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The purpose of this study is to investigate the relationship between off-balance-sheet (OBS) operating leases and long-term debt by analyzing firms’ debt risk profiles measured by the constraints on firms in the financial ratios in their debt covenants.

This study determines debt risk profiles using three measures: the ex ante probability of covenant violation (Demerjian and Owens, 2016), firms in violation of debt covenants and firms close to covenant violations.

High-risk firms according to all three measures, on average, have a significantly lower level of operating leases, indicating that these firms use OBS leases as a substitute for long-term debt. Interestingly, for firms operating in industries in which leases are widely available, firms with a high probability of covenant violation have a significantly higher level of operating leases, indicating that these firms use OBS leases as a complement to long-term debt. Further analysis indicates that lease financing is less costly than debt financing for these firms.

Overall, evidence of this study indicates that firms facing financial constraints may attempt to lease more of their assets, but the availability of leasing is constrained by their debt covenant obligations and the strength of the leasing market in its industry.

This study identifies states in which risky firms may treat leases as either complements or substitutes for long-term debt, implying that the leasing decision relates to the availability of an active leasing market for a firm’s assets and the firm’s financial constraints. The findings of this study support recent research showing that debt and leases are complementary in the presence of counterparty risk providing insight into the paradoxical relationship identified in prior research between leases and long-term debt.

We investigate the interaction of debt covenants and tax accounting on the adoption of Financial Interpretation No. 48 (FIN 48). We examine how firms respond to the potential tightening of covenant slack upon FIN 48 adoption and whether these actions are penalized by creditors and anticipated by equity markets. We find that upon FIN 48 adoption, the majority of sample corporate borrowers increase their tax reserves and reduce equity. Firms close to debt covenant violation were even more likely to increase tax reserves upon FIN 48 adoption; however, the size of the adjustment was relatively smaller, suggesting that the FIN 48 standards limited, but did not eliminate, firms use of discretion in reporting uncertain tax positions to avoid costly covenant violations. For firms near net worth debt covenant violation, the act of decreasing equity upon FIN 48 adoption imposes real economic costs, as the average cost of debt increased by 43 basis points. Finally, we extend prior research on the market response to FIN 48 by showing how the market response to FIN 48 adoption is a function of debt covenant slack and tax aggressiveness. Specifically, the cumulative abnormal return at the FIN 48 exposure draft release date is negative only for tax aggressive firms that are close to debt covenant violation.

Decision-making rationality is said to be bounded by managers’ cognitive capabilities. Recent studies indicate that accounting functions evolved to augment the cognitively bounded human brain in handling complex economic exchanges. The neuroscience discipline suggests that human brains have the ability to implement “automatic” processes of positive versus negative emotional stimuli to make rational decisions. Neuroscientific evidence shows that the activations in the ventral striatum decrease with negative emotional information/motives and increase with positive emotional information/motives. The authors, hence, argue that our understanding of the decision-making rationality in financial and managerial decisions could be enhanced by using a functional neuroimaging approach.

Decision-making rationality has been focal in debt covenant violation and earnings management research. The contracting theory predicts a relationship between managers’ decisions and the proximity of violating debt covenants. However, no prior research has investigated brain activities associated with the evaluation of debt covenant violation and earnings management. Meanwhile, in another strand of research, there is an extensive prior literature concerning the consequences of managers’ decisions and the use of accounting information in relation to their evaluative style, i.e., supervisory style. The authors argue that the relationship between the proximity to debt covenants violation and earnings management incentives is contingent upon managers’ supervisory style. However, no previous research has examined the impact of the supervisory style on earnings management in the context of the proximity to debt covenants violation and other earnings management incentives.

In this research note, we argue that neuroaccounting could be relied on to examine the relationship between the proximity to debt covenants and earnings management, contingent upon managers’ supervisory style, by capturing brain activities. The adoption of the neuroscience functional neuroimaging approach in this field should contribute to the understanding of managers’ behaviors and provide implications for research and practitioners. The goal of this research note is to provide a new avenue for future research in this field.

This study examines how creditor interventions after debt covenant violations affect corporate tax avoidance. Using a regression discontinuity design, we find that creditor interventions increase borrowers' tax avoidance. This effect is concentrated among firms with weaker shareholder governance before creditor interventions and among those with less bargaining power during subsequent debt renegotiations. Our results indicate that creditors play an active role in shaping corporate tax policy outside of bankruptcy.

Prior research provides evidence that firms make accounting choices to avoid violation of debt covenant provisions and the resulting costs of technical default. We extend this research by asking why some firms refrain from making accounting policy changes when faced with costs of technical default. We considered two possible explanations. First, we hypothesise that these defaulting firms may lack the flexibility to make accounting changes. Second, we hypothesise that these defaulting firms may lack incentive to change accounting methods. Results confirm prior research and indicate that defaulting firms make more accounting changes than non‐defaulting firms. The decision by defaulting firms to change or not change accounting methods during the three years ending in the year of a technical default of debt covenants can be explained in part by the ability of the firm and by the incentives of the firm to make a change.

The purpose of this paper is to evaluate the extent to which firms manage earnings prior to private debt issuance.

This is an empirical archival research paper using financial statement data and data related to private debt issuance.

The results indicate that, on average, firms engage in income-increasing earnings management in the period prior to a new private debt issuance. In addition, it was found that this income-increasing earnings management is limited to firms which have engaged in income-increasing earnings management to a greater extent in prior years.

This paper provides insight into how managers’ balance competing incentives to use income-increasing earnings management to obtain more favorable lending terms, and to use income-decreasing earnings management to reduce the risk of a future debt covenant violation. The results indicate that firms’ incentive to use income-increasing earnings management dominates. However, reputational concerns significantly constrain firms’ earnings management decisions prior to private debt issuance.

