04. the Importance of Accounting Changes-Beatty (SAI-BUN)

Journal of Accounting and Economics 33 (2002) 205227

The importance of accounting changes in debtcontracts: the cost of exibility in covenant

calculations$

Anne Beattya,*, K. Rameshb, Joseph Weberc

aSmeal College of Business, Pennsylvania State University, 215 Beam Business Adm. Building,

University Park, PA 16802, USAbAnalysis Group/Economics, Cambridge, MA 02138, USA

cSloan 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: [email protected] (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

1. Introduction

Prior research has focused on the importance of accounting changes in debtcontracts either by examining whether borrowers change accounting methods toreduce the probability of covenant violations or by examining stock price reactionsto mandated accounting changes. Although these ex post studies consider theimportance of accounting changes, they examine only one part of the contractingprocess. In this paper, we assess the ex ante importance of accounting changes indebt contracts by estimating the price borrowers willingly pay to include the effectsof accounting changes in the calculations of covenant compliance. Our ex anteapproach produces insights not provide by ex post studies of covenant violations.Specically, we estimate the amount paid by borrowers to retain the exibilityvoluntary accounting changes provide and to avoid the duplicate record keepingcosts associated with excluding accounting changes from the calculation of covenantcompliance.Watts and Zimmerman (1990) describe the importance of accounting changes

in the contracting process. Borrowers can use voluntary accounting changesex post to avoid covenant violations, which increases the moral hazard and adverseselection costs associated with the contracts. In contrast, standard setters imposemandatory accounting changes externally and, therefore, these changes impose onlylimited additional moral hazard costs on the contracting parties. Mandatoryaccounting changes nevertheless impose additional contracting costs because theyincrease the costs of investigating and resolving inadvertent violations, and theyincrease the costs associated with delays in covenant violations that predictdefault.Jensen and Meckling (1976) hypothesize that lenders ex ante anticipate the moral

hazard and adverse selection costs associated with voluntary accounting changes andprotect themselves against this possibility. We expect this protection to come in theform of higher interest rates for contracts that allow voluntary accounting changesto affect covenant compliance. Borrowers are willing to pay the higher interest rate ifthey sufciently value the exibility provided by voluntary accounting changes.Similarly, lenders will protect themselves from the increased contracting costsassociated with including mandatory changes by charging the borrower a higherinterest rate when mandatory accounting changes are included in covenantcompliance calculations. Borrowers may be willing to incur the higher interest ratecost if it is less than the expected duplicate record keeping costs associated withexcluding 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, weexamine 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 thedifference in rates charged when these changes are excluded will not capture thetreatment effect if a systematic difference exists in the loan rates that wouldotherwise be charged to the borrower. To control for this potential problem, we use a

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227206

Heckman (1976) selectivity correction variable derived from the determinants of thechoice 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 thecalculation of covenant compliance results in an average reduction in the loan spreadover LIBOR of 84 basis points. We also nd that excluding mandatory accountingchanges from the calculation of covenant compliance results in a reduction of theaverage loan spread of 71 basis points. These ndings indicate that accountingchanges are an important consideration in the debt contracting process. They suggestthat borrowers are willing to pay substantially higher interest rates to retainaccounting exibility that may help them avoid covenant violations and to avoidduplicate record keeping costs. They also suggest that lenders protect themselvesfrom the effects of accounting changes either by charging a higher rate whenaccounting changes are included in the calculation of covenant compliance, or byrestricting a rms ability to make accounting changes when the contracting costsassociated with the change are relatively large. These results are consistent withWatts and Zimmermans hypothesis that accounting changes are important in thelending process and that lenders consider the effects of accounting changes beforeentering 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 providesdescriptive statistics. We discuss our empirical results in Section 6, and Section 7presents our conclusions.

2. Background

The inclusion of voluntary versus mandatory accounting changes in thecalculation of debt covenant compliance may exert different effects on theprobability of covenant violations. Specically, the inclusion of voluntary account-ing changes will reduce the probability of covenant violation but the effect ofincluding mandatory changes on the probability of covenant violations is uncertain.However, the inclusion of either type of accounting change in the calculation ofcovenant compliance is likely to increase the contracting costs associated with thecontract 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 violatingaccounting-based covenants, previous research that examines whether managers usethis 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 circumventdividend restrictions, but instead cut their dividends. Healy and Palepu (1990)

