The Effects of Debt Contracting on Voluntary Accounting Method Changes Author(s): Anne Beatty and Joseph Weber Reviewed

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THEACCOUNTING REVIEW Vol. 78 No. 1 2003 January pp. 119-142

The
on

Effects

Contracting Voluntary Accounting Method Changes

Anne Beatty
Pennsylvania State University Massachusetts Institute of Technology

of

Debt

Joseph Weber

ABSTRACT: This study examines whetherthe provisionsof a firm'sbank debt contracts affect its accounting choices. Startingwith a sample of firms who have bank debt and who also voluntarily changed accounting methods, we investigate whether the likelihoodthat the change in accounting method increased (rather than decreased) the borrower's income depends on (1) whether the change in accounting method affects the bank debt contract calculations, (2) the expected costs of violating the bank debt covenants, (3) whether performance pricing provisions affect the interest rate on the loan, and (4) whether the bank debt contract contains accounting-based dividend restrictions.Aftercontrollingfor other motives for changing accounting methods, we find that borrowers whose bank debt contracts allow accounting method changes to affect contact calculations are more likely to make income-increasing rather than income-decreasing changes. This increase in likelihoodof an income-increasingchange is attenuated when expected costs of technical violation are lower because there is a single lender, and occurs for borrowers whose debt contacts have performance pricing and dividend restrictions. These results suggest that incentives to lower interest rates influence throughperformancepricingor to retaindividendpayment flexibility borrowers'accounting method choices, thereby addressing the fundamental questions posed by Fields et al. (2001) of whether,underwhat circumstances, and how accounting choice matters. Keywords: accounting choice; debt contracting;debt covenants;performance pricing;dividendrestrictions.
We thank two anonymous reviewers, Wayne Guay, Peter Joos, S. P. Kothari, Greg Miller, and seminar participant at MIT for helpful comments. We also thank Jennifer Altamuro, Shelley Herbein, and Hyunna Song for research assistance and Dick Dietrich for his insights about data availability at the SEC. Professor Beatty gratefully acknowledges financial support from PricewaterhouseCoopers and the Sloan Foundation. Submitted February 2002 Accepted August 2002

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The AccountingReview,January 2003 Data Availability: All data are available from public sources.

I. INTRODUCTION Watts and Zimmerman (1986, 216-217) argue that debt contracts that make covenant thresholds a function of financial ratios give borrowers an incentive to change accounting methods to avoid costly covenant violations. However, reviewing the empirical research on accounting choice, Fields et al. (2001, 275) state that "the evidence on whether accounting choices are motivated by debt covenant concerns is inconclusive." There are at least three reasons that previous research may underestimate the effects of debt contracting on managers' accounting choices. First, previous research that does not use the details of firms' actual debt contracts assumes that contract calculations are based on current accounting methods. However, Mohrman (1996) and Beatty, Ramesh, and Weber (2002) document that private debt contract calculations often prohibit firms from changing accounting methods. For these contracts, borrowers cannot use voluntary accounting method changes to avoid covenant violations. Thus, debt contracts give borrowers an incentive to change accounting methods only if the voluntary accounting method changes affect contract calculations. Second, existing research that focuses exclusively on debt covenants ignores other accounting-based features of debt contracts. Performance pricing is a relatively new feature in bank debt contracts that explicitly makes the interest rate charged on a bank loan a function of the borrower's current creditworthiness. Asquith et al. (2002) document that performance-pricing features typically measure the borrower's creditworthiness using financial ratios such as debt to earnings before interest, taxes, depreciation, and amortization (EBITDA), leverage, or interest coverage. That is, the interest rate charged in the contract does not remain fixed over the length of the loan, but varies inversely with changes in measures of financial performance. Compared to covenants under which accounting information affects loan rates only when the borrower violates a single threshold, performance pricing creates a more continuous and direct link between accounting information and interest rates. Thus, performance pricing likely gives managers additional incentives to make income-increasing accounting method changes. Previous research does not consider whether this feature of debt contracts influences accounting choice. Third, previous research has focused on borrowers who were either close to violating or had already violated covenants. These studies may underestimate the effect of debt contracting on accounting choice for cases in which borrowers have effectively used accounting changes to provide slack in financial covenants, and thus never come close to covenant violations. To provide more conclusive evidence that debt contracting concerns affect borrowers' accounting choices, we address these three limitations of prior research. First, our research design incorporates the fact that debt contracts often prohibit borrowers from using voluntary accounting method changes to affect contract calculations. This cross-sectional variation in bank debt provisions allows us to examine whether managers who have chosen to change their accounting methods are more likely to make income-increasing changes when the debt contract allows these changes to affect contract calculations. Second, we consider whether another debt contracting feature-accounting-based performance pricing-increases borrowers' tendencies to make their voluntary accounting method changes income-increasing rather than income-decreasing. Third, rather than restricting our sample to borrowers approaching covenant violations, we study all borrowers who make voluntary accounting changes, and control for their other incentives to change accounting methods. If borrowers effectively use changes in accounting methods to create slack in financial

