Sign reversal in the relationship between income smoothing and cost of debt

Amiram, Dan; Owens, Edward L.

doi:10.1111/jbfa.12295

Cited by 20 publications

(20 citation statements)

References 85 publications

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“…Second, regarding the debate over the costs and benefits of income smoothing, our study adds to the literature that documents the benefits of income smoothing (e.g., Amiram and Owens ; Demerjian et al ). Specifically, our evidence supports the view that income smoothing improves the usefulness of earnings for debt contracting by improving the usefulness of earnings‐based information in monitoring borrowers.…”

Section: Introductionmentioning

confidence: 99%

Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting

Demerjian

Donovan

Lewis-Western

2020

Contemporary Accting Res

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We investigate whether income smoothing affects the usefulness of earnings for contracting through the monitoring role of earnings‐based debt covenants. First, we examine initial contract design and predict that income smoothing will increase (decrease) the use of earnings‐based covenants if income smoothing improves (reduces) the usefulness of earnings to monitor borrowers. We find that private debt contracts to borrowers with greater income smoothing are more likely to include earnings‐based covenants. A structural model that explores the cause of this relationship provides evidence that smoothing improves the ability of earnings to reflect credit risk. Second, we examine technical default following contract inception. We find that income smoothing is associated with a lower likelihood of spurious technical default (when the borrower's economic performance has not declined but the loan nevertheless enters technical default). In contrast, we find no association between income smoothing and performance technical default (when the borrower's economic performance has declined). Collectively, this evidence is consistent with income smoothing improving the effectiveness of earnings‐based information in monitoring borrowers.

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Section: Introductionmentioning

confidence: 99%

Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting

Demerjian

Donovan

Lewis-Western

2020

Contemporary Accting Res

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“…Public market participants reward firms which report smooth earnings with lower cost of equity (Francis, LaFond, Olsson, & Schipper, 2005) and lower cost of debt (bond) (Li & Richie, 2016). Similarly, creditors and credit rating agencies also reward firms which have smoother income with lower cost of debt and better credit rating; they believe that smooth earnings signals reduced the probability of default risks (Amiram & Owens, 2018;Jung et al, 2013;Trueman & Titman, 1988). Given these findings, it comes to no surprise when Graham et al (2005) find that vast majority of top management prefer smooth earnings path.…”

Section: Literature Reviewmentioning

confidence: 99%

“…For instance, creditors view smooth earnings as the signal of a stable and viable business operation. They classify firms with smooth earnings as low loan default risk (Demerjian, Donovan, & Lewis-Western, 2017) and reward this type of firm with lower interest rate (Amiram & Owens, 2018;Gassen & Fülbier, 2015). Therefore, managers of private firms are inherently obliged to report smooth earnings to enjoy a better loan covenant and lower interest rate from creditors.…”

Section: Introductionmentioning

confidence: 99%

Earnings Smoothing and Bankruptcy Risk in Liquidating Private Firms

Shabani

Sofian

2018

AJFA

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Smooth earnings are preferred by managers and creditors because they represent a stable business operations as well as low loan default risks and thus creditors reward firms which have smooth earnings with better loan covenant terms and lower interest rates. Nonetheless, recent literature shows that earnings smoothing in public firms is associated with stock price crash risk. Using Altman Z” score to measure firm’s specific bankruptcy risk, this study examines the association between accrual earnings smoothing and bankruptcy risk in liquidating private firms in UK and finds that earnings smoothing significantly negatively affects those firms' bankruptcy risk. The finding implies that financially distressed firms engage with less earnings smoothing, possibly because they do not have the opportunity to engage in accrual earnings smoothing anymore. Nonetheless, further examination shows that these firms engage less with earnings smoothing because they are being monitored by external creditors, indicated by significantly high leverage during the last period before they are being liquidated.

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“…However, the costs of violation are lower for firms that can obtain a waiver than for those that cannot. macroeconomic distress or questionable accounting quality (see, e.g., Amiram & Owens, 2017;Gunn, Khurana, & Stein, 2017). 12 Beneish and Press (1995a) investigate the stock price reaction to a DCV disclosure.…”

Section: Debt Covenants and The Costliness Of Covenant Violationsmentioning

confidence: 99%

“…Roberts and Sufi () find that covenant violations are associated with increased interest rates. DCV may also result in the costly imposition of additional covenants during the negotiation process (Core & Schrand, ), and negotiation can be even more costly to borrowers if it coincides with periods of general macroeconomic distress or questionable accounting quality (see, e.g., Amiram & Owens, ; Gunn, Khurana, & Stein, )…”

Section: Background and Hypothesis Developmentmentioning

confidence: 99%

The market response to implied debt covenant violations

Stice

2018

Business Fin & Account

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Previous research documents a negative stock price reaction to the announcement of a debt covenant violation (DCV). However, managers of firms that violate a covenant often obtain waivers and renegotiate debt contracts with lenders before the SEC requires them to disclose a violation. Firms therefore may not report some covenant violations, and prior research has not documented their cost to shareholders. Exploiting the fact that over half of all private debt contracts contain a debt covenant reliant on some variation of accounting earnings, I construct a sample of firms with debt contracts that contain at least one earnings‐based covenant. Combining earnings‐based‐covenant contract values from debt agreements with information publicly available at the earnings announcement date, I predict firms in violation of a debt covenant and provide evidence that equity investors react negatively to these implied violations, regardless of whether managers ever disclose that a violation occurred. In additional tests, I find no evidence of a negative stock price reaction to a firm disclosure of a DCV that market participants could infer from previously reported earnings, but I demonstrate that equity investors do react to the disclosure of a violation of a balance‐sheet covenant that would not have been inferable. This study complements previous research on DCVs by documenting the costliness to shareholders of violations subsequently resolved with lenders but not disclosed.

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Sign reversal in the relationship between income smoothing and cost of debt

Cited by 20 publications

References 85 publications

Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting

Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting

Earnings Smoothing and Bankruptcy Risk in Liquidating Private Firms

The market response to implied debt covenant violations

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