1. The Effect of Debt Contracting on Voluntary Accounting Method Changes
Presented By:
Ira geraldina
Intan Oviantari
Nova Novita

2. Outline Introduction Research Questions Hypothesis Development
Methodology
Results
Sensitivity Analysis
Conclusions

3. INTRODUCTION
Debt contracts that make covenant thresholds a function of financial ratios give borrowers an incentive to change accounting methods to avoid costly covenant violations
(WZ, 1986)
The evidence on whether accounting choices are motivated by debt covenant concerns is inconclusive
(Fields et al., 2001)

4. Notes to Previous Researches
It does not use the details of firms’ actual debt contracts assumes that contract calculations are based on current accounting methods
It focuses exclusively on debt covenants, ignores other accounting-based features of debt contracts, such as performance pricing
It focused on borrowers who were either close to violating or had already violated covenants

5. Beatty & Weber Research
Examine accounting methods changes on income increasing choices for firms that allows to do so by debt contract
Examine the effect of accounting based performance pricing as incentive to increasing income by changing accounting methods
Examine all accounting changing motivations

6. Primary Research Question
Firm’s bank contracts
Accounting Choices
Income increasing or decreasing

7. Specifics Research Questions
Does allowing accounting changes to affect debt contract calculations influence accounting choice?
Do the expected costs of covenant violations influence accounting choice?
Does performance pricing influence accounting choice?
Do dividend restrictions influence accounting choice?

8. Hypothesis Development (Q1)
Healy & Palepu (1990)
Change accounting methods to increase dividend covenant restrictions limits
Sweeny (1994)
Change accounting methods to avoid violating financial covenant designed to monitor borrowers’ performance
Mohrman (1996); Beatty et al (2002)
Debt contract calculations are often based on the accounting rules

9. H1
Borrowers who change accounting methods will be more likely to make income-increasing (rather than income-decreasing) accounting method changes when such changes affect covenant calculations

10. Hypothesis Development (Q2)
WZ, 1986
Costly covenant violations give borrowers an incentives to make income increasing accounting methods changes to create slack in covenants
Benish & Press (1993)
Covenant violations cost the borrowers an average 80 basis point increase in the interest rate the lender charges on loan after renegotiation
Healy & Palepu (1990)
Firms preferred to cut the dividends they pay rather than violate the dividend restricting covenant

11. H2
Borrowers whose bank debt contracts allow voluntary accounting changes to affect contract calculation will be less likely to make income increasing (rather than income-decreasing) accounting method changes when they expect lower technical default cost

12. Hypothesis Development (Q3)
Asquith et al (2002)
Interest rate charged on loan in the average increase in interest rates charged when the borrowers ‘ performance one performance pricing level is 15 basis points
Beatty et al (2002)
A contract with performance pricing has a covenant based on the performance pricing ration
Performance pricing provide an additional incentive for borrowers to make income increasing accounting method changes

13. H3
Borrowers with debt contracts allowing voluntary accounting method changes to affect contract calculations will be more likely to make income increasing (rather than income decreasing) accounting changes if their contracts include accounting based performance pricing in addition to traditional covenants

14. Hypothesis Development (Q4)
Healy & Palepu (1990)
Borrowers incentive to make an income increasing accounting change may be lower for covenants affected by dividend payments
Sweeney (1994)
Covenants affected by dividend payments are more likely than other covenants to be binding, give a greater incentive to make an income increasing accounting chan

15. H4
The likelihood that borrowers with debt contracts allowing voluntary accounting method changes to affect contract calculations make income increasing (rather than income decreasing) accounting method change will depend on whether their debt contracts contain accounting based dividend restrictions

16. Methodology-Research Design H1 & H2

17. Methodology-Research Design H3 & H4

18. Sample
To Identify firms that change accounting method, We search all annual 10-K or quarterly 10-Q reports available on Lexis/Nexis from for exhibit 18 disclosures.
Then read each exhibit 18 report to determine whether the firm made a material accounting change.
Table 1 describe the results of this sample selection process.

20. We argue that our inferences are unlikely to be an artifact or sample selection bias for two reasons.
First, we examine the types of accounting changes made by the firms we exclude. And the effects of these changes on net income, to ensure that our data requirements are not systematically related to our dependent variable. We conclude that our data requirements did not results in an endogenous sample bias.
Second, we compare other characteristics or our sample firms and the exclude firms to ensure that our data these two groups of firm are not systematically different on other dimensions. We confirmed that these characteristics did not differ between the sample and exclude borrowers after partitioning on the accounting changes’ effect on net income.