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covenants so that they avoid coming close to violating their covenants, then our tests examining all accounting method changes are more powerful than tests employed in previous research that focused solely on borrowers who are close to or had already violated their borrowing firms make in their accounting methods, we identify a sample of borrowers with material bank debt who have chosen to make accounting changes. We determine whether

covenants. To provide evidence on how debt contractsaffect the sign of voluntarychanges that their contractshave accounting-based restrictivecovenants, dividend restrictions,or perwillformance-pricing requirements. Beatty,Ramesh,and Weber(2002) find thatborrowers ingly pay higherinterestratesto obtainbankdebt contractsthatallow voluntaryaccounting
changes to affect the calculation of financial terms in those debt contracts. We therefore

expect borrowersto make use of this costly flexibility.Consistentwith our hypothesis,we find that borrowerswho change their accountingmethodsare more likely to make incomeincreasingchanges if their debt contractsallow the changes to affect contractcalculations. This increase in likelihood of an income-increasing when accountingchange is attenuated the cost of a covenantviolation is lower because all the firm's bank debt is from a single
lender, and occurs only for borrowers whose contracts have performance-pricing provisions

and dividendrestrictions.

Our debt contracting results hold even after we control for other motives that borrowers

have for changing accountingmethods.Specifically,our results hold even afterwe control for the fact that incentivesarisingfrom executive compensationcontractsand incentivesto meet earninges benchmarksincrease borrowers' propensity to make income-increasing (ratherthan income-decreasing) changes. We also controlfor the fact that a borrowerwith a new Chief Executive Officer (CEO) who reports a large loss before the effect of the
accounting method change is more likely to report an income-decreasing accounting change tracting results also hold after controlling for tax incentives.

(consistentwith new CEOs of poorly performingfirmstaking "big baths"). Ourdebt con-

calculations. In addition, our evidence suggesting that incentives to lower interest rates through performance pricing and incentives to retain dividend payment flexibility appear to affect borrowers' accounting method choices helps address Fields et al.'s (2001) fundamental questions of whether, under what circumstances, and how accounting choice matters. Section II develops our hypotheses and Section III explains our research design. Section IV describes our sample selection and provides descriptive statistics. We discuss our empirical results in Section V, provide sensitivity analysis in Section VI, and present our conclusions in Section VII. II. HYPOTHESIS DEVELOPMENT Fields et al. (2001) discuss three motives for accounting choice: (1) contracting (including debt and management compensation contracts), (2) asset pricing, and (3) influencing external parties (e.g., the Internal Revenue Service [IRS]). This paper focuses on the relation between accounting method changes and debt contracting while controlling for the other incentives for accounting choice, as explained in Section III. Specifically, we examine the extent to which detailed provisions of debt contracts explain the sign of borrowers' voluntary changes in accounting methods. We focus on accounting method changes because Beatty, Ramesh, and Weber (2002) document that borrowers willingly pay higher interest rates to retain the flexibility to make voluntary accounting method changes that affect bank