A. Beatty et al. / Journal of Accounting and Economics 33 (2002) 205227 207

conclude that three possible explanations account for the lack of evidence supportingthe hypothesis that borrowers change accounting methods to avoid violating debtcovenants. First, they contend that borrowers may want to avoid the reputationeffects of changing accounting methods. Second, they suggest that the borrowersmay not have had sufcient accounting exibility to avoid covenant violations,although Healy and Palepu think this unlikely to be the case. Third, they argue thataccounting changes may be employed only when managers have no other mechanismavailable to avoid covenant violations, which is not the case for covenants thatrestrict 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 debt-contracting process. In contrast, their third argument would suggest that accountingchanges may not be important in covenants that restrict dividend payments, but maybe important for other covenants where accounting changes are the best mechanismavailable 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. Shedocuments a higher incidence of income increasing accounting changes in the year ofdefault and two subsequent years but not in the years leading up to the default. Inaddition, her cross-sectional analysis is inconclusive on whether default rms makeincome-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 covenantviolations may also be partly due to the research approach used. For example, expost studies could have limited power to detect the impact of these changes becausethey do not control for whether accounting changes have been excluded from thecalculation of covenant compliance. If lenders recognize that voluntary accountingchanges can help borrowers avoid covenant violations, then lenders can avoid thismoral hazard problem by contracting on the accounting principles used to calculatecovenant compliance. A second possible explanation for the lack of results inprevious ex post studies is that they limit their sample to borrowers who haveviolated or are close to violating their debt covenants. Sampling on the dependentvariable and excluding rms not at risk of violating their covenants from theirsample, 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 mandatoryaccounting changes creates only limited moral hazard problems because standardsetters impose mandatory changes externally.1 Moral hazard problems arise only tothe extent that borrowers can choose the timing of adoption of a new standard, themethod of recording the accounting change, or, in the case of an elimination of an

1One exception to this assumption is the inuence that borrowers can have by lobbying for changes in

GAAP.


accepted method, can choose among the remaining accepted accounting methods.2

However, mandatory accounting changes will increase contracting costs becausecovenants are optimized based on existing rules and may no longer be optimal whenthere is a mandated change in accounting methods. Mandatory accounting changesmay either increase or decrease the probability of covenant violations. Therefore,mandatory accounting changes may prevent or delay legitimate covenant violationsor may cause inadvertent covenant violations that do not reect the probability ofdefault. 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 theadoption of the new accounting standard for income taxes, the company was able tocomply with the accounting covenant (The Wall Street Journal, 2/4/93, p. B7). Incontrast, Fisher & Porter was required to adopt a mandated accounting standard onemployees vacation salaries, which was partially responsible for their violation oftheir 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 ofdebt arising from the adoption of SFAS 19 requiring the use of full cost accountingfor oil and gas exploration. Espahbodi et al. (1995) document a positive stock pricereaction associated with the adoption of the provision in SFAS 109 that allows therecognition of deferred tax assets. Parties to a credit agreement can insulatethemselves from any unintended economic consequences attributable to GAAPchanges by contracting ex ante on the set of accounting principles used to measurecompliance 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 contractsas a strategy for restricting managerial opportunism. They argue that by agreeing torestrict future opportunistic behavior, a borrower can reduce their borrowing costs.Thus, the borrower faces a trade-off between retaining the possibility of futureopportunistic behavior and obtaining a lower interest rate. Although the lendersmarket power will affect the required rate of return, the trade-off between reducedcontracting costs and interest rates should exist regardless of the lenders marketpower.3

2Consistent 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.


We contend that restricting a rms ability to make voluntary accountingchanges from the calculation of covenant compliance will similarly reducethe contracting costs associated with the debt agreement. Smith (1993), Wattsand Zimmerman (1986, 1990), and others have argued that managers canopportunistically use voluntary accounting changes to shift wealth from lenders toborrowers. Consistent with Jensen and Meckling (1976), these later studiessuggest that voluntary accounting changes increase the moral hazard and adverseselection costs associated with the debt, and restrictions on the use of voluntaryaccounting changes should result in a reduction of contracting costs and lowerinterest rates.Unlike voluntary accounting changes, the exclusion of mandatory accounting

changes will do little to reduce managerial opportunism since there are onlylimited moral hazard costs associated with externally imposed mandatory account-ing changes. Additional contracting costs do arise, however, from includingmandatory accounting changes in the calculation of covenant compliance.Leftwich (1983) argues that it is costly for lenders to determine whethercovenant violations that arise after a mandated change are indicative of achange in loan quality or a false warning. In addition, mandatory accountingchanges may increase contracting costs because they reduce the likelihoodof a violation occurring that predicts default. Thus, we expect that the exclusionof mandatory accounting changes from the calculation of covenant complianceshould also decrease the contracting costs of the debt and result in a lowerinterest rate.Although excluding mandatory and voluntary accounting changes from the

calculation of covenant compliance reduces contacting costs, it increases aborrowers record-keeping costs. The increased record-keeping cost includes thecost of maintaining two sets of accounting records and the costs of hiring anaccounting staff with an idiosyncratic knowledge of and expertise to cope withpotentially outdated accounting methods. The auditor must also have thisknowledge. In addition, Zimmerman (2000) suggests confusion could occur withina rm over which set of accounting records to use for a particular decision, and thatthere is also a potential of increased demand for differing sets of records from therms 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 withrestricting the rms ability to make accounting changes. Thus, the decision toexclude accounting changes from the calculation of covenant compliance will dependon the cost savings associated with restricting the rms ability to make accountingchanges and the duplicate record-keeping costs.4

4For 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.


