample, we rerun our analyses using the mean
value of the independent variables for rms with multiple contracts. Our results are qualitatively the same.
212
Mandatory
Voluntary
Include
Voluntary
Changes
Exclude
Voluntary
Changes
Total
Include Mandatory
Change
48
56
Exclude Mandatory
Changes
36
114
150
Total
84
122
206
Fig. 1. Classication of the effects of accounting changes on the calculation of covenant compliance.
4. Model development and research design

Based on the reasoning of Jensen and Meckling (1976), we expect that lenders will
adjust the spread charged on the loan in accordance with whether covenant
compliance calculations exclude or include the effects of voluntary and mandatory
accounting changes. We expect lenders to reduce the spread charged on the loan if
the borrower is willing to reduce the potential moral hazard costs by excluding
voluntary accounting changes from the calculation of covenant compliance.
Borrowers are willing to pay a premium to include voluntary accounting changes
if they sufciently value the exibility provided by voluntary accounting changes. We
also expect that lenders costs will be lower when mandatory accounting changes are
excluded from covenant compliance calculations. Although the reduction in moral
hazard costs from excluding mandatory accounting changes should be lower than for
voluntary changes, excluding mandatory changes will also reduce the costs that arise
when covenants are no longer optimally set. Therefore, we expect that lenders will
charge more if mandatory changes are included. Meanwhile, borrowers may be
willing to pay a premium to include mandatory changes if the duplicate record
keeping costs associated with excluding the changes are greater than the additional
interest costs created by including the changes.
To test the hypotheses that lenders will charge higher rates when either mandatory
or voluntary accounting changes are included in the calculation of covenant
compliance, we regress the borrowing rate on a dichotomous variable indicating
whether accounting changes are excluded in the calculation of covenant compliance.
We measure the borrowing rate using the spread over the London Inter Bank Offer
Rate (LIBOR). All loans examined in this study are variable rate loans where the
rate varies with LIBOR. Since the exclusion of accounting changes in the calculation
of covenant compliance is not randomly assigned to borrowers, we control for
potential self-selection bias in our estimate. In addition, we include control variables
that measure characteristics that have consistently been found in previous research
to be inuential in explaining the spread charged on loans. Specically, we draw on
the research of Blackwell et al. (1998), Booth (1992), and English and Nelsen (1999).
213
For our analysis of the effects of excluding accounting changes on the interest rates
charged on the loan, we run the following two separate regression models:
SPREAD bv0 Interceptbv1 SelectivityV bv2 ExcludeVoluntary
bv3 Securitybv4 Noratingcurrent bv5 S&Pratingcurrent
bv6 Maturitybv7 Loan=Assetsbv8 Size
bv9 Takeoverbv10 Revolveev ;
m
m
SPREAD bm
0 Interceptb1 SelectivityM b2 ExcludeMandatory
m
m
bm
3 Securityb4 Noratingcurrent b5 S&Pratingcurrent
m
m
bm
6 Maturityb7 Loan=Assetsb8 Size
m
m
bm
9 Takeoverb10 Revolvee ;
with
SPREADnumber of basis points above LIBOR charged on the loan;
SelectivityVselectivity correction l# i described by Greene (2000), derived from
the probit model of the decision to exclude voluntary changes using
(
f#g0 wi =F#g0 wi
if voluntary changes are excluded;
l# i
f#g0 wi =1 F#g0 wi if voluntary changes are included;
where l# i represents the tted probability, #g0 wi are the tted values from the rst
stage, calculated for each observation i; using the parameter estimates g and the
matrix of explanatory variables wi from the rst stage model; f represents the
normal distribution pdf, and F represents the normal distribution cdf;
SelectivityMselectivity correction l# i described by Greene (2000), derived from
the probit model of the decision to exclude mandatory changes calculated in the
same manner as for SelectivityV;
ExcludeVoluntarydichotomous variable that is equal to 1 if the contract
excludes the effects of voluntary accounting changes, 0 otherwise;
ExcludeMandatorydichotomous variable that is equal to 1 if the contract
excludes the effects of mandatory accounting changes, 0 otherwise;
Securitydichotomous variable equal to 1 if the contract requires collateral, 0
otherwise;
Noratingcurrentdichotomous variable equal to 1 if the borrower is not rated at the
time the contract is written, 0 otherwise;
S&Pratingcurrentnatural log of the rms S&P bond score (dened as 1 for A+,
the highest rated debt, to 12 for B, the lowest rated debt in our sample) at the time
the contract was written for borrowers with rated debt, 0 otherwise;
Maturitynumber of months between the start and end date of the contract;
Loan/Assetsamount of the loan divided by the total assets of the borrower;
Sizenatural log of the borrowers assets, in millions of dollars;
Takeoverdichotomous variable equal to 1 for takeover loans, 0 otherwise;
Revolvedichotomous variable equal to 1 for revolving loans, 0 otherwise.
214
We investigate the effects of excluding voluntary accounting changes by estimating