Our evidence that debt contractingconcerns affect borrowers'accountingchoices is more conclusive than previousresearchbecause we show thatborrowers take advantageof the flexibility to make income-increasingaccountingmethod changes that affect contract

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bility by makingvoluntaryaccountingmethodchanges to affect contractcalculations.

debt contract calculations. We therefore expect borrowers to make use of this costly flexi-

Does Allowing Accounting Changes to Affect Debt Contract Calculations Influence Accounting Choice? Previous research examining whether debt covenants affect borrowers'decisions to change accountingmethodsgenerallyassumes that the calculationsstipulatedin the covenantswill be based on currentaccountingmethods.For example,Healy and Palepu(1990) examine whetherborrowersclose to violating their dividendcovenant restrictions,which are typically defined as a percentageof net income or retained earnings, change their accountingmethodsto increasethose limits. Similarly,Sweeney (1994) investigateswhether borrowersuse accountingchanges to avoid violating financialcovenantsdesigned to monitor borrowers' performance. However, Mohrman (1996) and Beatty, Ramesh, and Weber (2002) document that debt contract calculations are often based on the accounting rules

that the borrowerused when the contract originated.For these contracts,the borrower cannotuse changesin accountingmethodsto avoid covenantviolations.The cross-sectional
variation in the effects of accounting method changes on contract calculations provides a

naturalsetting that allows us to investigatethe effects of debt contractingon borrowers' decisions to make accountingmethodchanges. Our first hypothesis is that borrowerswho change accountingmethods will be more likely to make income-increasing(rather than income-decreasing)accounting method

changes when such changes affect covenant calculations. Do the Expected Costs of Covenant Violations Influence Accounting Choice? Watts and Zimmerman (1986, 215-216) argue that costly covenant violations give borrowers an incentive to make income-increasing accounting method changes to create slack in covenants; however, evidence on the actual magnitude of the cost of covenant violations is mixed. On the one hand, Beneish and Press (1993) provide evidence that covenant violations that lenders have not waived as of the financial-reporting date cost the borrower an average 80 basis point increase in the interest rate the lender charges on the loan after renegotiation. Furthermore, Healy and Palepu (1990) find that firms close to contractually imposed dividend limitations generally cut the dividends they pay rather than violate the dividend-restricting covenants or change their accounting methods to circumvent the covenants. These findings suggest that borrowers perceive violating dividend restriction covenants to be more costly than cutting dividends. On the other hand, Dichev and Skinner (2002) report that lenders may commonly waive technical violations prior to the financial reporting date, and they argue that waived covenant violations are unlikely to be very costly to the borrower. These results suggest that the cost of technical covenant violations will be

lower the more likely it is for the lenderto waive violations.

Our second hypothesis is that borrowers whose bank debt contracts allow voluntary accounting changes to affect contract calculations will be less likely to make incomeincreasing (rather than income-decreasing) accounting method changes when they expect lower technical default costs.

Does Performance Pricing Influence Accounting Choice? We expect performance pricing, which is a relatively new debt-contracting feature, to give borrowers an additional incentive to make income-increasing accounting changes beyond the incentive provided by covenants. Accounting-based performance pricing explicitly makes the interest charged on a bank loan a function of the borrower's financial ratios,