3. Sample selection and classication of contracts

We obtain our initial sample of credit agreements from the Lexis-Nexisdatabase of corporate information using a keyword search to identify private loanagreements entered into during 19941996.5 Then we merged the sample of loanagreements collected from Lexis-Nexis with the Loan Pricing Corporation database,which resulted in a sample of 285 loan agreements. After eliminating agreementswithout the data required for our analysis, we reduced our sample to 206agreements.We assign the loan agreements to one of four categories based on whether

debt covenant compliance includes or excludes voluntary or mandatory accountingchanges. We classify those contracts that state that covenant calculations will bebased on nancial information prepared in accordance with GAAP as includingboth voluntary and mandatory accounting changes. Those that state thatcovenant calculations are based on GAAP as in effect on the date of theagreement, but do not require that the methods be applied in accordance with orin conformity with those used at the date of the agreement or that the principlesbe consistently applied, we classify as including voluntary changes but excludingmandatory changes. We classify contracts stating that covenant calculationswill be based on the principles used at the date of the agreement as excludingboth mandatory and voluntary changes. Finally, contracts that state that, forpurposes of calculating covenant compliance, the borrower is not allowed tomake any changes in accounting principles except for those required by GAAP, weclassify as excluding voluntary accounting changes and including mandatorychanges.6

We summarize the number of agreements in our sample that fall into each of thesefour categories in Fig. 1. Of the 206 agreements in our sample, 48 contracts includeboth mandatory and voluntary accounting changes when testing for compliance withdebt covenants; 36 agreements include voluntary but exclude mandatory accountingchanges; 114 exclude both types of changes; and only eight contracts excludevoluntary changes but include mandatory accounting changes. Given an averageloan size of $154 million, this sample represents total borrowings of $31billion.7

5By 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.6We 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.7Our 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.


4. Model development and research design

Based on the reasoning of Jensen and Meckling (1976), we expect that lenders willadjust the spread charged on the loan in accordance with whether covenantcompliance calculations exclude or include the effects of voluntary and mandatoryaccounting changes. We expect lenders to reduce the spread charged on the loan ifthe borrower is willing to reduce the potential moral hazard costs by excludingvoluntary accounting changes from the calculation of covenant compliance.Borrowers are willing to pay a premium to include voluntary accounting changesif they sufciently value the exibility provided by voluntary accounting changes. Wealso expect that lenders costs will be lower when mandatory accounting changes areexcluded from covenant compliance calculations. Although the reduction in moralhazard costs from excluding mandatory accounting changes should be lower than forvoluntary changes, excluding mandatory changes will also reduce the costs that arisewhen covenants are no longer optimally set. Therefore, we expect that lenders willcharge more if mandatory changes are included. Meanwhile, borrowers may bewilling to pay a premium to include mandatory changes if the duplicate recordkeeping costs associated with excluding the changes are greater than the additionalinterest 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 covenantcompliance, we regress the borrowing rate on a dichotomous variable indicatingwhether accounting changes are excluded in the calculation of covenant compliance.We measure the borrowing rate using the spread over the London Inter Bank OfferRate (LIBOR). All loans examined in this study are variable rate loans where therate varies with LIBOR. Since the exclusion of accounting changes in the calculationof covenant compliance is not randomly assigned to borrowers, we control forpotential self-selection bias in our estimate. In addition, we include control variablesthat measure characteristics that have consistently been found in previous researchto be inuential in explaining the spread charged on loans. Specically, we draw onthe research of Blackwell et al. (1998), Booth (1992), and English and Nelsen (1999).

Voluntary

IncludeVoluntaryChanges

ExcludeVoluntaryChanges

Total

Include MandatoryChange 48 8 56

Exclude MandatoryChanges

36 114 150

Man

dato

ry

Total 84 122 206

Fig. 1. Classication of the effects of accounting changes on the calculation of covenant compliance.