Eq. (1) for the 114 agreements that exclude both voluntary and mandatory changes
and the 36 agreements that include voluntary changes but exclude mandatory
changes. Similarly, we examine the effects of excluding mandatory accounting
changes by estimating Eq. (2) for the 36 agreements that exclude mandatory changes
but include voluntary changes and the 48 agreements that include both types of
changes.
The coefcients on the dichotomous variable indicating the exclusion of
accounting changes from the calculation of covenant compliance in our models
will not capture the treatment effect of excluding accounting changes if there is a
systematic difference in the loan prices of agreements that exclude accounting
changes. To control for this self-selection problem, we include selectivity correction
variables that we calculate following the formulas provided by Greene (2000). These
formulas use the estimated coefcients from probit models of the determinants of the
decision to exclude the effects of voluntary and mandatory accounting changes.8 To
obtain these coefcients, we estimate the determinants of the decision to exclude the
effects of voluntary and mandatory accounting changes from the calculation of
covenant compliance using two separate probit models. We discuss the results of this
estimation in Appendix B.
Without the selection correction, the coefcient on the exclusion of the accounting
change variable in the SPREAD regression will be biased if there is a correlation
between the error from the probit model of the decision to exclude an accounting
change and the error from the SPREAD regression model.9 Specically, our
SPREAD model would suffer from two forms of truncation bias reecting the
fact that we could not randomly assign the exclusion of accounting changes
to debt contracts. First, we do not observe the rate that would have been charged
for excluding accounting changes for contracts where the parties decided to
include those changes. Second, we do not observe the rate that would have
been charged for including accounting changes for those contracts where the
parties decided to exclude changes. The expected value of the error term from the
estimation of a regression on a truncated sample is not zero; therefore, the
estimated coefcients from the regression would be biased. We correct for
this bias by including the expected value of the error term in the regression
model.
If we assume that the error terms from our probit model u and our SPREAD
model e are distributed bivariate normal, then the expected value of e when
accounting changes are excluded will be proportional to the ratio of the normal
density function to the cumulative normal density function, both evaluated at the
predicted value from the exclusion of accounting changes model f#g0 wi =F#g0 wi :
When accounting changes are included, the expected value of e is proportional to
8
As suggested in Greene (2000), we also adjust the standard errors in the second stage.
Greene (2000) discusses this bias in the context of wages earned by individuals who choose to go to
college. The coefcient on the effect of college education on wages will be biased if those who choose to go
to college would earn higher wages regardless of whether they actually attend college.
9
215
f#g0 wi =1 F#g0 wi : The constant of proportionality in both cases is rse ; where r

