the effects of debt contracting on voluntary accounting method changes

8/2/2019 The Effects of Debt Contracting on Voluntary Accounting Method Changes

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The Effects of Debt Contracting on Voluntary Accounting Method Changes

Author(s): Anne Beatty and Joseph WeberReviewed work(s):Source: The Accounting Review, Vol. 78, No. 1 (Jan., 2003), pp. 119-142Published by: American Accounting AssociationStable URL: http://www.jstor.org/stable/3203298 .

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THEACCOUNTINGEVIEWVol. 78 No. 1January 003pp. 119-142

T h e E f f e c t s o f D e b t Contractingo n Voluntary Accounting

Method ChangesAnne Beatty

Pennsylvania State UniversityJoseph WeberMassachusetts Institute of Technology

ABSTRACT: hisstudy examines whetherthe provisionsof a firm'sbankdebtcontracts affect its accounting choices. Startingwith a sample of firmswhohave bank debt and who also voluntarily hanged accounting methods, weinvestigate whether the likelihood hat the change in accounting method in-creased (rather than decreased) the borrower's income depends on (1)whetherthe change in accounting method affects the bankdebt contractcal-culations, (2) the expected costs of violatingthe bank debt covenants, (3)whether performancepricingprovisions affect the interest rate on the loan,and (4) whether the bank debt contract contains accounting-based dividendrestrictions.Aftercontrolling or other motives for changingaccountingmeth-ods, we find that borrowerswhose bank debt contracts allow accountingmethod changes to affect contact calculations are more likelyto make in-come-increasing ratherthan income-decreasing changes. This increase inlikelihoodof an income-increasingchange is attenuated when expected costsof technical violationare lower because there is a single lender,and occursfor borrowers whose debt contacts have performancepricingand dividendrestrictions. These results suggest that incentives to lower interest ratesthrough performancepricingor to retaindividendpaymentflexibilitynfluenceborrowers'accounting method choices, thereby addressing the fundamentalquestions posed by Fields et al. (2001)of whether,underwhatcircumstances,and how accounting choice matters.Keywords:accountingchoice; debt contracting;debt covenants;performancepricing;dividendrestrictions.

We thank two anonymous reviewers, Wayne Guay, Peter Joos, S. P. Kothari, Greg Miller, and seminar par-ticipant at MIT for helpful comments. We also thank Jennifer Altamuro, Shelley Herbein, and Hyunna Song forresearch assistance and Dick Dietrich for his insights about data availability at the SEC. Professor Beatty gratefullyacknowledges financial support from PricewaterhouseCoopers and the Sloan Foundation.SubmittedFebruary 2002Accepted August 2002119


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The AccountingReview,January 003

Data Availability: All data are available from public sources.I. INTRODUCTIONWatts and Zimmerman (1986, 216-217) argue that debt contracts that make covenantthresholds a function of financial ratios give borrowers an incentive to change accountingmethods to avoid costly covenant violations. However, reviewing the empirical research on

accounting choice, Fields et al. (2001, 275) state that "the evidence on whether accountingchoices are motivated by debt covenant concerns is inconclusive." There are at least threereasons that previous research may underestimate the effects of debt contracting on man-agers' accounting choices.First, previous research that does not use the details of firms' actual debt contractsassumes that contract calculations are based on current accounting methods. However,Mohrman (1996) and Beatty, Ramesh, and Weber (2002) document that private debt con-tract calculations often prohibit firms from changing accounting methods. For thesecontracts, borrowers cannot use voluntary accounting method changes to avoid covenantviolations. Thus, debt contracts give borrowers an incentive to change accounting methodsonly if the voluntary accounting method changes affect contract calculations.Second, existing research that focuses exclusively on debt covenants ignores otheraccounting-based features of debt contracts. Performance pricing is a relatively new featurein bank debt contracts that explicitly makes the interest rate charged on a bank loan afunction of the borrower's current creditworthiness. Asquith et al. (2002) document thatperformance-pricing features typically measure the borrower's creditworthiness using fi-nancial ratios such as debt to earnings before interest, taxes, depreciation, and amortization(EBITDA), leverage, or interest coverage. That is, the interest rate charged in the contractdoes not remain fixed over the length of the loan, but varies inversely with changes inmeasures of financial performance. Compared to covenants under which accounting infor-mation affects loan rates only when the borrower violates a single threshold, performancepricing creates a more continuous and direct link between accounting information andinterest rates. Thus, performancepricing likely gives managers additional incentives to makeincome-increasing accounting method changes. Previous research does not consider whetherthis feature of debt contracts influences accounting choice.Third, previous research has focused on borrowers who were either close to violatingor had already violated covenants. These studies may underestimate the effect of debtcontracting on accounting choice for cases in which borrowers have effectively used ac-counting changes to provide slack in financial covenants, and thus never come close tocovenant violations.To provide more conclusive evidence that debt contracting concerns affect borrowers'accounting choices, we address these three limitations of prior research. First, our researchdesign incorporates the fact that debt contracts often prohibit borrowers from using vol-untary accounting method changes to affect contract calculations. This cross-sectional var-iation in bank debt provisions allows us to examine whether managers who have chosento change their accounting methods are more likely to make income-increasing changeswhen the debt contract allows these changes to affect contract calculations. Second, weconsider whether another debt contracting feature-accounting-based performance pric-ing-increases borrowers' tendencies to make their voluntary accounting method changesincome-increasing rather than income-decreasing. Third, rather than restricting our sampleto borrowers approaching covenant violations, we study all borrowers who make voluntaryaccounting changes, and control for their other incentives to change accounting methods.If borrowers effectively use changes in accounting methods to create slack in financial

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covenants so that they avoid coming close to violating their covenants, then our tests ex-amining all accounting method changes are more powerful than tests employed in previousresearch that focused solely on borrowers who are close to or had already violated theircovenants.To provideevidence on how debt contractsaffect the sign of voluntarychanges thatborrowing firms make in their accounting methods, we identify a sample of borrowers withmaterial bank debt who have chosen to make accounting changes. We determine whethertheir contractshave accounting-based estrictivecovenants,dividendrestrictions,or per-formance-pricing equirements. eatty,Ramesh,andWeber 2002) find thatborrowerswill-ingly pay higher nterestrates to obtainbank debtcontracts hatallow voluntaryaccountingchanges to affect the calculation of financial terms in those debt contracts. We thereforeexpectborrowers o make use of this costly flexibility.Consistentwith ourhypothesis,wefindthatborrowerswho changetheiraccountingmethodsaremorelikely to make income-increasingchangesif theirdebt contractsallow the changesto affect contractcalculations.

This increase in likelihood of an income-increasing ccountingchangeis attenuatedwhenthe cost of a covenantviolationis lower because all the firm's bank debt is from a singlelender, and occurs only for borrowers whose contracts have performance-pricing provisionsand dividendrestrictions.Our debt contracting results hold even after we control for other motives that borrowershave for changingaccountingmethods.Specifically,our resultshold even after we controlfor the fact thatincentivesarisingfromexecutivecompensation ontractsandincentivestomeet earningesbenchmarks increase borrowers'propensity to make income-increasing(rather hanincome-decreasing) hanges.We also controlfor the fact thata borrowerwitha new Chief Executive Officer(CEO) who reportsa large loss before the effect of theaccounting method change is more likely to report an income-decreasing accounting change(consistentwith new CEOs of poorlyperforming irmstaking"big baths").Our debt con-tracting results also hold after controlling for tax incentives.Our evidence that debt contractingconcernsaffect borrowers'accountingchoices ismoreconclusive thanpreviousresearchbecause we show thatborrowersakeadvantageofthe flexibility to make income-increasingaccountingmethodchanges that affect contractcalculations. In addition, our evidence suggesting that incentives to lower interest ratesthrough performance pricing and incentives to retain dividend payment flexibility appearto affect borrowers' accounting method choices helps address Fields et al.'s (2001) funda-mental questions of whether, under what circumstances, and how accounting choice matters.Section II develops our hypotheses and Section III explains our research design. SectionIV describes our sample selection and provides descriptive statistics. We discuss our em-pirical results in Section V, provide sensitivity analysis in Section VI, and present ourconclusions in Section VII.