For our analysis of the effects of excluding accounting changes on the interest ratescharged on the loan, we run the following two separate regression models:

SPREAD bv0 Interceptbv1 SelectivityV b

v2 ExcludeVoluntary

bv3 Securitybv4 Noratingcurrent b

v5 S&Pratingcurrent

bv6 Maturitybv7 Loan=Assetsb

v8 Size

bv9 Takeoverbv10 Revolvee

v; 1

SPREAD bm0 Interceptbm1 SelectivityM b

m2 ExcludeMandatory

bm3 Securitybm4 Noratingcurrent b

m5 S&Pratingcurrent

bm6 Maturitybm7 Loan=Assetsb

m8 Size

bm9 Takeoverbm10 Revolvee

m; 2

withSPREADnumber of basis points above LIBOR charged on the loan;SelectivityVselectivity correction #li described by Greene (2000), derived from

the probit model of the decision to exclude voluntary changes using

#li f#g0wi=F#g0wi if voluntary changes are excluded;

f#g0wi=1 F#g0wi if voluntary changes are included;

(

where #li represents the tted probability, #g0wi are the tted values from the rststage, calculated for each observation i; using the parameter estimates g and thematrix of explanatory variables wi from the rst stage model; f represents thenormal distribution pdf, and F represents the normal distribution cdf;SelectivityMselectivity correction #li described by Greene (2000), derived from

the probit model of the decision to exclude mandatory changes calculated in thesame 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 timethe 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.


We investigate the effects of excluding voluntary accounting changes by estimatingEq. (1) for the 114 agreements that exclude both voluntary and mandatory changesand the 36 agreements that include voluntary changes but exclude mandatorychanges. Similarly, we examine the effects of excluding mandatory accountingchanges by estimating Eq. (2) for the 36 agreements that exclude mandatory changesbut include voluntary changes and the 48 agreements that include both types ofchanges.The coefcients on the dichotomous variable indicating the exclusion of

accounting changes from the calculation of covenant compliance in our modelswill not capture the treatment effect of excluding accounting changes if there is asystematic difference in the loan prices of agreements that exclude accountingchanges. To control for this self-selection problem, we include selectivity correctionvariables that we calculate following the formulas provided by Greene (2000). Theseformulas use the estimated coefcients from probit models of the determinants of thedecision to exclude the effects of voluntary and mandatory accounting changes.8 Toobtain these coefcients, we estimate the determinants of the decision to exclude theeffects of voluntary and mandatory accounting changes from the calculation ofcovenant compliance using two separate probit models. We discuss the results of thisestimation 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 correlationbetween the error from the probit model of the decision to exclude an accountingchange and the error from the SPREAD regression model.9 Specically, ourSPREAD model would suffer from two forms of truncation bias reecting thefact that we could not randomly assign the exclusion of accounting changesto debt contracts. First, we do not observe the rate that would have been chargedfor excluding accounting changes for contracts where the parties decided toinclude those changes. Second, we do not observe the rate that would havebeen charged for including accounting changes for those contracts where theparties decided to exclude changes. The expected value of the error term from theestimation of a regression on a truncated sample is not zero; therefore, theestimated coefcients from the regression would be biased. We correct forthis bias by including the expected value of the error term in the regressionmodel.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 whenaccounting changes are excluded will be proportional to the ratio of the normaldensity function to the cumulative normal density function, both evaluated at thepredicted value from the exclusion of accounting changes model f#g0wi=F#g0wi:When accounting changes are included, the expected value of e is proportional to

8As suggested in Greene (2000), we also adjust the standard errors in the second stage.9Greene (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.


f#g0wi=1 F#g0wi: The constant of proportionality in both cases is rse; where ris 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 excludeaccounting changes. For each observation, the predicted value is calculated bytaking the scalar product of the vector of estimated coefcients from the probitmodel #g and the vector of the values of the explanatory variables included in themodel for that observation Wi: We include this ratio in the SPREAD model tocorrect for the bias in the estimated coefcients that arises from a non-zero expectedvalue of e: The expected coefcient on this variable will be the constant ofproportionality rse:Our SPREAD models also include characteristics that previous research, such as

Blackwell and Winters (1997), Blackwell et al. (1998), Booth (1992), and English andNelsen (1999), nds to be related to the loan price. These include the borrowers creditrisk, the maturity of the loan, the relative size of the loan, the size of the borrower, andwhether or not the purpose of the loan is for a takeover. Previous studies have foundthat interest rates are higher for collateralized loans, for borrowers without rated debt,for borrowers with lower rated debt, for loans with longer maturities, for relativelysmaller 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 alldocumented a positive association between the presence of a collateral requirementand default risk and have shown that the spread is higher on collateralized loans.Second, following Booths (1992) approach, we include two variables that capture thecredit rating of the borrower. We construct the rst variable by converting theStandard and Poors bond rating to a numerical score and then taking the log of thatscore (S&Pratingcurrent). We set this variable equal to zero for borrowers who do nothave rated debt. We assign a value of 1 to debt rated A+ (the highest rating in oursample), 2 to debt rated A, 3 to debt rated A, 4 to debt rated BBB+, and so on withB debt, the lowest rated debt in our sample, assigned a value of 12. This variablemeasures the effect of having higher quality rated debt conditional on having rateddebt. The second measure of credit risk is a dichotomous variable indicating whetherthe 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 theborrower by dividing the amount of the loan by the borrowers asset prior toentering into the loan (Loan/Assets). We rely on the log of the borrowers assets tomeasure borrower size. We use a dichotomous variable equal to 1 if the primarypurpose of the loan stated in the LPC database is for a corporate takeover. We dothis specically to measure the effects of the increased risks associated with takeoverloans. Previous research examines either revolving loans or term loans but not both.Because we think that this distinction may be important, we include a dichotomousvariable equal to 1 if the loan is a revolving loan to capture differences betweenrevolving credit and term loans.


