The Cost of Private Debt Covenant Violation
55 Pages Posted: 27 Sep 2009
Date Written: September 26, 2009
This study quantifies costs that firms are willing to incur to avoid violation of private debt covenants. The results indicate that as firms approach covenant violation they engage in income-increasing earnings management, which increases their tax liability. By estimating the extent of income-increasing activities and the additional tax costs incurred, this study arrives at a lower-bound estimate of the cost of violating private debt covenants. The mean (median) firm with relatively tight debt covenants increases its current tax liability by an amount equivalent to increasing the cost of debt financing by between 12.92 (10.72) and 22.72 (12.81) basis points (where firms with relatively loose debt covenants serve as the baseline). The magnitude of this estimate indicates that the expected costs of covenant violation are meaningful. Combined with recent evidence that private debt covenant violations occur frequently (Dichev and Skinner, 2002; Roberts and Sufi, 2009b), this implies debt covenants and expected violations are economically important.
Keywords: Debt Covenants, Book-Tax Conformity, Earnings Management, Accruals
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