II. HYPOTHESIS DEVELOPMENTFields et al. (2001) discuss three motives for accounting choice: (1) contracting (in-cluding debt and management compensation contracts), (2) asset pricing, and (3) influencingexternal parties (e.g., the Internal Revenue Service [IRS]). This paper focuses on the relationbetween accounting method changes and debt contracting while controlling for the otherincentives for accounting choice, as explained in Section III. Specifically, we examine theextent to which detailed provisions of debt contracts explain the sign of borrowers' vol-untary changes in accounting methods. We focus on accounting method changes becauseBeatty, Ramesh, and Weber (2002) document that borrowers willingly pay higher interestrates to retain the flexibility to make voluntary accounting method changes that affect bank

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debt contract calculations. We therefore expect borrowers to make use of this costly flexi-bility by making voluntaryaccountingmethodchangesto affect contractcalculations.Does Allowing Accounting Changes to Affect Debt Contract Calculations InfluenceAccounting Choice?Previous researchexaminingwhetherdebt covenants affect borrowers'decisions tochangeaccountingmethodsgenerallyassumes that the calculationsstipulated n the cove-nantswill be based on currentaccountingmethods.Forexample,Healy andPalepu(1990)examinewhetherborrowersclose to violatingtheir dividend covenantrestrictions,whichare typically defined as a percentageof net income or retainedearnings, change theiraccountingmethods o increase hoselimits.Similarly,Sweeney(1994) investigateswhetherborrowersuse accountingchangesto avoidviolatingfinancialcovenantsdesignedto mon-itor borrowers' performance. However, Mohrman (1996) and Beatty, Ramesh, and Weber(2002) document that debt contract calculations are often based on the accounting rulesthat the borrowerused when the contractoriginated.For these contracts,the borrowercannotuse changes n accountingmethods o avoid covenantviolations.The cross-sectionalvariation in the effects of accounting method changes on contract calculations provides anaturalsetting that allows us to investigatethe effects of debt contractingon borrowers'decisionsto makeaccountingmethodchanges.Ourfirsthypothesisis thatborrowerswho change accountingmethodswill be morelikely to make income-increasing(ratherthan income-decreasing)accounting methodchanges when such changes affect covenant calculations.Do the Expected Costs of Covenant Violations Influence Accounting Choice?Watts and Zimmerman (1986, 215-216) argue that costly covenant violations giveborrowers an incentive to make income-increasing accounting method changes to createslack in covenants; however, evidence on the actual magnitude of the cost of covenantviolations is mixed. On the one hand, Beneish and Press (1993) provide evidence thatcovenant violations that lenders have not waived as of the financial-reportingdate cost theborrower an average 80 basis point increase in the interest rate the lender charges on theloan after renegotiation. Furthermore, Healy and Palepu (1990) find that firms close tocontractually imposed dividend limitations generally cut the dividends they pay rather thanviolate the dividend-restrictingcovenants or change their accounting methods to circumventthe covenants. These findings suggest that borrowers perceive violating dividend restrictioncovenants to be more costly than cutting dividends. On the other hand, Dichev and Skinner(2002) report that lenders may commonly waive technical violations prior to the financialreporting date, and they argue that waived covenant violations are unlikely to be very costlyto the borrower. These results suggest that the cost of technical covenant violations will belower the morelikely it is for the lenderto waive violations.Our second hypothesis is that borrowers whose bank debt contracts allow voluntaryaccounting changes to affect contract calculations will be less likely to make income-increasing (rather than income-decreasing) accounting method changes when they expectlower technical default costs.Does Performance Pricing Influence Accounting Choice?We expect performance pricing, which is a relatively new debt-contracting feature, togive borrowers an additional incentive to make income-increasing accounting changes be-yond the incentive provided by covenants. Accounting-based performance pricing explicitlymakes the interest charged on a bank loan a function of the borrower's financial ratios,

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such as debt to EBITDA, leverage,or interestcoverage.That is, the interest rate in thecontract s not fixed over the length of the loan but varies inverselywith changes in ac-countingmeasuresof financialperformance,which are typically assessed quarterlyusingthe previousfour quarters'results. Performancepricing may increasethe importanceofdebt contracts n accountingchoiceby providinga more continuousand direct inkbetweenaccounting nformationand interestrates than covenantsprovide.Asquithet al. (2002) provide descriptiveevidenceon this new featurefoundprimarilyin bank debtcontracts.They document hat at the inceptionof the contract he interestratechargedon the loan is rarelyabove the top level or below the bottom evel of the perform-ance-pricinggrid, that the averagegrid has five levels, and that the averageincrease ininterest rates charged when the borrower'sperformancedeterioratesone performance-pricing evel is 15 basis points. Beatty,Dichev,andWeber(2002) document hata contractwith performancepricing typicallyhas a covenantbased on the performancepricingratiothat is set at one level of performancebelow the worst level included n the grid.Becauseperformance-pricingridshave multiple evels, deteriorationsn a borrower'sperformancemay resultin a new performance-pricingevel, and thus a higherinterestrate,even if theborrower'sperformancenever deterioratesenough to violate the covenant. In addition,improvementsn a borrower'sperformancemay result in a lower interest rate if the bor-rower reaches a betterperformance-pricingevel. Thus,we expect performancepricingtoprovidean additional ncentive orborrowerso make ncome-increasing ccountingmethodchanges.Ourthirdhypothesis s thatborrowerswith debt contractsallowing voluntaryaccount-ing methodchanges to affect contractcalculations will be more likely to make income-increasing(rather han income-decreasing)accountingmethodchanges if their contractsincludeaccounting-based erformancepricingin addition o traditional ovenants.

Do Dividend Restrictions Influence Accounting Choice?Borrowers' ncentivesto makeincome-increasing ccountingmethodchanges may alsodependon whether theirdebt contractscontain dividendrestrictionsbased on accountingperformance.Debt contractsoften have covenants hat eitherexplicitlylimit dividendpay-ments to be less than a given percentageof net income, or implicitly limit dividendpaymentsby includingcovenantsaffectedby dividends e.g., networth,tangiblenet worth,or leverageratiocovenants).The incentivesto makeincome-increasingather han ncome-decreasingaccountingmethodchanges providedby covenants thatexplicitly or implicitlyrestrictdividendsmay differ fromthose providedby other covenants(e.g., workingcapitalor coverageratiocovenants).Healy andPalepu(1990) suggestthatborrowers'ncentivetomake an income-increasingaccountingchange may be lower for covenantsaffectedbydividendpayments,because borrowershave the option to reduce dividends ratherthanviolating the covenant.On the otherhand,Sweeney (1994) documents hatcovenants af-fectedby dividendpaymentsaremorelikely thanothercovenants o be binding,suggestingthatthey may give borrowersa greater ncentive to make an income-increasing ccountingchange. Thus, we are unable to predictthe directionin which dividendrestrictionswillaffectborrowers'accountingchoices.Our fourthhypothesisis thereforea nondirectional ne: the likelihoodthat borrowerswith debt contractsallowing voluntaryaccountingmethodchangesto affect contractcal-culations make income-increasing(ratherthan income-decreasing)accounting methodchanges will depend on whethertheir debt contractscontain accounting-baseddividendrestrictions.