5. Descriptive statistics

Table 1 shows the means and standard deviations of the variables we use tomeasure loan, borrower and lender characteristics. Loans that exclude bothmandatory and voluntary accounting changes are more likely to require security,to be entered into by borrowers with worse credit ratings, and to have a longermaturity than those that include either voluntary changes or both voluntary andmandatory changes. Given our expectation that moral hazard costs and the costs ofdelayed covenant violations will be increasing in the borrowers credit risk and thematurity of the loan, this is consistent with the exclusion of accounting changes whenthere 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

Exclude all

accounting

changes

Include all

accounting

changes

Include

voluntary

exclude

mandatory

Exclude

voluntary

include

mandatory Entire sample

SPREAD 168.6 124.4 130.9 184.4 152.3

(110.6) (91.0) (97.7) (111.8) (104.2)

Security 0.69 0.38 0.53 0.75 0.59

(0.46) (0.49) (0.51) (0.46) (0.49)

S&Pratingcurrent 0.68 0.41 0.48 0.27 0.57

(0.96) (0.81) (0.79) (0.78) (0.90)

Noratingcurrent 0.63 0.73 0.67 0.88 0.67

(0.48) (0.45) (0.48) (0.35) (0.47)

Maturity 54.9 36.1 48.5 44.0 49.0

(21.5) (21.6) (21.4) (21.2) (22.7)

#lenders 1.73 0.97 1.54 1.38 1.51

(0.97) (1.01) (1.28) (0.79) (1.07)

#book-taxdiff 6.31 5.77 6.27 5.63 6.15

(3.10) (2.59) (2.20) (3.78) (2.86)

Loan/Assets 0.37 0.57 0.40 0.30 0.42

(0.37) (1.31) (0.38) (0.25) (0.71)

Loan/#lenders 21.65 27.31 25.78 9.56 23.22

(33.3) (36.72) (18.14) (8.55) (31.53)

Freqlender 0.28 0.17 0.17 0.13 0.23

(0.45) (0.38) (0.38) (0.35) (0.42)

Size 5.73 5.43 5.82 4.84 5.64

(1.45) (1.72) (1.85) (0.98) (1.58)

Takeover 0.34 0.14 0.22 0.00 0.26

(0.48) (0.36) (0.42) (0.00) (0.44)

Revolve 0.56 0.69 0.64 0.50 0.60

(0.50) (0.47) (0.49) (0.53) (0.49)


for loans that exclude both types of accounting changes than for other loans. This isconsistent with the exclusion of accounting changes when renegotiation costs arehigher, since most contract modications require a supermajority of lenders. We alsoobserve that the borrowers who enter into contracts that exclude both mandatoryand voluntary accounting changes have a greater number of book-tax differences inaccounting methods. Given that these differences are likely to be greater when it isless costly for borrowers to maintain records that use different accounting methods,this is consistent with the exclusion of accounting changes when duplicate recordkeeping costs are lower. We report the results of our multivariate examination of theeffects of these characteristics on the decision to exclude accounting changes inAppendix B.

Table 1 (continued)

Variable

Exclude all

accounting

changes

Include all

accounting

changes

Include

voluntary

exclude

mandatory

Exclude

voluntary

include

mandatory Entire sample

S&Pratingfuture 0.89 0.58 0.91 0.00 0.79

(0.96) (0.88) (0.94) (0.00) (0.94)

Noratingfuture 0.63 0.63 0.50 1.00 0.54

(0.48) (0.49) (0.51) (0.00) (0.50)

Number of loans 114 48 36 8 206

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 withrated debt, 0 otherwise;

Noratingcurrentdichotomous variable equal to 1 if the borrower is not rated, 0 otherwise;

Maturitynumber of months between the start and end date of the contract;

#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/Assetsamount of the loan divided by the total assets of the borrower;

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;

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;

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, 0otherwise;

Noratingfuturedichotomous variable equal to 1 if the borrower is not rated at the end of scal 1998, 0

otherwise.


