Firms' Off‐Balance Sheet and Hybrid Debt Financing: Evidence from Their Book‐Tax Reporting Differences

Abstract

We match large U.S. corporations' tax returns during 1989-2001 to their financial statements to construct a firm-level proxy of firms' use of off-balance sheet and hybrid debt financing. We find that firms with less favorable prior-period Standard & Poor's (S&P) bond ratings or higher leverage ratios in comparison to their industry report greater amounts of interest expense on their tax returns than to investors and creditors on their financial statements. These between-firm results are consistent with credit-constrained firms using more structured financing arrangements. Our within-firm tests also suggest that firms use more structured financing arrangements when they enter into contractual loan agreements that provide incentives to manage debt ratings. Specifically, we find that after controlling for S&P bond rating and industry-adjusted leverage, our sample firms report greater amounts of interest expenses for tax than for financial statement purposes when they enter into performance pricing contracts that use senior debt rating covenants to set interest rates. Furthermore, we find that the greatest book-tax reporting changes occur when firms become closer to violating these debt rating covenants. These latter findings are consistent with firms' contractual debt covenants influencing their use of off-balance sheet and hybrid debt financing. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2005.

Do rating agencies cater? Evidence from rating-based contracts

“…Column 2 reports the coefficients for the main control variables Leverage, Opmargin, and Tangibility. Prior research on off-balance-sheet-finance finds that credit-constrained firms are more likely to raise off-balance-sheet debt (Beatty et al, 1995;Mills and Newberry, 2005). Consistent with this claim, I find OFFBS decreases in Opmargin and increases in Tangibility.…”

“…Thus, I control for borrower characteristics that determine credit risk and that would be reflected in the rating agency's adjustments, such as leverage, profitability, size, and short-term liquidity. Factors similar to those determining the choice of debt, as well as financial reporting benefits, drive the use of off-balance-sheet finance (Beatty et al, 1995;Mills and Newberry, 2005). The proportion of debt in the capital structure depends on the riskiness of the underlying cash flows and asset tangibility.…”

“…When debt contracts rely on accounting-based covenants, debt holders are likely to provide 10 Borrowers also choose off-balance-sheet debt to raise external finance because of its financial reporting treatment. The off-balance-sheet treatment results in financial reporting benefits, such as reporting a lower balance sheet-based leverage ratio to comply with covenants or to appear less risky (Beatty et al, 1995;Engel et al, 1999;Mills and Newberry, 2005). The rating agency's estimate of off-balance-sheet debt is based on the borrower's disclosures.…”

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

“…9 This finding complements prior evidence that changes in the short-term versus long-term classification of debt on the balance sheet have implications for managing leverage ratios (Gramlich et al 2001) and for debt-rating downgrades (Gramlich et al 2006). 10 A discussion of these consolidation rule differences is provided in Mills and Newberry (2005). In a typical arrangement, the company creates a trust that issues nonvoting preferred stock and transfers the proceeds to the parent company as a loan.…”

Will a departure from tax-based accounting encourage tax noncompliance? Archival evidence from a transition economy

“…Most of the later period book-tax differences in our sample are similar to those found in US studies. However, our data do not have the differences due to sophisticated transactions such as off-balance-sheet financing using special purpose entities and debt-equity hybrid instruments that Mills and Newberry (2005) mention. Table 2 shows the results of our stage-one estimation of the probit regression for each of the three conformity periods.…”