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TheAccounting eview, anuary003III. RESEARCH DESIGNAll of our tests use a sample of borrowerswho have bank debt and who have alsomade voluntary changes in their accounting methods. Focusing on firms that make account-

ing changes has the advantage of requiring that the firms have enough flexibility to makean accountingchange.Firms that want to makeincome-increasing ccountingchangesbutare unable to do so should make no such changes and thereforenot be includedin oursample.This increases the powerof our tests relativeto priorresearch hat examines thedebt-contracting ypothesisusing samplesof borrowerswho are close to violatingcove-nants,which suffers from the problemthat many of these borrowersmay not have theflexibility to make accounting changes.We focus on the effect of bank debt (rather than public debt) provisions on the bor-rower's voluntary accounting method changes for three reasons. First, Beatty, Ramesh, andWeber(2002) find that,in contrast o publicdebt, there is variation n whetherbank debtcontracts allow voluntary accounting changes to affect contract calculations. Second,El-GazaarandPastena(1991) find that bank debt contractsvirtuallyalwayscontaincove-nants,whereaspublicdebtoften does not, and that the covenants n bank debtaretypicallytighter than those in public debt.' Third, Asquith et al. (2002) find that, unlike public debt,many bank debt contracts have performance-pricing provisions, an innovation that likelyprovides additional incentives for firms to make income-increasing accounting changes.The greatercross-sectionalvariation n whetheraccountingchangesaffect contractcalcu-lations, combined with the potentially greater importance of covenants and performancepricing in bank debt compared to public debt, should increase the power of our tests.Testing Hypotheses 1 and 2

We test our first hypothesis by examining whether a borrower's decision to make anincome-increasing (rather than an income-decreasing) accounting method change dependson whether that change affects debt contract calculations. We test our second hypothesisby examining whether this relation depends on the expected costs of technical covenantviolations. To control for other incentives for making income-increasing accounting methodchanges, such as those provided by management compensation contracts, asset pricing, andexternal parties like the IRS, as described by Fields et al. (2001), we estimate the followinglogistic regression:INCREASE = Po + PiACC_Change + ,20ne_Lender + P3COMP + I4SMLOSS

+ PsSMLOSS_NL + P6LGLOSS + I7LGLOSS_ACEO+ P8NOL+ fgSIZE + E, (1)where:

Dependent Variable:INCREASE = 1 if the accounting method change increases income and equity,0 otherwise.

Our examination of public debt and private placement agreements that are available online revealed that few ofthese contracts contained covenants or accounting-based performance pricing.

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Debt-ContractingndependentVariables:ACC_Change= 1 if contractallows accountingchanges to affect calculations,0otherwise;andOne_lender= 1 if accountingmethodchangesaffect debt contractcalculationsand a single lender makes the loan, 0 otherwise.ControlVariables:COMP= 1 if the firmindicates that the managers'bonusesdependon fi-nancialperformanceand the CEO received a bonus in the yearpriorto the accountingchange,0 otherwise;SMLOSS= 1 if the firm'searningsbefore the effect of the accounting hangeis between0 and -1 percentof assets, 0 otherwise;SMLOSS_NL= 1 if the firm'searningsbefore the effect of the accounting hangeis between0 and -1 percentof assets and the firm is not listedon a majorstock exchange,0 otherwise;LGLOSS= 1 if the firm'searningsbefore the effect of the accounting hangeis less than -1 percentof assets, 0 otherwise;LGLOSS_ACEO= 1 if the firm'searnings,before the effect of theaccounting hange,is less than -1 percentof assets and the firm'sCEOchangedinthe year priorto the accountingchange,0 otherwise;NOL = 1 for borrowerswho have a net operating oss carryforwardndmakean accountingchangethat has a taxeffect,0 otherwise;andSIZE = the log of the firm's assets before the effect of the accountingchange.

Our dependent variable is a simple dichotomous variable that equals 1 if the accountingchange increases the current period net income, and 0 if the accounting method changedecreases net income.Debt-Contracting VariablesTo test our first hypothesis, our logit includes a dichotomous independent variable(ACC_Change) that equals 1 if the borrower has any bank debt contracts that allow ac-counting changes to affect contract calculations, 0 otherwise. To classify the effect ofaccounting changes on a borrower's contract calculations, we obtain copies of all of thebank debt contracts the borrower has entered at the time of the accounting change. We thenuse an approach similar to Mohrman (1996) and Beatty, Ramesh and Weber (2002) toidentify whether accounting changes affect the contract calculations. Specifically, we clas-sify a contract as not allowing voluntary accounting changes to affect calculations if thecontract states either (1) that the borrower shall not make any significant change in ac-counting treatmentor reporting practices, except as required by generally accepted account-ing principles (GAAP) or (2) that accounting terms will be based on financial informationprepared in accordance with GAAP as in effect and applied on the date of the agreement.If any of a borrower's bank debt contracts allow accounting changes to affect calculations,we then set ACC_Change equal to 1. Only when all of the firm's bank debt contractsprohibit accounting changes from affecting calculations do we set ACC_Change equal tozero.To test our second hypothesis, we include a dichotomous independent variable(One_lender) equal to 1 if accounting method changes affect debt contract calculations anda single lender makes the loan, 0 otherwise. Asquith et al. (2002) argue that renegotiation

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costs are lower when there is a single lender, because contracts typically require a majority,supermajority, or unanimous consent of all lenders to waive a covenant. Therefore, theexpectedcosts of technicaldefault are lower when there is only one lender.2Control VariablesTo isolate the relationbetween accounting changes and debt contractingcosts, wecontrol for firms' other incentives to make accounting changes. In their summary of theempirical and theoretical accounting choice literature, Fields et al. (2001) suggest thatmanagement compensation contracts, asset pricing, and external parties such as the IRSprovide additional incentives affecting firms' accounting choices beyond those provided bydebtcontracting.To control for incentivesarising from accounting-based ompensationcontracts,weinclude a dichotomous variable (COMP) equal to 1 if a firm indicates that its managers'bonuses depend on accounting-based measures and its CEO received a bonus in the yearprior to the accounting change. We expect firms that pay accounting-performance-basedbonuses to be more likely than other firms to make income-increasing (ratherthan income-decreasing)accountingmethodchanges.To captureborrowers' sset-pricingncentivesto manageearnings,we control for bor-rowers'potentialattempts o increaseshareprices by avoidingreporting loss. Specifically,we include two variables o controlfor borrowers'use of accountingchangesto achievethe positive earningsthresholdBurgstahler nd Dichev (1997) document.We set the firstvariable (SMLOSS) equal to 1 if the firm would have reported a loss of 1 percent of assetsor less priortoohe effect of the accountingchange.These firmshavean incentiveto makean income-increasing ccountingchangeto avoidreportinga loss. We construct he secondvariable (SMLOSS_NL) by interacting SMLOSS with a dichotomous variable equal to 1for firms not listed on a major stock exchange, 0 otherwise. Based on the results reportedin Beatty,Ke, and Petroni(2002), we expect firms not listed on a majorexchangeto haveless incentive to avoid missing earnings benchmarks.For firms expecting to reporta large loss in the absence of an accountingchange,management compensation and asset-pricing incentives may prompt managers to increasethe magnitude of the loss to create reserves for the future. We include two variables tocontrol for this "big bath" incentive. The first variable (LGLOSS) equals 1 if the firmwould have reported a loss greater than 1 percent of assets prior to the effect of the ac-counting change. We construct the second variable (LGLOSS_ACEO) by interactingLGLOSS with a dichotomous variable equal to 1 if the firm changed CEOs in the yearprior to the accounting change, 0 otherwise. We expect the big bath incentive to be higherfor new CEOs who can use poor past performance to explain the magnitude of the loss.To control for borrowers' tax incentives to change accounting methods, we include adichotomous variable (NOL) equal to 1 for borrowers who have net operating loss carry-forwards, and who also make accounting changes that have tax effects; 0 otherwise. Weexpect firms with NOL carryforwards to be more likely than others to make income-increasing accounting method changes that affect tax accounting.Finally, we include the log of a firm's assets to control for firm size (SIZE). We makeno prediction about the effect of firm size on the likelihood the manager makes an income-increasing rather than income-decreasing accounting method change.2 This hypothesis assumes that the covenants in contracts with single lenders are similar to the covenants incontracts with multiple lenders. We investigate the validity of this assumption, and find that the average numberof covenants is virtually the same.

