Further Evidence on Consequences of Debt Covenant Violations

Abstract

We present new evidence on debt covenant violation (DCV) consequences that have not previously been examined in the literature. In particular, we show that a DCV triggers significant information asymmetry and uncertainty on the part of shareholders and auditors as reflected in higher bid-ask spreads, return volatility, and audit fees. Further, these consequences occur even when lender-imposed costs are relatively lower, consistent with the act of default itself triggering shareholder and auditor uncertainty. The results highlight costs to the firm of having bright-line rules in contracts, and add to an understanding of the consequences of DCVs. Nouvelles donn ees attestant les cons equences de la transgression des clauses restrictives R ESUM ELes auteurs pr esentent de nouvelles donn ees qui attestent les cons equences de la transgression des clauses restrictives des contrats de prêt et qui n'ont pas retenu l'attention des chercheurs jusqu' a maintenant. Ils montrent en particulier que la transgression des clauses restrictives se solde par des niveaux elev es d'asym etrie de l'information et d'incertitude des actionnaires et des auditeurs, ainsi qu'en t emoignent les valeurs sup erieures des ecarts acheteur-vendeur, de la volatilit e des rendements et des honoraires d'audit. En outre, ces cons equences se manifestent même lorsque les coûts exig es par le prêteur sont relativement plus faibles, de la même fac ßon que le d efaut de paiement lui-même d eclenche l'incertitude chez les actionnaires et les auditeurs. Les r esultats mettent en lumi ere les coûts que suppose pour une entreprise la stipulation de r egles claires dans les contrats, et ils permettent de mieux comprendre les cons equences de la transgression des clauses restrictives.

Debt Covenant Violations, Firm Financial Distress, and Auditor Actions

“… This finding is consistent with a concurrent study that also finds a positive association between debt covenant violations and audit fees (Gao, Khan, and Tan ). However, Gao et al.…”

“…This finding is consistent with a concurrent study that also finds a positive association between debt covenant violations and audit fees (Gao, Khan, and Tan 2015). However, Gao et al focus on shareholders' reactions to debt covenant violations by examining associations between violations and information asymmetry and uncertainty in the market.…”

Institutional Ownership and Corporate Tax Avoidance: New Evidence

“…The RDD is estimated non-parametrically (Hahn, Todd, and Van der Klaauw 2001;Lee and Lemieux 2010;Tan 2013;Gao, Khan, and Tan 2016) to allow flexible function forms. As Lee and Lemieux (2010) note, the inclusion of baseline covariates (independent variables) is irrelevant in the RDD given the locally randomized assignment to the treatment sample (and we verify in Section 4.1 below that firms around the threshold do not have significant differences in firm characteristics, consistent with locally randomized assignment).…”

Effect of European audit firms on cost of debt and earnings management in private clients audit market segment

“…Agency conflicts between lenders and owners/management can also create EM incentive, enhanced in the case of earnings-based debt covenants (Watts and Zimmerman, 1986;DeFond and Jiambalvo, 1994;Sweeney, 1994;Dichev and Skinner, 2002;Gao et al, 2017;Li, 2016). Note also that, especially after the Basel accords, the stability of the banking and financial system has been found to critically depend on client financial reporting transparency (Bushman and Landsman, 2010), making earnings an attribute of crucial importance.…”