6. Results

Table 2 reports the results of our regression model comparing the loan spreads forcontracts that exclude voluntary accounting changes to the loan spreads forcontracts that include voluntary accounting changes in the calculation of covenantcompliance. After controlling for other factors known to affect loan pricing and forthe selectivity correction, we nd the spread on loans that exclude voluntaryaccounting changes is 84.53 basis points lower than for those where these changesare allowed to affect the calculation of compliance with covenants.10 This nding isconsistent with the idea that there is a reduction in contracting costs when theborrowers ability to change accounting methods to avoid covenant violations isrestricted. The magnitude of the difference in loan spreads seems reasonable given anaverage stated default premium of 230 basis points for a subset of the loans in oursample.11 We nd a positive coefcient on our selectivity correction variable, whichis what we would expect if voluntary accounting changes are more likely to beexcluded 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 higherfor borrowers with higher credit risk and for takeover loans. Loan spreads are lowerfor larger borrowers and for relatively larger loans. We also nd that loan spreadsare higher for revolving loans relative to term loans. We do not nd a signicantcoefcient on the maturity variable, which is consistent with Booths (1992)conclusion that maturity is important in explaining loans spreads when the spread isbased on the CD rate, but it is not important when the spread is based on the LIBORrate.Table 3 reports the results of our regression model comparing the loan spreads

for contracts that exclude mandatory accounting changes to those that includethem in the calculation of covenant compliance. After controlling for otherfactors known to affect loan pricing and for the selectivity correction, we ndthat the spread on loans that exclude mandatory accounting changes is 71 basispoints lower than for those where these changes are allowed to affect the calculationof compliance with covenants.12 This result is what would be expected if contractcosts are reduced by the exclusion of mandatory accounting changes. We nd apositive and signicant coefcient on our selectivity correction variable. A positivecoefcient on the selectivity correction variable indicates that a higher rate is chargedto borrowers who are likely to have higher costs of investigating covenant violationsto determine whether they indicate a change in loan quality or a false warning.

10When we omit the selectivity correction from the model, the coefcient on excluding voluntary

changes is not statistically signicant.11For 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.12When we omit the selectivity correction variable from the regression, the coefcient on excluding

mandatory is insignicant.


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 +/ 249.32 4.04***

SelectivityV +/ 59.46 2.00**

ExcludeVoluntary 84.53 1.70**

Security + 95.75 5.26***

Noratingcurrent + 62.82 1.50*

S&Pratingcurrent + 31.28 1.53*

Maturity + 0.20 0.65

Loan/Assets 40.64 2.27**

Size 24.25 3.87***

Takeover + 49.16 3.89***

Revolve +/ 34.03 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 #li described by Greene (2000), derived from the probit model of thedecision to exclude voluntary changes using

#li f#g0wi=F#g0wi if voluntary changes are excluded;

f#g0wi=1 F#g0wi if voluntary changes are included;

(

where #li represents the tted probability, #g0wi are the tted values from the rst stage, f represents thenormal distribution pdf, and F represents the normal distribution cdf;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;







Revolvedichotomous variable equal to 1 for revolving loans, 0 otherwise.


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 +/ 220.29 2.86***

SelectivityM +/ 41.61 1.80*

ExcludeMandatory 71.01 1.92**

Security + 101.48 6.37***

Noratingcurrent + 37.70 1.13S&Pratingcurrent + 8.51 0.53Maturity + 0.73 2.16**

Loan/Assets 14.61 2.33**

Size 27.08 4.47***

Takeover + 44.36 3.03***

Revolve +/ 40.97 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 #li described by Greene (2000), derived from the probit model of thedecision to exclude voluntary changes using

#li f#g0wi=F#g0wi if mandatory changes are excluded;

f#g0wi=1 F#g0wi if mandatory changes are included;

(

where #li represents the tted probability, #g0wi are the tted values from the rst stage, f represents thenormal distribution pdf, and F represents the normal distribution cdf;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;







Revolvedichotomous variable equal to 1 for revolving loans, 0 otherwise.


