Costs of technical violation of accounting-based debt covenants

Abstract

SYNOPSIS AND INTRODUCTION: 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

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