is the correlation of u and e; and se is the standard deviation of e:
We can estimate the expected value of e for the observation based on whether
accounting changes are excluded from the probit model of the decision to exclude
accounting changes. For each observation, the predicted value is calculated by
taking the scalar product of the vector of estimated coefcients from the probit
model #g and the vector of the values of the explanatory variables included in the
model for that observation Wi : We include this ratio in the SPREAD model to
correct for the bias in the estimated coefcients that arises from a non-zero expected
value of e: The expected coefcient on this variable will be the constant of
proportionality rse :
Our SPREAD models also include characteristics that previous research, such as
Blackwell and Winters (1997), Blackwell et al. (1998), Booth (1992), and English and
Nelsen (1999), nds to be related to the loan price. These include the borrowers credit
risk, the maturity of the loan, the relative size of the loan, the size of the borrower, and
whether or not the purpose of the loan is for a takeover. Previous studies have found
that interest rates are higher for collateralized loans, for borrowers without rated debt,
for borrowers with lower rated debt, for loans with longer maturities, for relatively
smaller loans, for smaller borrowers, and for loans used for takeovers.
We measure the borrowers credit risk in two ways. First, we include a dichotomous
variable equal to one if the agreement requires collateral (Security). Berger and Udell
(1990), Scott and Smith (1986), Booth (1995) and English and Nelsen (1999) have all
documented a positive association between the presence of a collateral requirement
and default risk and have shown that the spread is higher on collateralized loans.
Second, following Booths (1992) approach, we include two variables that capture the
credit rating of the borrower. We construct the rst variable by converting the
Standard and Poors bond rating to a numerical score and then taking the log of that
score (S&Pratingcurrent). We set this variable equal to zero for borrowers who do not
have rated debt. We assign a value of 1 to debt rated A+ (the highest rating in our
sample), 2 to debt rated A, 3 to debt rated A, 4 to debt rated BBB+, and so on with
B debt, the lowest rated debt in our sample, assigned a value of 12. This variable
measures the effect of having higher quality rated debt conditional on having rated
debt. The second measure of credit risk is a dichotomous variable indicating whether
the borrower has rated debt at the time of the agreement (Noratingcurrent).
We measure the maturity of the loan using the number of months that the loan
will be outstanding (Maturity). We measure the relative size of the loan to the
borrower by dividing the amount of the loan by the borrowers asset prior to
entering into the loan (Loan/Assets). We rely on the log of the borrowers assets to
measure borrower size. We use a dichotomous variable equal to 1 if the primary
purpose of the loan stated in the LPC database is for a corporate takeover. We do
this specically to measure the effects of the increased risks associated with takeover
loans. Previous research examines either revolving loans or term loans but not both.
Because we think that this distinction may be important, we include a dichotomous
variable equal to 1 if the loan is a revolving loan to capture differences between
revolving credit and term loans.
216
5. Descriptive statistics
Table 1 shows the means and standard deviations of the variables we use to
measure loan, borrower and lender characteristics. Loans that exclude both
mandatory and voluntary accounting changes are more likely to require security,
to be entered into by borrowers with worse credit ratings, and to have a longer
maturity than those that include either voluntary changes or both voluntary and
mandatory changes. Given our expectation that moral hazard costs and the costs of
delayed covenant violations will be increasing in the borrowers credit risk and the
maturity of the loan, this is consistent with the exclusion of accounting changes when
there are higher contracting costs. The number of lenders providing funds is larger
Table 1
Mean and standard deviation of borrower, lender, and loan characteristics for a sample of 114 loan
agreements that exclude both voluntary and mandatory accounting changes from calculation of covenant
compliance, 48 agreements that include both types of accounting changes, 36 agreements that include
voluntary but exclude mandatory changes, and for the entire sample
Variable
SPREAD
Security
S&Pratingcurrent
Noratingcurrent
Maturity
#lenders
#book-taxdiff
Loan/Assets
Loan/#lenders
Freqlender
Size
Takeover
Revolve
Exclude all
accounting
changes
Include all
accounting
changes
Include
voluntary
exclude
mandatory
Exclude
voluntary
include
mandatory
Entire sample
168.6
(110.6)
0.69
(0.46)
0.68
(0.96)
0.63
(0.48)
54.9
(21.5)
1.73
(0.97)
6.31
(3.10)
0.37
(0.37)
21.65
(33.3)
0.28
(0.45)
5.73
(1.45)
0.34
(0.48)
0.56
(0.50)
124.4
(91.0)
0.38
(0.49)
0.41
(0.81)
0.73
(0.45)
36.1
(21.6)
0.97
(1.01)
5.77
(2.59)
0.57
(1.31)
27.31
(36.72)
0.17
(0.38)
5.43
(1.72)
0.14
(0.36)
0.69
(0.47)
130.9
(97.7)
0.53
(0.51)
0.48
(0.79)
0.67
(0.48)
48.5
(21.4)
1.54
(1.28)
6.27
(2.20)
0.40
(0.38)
25.78
(18.14)
0.17
(0.38)
5.82
(1.85)
0.22
(0.42)
0.64
(0.49)
184.4
(111.8)
0.75
(0.46)
0.27
(0.78)
0.88
(0.35)
44.0
(21.2)
1.38
(0.79)
5.63
(3.78)
0.30
(0.25)
9.56
(8.55)
0.13
(0.35)
4.84
(0.98)
0.00
(0.00)
0.50
(0.53)
152.3
(104.2)
0.59
(0.49)
0.57
(0.90)
0.67
(0.47)
49.0
(22.7)
1.51
(1.07)
6.15
(2.86)
0.42
(0.71)
23.22
(31.53)
0.23
(0.42)
5.64
(1.58)
0.26
(0.44)
0.60
(0.49)
217
Table 1 (continued)
Variable
S&Pratingfuture
Noratingfuture
Number of loans
Exclude all
accounting
changes
0.89
(0.96)
0.63
(0.48)
114
Include all
accounting
changes
0.58
(0.88)
0.63
(0.49)
48
Include
voluntary
exclude
mandatory
Exclude
voluntary
include
mandatory
0.91
(0.94)
0.50
(0.51)
36
0.00
(0.00)
1.00
(0.00)
8
Entire sample
0.79
(0.94)
0.54
(0.50)
206
Variable definitions:
SPREADinterest rate on the loan stated as the number of basis points above the LIBOR rate;