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Testing Hypotheses 3 and 4To test our third and fourth hypotheses, we re-estimate our model by substituting thespecific type of debt contract feature affected by the accounting method changes for ourACC_Change variable. We partition firms whose contracts allow accounting changes toaffect contract calculations into four mutually exclusive categories: those with neither per-formance pricing nor dividend restriction provisions; those with performance-pricing butno dividend restrictions; those with dividend restrictions but no performance-pricing; andthose with both performance-pricing and dividend restrictions. Specifically, we estimate thefollowing logistic regression:INCREASE = Po + PlaNoPPorDiv_Res + IlbPP + P,cDiv_Res

+ PldPP&Div_Res + p20ne_Lender + P3COMP + P4SMLOSS+ PsSMLOSS_NL + P6LGLOSS + p7LGLOSS_ACEO+ 3sNOL + P9SIZE+ e, (2)

where:NoPPorDiv_Res = 1 if the contract allows accounting changes to affect contractcalculations but contains neither an accounting-based perform-ance-pricing provision nor an accounting-based dividend restric-tion, 0 otherwise;PP = 1 if the contract allows accounting changes to affect contractcalculations and contains an accounting-based performance-pricing provision but not an accounting-based dividend restric-tion, 0 otherwise;Div_Res = 1 if the contract allows accounting changes to affect contractcalculations and contains an accounting-based dividend restric-tion but not an accounting-based performance-pricing provision,0 otherwise; andPP&Div_Res = 1 if the contract allows accounting changes to affect contractcalculations and contains both an accounting-based performancepricing provision and an accounting-based dividend restriction, 0otherwise.

All other variables are as defined in Model (1).Since all borrowers in our sample have some type of accounting-based covenant, thisresearch design allows us to examine the incremental effect of performance pricing and todifferentiate between covenants that are linked to dividend restrictions vs. those that arenot.IV. SAMPLETo obtain a sample of firms that have bank debt and also made material voluntaryaccounting changes, we conduct a keyword search on the Lexis/Nexis database.3When a

firm makes a nonmandated accounting change, the Securities and Exchange Commission3We searched he 10-Ksand 10-Qsfiled on theLexis/Nexis databaseusingthephrase"exhibit18"and"Letterre Change n AccountingPrinciples."

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(SEC) requires the firm's independent accountant to issue a "preferability letter" com-menting on whether they prefer the new accounting method relative to the prior method.The firm must file these letters with the SEC as exhibit 18 in their annual 10-K or quarterly10-Q financial statements.To identify firms that change accounting methods, we search all 10-K and 10-Q reportsavailable on Lexis/Nexis from 1995 through 2000 for exhibit 18 disclosures. Then we readeach exhibit 18 report to determine whether the firm made a material accounting change.Table 1 describes the results of this sample selection process. This search yields a sampleof 296 firms that made accounting changes from January 1, 1995, through June 30, 2000.From these 296 firms, we exclude 48 that made accounting changes that had no effect onincome statement or balance sheet accounts (e.g., changes in the format of the incomestatement, changes in the definition of a cash equivalent, or immaterial changes in account-ing methods) and we also exclude two firms whose preferability letters were actually formandatory accounting changes. We also excluded five firms that were banks oras d banksas significant subsidiaries, because banks' accounting method choices may be affected byregulatory incentives.We then used the debt footnotes to determine the amount and type of debt outstanding,and used the exhibit list at the end of each filing to determine whether the borrower fileda debt contract and, if so, the exact filing that includes that debt contract. Based on this

TABLE1Sample SelectionProcessBorrowersMaking Material Voluntary AccountingMethod Changes during 1995-2000

Firmsthat filed "preferabilityetters"with the SECa 296Less:Firmsthat madeaccounting hangesthat had no effect on balancesheetor incomestatement accountsb 48

Financial institutions 5Firmsthat mademandatory ccounting hanges mproperly lassifiedas voluntary hanges 2Firmswith no bank debtor with immaterial ankdebt 65

Nonfinancialirmswith materialbankdebtthat madematerialvoluntary ccounting hanges 176Less:Firmswithbankdebtthat exceedsthe SEC'smaterialityhresholdof 10 percentof assets,butdo not report ilingthe debtcontractwiththe SECin their10-Kexhibit list 24

Firmsthat indicated n their 10-Kexhibit ist that bankdebt was filed with the SEC,butwe could not findthe contracton EDGARC 27Firms n oursample 125aWhena firm makesa nonmandatedccounting hange,the SECrequires he firm's ndependent ccountantoissue a "preferabilityetter"commenting n thepreferabilityf the new accountingmethodrelative o thepriormethod.b Examples ncludechanges n the formatof the incomestatement,hanges n the definitionof a cashequivalent,or immaterial hanges n accountingmethods.cAlthoughmostof theindicatedilingsare available nglobalaccess,we cannot onfirmwhether he debtcontractswerefiledor examine iled contractsbecauseoursubscriptionoesnot allowus to view most of thesefilings.

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BeattyandWeber-Effects of DebtContracting n AccountingChanges

analysis, we excluded another 65 firms with no bank debt or with immaterial bank debt.4These adjustments left a sample of 176 nonfinancial firms with material bank debt that alsomadevoluntarymaterialchangesin accountingmethods.For each of these 176 borrowers,we systematicallysearched their debt footnotes,10-Ks, 10-Qs, 8-Ks, and all their registration tatements iled online to obtaincopies oftheir debt contracts.We identified24 firms whose footnotes indicatethatthey have a ma-terialbank debt contract,but whose exhibit indexes indicate thatthey did not file copiesof the bank debt with the SEC. More specifically, we examin the exhibitindex ine ie theborrower's 10-K filed before and after the accounting change to determine whether theborrower filed the bank debt contract. For each of these 24 firms, no reference to any bankdebt contracts appeared in the entire exhibit index. If the exhibit indexes of the 10-Ks filedbefore and after the accounting change did not mention bank debt, we assume that theborrower never filed it with the SEC.5 In addition, we could not access debt contracts foranother 27 firms, even though their exhibit index indicates that they filed bank debt contractswith the SEC.6 Because our study focuses on the effects of debt contract provisions suchas covenants, dividend restrictions, and performance pricing on borrowers' voluntary ac-counting changes, and we do not know whether these debt contracts allowed accountingchanges to affect contract calculations, we must exclude these 51 borrowers from thesample.This sample selection process yielded our final sample of 125 firms.7 Although oursample attrition rate is high, we argue that our inferences are unlikely to be an artifact ofsample selection bias for two reasons. First, we examine the types of accounting changesmade by the firms we exclude, and the effects of these changes on net income, to ensurethat our data requirements are not systematically related to our dependent variable. We findthese firms' accounting changes are remarkably similar to those made by the sample firms.Of the 51 firms excluded from the sample, 29 (57 percent) made income-increasing ac-counting changes and 22 (43 percent) made income-decreasing accounting changes, com-pared to 54 percent increases and 46 percent decreases in our sample firms. The differencebetween these two groups is not statistically significant. As for the sample firms, the mostcommon accounting changes for the excluded firms were, in order of frequency, for inven-tory, depreciation/capitalization, and revenue recognition. Thus, we conclude that our datarequirements did not result in an endogenous sample selection bias.Second, we compare other characteristics of our sample firms and the excluded firmsto ensure that these two groups of firms are not systematically different on other dimensions.Specifically, we compare asset sizes, leverage ratios, and the proportion of borrowers re-porting small and large losses before the effect of the accounting changes. None of these4 Rule 601 of regulationSK allows borrowers ome latitude n filingtheirdebtcontracts.Specifically,he SECrequiresborrowers o file a copy of a debt contractf it is material,wheretheSECgenerallydefinesmaterialityas 10 percentof the firm'sassets. See Press and Weintrop 1990) for more discussion of the SEC's filingrequirementsorprivatedebtcontracts.Weclassified irmsas having mmaterial ankdebt f no bankdebtfilingswere listedin their exhibit ndexesand the amountof the bank debtdisclosed n theirfootnoteswas less than10 percentof their assets.5 We tested the validityof this assumptionby conducting xhaustiveonlinesearches or debtcontracts or eachof these firms,and we were unable to locate copies of any of the bankdebtoutstanding t the time the firmmade the accounting hange.Theinability o findanycontracts nlinesupportsheassumptionhat he 24 firmsnever filed thesedebt contractswith the SEC.6 Althoughmost of the indicated ilings are availableon the GlobalAccess database,we can neitherconfirmwhether hese 27 firms filed nor can we examineany contracts hese 27 firmsmighthave filed becauseoursubscriptiono ThomsonFinancialdoes not allow us to view most of thesefilings.7 Our ogit regressions equireadditional ata,reducing he samplesize to 121 in thatanalysis.