The coefcients on our control variables are largely consistent with the ndings ofprevious research, such as Blackwell et al. (1998), Booth (1992), and English andNelsen (1999), and with the results reported in Table 2. Specically, loan spreads arehigher for secured debt, for debt with longer maturities, and for takeover loans; andloan 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 onrated debt is related to the price of the loan even though other measures of risk arerelated 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 holdingconstant the decision about the other type of change to avoid difculties inidentifying structural equations for the potentially joint decision of excluding the twotypes of accounting changes. In sensitivity tests, we make unconditional comparisonsof the decisions to exclude mandatory and voluntary accounting changes byincluding all observations in each model. Specically, we compare the 122agreements that exclude voluntary changes to the 84 agreements that do not, andwe compare the 150 agreements that exclude mandatory changes to the 56agreements that do not. In our unconditional SPREAD model, we calculate theselectivity correction variables using unconditional probit models that include all 206observations in the examination of each accounting change decision. In this analysis,we estimate the SPREAD regression model including two selectivity correctionvariables, one for the choice to exclude voluntary changes and the other for thechoice 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 basispoints lower than for those where voluntary changes are allowed to inuencethe calculation of compliance with covenants. This is very similar to the resultreported in Table 2. We nd no signicant difference in the SPREADwhen agreements include both types of accounting changes versus when theyinclude only voluntary accounting changes. This result is not consistent withthe result of our conditional analysis reported in Table 3, where we found thatthe exclusion of mandatory accounting changes resulted in a signicantlylower SPREAD. Finally, when agreements exclude voluntary accounting changesbut include mandatory changes, we nd that the SPREAD is 165 basis pointslower than when voluntary changes are included and mandatory changesare excluded.13 Because of the small number of agreements that exclude voluntaryand include mandatory accounting changes we were unable to make a conditional

13When 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.


comparison for this group. The magnitude and signicance of the othercontrol variables are similar to those reported in Tables 2 and 3, with all thevariables that were signicant in both tables remaining signicant in theunconditional model.

7.2. Measurement of credit risk

We test the sensitivity of our results with respect to the measurement of creditratings by redening the S&Prating variable as the bond rating without taking thelog of that rating. Our results using this redened variable are unchanged, althoughthe signicance on the coefcients on this variable in the voluntary accountingchanges models increases. We also redene this variable by setting the highest ratingequal to 2 rather than 1 before taking the log. Again our results are qualitativelyunchanged.

7.3. Measurement of fixed costs

If there is a xed component of the costs of monitoring and renegotiatingcontracts then the spread over the LIBOR rate charged may be decreasing in theloan size. We measure size in our SPREAD regressions as the log of sales. Thisvariable may capture the effect of these xed costs. We also test the sensitivity of ourresults to the inclusion of the log of the loan. This variable is insignicant in ourSPREAD models when size is also included in the model. These ndings areconsistent with Booth (1992).

8. Conclusion

We examine the ex ante importance of accounting changes in debt contracts byestimating the price that borrowers willingly pay to retain the exibility provided byvoluntary accounting changes and to avoid the duplicate record keeping costsassociated with excluding accounting changes from the calculation of covenantcompliance.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 thatborrowers are willing to pay substantially higher interest rates to retain accountingexibility that may help them avoid covenant violations. It also suggests that lendersprotect themselves from the moral hazard and adverse selection costs of includingvoluntary accounting changes in debt covenant compliance. This protection isattained either by charging a higher rate when accounting changes are included inthe calculation of covenant compliance, or by restricting a rms ability to makeaccounting changes when the contracting costs associated with the change arerelatively 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


mandatory accounting changes may reduce the expected renegotiation costs of theloan and that borrowers can benet from this reduction in expected costs throughlower interest rates. Our sensitivity analysis indicates, however, that the results formandatory 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 havefound evidence of the ex post importance of accounting changes in debt contracts forborrowers who violate their accounting based covenants. Our ex ante approachextends the results or prior research because it assesses the importance of accountingchanges regardless of whether borrowers violate their covenants.

Appendix A

This appendix provides an example of each of the four different types ofaccounting denitions that may govern the contract.

A.1. Exclude voluntary and mandatory accounting changes

Company: PeeblesGAAP shall mean generally accepted accounting principles in the United States of

America as in effect on the date of this Agreement consistently applied; it beingunderstood and agreed that determinations in accordance with GAAP for purposesof Section 8, including dened terms as used therein, are subject (to the extentprovided 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 GAAPconsistently applied throughout the periods involved (except as set forth in the notesthereto or as otherwise disclosed in writing by the Borrower to the Lenders);provided, however, that (i) except as otherwise specically provided herein, allcomputations determining compliance with Section 8, including denitions usedtherein, shall utilize accounting principles and policies in effect at the time of thepreparation of, and in conformity with those used to prepare, the January 28, 1995historical nancial statements of the Borrower delivered to the Lenders pursuant toSection 6.10(b), and (ii) that if at any time the computations determining compliancewith Section 8 utilize accounting principles different from those utilized in thenancial statements furnished to the Lenders, such nancial statements shall beaccompanied by reconciliation work-sheets.

A.2. Include voluntary and mandatory accounting changes

Company: ServtecGAAP means generally accepted accounting principles as in effect from time to

time as set forth in the opinions, statements and pronouncements of the AccountingPrinciples Board of the American Institute of Certied Public Accountants, the


Financial Accounting Standards Board and such other Persons who shall beapproved by a signicant segment of the accounting profession and concurred in bythe independent certied public accountants certifying any audited nancialstatements 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 tobe made hereunder and all nancial information required to be provided hereundershall be done or prepared in accordance with GAAP.