Securitydichotomous variable equal to 1 if the contract requires collateral, 0 otherwise;
S&Pratingcurrentnatural log of the rms S&P bond score (dened as 1 for A+, the highest rated debt, to
12 for B, the lowest rated debt in our sample) at the time the contract was written for borrowers with
rated debt, 0 otherwise;
Noratingcurrentdichotomous variable equal to 1 if the borrower is not rated, 0 otherwise;
#lendersnatural log of the number of lenders providing funds to the borrower;
#book-taxdiffnumber of book to tax differences reported in the borrowers nancial statement
footnotes;
Loan/#lendersdollar value of the loan divided by number of lenders providing funds to the borrower;
Freqlenderdichotomous variable equal to 1 if one of the three most frequent lenders is an agent on the
contract, 0 otherwise;
Revolvedichotomous variable equal to 1 for revolving loans, 0 otherwise;
S&Pratingfuturenatural log of the rms S&P bond score (dened as 1 for A+, the highest rated debt, to
12 for B, the lowest rated debt in our sample) at the end of scal 1998 for borrowers with rated debt, 0
otherwise;
Noratingfuturedichotomous variable equal to 1 if the borrower is not rated at the end of scal 1998, 0
otherwise.
for loans that exclude both types of accounting changes than for other loans. This is
consistent with the exclusion of accounting changes when renegotiation costs are
higher, since most contract modications require a supermajority of lenders. We also
observe that the borrowers who enter into contracts that exclude both mandatory
and voluntary accounting changes have a greater number of book-tax differences in
accounting methods. Given that these differences are likely to be greater when it is
less costly for borrowers to maintain records that use different accounting methods,
this is consistent with the exclusion of accounting changes when duplicate record
keeping costs are lower. We report the results of our multivariate examination of the
effects of these characteristics on the decision to exclude accounting changes in
Appendix B.
218
6. Results
Table 2 reports the results of our regression model comparing the loan spreads for
contracts that exclude voluntary accounting changes to the loan spreads for
contracts that include voluntary accounting changes in the calculation of covenant
compliance. After controlling for other factors known to affect loan pricing and for
the selectivity correction, we nd the spread on loans that exclude voluntary
accounting changes is 84.53 basis points lower than for those where these changes
are allowed to affect the calculation of compliance with covenants.10 This nding is
consistent with the idea that there is a reduction in contracting costs when the
borrowers ability to change accounting methods to avoid covenant violations is
restricted. The magnitude of the difference in loan spreads seems reasonable given an
average stated default premium of 230 basis points for a subset of the loans in our
sample.11 We nd a positive coefcient on our selectivity correction variable, which
is what we would expect if voluntary accounting changes are more likely to be
excluded when contracting costs, such as moral hazard and adverse selection costs,
are higher.
The coefcients on our control variables are for the most part consistent with the
ndings of previous research. More specically, we nd that loan spreads are higher
for borrowers with higher credit risk and for takeover loans. Loan spreads are lower
for larger borrowers and for relatively larger loans. We also nd that loan spreads
are higher for revolving loans relative to term loans. We do not nd a signicant
coefcient on the maturity variable, which is consistent with Booths (1992)
conclusion that maturity is important in explaining loans spreads when the spread is
based on the CD rate, but it is not important when the spread is based on the LIBOR
rate.
Table 3 reports the results of our regression model comparing the loan spreads
for contracts that exclude mandatory accounting changes to those that include
them in the calculation of covenant compliance. After controlling for other
factors known to affect loan pricing and for the selectivity correction, we nd
that the spread on loans that exclude mandatory accounting changes is 71 basis
points lower than for those where these changes are allowed to affect the calculation
of compliance with covenants.12 This result is what would be expected if contract
costs are reduced by the exclusion of mandatory accounting changes. We nd a
positive and signicant coefcient on our selectivity correction variable. A positive
coefcient on the selectivity correction variable indicates that a higher rate is charged
to borrowers who are likely to have higher costs of investigating covenant violations
to determine whether they indicate a change in loan quality or a false warning.
10
When we omit the selectivity correction from the model, the coefcient on excluding voluntary
changes is not statistically signicant.
11
For 120 of the agreements in our sample, the contract explicitly states an additional interest rate
spread that will be charged if the borrower is in technical default of the loan. The default premia for our
sample agreements ranges from 100 to 650 basis points.
12
When we omit the selectivity correction variable from the regression, the coefcient on excluding
mandatory is insignicant.
219
Table 2
Coefcients and t-statistics from a regression of the basis points above the LIBOR rate charged on the
loan on a dichotomous variable measuring the exclusion of voluntary accounting changes from the
calculation of debt covenant compliance, a selectivity correction variable and other control variables. The
sample consists of 36 agreements that include voluntary and exclude mandatory changes and 114
agreements that exclude both voluntary and mandatory changes
SPREAD b0 Interceptb1 SelectivityV b2 ExcludeVoluntaryb3 Securityb4 Noratingcurrent
b5 S&Pratringcurrent b6 Maturityb7 Loan=Assetsb8 Size
b9 Takeoverb10 Revolvee:
Variable
Predicted
Coefcient
t-Statistic
Intercept
SelectivityV
ExcludeVoluntary
Security
Noratingcurrent
S&Pratingcurrent
Maturity
Loan/Assets
Size
Takeover
Revolve
+/
+/