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130 The AccountingReview,January 003

characteristics was significantly different between our sample and the excluded borrowers.Furthermore,we confirmed that these characteristics did not differ between the sample andexcluded borrowers after partitioning on the accounting changes' effect on net income.Descriptive StatisticsTable 2 provides descriptive evidence on our sample firms' accounting method changes.The sample is split fairly evenly between income-increasingand income-decreasingac-counting changes, with 67 increases and 58 decreases. The most common change is in themethod of accounting for inventory, which represents 42 percent of our sample. Of the 53inventory accounting changes, 41 are changes from LIFO to some other inventory account-ing method, 6 are changes from FIFO to LIFO, and 6 are other changes in inventorymethods, such as changes in overhead allocation. Changes in capitalization of assets, de-preciation, and revenue recognition methods each represent roughly 15 percent of the vol-untary accounting changes in our sample. Nearly two thirds of the changes in capitalizationreduced income, whereas the split between increases and decreases is fairly even for de-preciation changes and changes in revenue recognition as well as for the sample as a whole.

V. RESULTSUnivariate AnalysisTable 3 presents univariate analyses of the direction and (signed) magnitude (scaled byassets before the effect of the change) of the income effect of the accounting methodchange. Panel A of Table 3 presents the actual and expected (assuming independence)number of income-increasing vs. income-decreasing accounting changes for borrowerswhose debt contracts allow voluntary accounting changes to affect calculations vs. thosethat do not. We find that 75 borrowers have at least one debt contract that allows voluntarychanges to affect contract calculations, and 50 of our borrowers do not have any bank debtcontracts that allow voluntary accounting changes to affect calculations. The accounting

TABLE2AccountingMethod ChangesPartitionedby Effect on Income for BorrowersMakingVoluntary AccountingMethod Changesduring 1995-2000

Typeof AccountingChange Total Income-Increasing Income-DecreasingCapitalizingo expensingcosts or expensing 19 7 12to capitalizingDepreciation olicies 18 10 8Gains on pensionassets 4 4 0Goodwill 5 0 5Inventory ccounting-from LIFO 41 23 18Inventoryaccounting-from FIFO 6 4 2Inventory ccounting-Other 6 6 0Revenuerecognition 14 6 8Other 12 7 5

Total 125 67 5825 67 58otal


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TABLE 3Tests of Independencebetween WhetherAccounting Changes Affect Contract Calculationsand the Sign and Magnitudeof the Effect of the Accounting Change on IncomePanelA: ContingencyTableof Actual and (Expected)Numberof FirmsMakingAccountingChanges,Testingor Independence etween WhetherAccountingChangesAffectContractCalculationsand WhetherAccountingChangeis Income-Increasings.Income-Decreasing

AccountingMethod AccountingMethodChangesAffect ChangesDo Not AffectContractCalculations ContractCalculations TotalIncome-increasing 46 21accountingchange (40.2) (26.8) 67Income-decreasing 29 29 58accountingchange (34.8) (23.2)Total 75 50 125

Testof independence Chi-square .51 p-value0.04PanelB: WilcoxonRankSum Testof Independence f Distribution f IncomeEffectof AccountingMethodChange or Borrowerswith Debt ContractCalculationsAffectedor NotAffectedbyAccountingMethodChanges

AccountingMethod AccountingMethodChangesAffect ChangesDo NotAffectContractCalculations ContractCalculations

Actual ranksum 69.42 53.36Expectedranksum (63) (63)Test of independence Z-statistic2.42 p-value0.008

method change increases income for 61 percent (46/75) of borrowers whose debt contractsallow the changes to affect calculations vs. only 42 percent (21/50) of borrowers whosecontracts do not allow voluntary accounting changes to affect the calculations. The Chi-square statistic for independence of these two characteristics is 4.51, which is significantat the 4 percent level.Panel B of Table 3 presents the actual and expected (assuming independence) rank sumof the magnitude of the income effect of the accounting method change for borrowerswhose debt contracts allow voluntary accounting changes to affect calculations vs. thosethat do not. We find that when accounting method changes affect the contract calculations,borrowers make accounting changes that more positively affect income. We perform aWilcoxon rank sum test of the distribution of the income effect of the accounting changefor borrowers with debt contract calculations affected by accounting method changes vs.those without, and reject independence of the distribution of the income effect of the ac-counting change across these two types of borrowers at the 0.008 level.Table 4 presents the means and standarddeviations of our independent variables, par-titioned by the direction in which the accounting change affects income, as well ast-statistics for the differences between the means of these two groups. Several of the debt-contracting variables differ significantly between borrowers making income-increasing (vs.

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TABLE 4Mean and (StandardDeviation)of IndependentVariables Partitionedby the Effect of theAccountingMethod Change on Income

VariableDebtContractingVariables

Acc_ChangeNoPPorDiv_ResPPDiv_ResPP&Div_ResOne_Lender

ControlVariablesCOMPSMLOSSSMLOSS_NLLGLOSS

LGLOSS_ACEONOLSIZE

NLISTACEO

Numberof Firmsa(continued on next page)

PredictedSign ofDifference

+

+

+

+

+

+

+

+

+

+?

Income-IncreasingMean(std. dev.)

0.69(0.46)0.09

(0.29)0.13(0.34)0.25

(0.44)0.21

(0.41)0.09

(0.29)

0.57(0.50)0.18

(0.39)0.03

(0.39)0.19

(0.40)0.02

(0.40)0.12(0.33)13.51(1.89)0.15

(0.36)0.08

(0.27)67

Income-DecreasingMean(std. dev.)

0.50(0.50)0.19

(0.40)0.07(0.26)0.14

(0.44)0.10

(0.31)0.17

(0.38)

0.34(0.48)0.16

(0.37)0.12

(0.37)0.31

(0.47)0.12

(0.47)0.16(0.37)13.18(1.83)0.36

(0.48)0.18

(0.38)58

DifferenceMean(t-statistic)

0.19(2.15)**

-0.10(-1.63)

0.06(1.22)0.11

(1.65)*0.11

(1.64)*-0.08

(-1.38)

0.23(2.53)***0.02

(0.35)-0.09

(-1.89)*-0.12

-(1.63)*-0.10

(-2.41)***-0.04(-0.58)

0.33(1.00)

-0.21(-2.81)***-0.10

(-1.59)*

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BeattyandWeber-Effects of Debt Contracting n AccountingChangesTABLE 4 (continued)

***, **, and * Indicate significance at the 1 percent, 5 percent, and 10 percent levels, respectively, for one- ortwo-tailed ests as appropriate.aWe could not obtain proxy statements for four borrowers, so there are only 121 observations for the COMP,LGLOSS_ACEO,nd ACEOvariables.Variable DefinitionsDebtContractingVariables:ACC_Change 1 if contractallowsaccounting hangesto affectcalculations, otherwise;NoPPorDiv_Res = 1 if the contract allows accounting changes to affect calculations but contains neither anaccounting-based erformance ricingprovisionnor an accounting-basedividend estriction,0 otherwise;PP = 1 if the contractallowsaccounting hangesto affectcalculations nd containsanaccounting-based performancepricing provisionbut not an accounting-based ividendrestriction,0otherwise;