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such as debt to EBITDA, leverage, or interest coverage. That is, the interest rate in the contractis not fixed over the length of the loan but varies inversely with changes in accounting measuresof financialperformance,which are typically assessed quarterlyusing the previous four quarters'results. Performancepricing may increase the importanceof debt contractsin accountingchoice by providinga more continuousand directlink between accountinginformationand interestrates than covenantsprovide. Asquith et al. (2002) providedescriptiveevidence on this new featurefound primarily in bank debt contracts.They documentthat at the inceptionof the contractthe interestrate chargedon the loan is rarelyabove the top level or below the bottomlevel of the performance-pricinggrid, that the average grid has five levels, and that the average increase in interest rates charged when the borrower'sperformancedeterioratesone performancepricinglevel is 15 basis points. Beatty,Dichev, and Weber(2002) documentthat a contract with performance pricing typically has a covenantbased on the performance pricing ratio that is set at one level of performance below the worst level includedin the grid. Because in performance-pricing grids have multiplelevels, deteriorations a borrower's performance level, and thus a higher interestrate, even if the may result in a new performance-pricing borrower'sperformancenever deterioratesenough to violate the covenant. In addition, improvementsin a borrower'sperformancemay result in a lower interestrate if the borrower reaches a betterperformance-pricing level. Thus, we expect performance pricing to incentivefor borrowers makeincome-increasing to providean additional accountingmethod changes. Our thirdhypothesisis that borrowerswith debt contractsallowing voluntaryaccounting method changes to affect contractcalculationswill be more likely to make incomeincreasing (ratherthan income-decreasing)accountingmethod changes if their contracts include accounting-based covenants. performance pricing in additionto traditional Do Dividend Restrictions Influence Accounting Choice? Borrowers'incentivesto make income-increasing accountingmethodchangesmay also on whethertheir debt contractscontain dividendrestrictionsbased on accounting depend Debt contractsoften have covenantsthat either explicitly limit dividendpayperformance. ments to be less than a given percentage of net income, or implicitly limit dividend paymentsby includingcovenantsaffectedby dividends(e.g., net worth,tangiblenet worth, or leverageratio covenants).The incentivesto make income-increasing ratherthanincomemethod changes providedby covenantsthat explicitly or implicitly decreasingaccounting restrictdividendsmay differ from those providedby other covenants(e.g., workingcapital or coverage ratio covenants).Healy and Palepu (1990) suggest that borrowers' incentiveto make an income-increasingaccountingchange may be lower for covenants affected by dividend payments, because borrowershave the option to reduce dividends ratherthan violating the covenant. On the other hand, Sweeney (1994) documentsthat covenants affected by dividendpaymentsare more likely thanothercovenantsto be binding,suggesting that they may give borrowersa greaterincentiveto make an income-increasing accounting change. Thus, we are unable to predict the direction in which dividend restrictionswill affect borrowers'accountingchoices. Our fourthhypothesis is thereforea nondirectional one: the likelihood that borrowers with debt contractsallowing voluntaryaccountingmethod changes to affect contractcalculations make income-increasing (rather than income-decreasing)accounting method dividend changes will depend on whether their debt contractscontain accounting-based restrictions.

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TheAccounting 2003 Review, January III. RESEARCH DESIGN All of our tests use a sample of borrowerswho have bank debt and who have also

made voluntary changes in their accounting methods. Focusing on firms that make accounting changes has the advantage of requiring that the firms have enough flexibility to make

an accountingchange. Firms that want to make income-increasing accountingchangesbut are unable to do so should make no such changes and thereforenot be included in our sample. This increasesthe power of our tests relative to prior researchthat examines the debt-contracting hypothesisusing samples of borrowerswho are close to violating covenants, which suffers from the problem that many of these borrowersmay not have the
flexibility to make accounting changes. We focus on the effect of bank debt (rather than public debt) provisions on the borrower's voluntary accounting method changes for three reasons. First, Beatty, Ramesh, and

Weber(2002) find that, in contrastto public debt, there is variationin whetherbank debt contracts allow voluntary accounting changes to affect contract calculations. Second, El-Gazaarand Pastena(1991) find that bank debt contractsvirtuallyalways containcovenants,whereaspublic debt often does not, and thatthe covenantsin bankdebt are typically
tighter than those in public debt.' Third, Asquith et al. (2002) find that, unlike public debt, many bank debt contracts have performance-pricing provisions, an innovation that likely provides additional incentives for firms to make income-increasing accounting changes.

The greatercross-sectionalvariationin whetheraccountingchanges affect contractcalculations, combined with the potentially greater importance of covenants and performance pricing in bank debt compared to public debt, should increase the power of our tests.

