Costs of Technical Violation of Accounting-Based Debt Covenants

• Published in: The Accounting review 1993-04, Vol.68 (2), p.233-257
• Main Authors: Beneish, Messod D., Eric Press
• Format: Article
• Language: English
• Subjects: A Forum on the Effects of Violating Debt Covenants; Accounting theory; Cost estimates; Covenants; Credit management; Debt contracts; Debt management; Debt refinancing; Debt repayment; Financial leverage; Financial management; Fines & penalties; Interest costs; Interest rates; Lenders; Loan agreements; Market value; Statistical analysis; Studies; Violations; Waivers
• ISSN: 0001-4826; 1558-7967

Costs associated with the violation of accounting-based covenants in debt agreements are presumed to be material by both accounting regulators and researchers. The Financial Accounting Standards Board, for example, delayed the implementation of its pronouncement on pension reporting, SFAS No. 87, for two years to allow firms sufficient time to "renegotiate or to obtain waivers of provisions of some legal contracts" (FASB 1985, par. 260). Numerous studies in accounting research hypothesize that it is costly for firms to violate accounting covenants in debt agreements, and this supposition figures in research on such issues as the economic impact of mandated and voluntary accounting changes (see, e.g., Holthausen 1981; Leftwich 1981; Lys 1984) and the determinants of accounting choice (see, e.g., Trombley 1989; Zmijewski and Hagerman 1981). Although research in financial economics has studied some of the costs shareholders bear when there are debt service defaults or bankruptcy filings, the costs associated with technical violation-the violation of covenants other than debt service-have not been documented. This study investigates the costs of technical violation for a sample of 91 firms that violated accounting-based covenants in debt agreements between 1983 and 1987. The sample includes firms for which the technical violation was sufficiently material to merit disclosure. We provide direct evidence of refinancing and restructuring costs by examining changes in terms of debt agreements, and changes in investing and financing decisions. Refinancing costs arise because lenders raise interest rates on loans and notes following violation. We estimate that increased interest costs resulting from violation range between 0.84 and 1.63 percent of the market value of sample firms' equity. Restructuring costs stem from lenders' demands for partial or full repayment. Nearly half the sample firms either refinanced their debt or divested assets within one year of violation, stating that the proceeds were to reduce the outstanding balances of violated debt agreements. We estimate that the costs of restructuring debt represent an average of 0.37 percent of sample firms' market value of equity. We also present some evidence that there are costs associated with modifying operations, although we cannot estimate their magnitude; lenders' repayment demands impose restructuring costs by forcing firms to eliminate profitable investment projects. In addition to these costs, incre