Div_Res = 1 if thecontractallowsaccounting hanges o affectcalculations nd containsanaccounting-baseddividendbut not an accounting-basederformance ricingprovision,0 otherwise;PP&Div_Res= 1 if the contractallows accounting hangesto affectcalculationsand containsboth an ac-counting-based erformance ricingprovisionand an accounting-basedividend estriction,otherwise;andOne_lender= 1 if accountingmethodchangesaffectdebtcontractcalculationsand a single lendermakesthe loan,0 otherwise.ControlVariables:COMP= 1 if the firm indicates hat the managers'bonusesdependon financialperformancend theCEOreceiveda bonusin the year prior o the accounting hange,0 otherwise;SMLOSS= 1 if the firm'searnings,before the effect of the accountingchange,is between0 and -1percentof assets,0 otherwise;SMLOSS_NL= 1 if the firm'searnings,before the effect of the accounting hange,is between 0 and -1percentof assets andthe firm s not listedon a majorstockexchange,0 otherwise;LGLOSS= 1 if the firm'searnings,before the effect of the accounting hange, s less than -1 percentofassets,0 otherwise;LGLOSS_ACEO = 1 if the firm's earnings, before the effect of the accounting change, is less than -1 percent ofassets and the firm'sCEOchanged n the yearprior o the accounting hange,0 otherwise;NOL = 1 for borrowers hathave a net operatingoss carryforwardnd makean accounting hangethat has a tax effect,0 otherwise;SIZE= the log of the firmsassets before the effect of the accounting hange;NLIST= 1 for firmsnot listedon a major tockexchange,0 otherwise; ndACEO= 1 if the firm'sCEOchanged n the year prior o the accounting hange,0 otherwise.

income-decreasing)accountingchanges. Voluntary hanges in accountingmethods affectdebt contract calculations for 69 percent of the firms that make income-increasing account-ing method changes, compared to only 50 percent of those that make income-decreasingchanges. Borrowers that make income-increasing accounting method changes are morelikely to face dividend restrictions affected by those changes than are borrowers who makeincome-decreasing accounting changes.Table 4 also reportsthat some of our control variablesdiffer significantlybetweenborrowerswho make income-increasingvs. income-decreasingchanges. Borrowerswhopay their executives bonuses based on accounting performance are more likely to makeincome-increasing accounting method changes. An income-increasing accounting methodchange is less likely to be made by an unlisted firm that reports a small loss, or by aborrower that reports a large loss, especially if the firm changed its CEO in the year of theaccounting change.

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The Accounting Review, January2003

Correlations among Independent VariablesFields et al. (2001) suggest thata limitationof previousaccountingchoice studies isthat they typically examine only one potential motive for making accounting choices, with-out controlling for other possible motives. The correlations among our independent varia-bles reported in Table 5 provide evidence on the extent of the "correlatedomitted variable"problemassociatedwith focusingon a single motive.In general,we observe no significantcorrelationsbetweenour debt-contractingaria-bles (ACC_Change, NoPPorDiv_Res, PP, Div_Res, and One_Lender) and other factors thatmight influence the accounting choice decision (COMP, SMLOSS, SMLOSS_NL,LGLOSS, LGLOSS_ACEO, NOL, SIZE, NLIST, and ACEO). In particular,whether a debtcontract allows accounting method changes to affect contract calculations (ACC_Change)is not significantly correlated with any of the control variables. The second column ofTable 5 does show, however, that when accounting changes affect contract calculationsand no accounting-based performance-pricingor dividend restrictions exist (i.e.,NoPPorDiv_Res =1), borrowers are less likely to pay their executives a bonus based onaccounting performance and are more likely to report large losses. These correlations sug-gest that it may be important o control for management ompensationand incentives tomeet earningsbenchmarkswhen we test our debt-contracting ypotheses.Manyof ourindependent ariablesarecorrelatedwithborrower ize. Specifically, argerborrowers are more likely to have accounting-based dividend restrictions that are not com-bined with performance pricing, and are more likely to pay their executives accounting-basedperformance onuses.Meanwhile, argerborrowers'debtcontractsare less likely toallow accounting changes to affect contract calculations when there are no dividend restric-tions or performance pricing. Larger borrowers are also less likely to report a large lossbefore the effect of the accounting change, or an NOL, and are less likely not to list theirshares on a major exchange. Not surprisingly, borrowers with NOLs are more likely toreport losses, either large or small; are more likely to experience CEO turnover; and areless likely to pay theirexecutivesa bonusbasedon accountingperformance.Regression AnalysisTable6 reports he resultsof our logistic regressions.Model (1), which we use to testHypotheses 1 and 2, has explanatory power of 24.3 percent. This model correctly classifies81.6 percentof the accountingmethodchangesas increasingor decreasing ncome,com-paredto a naive predictionaccuracyrateof 55.4 percent f we assume that all accountingchangesincrease ncome.The secondmodel,whichwe use to test Hypotheses3 and4, hasslightlyhigherexplanatorypowerat 27.8 percentandcorrectlyclassifies 84 percentof theaccountingchangesas eitherincome-increasing r income-decreasing.8The significantlypositivecoefficienton ACC_Changen Model (1) indicatesthatbor-rowers that change accounting methods are more likely to make changes that increaseincome when the changes affect debt contract calculations. Following Amemiya (1981,1488), we convert the estimated coefficient to a change in probability by multiplying theestimated ogit coefficientby 0.25. Borrowersare 39 percent(1.57 x 0.25) morelikely tomake income-increasing rather han income-decreasing)accountingchanges when their8 The sign and magnitude of the effect of the accounting change are the same on both net income and net worthwhen the firm accounts for changes in accounting methods using either the cumulative effect or prospective

method. However, 22 of our sample borrowers use the retroactiveapproach,where changes in accounting methodshave different income statement and net worth effects. Excluding these firms from our analyses does not alterour conclusions.

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TABLE 5Pearson Correlationsamong IndependentVariables(significancelevels in parentheses)ACC_ NoPPor Div- PP&Div_ One_ SM SM LG

Change DivjRes PP Res Res Lender COMP LOSS LOSS_NL LOSSACC_ChangeNoPPorDiv_Res

1.000.33(0.00) 1.00

PPDiv-ResPP&Div_ResOne_LenderCOMPSMLOSSSMLOSS_NLLGLOSSLGLOSS_ACEO

0.28 -0.14 1.00(0.00) (0.13)0.41 -0.19 -0.17 1.00(0.00) (0.02) (0.06)0.36 -0.17 -0.15 -0.22

(0.00) (0.05) (0.10) (0.01)0.31 0.27 -0.13 0.23(0.00) (0.00) (0.15) (0.00)0.01 -0.23 -0.00 0.12(0.94) (0.01) (0.99) (0.19)0.02 0.01 -0.01 -0.06(0.80) (0.92) (0.89) (0.48)0.04 -0.02 0.11 -0.06(0.67) (0.82) (0.23) (0.49)0.09 0.20 0.11 -0.15(0.31) (0.02) (0.23) (0.10)0.09 0.19 0.12 -0.13(0.34) (0.04) (0.18) (0.15)

1.000.03 1.00(0.76)0.12 0.03 1.00(0.1I9) (0.76)0.10 -0.04 0.05 1.00(0.29) (0.63) (0.55)0.05 -0.01 -0.01 0.62 1.00(0.60) (0.88) (0.90) (0.00)0.00 0.06 -0.09 -0.26 -0.16 1.00(0.98) (0.53) (0.33) (0.01) (0.07)

-0.02 0.10 -0.19 -0.12 -0.07 0.46(0.85) (0.27) (0.04) (0.20) (0.44) (0.00


19/25

TABLE 5 (continued)ACC_ NoPPor Div- PP&Div- One- SM SM LGChange Div-Res PP Res Res Lender COMP LOSS LOSS_NL LOSS

NOL 0.04 0.05 0.09 -0.08 0.02 -0.01 -0.18 0.00 0.16 0.31(0.67) (0.60) (0.30) (0.37) (0.84) (0.89) (0.04) (0.92) (0.07) (0.00SIZE -0.04 -0.24 -0.07 0.24 -0.04 -0.39 0.21 0.10 -0.10 -0.22

(0.67) (0.01) (0.43) (0.01) (0.70) (0.00) (0.02) (0.29) (0.27) (0.01NLIST -0.02 0.04 -0.01 -0.10 0.05 0.06 -0.16 0.19 0.49 0.14(0.80) (0.64) (0.88) (0.26) (0.56) (0.53) (0.07) (0.04) (0.00) (0.1IA~CEO 0.06 0.08 0.11 0.00 -0.09 0.16 -0.11 -0.03 0.10 0.25(0.51) (0.41) (0.22) (0.98) (0.34) (0.07) (0.72) (0.72) (0.27) (0.01Variables are defined in Table 4.