Testing Hypotheses 1 and 2

We test our first hypothesis by examining whether a borrower's decision to make an income-increasing (rather than an income-decreasing) accounting method change depends on whether that change affects debt contract calculations. We test our second hypothesis by examining whether this relation depends on the expected costs of technical covenant violations. To control for other incentives for making income-increasing accounting method changes, such as those provided by management compensation contracts, asset pricing, and external parties like the IRS, as described by Fields et al. (2001), we estimate the following logistic regression: INCREASE = Po + PiACC_Change + ,20ne_Lender + P3COMP + I4SMLOSS + PsSMLOSS_NL + P6LGLOSS + I7LGLOSS_ACEO + P8NOL+ fgSIZE + E, where: Dependent Variable: INCREASE = 1 if the accounting method change increases income and equity, 0 otherwise.
Our examination of public debt and private placement agreements that are available online revealed that few of these contracts contained covenants or accounting-based performance pricing.

(1)

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Variables: Debt-Contracting Independent = 1 if contractallows accountingchanges to affect calculations,0 ACC_Change otherwise;and One_lender= 1 if accountingmethod changes affect debt contractcalculations and a single lender makes the loan, 0 otherwise. ControlVariables: COMP = 1 if the firm indicates that the managers'bonuses depend on financial performanceand the CEO received a bonus in the year priorto the accountingchange, 0 otherwise; SMLOSS = 1 if the firm'searningsbefore the effect of the accountingchange is between 0 and -1 percentof assets, 0 otherwise; SMLOSS_NL= 1 if the firm'searningsbefore the effect of the accountingchange is between 0 and -1 percentof assets and the firm is not listed on a majorstock exchange, 0 otherwise; LGLOSS = 1 if the firm'searningsbefore the effect of the accountingchange is less than -1 percentof assets, 0 otherwise; = LGLOSS_ACEO 1 if the firm'searnings,beforethe effect of the accountingchange, is less than -1 percentof assets and the firm's CEO changed in the year priorto the accountingchange, 0 otherwise; NOL = 1 for borrowerswho have a net operatingloss carryforward and make an accountingchange thathas a tax effect, 0 otherwise;and SIZE = the log of the firm's assets before the effect of the accounting change.
Our dependent variable is a simple dichotomous variable that equals 1 if the accounting change increases the current period net income, and 0 if the accounting method change decreases net income. Debt-Contracting Variables To test our first hypothesis, our logit includes a dichotomous independent variable (ACC_Change) that equals 1 if the borrower has any bank debt contracts that allow accounting changes to affect contract calculations, 0 otherwise. To classify the effect of accounting changes on a borrower's contract calculations, we obtain copies of all of the bank debt contracts the borrower has entered at the time of the accounting change. We then use an approach similar to Mohrman (1996) and Beatty, Ramesh and Weber (2002) to identify whether accounting changes affect the contract calculations. Specifically, we classify a contract as not allowing voluntary accounting changes to affect calculations if the contract states either (1) that the borrower shall not make any significant change in accounting treatment or reporting practices, except as required by generally accepted accounting principles (GAAP) or (2) that accounting terms will be based on financial information prepared in accordance with GAAP as in effect and applied on the date of the agreement. If any of a borrower's bank debt contracts allow accounting changes to affect calculations, we then set ACC_Change equal to 1. Only when all of the firm's bank debt contracts prohibit accounting changes from affecting calculations do we set ACC_Change equal to zero. To test our second hypothesis, we include a dichotomous independent variable (One_lender) equal to 1 if accounting method changes affect debt contract calculations and a single lender makes the loan, 0 otherwise. Asquith et al. (2002) argue that renegotiation

