The importance of accounting changes in debt contracts: the cost of flexibility in covenant calculations

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Journal of Accounting and Economics 33 (2002) 205–227The importance of accounting changes in debt
contracts: the cost of ?exibility in covenant
calculations$
Anne Beattya,*, K. Rameshb, Joseph Weberc
aSmeal College of Business, Pennsylvania State University, 215 Beam Business Adm. Building,
University Park, PA 16802, USA
b
Analysis Group/Economics, Cambridge, MA 02138, USA
c
Sloan School of Management, Massachusetts Institute of Technology, Cambridge, MA 02142, USA
Received 2 May 2000; received in revised form 30 November 2001Abstract
In this paper, we examine how the exclusion of voluntary and mandatory accounting
changes from the calculation of covenant compliance affects the interest rate charged on the
loan. After controlling for self-selection bias and other factors known to affect loan spreads,
we ?nd that the rate charged is 84 basis points lower when voluntary accounting changes are
excluded and 71 basis points lower when mandatory accounting changes are excluded. Our
results suggest that borrowers are willing to pay substantially higher interest rates to retain
accounting ?exibility that may help them avoid covenant violations and to avoid duplicate
record-keeping costs. r 2002 Elsevier Science B.V. All rights reserved.
JEL classi?cation: M4; G32
Keywords: Debt contracting; Accounting change; Covenant; Accounting choice$
We would like to thank Robert Bowen and Angela Davis (the referees), Paul Asquith, Paul Fischer,
Bob Holthausen, S.P. Kothari, Richard Leftwich, Thomas Lys (the editor), Jody Magliolo, Ed Maydew,
Karl Muller, Katherine Schipper, Linda Vincent, and seminar participants at the University of Chicago,
University of Florida and the Pennsylvania State University for helpful comments. Anne Beatty gratefully
acknowledges ?nancial support from PricewaterhouseCoopers.
*Corresponding author. Tel.: +1-814-863-0707; fax: +1-814-863-8393.
E-mail address: [email protected] (A. Beatty).0165-4101/02/$ – see…