20/25


TABLE 6Coefficientsand (t-statistics)from Logit Regressionsof the Sign of the Income Effect ofVoluntaryAccounting Changeson Debt Contractingand Control VariablesSample of 64 Income-Increasingand 57 Income-DecreasingVoluntary AccountingMethodChanges, 1995-2000

Variable

InterceptDebt ContractingVariables

Acc_ChangeNoPPorDiv_ResPPDiv_ResPP&Div_Res

One_lenderControlVariables

COMPSMLOSSSMLOSS_NL

LGLOSSLGLOSS_ACEONOLSIZE

PseudoR2PercentCorrectlyPredicted

+-2.36

(-2.99)***

***, **, and * Indicatesignificanceat the 1 percent,5 percent,and 10 percent evels, respectively,or one- ortwo-tailed ests as appropriate.Variables re defined n Table4.

PredictedSign

+

+

Model(1)Coefficient(t-statistic)2.36

(1.28)

Model(2)Coefficient(t-statistic)2.92

(1.49)1.57

(3.19)***+

+

+

0.20(0.26)2.34

(2.42)***1.84

(2.72)***2.01

(2.52)***-2.41

(-2.72)***

+

+

+-+

1.31(2.71)***1.69

(1.87)**-5.13

(-3.23)***-1.01

(- 1.69)**-2.04

(-1.62)*1.14

(1.49)*0.24

(1.74)*24.3%

1.15(2.32)***1.96

(2.14)**-5.91

(-3.42)***-0.96

(- 1.55)*-2.59

(- 1.78)**1.29

(1.62)*0.28

(1.89)*27.8%

81.6 84.0

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debt contracts allow the accounting changes to affect contract calculations.9 This supportsour first hypothesis, that debt contracting is an important consideration in borrowers' ac-counting method change decisions.The significant negative coefficient on One_Lender is consistent with our second hy-pothesis that borrowers that change accounting methods are less likely to make income-increasing accounting changes when the expected costs of technical default are lower, asshould be the case when all of their bank debt contracts are from a single lender.Model (2) partitions ACC_Change into four mutually exclusive subgroups to provideevidence on our third hypothesis (that performance pricing provides additional incentivesbeyond those provided by traditional covenants) and our fourth hypothesis (that the incen-tives provided by covenants restricting dividend payments, either directly or indirectly, maydiffer from those provided by other covenants). The significantly positive coefficient on PPindicates that borrowers that make accounting changes are 59 percent (2.34 x 0.25) morelikely to make income-increasing accounting method changes when the changes not onlyaffect their covenants, but also affect their interest rates through performance-pricing pro-visions. This supports our third hypothesis. The coefficient on Div_Res indicates that bor-rowers are 46 percent (1.84 x 0.25) more likely to make income-increasing (rather thanincome-decreasing) accounting method changes when the changes affect their dividendrestrictions. This is consistent with our fourth hypothesis. The coefficient on PP&Div_Resindicates that borrowers with both performance-pricing and dividend restrictions are 50percent (2.01 x 0.25) more likely to report income-increasing accounting method changesthan are borrowers with neither performance-pricing nor dividend restrictions. However,the coefficient on this variable is not significantly different from the coefficients on PP oron Div_Res. The insignificant coefficient on NoPPorDiv_Res indicates that we find noevidence that borrowers without performance-pricing or dividend restrictions were morelikely to report income-increasing accounting method changes.We also find some evidence that management compensation incentives influence thechoice between income-increasing and income-decreasing accounting method changes. Spe-cifically, when managers receive accounting-based performance bonuses (COMP) they aremore likely to make income-increasing changes. In addition, consistent with a "big bath"story, borrowerswith new CEOs who report large losses before the effects of the accountingmethod changes (LGLOSS_ACEO) are more likely to report income-decreasing accountingchanges than income-increasing changes.We also find some evidence that noncontracting motives to manage earnings affectborrowers' decisions to make income-increasing vs. income-decreasing accounting methodchanges. Specifically, we find borrowers with shares listed on a major exchange expect-ing to report a small loss prior to the accounting method change (SMLOSS) are morelikely to report an income-increasing change, while those not listed on a major exchangeare more likely to report an income-decreasing change (SMLOSS_NL). This is consistentwith the Beatty, Ke, and Petroni (2002) conclusion that exchange-listed firms are morelikely to manage earnings to beat earnings benchmarks than are firms that are not listed ona major exchange.Finally, we find some evidence that external parties affect accounting choices. Specif-ically, borrowers with NOL carryforwards who make accounting changes affecting taxes

9 The conversionactor s obtainedby taking hederivative f thepredicted robabilitywithrespect o aparticularindependent ariable.Fora linearprobabilitymodelthat derivative qualsthe estimated oefficient.Fora logitmodelthatderivative qualsthe estimated oefficientmultipliedby the exponential f the predictedprobabilitydividedby the squareof 1 plustheexponential f the predictedprobability.

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are more likely to make income-increasing accounting changes than borrowers without suchcarryforwards.VI. SENSITIVITY ANALYSIS

Signed Magnitude of Income EffectThe tests of our hypotheses reported in Table 6 examine the sign of the income effectof the accounting method change but not the magnitude of the effect. In Table 7, we reportthe results of rank regressions of the signed magnitude of the income effect of the account-ing change, scaled by assets before the effect of the change. The results are largely con-sistent with those from our logistic analyses. As our first hypothesis predicts, borrowersmake accounting changes that have more positive effects on income when the accountingchanges affect their debt contract calculations. Consistent with our second hypothesis, bor-rowers make accounting changes that have a less positive effect on income when the ac-counting changes affect their debt contract calculation, but the costs of covenant violationare lower because all of their bank debt contracts are with a single lender. With respect toour third and fourth hypotheses, borrowers whose bank debt has performance-pricing anddividend restrictions make accounting changes that have a more positive effect on incomeand, in fact, these appear to be the two most significant debt-contracting factors explainingthe magnitude of the income effect. The results on our control variables largely conformto the results from our previous analyses. However, the performance-based executive bonuscompensation variable (COMP) is insignificant in our rank regressions.We examine the sensitivity of our rank regression results to two alternative specifica-tions. First, we re-estimate the regressions without ranking the data. After winsorizing thedependent variable for three outliers that fall more than 5 standard deviations from themean, we obtain results similar to those in Table 7. We also obtain similar results whenwe re-estimate the rank regressions using the unscaled income effect of the accountingmethod change as the dependent variable.Debt-Contracting VariablesWe consider all bank debt contracts when we construct our debt-contracting variables.However, these variables do not incorporate covenants on non-bank debt. Since covenantson non-bank debt typically allow accounting changes to affect contract calculations (seeSmith and Warner 1979), we include a dichotomous variable (PUB_COV) equal to 1 forfirms with covenants on non-bank debt. When we include PUB_COV as another debt-contracting variable its coefficient is insignificant and our other results remain similar. Wealso include another variable equal to 1 if the borrower has public debt and accountingchanges do not affect bank-debt calculations, 0 otherwise (PUB_COV x [1 - ACC_COV]).Again, the coefficient on this variable is insignificant, indicating that covenants on publicdebt do not appear to affect whether borrowers' accounting changes are income-increasingvs. income-decreasing, regardless of whether these accounting changes affect bank debtcalculations. Our other results remain similar.Our debt-contracting variables capture the average effect of accounting-based covenantson the decision to record an income-increasing vs. an income-decreasing accounting change.However, this relation is likely to differ cross-sectionally, reflecting differences in expectedcost of future violations. Since our One_Lender variable measures these differences onlyindirectly, we considered an alternative (indirect) proxy as an additional debt-contractingvariable in our analyses. Following El-Gazaar and Pastena (1991), we consider the numberof covenants as a measure of tightness of covenant restrictions. The number of covenantsis not significant in our models. This may indicate either that the initial covenant tightness