+
+
+
+

+
+/
249.32
59.46
84.53
95.75
62.82
31.28
0.20
40.64
24.25
49.16
34.03
4.04***
2.00**
1.70**
5.26***
1.50*
1.53*
0.65
2.27**
3.87***
3.89***
3.21***
Adjusted R2
70%
** Signicant at the 5% level using either a one or two tailed test as appropriate.
*** Signicant at the 1% level using either a one or two tailed test as appropriate.
SelectivityVselectivity correction l# i described by Greene (2000), derived from the probit model of the
decision to exclude voluntary changes using
(
f#g0 wi =F#g0 wi
if voluntary changes are excluded;
#li
f#g0 wi =1 F#g0 wi if voluntary changes are included;
# represents the tted probability, #g0 wi are the tted values from the rst stage, f represents the
where li
ExcludeVoluntarydichotomous variable that is equal to 1 if the contract excludes the effects of
voluntary accounting changes, 0 otherwise;
Noratingcurrentdichotomous variable equal to 1 if the borrower is not rated at the time the contract is
written, 0 otherwise;
220
Table 3
Coefcients and t-statistics from a regression of the basis points above the LIBOR rate charged on the
loan on a dichotomous variable measuring the exclusion of mandatory accounting changes from the
calculation of debt covenant compliance, a selectivity correction variable and other control variables. The
sample consists of 36 agreements that include voluntary and exclude mandatory changes and 48
agreements that include both voluntary and mandatory changes
SPREAD b0 Interceptb1 SelectivityM b2 ExcludeMandatoryb3 Security
b4 Noratingcurrent b5 S&Pratringcurrent b6 Maturity
b7 Loan=Assetsb8 Sizeb9 Takeoverb10 Revolvee:
Variable
Predicted
Coefcient
t-statistic
Intercept
SelectivityM
ExcludeMandatory
Security
Noratingcurrent
S&Pratingcurrent
Maturity
Loan/Assets
Size
Takeover
Revolve
+/
+/

