Bank debt covenants and firms’ responses to FAS 150 liability recognition: evidence from trust preferred stock

Abstract

We examine the relation between accounting-based debt contracts and the economic response of firms with trust preferred stock (TPS) to mandated liability recognition under Financial Accounting Standard (FAS) 150. Our results show that firms' financial covenants significantly affect their choice to redeem versus reclassify their outstanding TPS. Specifically, firms with bank debt covenants that would be adversely impacted by recognizing TPS as a debt liability are 26.88% more likely to redeem their TPS after FAS 150. We also find that firms are significantly more likely to redeem versus reclassify their TPS after FAS 150 if they used the original TPS proceeds to retire existing debt (id est, to enhance their balance sheets). Our findings suggest that when bank debt contracts use ''floating'' Generally Accepted Accounting Principles (GAAP) to construct financial covenant terms, changes in the underlying GAAP measure significantly influence firms' economic behavior.

Mandatory accounting change and debt covenant violation: Additional evidence from SFAS 150

“…Model 1 relates to testing H1a. Consistent with the test variable of Moser et al (2011), AFFECT captures the presence of a debt contract adversely affected by SFAS 150. In particular, AFFECT is coded 1 for sample firms subject to private debt containing leverage or covenant constraints that will be tightened upon SFAS 150 adoption, 0 otherwise.…”

“…To proxy for managers’ concerns over the impact of a mandatory accounting change on firms’ violation likelihood, prior literature has used several alternatives. One proxy is the existence of a debt covenant constraint that will be tightened due to the mandatory accounting change (Moser et al, 2011). While this proxy considers the accounting-based features of debt covenants by focusing on only those covenants whose compliance is affected by changes in accounting, it presumes an equal impact of a mandatory accounting change on violation likelihood irrespective of a firm’s actual proximity to violating the covenant constraint.…”

“…Moser et al (2011) find that firms, in response to SFAS 150, are more likely to redeem trust preferred stock (TPS) rather than reclassify as a liability when subject to financial covenants whose constraints will be tightened by recognising TPS as a liability. My study is related to, but differs from, the work of Moser et al (2011) on several grounds. First, TPS is equivalent to straight debt for tax purposes, with dividend payments to TPS holders being deductible.…”

“…Given the tax considerations TPS issuers face in deciding whether to restructure to avoid SFAS 150, which MRPS issuers do not face, it is reasonable to assume their responses to SFAS 150 may differ. Second, Moser et al (2011) examine whether firms’ decision to redeem is associated with the presence of a debt covenant affected by SFAS 150, while I quantify the magnitude of the decision to redeem and examine whether the magnitude of redemption is also associated with either the proximity to covenant thresholds prior to, or the increase in proximity to covenant thresholds due to, SFAS 150. Third, my study separates the balance sheet and income statement effects of SFAS 150 by examining the impact of SFAS 150 on proximity to leverage and interest coverage covenant violation individually.…”

“…Third, my study helps resolve how to measure managers' concerns over the likelihood of violating a financial covenant due to a mandatory accounting change. Conflicting evidence exists as to whether managers' decision to avoid covenant violation due to a mandatory accounting change is influenced by the existence of a financial covenant that will be tightened by the accounting change (Moser et al, 2011), the tightness of the covenant constraint prior to the accounting change (Collins et al, 1981;Espahbodi et al,1995Espahbodi et al, , 1991Leftwich, 1981;Lys, 1984;Salatka, 1989) or the increase in tightness of the covenant constraint due to the accounting change (Begley, 1990;El-Gazzar, 1993;Watts and Zimmerman, 1986). The findings of my study help resolve such mixed evidence by testing all three measures of violation likelihood.…”