21. Descriptive Statistics
Table 2 provides descriptive evidence on our sample firm’s accounting method changes.

22. Results – Univariate Analysis

25. Correlation Among Independent Variables

26. Correlation Among Independent variables

28. Table 6 Model 1 Test H1 and H2 has explanatory power of 24,3% Model 2

29. Support H1 (Table 6 Model 1)
Acc_Change:
Significant and positive coefficient
Indicates; borrower more likely to make changes that increase income when the changes affect debt contract calculation
Amemiya (1981,1488):
∆ prob X 0.25
Borrowers are 39% (1.57x0.25) more likely to make income increasing accounting changes when their debt contracts allow the accounting changes to affect contract calculation

30. Support H2 (Table 6 Model 1)
One_Lender:
Significant negatif
Technical default cost are lower = less likely to make income increasing acc changes

31. Support H3 (Table 6 Model 2)
PP: significant and positive
59% (2.34x0.25) borrower more likely to make income increasing when the changes not only affect their covenant, but also affect their interest rates through performance pricing provision

32. Support H4 (Table 6 Model 2)
Div_Res:
Significant positive
46% (1.84x0.25) borrowers are more likely to make income increasing acc method changes when the changes affect their dividend restriction

33. Table 6 Model 2
PP&Div_Res significant and positive: indicates that borrowers with both performance pricing and dividend restriction are 50% (2.02x0.25)
The insignificant coefficient on NoPPorDiv_Res indicates that we find no evidence that borrowers without performance pricing or dividend restriction were more likely to report income increasing acc method changes.

34. Management Compensation Incentive
Management compensation incentives influence the choice between income increasing and income decreasing acc method changes.
When managers receive accounting-based performance bonuses (COMP) they are more likely to make income icreasing changes.
Consistent with a “big bath”story, borrowers with new CEOs who report large losses before the effect s of the accounting method changes (LGLOSS_∆CEO) are more likely to report income decreasing accountingchanges._

35. Noncontracting Motives
Noncontracting motives to manage earnings affect borrowers’ decisions to make income increasing vs income decreasing acc method changes.
Borrowers with share listed on a major exchange expecting to report a small loss prior to the acc method change (SMLOSS) are more likely to report an income increasing changes, while those not listed on a major exchange are more likely to report an income decreasing change (SMLOSS_NL)
This is consistent with Beatty, Ke and Petroni (2002) conclusion that exchange –listed firms are more likely to manage earnings to beat earnings benchmark than are firms that are not listed on a major exchange.

36. External Parties External parties affect accounting choices
Borrowers with NOL carryforwards who make accounting changes affecting taxes are more likely to amke income-increasing accounting changes than borrowers without such carryforwards.

37. Sensitivity Analysis (Table 7)
Signed Magnitude of Income Effect
Debt Contracting Variable

38. Signed Magnitude of Income Effect (Table 7)
The result are largely consistent with those from logistic analysis (table 6).
Support H1: borrowers make accounting changes that have more positive effects on income when the acc changes affect their debt contract calculation.
Support H2: borrowers make acc changes that have a less positive effect on income when the acc changes affect their debt contract calculation,but the costs of covenant violation are lower because all of their bank debt contracts are with a single lender.
Support H3 and H4: borrowers whose bank debt has performance pricing and dividend restrictions make acc changes that have a more positive effect on income and, in fact, these appear to be the most significant debt contracting factors explaining the magnitude of the income effect.
The result on control variable largely conform to the result from previous analyses.
The performance based-executive bonus compensation variable (COMP) is insignificant in rank regressions.
Of covenant violation

39. The Sensitivity of Rank Regression (Table 7)
First specification
Re-estimate the regression result without ranking the data.
After winsorizing the dependent variable for three outliers that fall more than 5 standard deviation from the mean
Obtain result similar to those in table 7
Second specification
Obtain similar result when re-estimate the rank regression using the unscaled income effect of the accounting method changes as dependent variable.

40. Debt Contracting Variable
(PUB_COV) equal to 1 for firm with covenants on non bank debt (another debt contracting variable)
Coefficient (PUB_COV) is insignificant
See Smith and Warner, 1979
(PUB_COV X (1-ACC_COV) equal to 1 if the borrower has public debt and accounting changes do not affect bank-debt calculation
(PUB_COV X (1-ACC_COV) is insignificant indicating that covenant on public debt do not appear to affect whether borrower’ accounting changes are income increasing vs income decreasing regardless of whether borrowers’ acc changes affect bank debt calculations.

41. Debt Contracting Variable
One_Lender
See El-Gazaar and Pastena, 1991
The number of covenants is not significant in this model
Indicate either that the initial covenant tighness is not an important of the subsequent acc choice decision, or that the number of covenants is not a good proxy for covenant tighness

43. Fact
(1) Many recent debt contract do not allow borrowers to use voluntary accounting method changes to affect contract calculation
(2) Debt contracts often include performance pricing features as well as debt covenants
(3) Debt contracting decisions may affect accounting choices of borrowerswho are not approaching covenant violations

44. Conclusions Income Increasing
When debt contracts allow these changes to affect contract calculation.
The increase of income increasing lower
When the borrower expect cost of technical violation to be lower because all of the borrowers’ bank debt is from a single lender.
These results, which hold even after controlling other motives
Executive compensation incentives, incentives to meet earning benchmark, and incentives to reduces taxes.

45. Conclusions
Borrrower that voluntary change their acc methods →Income increasing → if their debt contracts include acc-based-performance pricing or dividend restriction
Incentives to lower interest rate through performance pricing or to retain dividend payment influence borrower acc choices
Addresing Fields et al.(2001) fundamental question of whether, under what circumtances, and how accounting chice matters

46. Data Limitations 1
Do not include borrower that do not file their bank debt contracts with SEC
To mitigate this concern, provide evidence that these borrowers made voluntary acc changes 2
Cannot directly test whether an accounting changes