+
+
+
+

+
+/
220.29
41.61
71.01
101.48
37.70
8.51
0.73
14.61
27.08
44.36
40.97
2.86***
1.80*
1.92**
6.37***
1.13
0.53
2.16**
2.33**
4.47***
3.03***
4.25***
Adjusted R2
82%
** Signicant at the 5% level using either a one or two tailed test as appropriate.
***Signicant at the 1% level using either a one- or two-tailed test as appropriate.
SelectivityMselectivity correction l# i described by Greene (2000), derived from the probit model of the
decision to exclude voluntary changes using
(
f#g0 wi =F#g0 wi
if mandatory changes are excluded;
#li
f#g0 wi =1 F#g0 wi if mandatory changes are included;
where l# i represents the tted probability, #g0 wi are the tted values from the rst stage, f represents the
ExcludeMandatorydichotomous variable that is equal to 1 if the contract excludes the effects of
mandatory accounting changes, 0 otherwise;
Noratingcurrentdichotomous variable equal to 1 if the borrower is not rated at the time the contract is
written, 0 otherwise;
221
The coefcients on our control variables are largely consistent with the ndings of
previous research, such as Blackwell et al. (1998), Booth (1992), and English and
Nelsen (1999), and with the results reported in Table 2. Specically, loan spreads are
higher for secured debt, for debt with longer maturities, and for takeover loans; and
loan spreads are lower for larger borrowers, and for relatively large loans.
Surprisingly, we do not nd that the existence of rated debt or the credit rating on
rated debt is related to the price of the loan even though other measures of risk are
related to the loan spread in the expected way.
7. Sensitivity analysis
7.1. Conditional versus unconditional analysis
We examine the decision to exclude one type of accounting change while holding
constant the decision about the other type of change to avoid difculties in
identifying structural equations for the potentially joint decision of excluding the two
types of accounting changes. In sensitivity tests, we make unconditional comparisons
of the decisions to exclude mandatory and voluntary accounting changes by
including all observations in each model. Specically, we compare the 122
agreements that exclude voluntary changes to the 84 agreements that do not, and
we compare the 150 agreements that exclude mandatory changes to the 56
agreements that do not. In our unconditional SPREAD model, we calculate the
selectivity correction variables using unconditional probit models that include all 206
observations in the examination of each accounting change decision. In this analysis,
we estimate the SPREAD regression model including two selectivity correction
variables, one for the choice to exclude voluntary changes and the other for the
choice to exclude mandatory changes.
In our unconditional SPREAD model, we nd that the spread on loans
that exclude both mandatory and voluntary accounting changes is 83.6 basis
points lower than for those where voluntary changes are allowed to inuence
the calculation of compliance with covenants. This is very similar to the result
reported in Table 2. We nd no signicant difference in the SPREAD
when agreements include both types of accounting changes versus when they
include only voluntary accounting changes. This result is not consistent with
the result of our conditional analysis reported in Table 3, where we found that
the exclusion of mandatory accounting changes resulted in a signicantly
lower SPREAD. Finally, when agreements exclude voluntary accounting changes
but include mandatory changes, we nd that the SPREAD is 165 basis points
lower than when voluntary changes are included and mandatory changes
are excluded.13 Because of the small number of agreements that exclude voluntary
and include mandatory accounting changes we were unable to make a conditional
13
When we omit the selectivity correction variables from the regression model, the coefcient on all
three variables measuring the effects of excluding accounting principles are insignicant.
222
comparison for this group. The magnitude and signicance of the other
control variables are similar to those reported in Tables 2 and 3, with all the
variables that were signicant in both tables remaining signicant in the
unconditional model.
7.2. Measurement of credit risk
We test the sensitivity of our results with respect to the measurement of credit
ratings by redening the S&Prating variable as the bond rating without taking the
log of that rating. Our results using this redened variable are unchanged, although
the signicance on the coefcients on this variable in the voluntary accounting
changes models increases. We also redene this variable by setting the highest rating
equal to 2 rather than 1 before taking the log. Again our results are qualitatively
unchanged.
7.3. Measurement of fixed costs
If there is a xed component of the costs of monitoring and renegotiating
contracts then the spread over the LIBOR rate charged may be decreasing in the
loan size. We measure size in our SPREAD regressions as the log of sales. This
variable may capture the effect of these xed costs. We also test the sensitivity of our
results to the inclusion of the log of the loan. This variable is insignicant in our
SPREAD models when size is also included in the model. These ndings are
consistent with Booth (1992).
8. Conclusion
We examine the ex ante importance of accounting changes in debt contracts by
estimating the price that borrowers willingly pay to retain the exibility provided by
voluntary accounting changes and to avoid the duplicate record keeping costs
associated with excluding accounting changes from the calculation of covenant
compliance.
We nd that the spread on loans that exclude voluntary accounting changes is 84
basis points lower than for those that include those changes. This result suggests that
borrowers are willing to pay substantially higher interest rates to retain accounting
exibility that may help them avoid covenant violations. It also suggests that lenders
protect themselves from the moral hazard and adverse selection costs of including
voluntary accounting changes in debt covenant compliance. This protection is
attained either by charging a higher rate when accounting changes are included in
the calculation of covenant compliance, or by restricting a rms ability to make
accounting changes when the contracting costs associated with the change are
relatively large.
We also provide evidence that lenders consider the effects of mandatory
accounting changes before entering into a contract. We nd that the exclusion of
223
mandatory accounting changes may reduce the expected renegotiation costs of the
loan and that borrowers can benet from this reduction in expected costs through
lower interest rates. Our sensitivity analysis indicates, however, that the results for
mandatory changes are not as robust as for voluntary changes.
Our ndings, which indicate that accounting changes are ex ante an important
consideration in the debt contracting process, support previous studies that have
found evidence of the ex post importance of accounting changes in debt contracts for
borrowers who violate their accounting based covenants. Our ex ante approach
extends the results or prior research because it assesses the importance of accounting
changes regardless of whether borrowers violate their covenants.
Appendix A
This appendix provides an example of each of the four different types of
accounting denitions that may govern the contract.
A.1. Exclude voluntary and mandatory accounting changes
Company: Peebles
GAAP shall mean generally accepted accounting principles in the United States of
America as in effect on the date of this Agreement consistently applied; it being
understood and agreed that determinations in accordance with GAAP for purposes
of Section 8, including dened terms as used therein, are subject (to the extent
provided therein) to Section 12.07(a).
12.07 Calculations; Computations. (a) The nancial statements to be furnished to
the Lenders pursuant hereto shall be made and prepared in accordance with GAAP
consistently applied throughout the periods involved (except as set forth in the notes
thereto or as otherwise disclosed in writing by the Borrower to the Lenders);
provided, however, that (i) except as otherwise specically provided herein, all
computations determining compliance with Section 8, including denitions used
therein, shall utilize accounting principles and policies in effect at the time of the
preparation of, and in conformity with those used to prepare, the January 28, 1995
historical nancial statements of the Borrower delivered to the Lenders pursuant to
Section 6.10(b), and (ii) that if at any time the computations determining compliance
with Section 8 utilize accounting principles different from those utilized in the
nancial statements furnished to the Lenders, such nancial statements shall be
accompanied by reconciliation work-sheets.
A.2. Include voluntary and mandatory accounting changes
Company: Servtec
GAAP means generally accepted accounting principles as in effect from time to
time as set forth in the opinions, statements and pronouncements of the Accounting
Principles Board of the American Institute of Certied Public Accountants, the
224
Financial Accounting Standards Board and such other Persons who shall be
approved by a signicant segment of the accounting profession and concurred in by
the independent certied public accountants certifying any audited nancial
statements of the Company.
Section 1.03. Accounting Terms. All accounting terms not dened herein shall be
construed in accordance with GAAP, as applicable, and all calculations required to
be made hereunder and all nancial information required to be provided hereunder
shall be done or prepared in accordance with GAAP.
A.3. Include voluntary accounting changes and exclude mandatory changes
Company: Emcon
GAAP means generally accepted accounting principles and practices consistent
with those principles and practices promulgated or adopted by the Financial
Accounting Standards Board and the Board of the American Institute of Certied
Public Accountants, their respective predecessors and successors. Each accounting
term used but not otherwise expressly dened herein shall have the meaning given it
by GAAP.
8.8 Accounting Terms. Except as otherwise provided in this Agreement,
accounting terms and nancial covenants and information shall be determined
and prepared in accordance with GAAP as in effect on the date of this
Agreement.
A.4. Include mandatory accounting changes and exclude voluntary
Company: American Disposal Services
GAAP means generally accepted accounting principles set forth from time to time
in the opinions and pronouncements of the Accounting Principles Board and the
American Institute of Certied Public Accountants and statements and pronouncements of the Financial Accounting Standards Board (or agencies with similar
functions of comparable stature and authority within the US accounting profession),
which are applicable to the circumstances as of the date of determination.
8.19 Accounting Changes. The Company shall not, and shall not permit any
Subsidiary to, make any signicant change in accounting treatment or reporting
practices, except as required by GAAP, or change the scal year of the Company or
of any Subsidiary.
Appendix B
This appendix provides details about the probit models that we use to estimate the
selectivity correction that is included in Eqs. (1) and (2)
Table 4 provides coefcients and (t-statistics) from the probit regression models of
the exclusion of accounting changes from the covenant compliance calculation.
225
We nd that contracts are more likely to exclude voluntary accounting changes