The paper fills a notable void in the literature by investigating firms’ earnings management activity prior to private lending agreements, and thereby provides new insights into both the relation between private debt and accounting quality, and the literature investigating the use of earnings management to avoid debt covenant violations.

The purpose of this paper is to investigate the association between the purpose of a loan and the type of debt covenants, separated into balance sheet-based and income statement-based covenants.

Using private loan deal observations obtained from the DealScan database over the period between 1996 and 2013, the authors classify the sample loan deals into three categories based on the purpose of borrowing, namely, borrowings for corporate daily operating purposes, financing purposes and acquisition and investing purposes. The authors conduct multinomial logistic regression analysis to test the relationship between the choice of financial ratios in a debt covenant and the purpose of a loan, controlling for financing constraints and other factors that have been identified as important to debt covenant analysis in prior studies.

The results provide evidence that the purpose of the loan is significantly associated with the type of debt covenants, suggesting that the lender and the borrower have considered the loan purpose when structuring their debt agreements. More specifically, the results indicate that the loans borrowed to fund acquisitions or long-term investment projects are more likely to have income statement-based covenants and less likely to have balance sheet-based covenants. In contrast, the loans borrowed for corporate daily operating purposes or financing purposes are more likely to contain balance sheet-based covenants relative to income statement-based covenants.

The authors show that loan purpose is significantly associated with the choice between income statement-based and balance sheet-based covenants. This result further illustrates ways in which accounting information improves contracting efficiency. The results are limited to the US market with its institutional structure. In future studies, it would be interesting to perform similar investigations on firms in other countries.

The findings contain important and economically significant implications indicating that loan lenders and borrowers agree to include different types of accounting information (that is, income statement- versus balance sheet-based financial ratios) in their loan covenants for different purpose loans.

Overall, the results provide important evidence regarding the connection between debt covenant structure and loan purpose. In doing so, it contributes to the literature on debt contract design (Dichev and Skinner 2002; Chava and Roberts 2008; Demerjian 2011; Christensen and Nikolaev 2012). Despite much interest in debt contract design, Skinner (2011) argues that there still exists incomplete knowledge of the economic factors that structure debt contracts. Income statement-based covenants depend on measures of profitability and efficiency and act as trip wires that transfer control rights to lenders when borrowing firms’ performance deteriorates. On the other hand, balance sheet-based covenants rely on information about sources and uses of capital and align interests between borrowing firms and lenders by restricting the borrower’s capital structure. The authors show that loan purpose is significantly associated with the choice between income statement-based and balance sheet-based covenants. This result further illustrates ways in which accounting information improves contracting efficiency.

This study is the first to identify differences in trends over time for the use of income statement- and balance sheet-based covenants as it relates to different loan purposes. The authors build on prior research to examine the degree to which loan purpose is associated with the choice between income statement-based and balance sheet-based covenants.

The purpose of this study is to examine the effect of bank interventions on bond performance in relation to loan covenant violations.

This paper tests the following questions: do bondholders receive benefits from bank interventions? Is bond performance related to the probability of bank interventions? Is the turnover of a chief executive officer (CEO) associated with bank interventions and bond performance? Abnormal bond returns, the difference between bond returns and matched bond index returns are used to measure bond performance. An estimated outstanding loan balance is used to measure the probability of bank interventions. CEO turnover is identified from proxy statements and categorized into forced and voluntary CEO turnovers. Event studies and regression analysis were used to answer the above research questions.

This paper finds that both short-term and long-term bond returns increase after covenant violations, bond performance is positively related to the probability of bank interventions, forced CEO turnovers are positively associated with the probability of bank interventions and firms with forced CEO turnovers tend to have superior bond performance.

This paper is the first to explore the relation between bank interventions and bond performance.

This study aims to examine whether managers use discretion in determining transitional goodwill impairment loss (initial impairment loss or IIL) upon the adoption of SFAS no. 142, Goodwill and Other Intangible Assets, and whether and how the market reacts to the impairment loss and to the absence of goodwill amortization.

Various empirical models are applied to a sample of 870 firms that completed the IIL test.

It is found that more highly leveraged firms (firms that have undergone a recent management change) report lower (greater) goodwill impairment. Stock return is not associated with a boost in earnings caused by elimination of goodwill amortization, but it is negatively associated with an unexpected IIL, with the association being stronger for highly leveraged firms. Subsequently, analysts revise earnings forecasts for upcoming quarters downward in response to the unexpected IIL.

Possibility of measurement errors in proxies is a caveat.

The findings are consistent with the strategic reduction of the goodwill impairment by management to avoid the violation of debt covenants and with the notion that new managers take a big bath so they can report higher earnings in the future. The market tests imply that unexpected IIL provides value‐relevant information about a negative view of the future profit‐making potential of the firm or an adverse impact on its debt contracts. No association with elimination of goodwill amortization can be interpreted as the market's anticipation or the lack of information content in goodwill amortization.

This research helps better understand the importance of managers' incentives in determining IIL as well as the stock market effect of the announcement of the IIL and the exclusion of goodwill amortization.

We examine earnings management in non-publicly listed companies, with a focus on for-profit (FP) hospice organizations, and extend the accounting earnings management literature to the hospice industry. FP hospice organizations file Medicare cost reports that include complete financial statements not otherwise publicly available. Managers of FP hospice organizations have incentives to manage earnings to increase performancebased bonuses, meet or beat bond covenant requirements, or avoid public scrutiny. We find total accruals are significantly positively associated with profitability, debt, and size factors. However, discretionary accruals are significantly negatively associated with debt and size, but not profitability. Thus, monitoring and political cost factors appear to effectively mitigate earnings management in this industry sector.