The cost of private debt covenant violation

This study quantifies costs that firms are willing to incur to avoid violation of private debt covenants. The results indicate that as firms approach covenant violation they engage in income-increasing earnings management, which increases their tax liability. By estimating the extent of income-increasing activities and the additional tax costs incurred, this study arrives at a lower-bound estimate of the cost of violating private debt covenants. The mean (median) firm with relatively tight debt covenants increases its current tax liability by an amount equivalent to increasing the cost of debt financing by between 12.92 (10.72) and 22.72 (12.81) basis points (where firms with relatively loose debt covenants serve as the baseline). The magnitude of this estimate indicates that the expected costs of covenant violation are meaningful. Combined with recent evidence that private debt covenant violations occur frequently (Dichev and Skinner, 2002; Roberts and Sufi, 2007a), this implies debt covenants and expected violations are economically important

Direct Evidence on the Informational Properties of Earnings in Loan Contracts

Using a sample of firms that disclose the realizations of earnings used for determining covenant compliance in loan contracts, we provide the first direct evidence on the informational properties of earnings used in the performance covenants included in debt contracts. We find that the earnings measure used in performance covenants does not exhibit asymmetric loss timeliness and has significantly greater cash flow predictive ability than GAAP measures of earnings. We suggest that these results reflect the idea that contracting parties design accounting rules for performance covenants to enhance their efficacy as “tripwires”

Where do firms manage earnings?

Despite decades of research on how, why, and when companies manage earnings, there is a paucity of evidence about the geographic location of earnings management within multinational firms. In this study, we examine where companies manage earnings using a sample of 2,067 U.S. multinational firms from 1994 to 2009. We predict and find that firms with extensive foreign operations in weak rule of law countries have more foreign earnings management than companies with subsidiaries in locations where the rule of law is strong. We also find some evidence that profitable firms with extensive tax haven subsidiaries manage earnings more than other firms and that the earnings management is concentrated in foreign income. Apart from these results, we find that most earnings management takes place in domestic income, not foreign income.Arthur Andersen (Firm) (Arthur Andersen Faculty Fund

When Does Tax Avoidance Result in Tax Uncertainty?

© 2019 American Accounting Association. All rights reserved. We investigate the relation between tax avoidance and tax uncertainty, where tax uncertainty is the amount of unrecognized tax benefits recorded over the same time period as the tax avoidance. On average, we find that tax avoiders, i.e., firms with relatively low cash effective tax rates, bear significantly greater tax uncertainty than firms that have higher cash effective tax rates. We find that the relation between tax avoidance and tax uncertainty is stronger for firms with frequent patent filings and tax haven subsidiaries, proxies for intangible-related transfer pricing strategies. The findings have implications for several puzzling results in the literature