when accounting discretion is likely to result in larger moral hazard costs, as
measured by Security a proxy for borrowers credit risk. We also nd that
conditional on the borrowers credit risk at the date of the loan, voluntary
accounting changes are less likely to be excluded when the borrowers future credit
risk is likely to rise. Assuming that borrowers have information about their future
credit risk that lenders do not have, this is consistent with an adverse selection
problem associated with voluntary accounting changes.
We nd that mandatory accounting changes are more likely to be excluded from
loan agreements when the lender faces higher costs of investigating covenant
violations to determine whether they indicate a change in loan quality or a false
warning. We use the borrowers credit risk to capture the costs of delays in covenant
violations and the maturity of the loan to measure the probability that a mandatory
Table 4
Coefcients and (t-statistics) from the following probit regression models of the exclusion of accounting
changes from the covenant compliance calculation
ExcludeVoluntary gv0 Interceptgv1 Securitygv2 S&Pratringcurrent gv3 Noratingcurrent
gv4 Maturitygv5 #lendersgv6 book-taxdiffgv7 Loan=assets
gv8 Loan=#lendersgv9 Freqlendergv10 S&Pratingfuture
gv11 Noratingfuture uv
and
m
m
m
ExcludeMandatory gm
0 Interceptg1 Securityg2 S&Pratringcurrent g3 Noratingcurrent
m
m
m
gm
4 Maturityg5 #lendersg6 book-taxdiffg7 Loan=assets
m
m
gm
8 Loan=#lendersg9 Freqlenderu :
Variable
Predicted
Exclude voluntary coefcient

(t-statistic)
Exclude mandatory coefcient

(t-statistic)
Intercept
Security
S&Pratingcurrent
Noratingcurrent
Maturity
#lenders
#book-taxdiff
Loan/Assets
Loan/#lenders
0.09
(0.09)
0.60
(1.96)**
1.28
(2.45)**
2.42
(2.31)**
0.004
(0.76)
0.19
(1.27)
0.03
(0.62)
0.38
(1.04)
0.001
(0.21)
3.40
(2.89)***
1.13
(2.78)**
0.31
(0.78)
0.89
(1.10)
0.01
(1.58)*
0.61
(2.84)***
0.14
(1.74)**
0.10
(0.54)
0.003
(0.63)
226
Table 4 (continued)
Variable
Predicted
Exclude voluntary coefcient