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TABLE 7Coefficientsand (t-statistics)from Rank Regressionsof the Effect of VoluntaryAccountingChangeson the Income Effect of the Accounting Change (Scaled by Assets Before the Effectof the Change)on Contractingand Control VariablesSample of 64 Income-Increasingand 57 Income-DecreasingVoluntaryAccountingMethodChanges, 1995-2000Model(1) Model(2)Predicted Coefficient CoefficientVariable Sign (t-statistic) (t-statistic)

50.30 53.14Intercept + (5.79)*** (5.99)***DebtContractingVariableACC_Chang 20.98+ (3.21)**

4.57NoPPorDiv_Res + (0.44)34.25

PP + (3.27)***26.25

Div_Res + (2.86)***15.82PP&Div_Res + (1.70)**

-32.27One_Lender (-3.04)**ControlVariables

COMPSMLOSSSMLOSS_NL

LGLOSSLGLOSS_ACEONOLSIZE

AdjustedR2

+

+

+

+

8.58(1.34)*27.56(2.62)***

-41.56(-2.59)**-0.95(0.11)

-20.53(- 1.45)*17.16(1.76)**

-0.05(-0.53)

15.25%

-29.57(-2.63)***6.65

(1.02)32.02(3.04)***

-47.60(-2.97)***

0.64(0.08)-20.14(- 1.43)*

16.42(1.71)**

-0.09(-0.87)

17.8%***, **, and * Indicate ignificanceat the 1 percent,5 percent,and 10 percent evels, respectively,or one- ortwo-tailedestsas appropriate.Variable re defined n Table4.

140

ic

ic

ic


24/25


is not an important determinant of the subsequent accounting choice decision, or that thenumber of covenants is not a good proxy for covenant tightness.VII. CONCLUSIONS

Fields et al. (2001, 301) argue that "research on accounting choice addresses the fun-damental question of whether accounting matters." However, they also state that "the ev-idence on whether accounting choices are motivated by debt covenant concerns is incon-clusive." By analyzing contract-specific details, we provide sharper evidence on theimportance of debt contracts in borrowers' accounting choices. Specifically, our tests cap-italize on the facts that (1) many recent debt contracts do not allow borrowers to usevoluntary accounting method changes to affect contract calculations, (2) debt contracts ofteninclude performance pricing features as well as debt covenants, and (3) debt contractingdecisions may affect accounting choices of borrowers who are not approaching covenantviolations.

We find that borrowers that make accounting method changes are more likely to makeincome-increasing changes when their debt contracts allow these changes to affect contractcalculations. This increase in likelihood of an income-increasing accounting change is lowerwhen the borrower expects costs of technical violation to be lower because all of theborrower's bank debt is from a single lender. These results, which hold even after control-ling for other motives for changing accounting methods (such as executive compensationincentives, incentives to meet earnings benchmarks, and incentives to reduce taxes), suggestthat debt contracts influence borrowers' accounting choices. We also find that borrowersthat voluntarily change their accounting methods are more likely to make income-increasingchanges if their debt contracts include accounting-based performance-pricing or dividendrestrictions. These results suggest that incentives to lower interest rates through performancepricing or to retain dividend payment flexibility influence borrowers' accounting methodchoices, thereby providing indirect evidence addressing the Fields et al. (2001) fundamentalquestions of whether, under what circumstances, and how accounting choice matters.Our focus on contract-specific details for borrowers who need not be approachingcovenant violations creates two important data limitations. First, our tests do not includeborrowers that do not file their bank debt contracts with the SEC because contract-specificinformation is unavailable for these borrowers. This could affect the generalizability of ourresults if the relation between debt contracting and accounting choice differs for theseborrowers. To mitigate this concern we provide evidence that these borrowers made vol-untary accounting changes that are similar to those made by our sample borrowers. Inaddition, we document that the excluded borrowers and sample borrowers are similar alonga number of dimensions including firm size, income before the accounting change, andleverage.Second, we cannot directly test whether an accounting change (1) reduced the interestrate charged on the loan based on the performance pricing grid, (2) increased the borrower'sflexibility to pay dividends, or (3) reduced the likelihood the borrower would violate acovenant. Since our sample includes borrowers that may be making accounting changesnot only to affect the current debt contracting calculations, but also future calculations, wewould need to estimate the effect of their accounting change on the interest rate, dividendspaid, and covenant violations both in the quarterof the accounting change, and in all futurequarters that could be affected by the accounting change as well. Since most borrowershave equity-based covenants and dividend restrictions, this means an accounting changewould affect all future calculations until the debt matures. In addition, it is difficult todevelop such estimates using only publicly available currentperiod data. For example, when

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we use balance sheet data available in the financial statements, the ratios we calculate arenot equal to the ratios used in the debt contracts. For all these reasons, we leave it to futureresearch to quantify the effects of borrowers' voluntary changes in accounting methods ontheir interest rates, dividend payments, and probability of covenant violations.REFERENCES

Amemiya,T. 1981. Qualitative esponsemodel:A survey.Journalof EconomicLiterature19 (De-cember):1483-1586.Asquith,P., A. Beatty,and J. Weber.2002. Performance ricingin privatedebt contracts.Workingpaper,Massachusetts nstituteof Technology,Cambridge,MA.Beatty,A., I. Dichev,and J. Weber.2002. The role and characteristicsf accounting-basederform-ance pricing n privatedebt contracts.Workingpaper,Universityof Michigan,Ann Arbor,MI., B. Ke,andK. Petroni.2002. Earningsmanagemento avoidearningsdeclinesacrosspubliclyand privately held banks. The Accounting Review 77 (July): 547-570., K. Ramesh,and J. Weber.2002. The importance f accountingchangesin debtcontracts:Thecost of flexibility n covenantcalculations. ournalof AccountingandEconomics33 (June):205-227.

Beneish, D., and E. Press.1993.Costs of technicalviolationof accounting-basedebt covenants.TheAccounting Review 68 (April): 233-257.Burgstahler,D., andI. Dichev. 1997. Earningsmanagemento avoidearningsdecreasesand losses.Journal of Accounting and Economics (December) 24: 99-126.Dichev, I., and D. Skinner.2002. Large-samplevidenceon the debt covenanthypothesis.JournalofAccounting Research 40 (September).El-Gazaar,S., and V. Pastena. 1991. Factorsaffectingthe scope and initial tightnessof covenantrestrictionsn privateendingagreements.ContemporaryccountingResearch8 (Fall):132-151.Fields, T., T. Lys, and L. Vincent.2001. Empiricalresearchon accountingchoice. Journalof Ac-counting and Economics 31 (September): 255-307.Healy, P., and K. Palepu. 1990. Effectivenessof accounting-based ividendcovenants.JournalofAccounting and Economics 12 (January):97-124.Mohrman,M. 1996. The use of fixed GAAPprovisions n debtcontracts.AccountingHorizons10(September): 8-91.Press, E., and J. Weintrop.1990.Accounting-basedonstraintsn publicandprivatedebtagreements:Theirassociationwith leverageand impacton accountingchoice. Journalof AccountingandEconomics 12 (January):65-95.Smith, C., andJ. Warner. 979. On financialcontracting:An analysisof bondcovenants.JournalofFinancial Economics 7 (June): 117-161.Sweeney,A. 1994. Debt-covenantviolationsand managers'accountingresponses.Journalof Ac-counting and Economics 17 (May): 281-308.Watts,R., and J. Zimmerman. 986. PositiveAccountingTheory.EnglewoodCliffs,NJ:PrenticeHall.

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