A.3. Include voluntary accounting changes and exclude mandatory changes

Company: EmconGAAP means generally accepted accounting principles and practices consistent

with those principles and practices promulgated or adopted by the FinancialAccounting Standards Board and the Board of the American Institute of CertiedPublic Accountants, their respective predecessors and successors. Each accountingterm used but not otherwise expressly dened herein shall have the meaning given itby GAAP.8.8 Accounting Terms. Except as otherwise provided in this Agreement,

accounting terms and nancial covenants and information shall be determinedand prepared in accordance with GAAP as in effect on the date of thisAgreement.

A.4. Include mandatory accounting changes and exclude voluntary

Company: American Disposal ServicesGAAP means generally accepted accounting principles set forth from time to time

in the opinions and pronouncements of the Accounting Principles Board and theAmerican Institute of Certied Public Accountants and statements and pronounce-ments of the Financial Accounting Standards Board (or agencies with similarfunctions 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 reportingpractices, except as required by GAAP, or change the scal year of the Company orof any Subsidiary.

Appendix B

This appendix provides details about the probit models that we use to estimate theselectivity 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.


We nd that contracts are more likely to exclude voluntary accounting changeswhen accounting discretion is likely to result in larger moral hazard costs, asmeasured by Security a proxy for borrowers credit risk. We also nd thatconditional on the borrowers credit risk at the date of the loan, voluntaryaccounting changes are less likely to be excluded when the borrowers future creditrisk is likely to rise. Assuming that borrowers have information about their futurecredit risk that lenders do not have, this is consistent with an adverse selectionproblem 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 covenantviolations to determine whether they indicate a change in loan quality or a falsewarning. We use the borrowers credit risk to capture the costs of delays in covenantviolations 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 Securityg

v2 S&Pratringcurrent g

v3 Noratingcurrent

gv4 Maturitygv5 #lendersg

v6 book-taxdiffg

v7 Loan=assets

gv8 Loan=#lendersgv9 Freqlenderg

v10 S&Pratingfuture

gv11 Noratingfuture uv

and

ExcludeMandatory gm0 Interceptgm1 Securityg

m2 S&Pratringcurrent g

m3 Noratingcurrent

gm4 Maturitygm5 #lendersg

m6 book-taxdiffg

m7 Loan=assets

gm8 Loan=#lendersgm9 Freqlenderu

m:

Variable Predicted Exclude voluntary coefcient Exclude mandatory coefcient

(t-statistic) (t-statistic)

Intercept 7 0.09 3.40(0.09) (2.89)***

Security + 0.60 1.13

(1.96)** (2.78)**

S&Pratingcurrent + 1.28 0.31

(2.45)** (0.78)

Noratingcurrent + 2.42 0.89

(2.31)** (1.10)

Maturity + 0.004 0.01

(0.76) (1.58)*

#lenders + 0.19 0.61

(1.27) (2.84)***

#book-taxdiff + 0.03 0.14

(0.62) (1.74)**

Loan/Assets 0.38 0.10(1.04) (0.54)

Loan/#lenders + 0.001 0.003(0.21) (0.63)


accounting change will occur during the life of the loan. We also nd that mandatoryaccounting changes are more likely to be excluded the higher the costs ofrenegotiating the loan, measured using the number of lenders. Finally, we nd thatmandatory accounting changes are more likely to be excluded when the costs ofduplicate record keeping are higher. We use the number of differences in accountingmethods 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 toreduce the contracting costs that arise when the calculation of covenant complianceincludes accounting changes.

Table 4 (continued)

Variable Predicted Exclude voluntary coefcient Exclude mandatory coefcient

(t-statistic) (t-statistic)

Freqlender 7 0.21 (0.91)(0.66) (0.88)

S&Pratingfuture 1.48(2.22)**

Noratingfuture 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, 0otherwise;

Noratingfuturedichotomous variable equal to 1 if the borrower is not rated at the end of scal 1998, 0

otherwise.


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The importance of accounting changes in debt contracts: the cost of flexibility in covenant calculationsIntroductionBackgroundThe effects of voluntary accounting changes on covenant complianceThe effects of mandatory accounting changes on covenant complianceReduction in contracting costs from excluding voluntary and mandatory accounting changes

Sample selection and classification of contractsModel development and research designDescriptive statisticsResultsSensitivity analysisConditional versus unconditional analysisMeasurement of credit riskMeasurement of fixed costs

ConclusionExclude voluntary and mandatory accounting changesInclude voluntary and mandatory accounting changesInclude voluntary accounting changes and exclude mandatory changesInclude mandatory accounting changes and exclude voluntary

References

Documents

04. the Importance of Accounting Changes-Beatty (SAI-BUN)