(t-statistic)
Exclude mandatory coefcient

(t-statistic)
Freqlender
(0.91)
(0.88)
S&Pratingfuture
Noratingfuture
0.21
(0.66)
1.48
(2.22)**
2.79
(2.44)**
Pseudo R2
11.9%
18.4%
*Signicant at the 10% level using either a one or two tailed test as appropriate.
**Signicant at the 5% level using either a one or two tailed test as appropriate.
*** Signicant at the 1% level using the appropriate one- or two-tailed test.
ExcludeVoluntarydichotomous variable equal to 1 if voluntary accounting changes are excluded from
the calculation of covenant compliance, 0 otherwise;
ExcludeMandatorydichotomous variable equal to 1 if mandatory accounting changes are excluded from
the calculation of covenant compliance, 0 otherwise;
Noratingcurrentdichotomous variable equal to 1 if the borrower is not rated, 0 otherwise;
#lendersnatural log of the number of Lenders providing funds to the borrower;
#book-taxdiffnumber of book-to-tax differences reported in the borrowers nancial statement
footnotes;
Loan/#lendersdollar value of the loan divided by the number of Lenders;
Freqlenderdichotomous variable equal to 1 if one of the three most frequent Lenders is an agent on the
contract, 0 otherwise;
S&Pratingfuturenatural log of the rms S&P bond score (dened as 1 for A+, the highest rated debt, to
12 for B, the lowest rated debt in our sample) at the end of scal 1998 for borrowers with rated debt, 0
otherwise;
Noratingfuturedichotomous variable equal to 1 if the borrower is not rated at the end of scal 1998, 0
otherwise.
accounting change will occur during the life of the loan. We also nd that mandatory
accounting changes are more likely to be excluded the higher the costs of
renegotiating the loan, measured using the number of lenders. Finally, we nd that
mandatory accounting changes are more likely to be excluded when the costs of
duplicate record keeping are higher. We use the number of differences in accounting
methods between nancial and tax reporting to measure these costs.
These results suggest that ex ante accounting methods inuence the debt
contracting process and that the contracting parties design debt agreements to
reduce the contracting costs that arise when the calculation of covenant compliance
includes accounting changes.
227
References
Berger, A., Udell, G., 1990. Collateral, loan quality, and bank risk. Journal of Monetary Economics 25,
2142.
Blackwell, D.W., Winters, D.B., 1997. Banking relationships and the effect of monitoring on loan pricing.
The Journal of Financial Research X (Summer), 275289.
Blackwell, D.W., Nolend, T.R., Winters, D.B., 1998. The value of auditor assurance: evidence from loan
pricing. Journal of Accounting Research 36 (Spring), 5770.
Booth, J.R., 1992. Contract costs, bank loans, and the cross-monitoring hypothesis. Journal of Financial
Economics 31, 2542.
Booth, J.R., 1995. Structure and pricing of large bank loans. Federal Reserve Bank of San Francisco
Economic Review 3, 5662.
English, W.B., Nelsen, W.R., 1999. Bank risk rating of business loans. Working paper, Federal Reserve
Board of Governors.
Espahbodi, H., Espahbodi, P., Tehranian, H., 1995. Equity price reaction to the pronouncements related
to accounting for income taxes. Accounting Review 70, 655668.
Greene, W.H., 2000. Econometric Analysis. Prentice Hall, Upper Saddle River, NJ.
Healy, P.M., Palepu, K.G., 1990. Effectiveness of accounting-based dividend covenants. Journal of
Accounting and Economics 12, 97124.
Heckman, J., 1976. The common structure of statistical models of truncation, sample selection, and
limited dependent variables and a simple estimator for such models. Annals of Economic and Social
Measurement 5, 475492.
Jensen, M.C., Meckling, W.H., 1976. Theory of the rm: managerial behavior, agency costs and
ownership structure. Journal of Financial Economics 3, 305360.
Leftwich, R., 1983. Accounting information in private markets: evidence from private lending agreements.
Accounting Review 58, 2342.
Lys, T., 1984. Mandated accounting changes and debt covenants the case of oil and gas accounting.
Journal of Accounting and Economics 6, 3965.
Mohrman, M.B., 1996. The use of xed GAAP provisions in debt contracts. Accounting Horizons 10,
7891.
Scott, J., Smith, T., 1986. The effects of the bankruptcy reform act of 1978 on small business loan
repricing. Journal of Financial Economics 16, 119140.
Smith, C.W., 1993. A perspective on accounting-based covenant violations. Accounting Review 68,
289303.
Sweeney, A.P., 1994. Debt-covenant violations and managers accounting responses. Journal of
Accounting and Economics 17, 281308.
Watts, R., Zimmerman, J.L., 1986. Positive Accounting Theory. Prentice Hall, Englewood Cliffs, NJ.
Watts, R., Zimmerman, J.L., 1990. Positive accounting theory: a ten year perspective. The Accounting
Review 65, 131156.
Zimmerman, J.L., 2000. Accounting for Decision Making and Control. McGraw-Hill, Columbus, OH.

The Importance of Accounting Changes-Beatty (SAI-BUN)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Importance of Accounting Changes-Beatty (SAI-BUN)

Uploaded by

Copyright:

Available Formats

Journal of Accounting and Economics 33 (2002) 205227

The importance of accounting changes in debt

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

We contend that restricting a rms ability to make voluntary accounting

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

3. Sample selection and classication of contracts

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

4. Model development and research design

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

We investigate the effects of excluding voluntary accounting changes by estimating

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

f#g0 wi =1  F#g0 wi : The constant of proportionality in both cases is rse ; where r

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

We nd that contracts are more likely to exclude voluntary accounting changes

Exclude voluntary coefcient

Exclude mandatory coefcient

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

Exclude voluntary coefcient

Exclude mandatory coefcient

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227

You might also like

f#g0 wi =1 F#g0 wi : The constant of proportionality in both cases is rse ; where r