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costs are lower when there is a single lender, because contracts typically require a majority, supermajority, or unanimous consent of all lenders to waive a covenant. Therefore, the

expected costs of technicaldefault are lower when there is only one lender.2 Control Variables To isolate the relation between accounting changes and debt contractingcosts, we
control for firms' other incentives to make accounting changes. In their summary of the empirical and theoretical accounting choice literature, Fields et al. (2001) suggest that management compensation contracts, asset pricing, and external parties such as the IRS provide additional incentives affecting firms' accounting choices beyond those provided by

debt contracting. To control for incentives arising from accounting-based compensationcontracts,we

include a dichotomous variable (COMP) equal to 1 if a firm indicates that its managers' bonuses depend on accounting-based measures and its CEO received a bonus in the year prior to the accounting change. We expect firms that pay accounting-performance-based bonuses to be more likely than other firms to make income-increasing (rather than income-

decreasing)accountingmethodchanges. incentivesto manageearnings,we controlfor borTo captureborrowers' asset-pricing a rowers'potentialattemptsto increaseshareprices by avoidingreporting loss. Specifically, we include two variablesto control for borrowers'use of accountingchanges to achieve and Dichev (1997) document.We set the first the positive earningsthresholdBurgstahler
variable (SMLOSS) equal to 1 if the firm would have reported a loss of 1 percent of assets

or less priortohe effect of the accountingchange. These firmshave an incentiveto make to an income-increasing accountingchange to avoid reportinga loss. We constructthe second
variable (SMLOSS_NL) by interacting SMLOSS with a dichotomous variable equal to 1 for firms not listed on a major stock exchange, 0 otherwise. Based on the results reported less incentive to avoid missing earnings benchmarks.

in Beatty,Ke, and Petroni(2002), we expect firmsnot listed on a majorexchange to have For firms expecting to report a large loss in the absence of an accountingchange,
management compensation and asset-pricing incentives may prompt managers to increase the magnitude of the loss to create reserves for the future. We include two variables to control for this "big bath" incentive. The first variable (LGLOSS) equals 1 if the firm would have reported a loss greater than 1 percent of assets prior to the effect of the accounting change. We construct the second variable (LGLOSS_ACEO) by interacting LGLOSS with a dichotomous variable equal to 1 if the firm changed CEOs in the year prior to the accounting change, 0 otherwise. We expect the big bath incentive to be higher for new CEOs who can use poor past performance to explain the magnitude of the loss. To control for borrowers' tax incentives to change accounting methods, we include a dichotomous variable (NOL) equal to 1 for borrowers who have net operating loss carryforwards, and who also make accounting changes that have tax effects; 0 otherwise. We expect firms with NOL carryforwards to be more likely than others to make incomeincreasing accounting method changes that affect tax accounting. Finally, we include the log of a firm's assets to control for firm size (SIZE). We make no prediction about the effect of firm size on the likelihood the manager makes an incomeincreasing rather than income-decreasing accounting method change.
2

This hypothesis assumes that the covenants in contracts with single lenders are similar to the covenants in contracts with multiple lenders. We investigate the validity of this assumption, and find that the average number of covenants is virtually the same.

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Testing Hypotheses 3 and 4 To test our third and fourth hypotheses, we re-estimate our model by substituting the specific type of debt contract feature affected by the accounting method changes for our ACC_Change variable. We partition firms whose contracts allow accounting changes to affect contract calculations into four mutually exclusive categories: those with neither performance pricing nor dividend restriction provisions; those with performance-pricing but no dividend restrictions; those with dividend restrictions but no performance-pricing; and those with both performance-pricing and dividend restrictions. Specifically, we estimate the following logistic regression: INCREASE = Po + PlaNoPPorDiv_Res + IlbPP + P,cDiv_Res + PldPP&Div_Res + p20ne_Lender + P3COMP + P4SMLOSS + PsSMLOSS_NL + P6LGLOSS + p7LGLOSS_ACEO + 3sNOL + P9SIZE+ e, where: NoPPorDiv_Res = 1 if the contract allows accounting changes to affect contract calculations but contains neither an accounting-based performance-pricing provision nor an accounting-based dividend restriction, 0 otherwise; PP = 1 if the contract allows accounting changes to affect contract calculations and contains an accounting-based performancepricing provision but not an accounting-based dividend restriction, 0 otherwise; Div_Res = 1 if the contract allows accounting changes to affect contract calculations and contains an accounting-based dividend restriction but not an accounting-based performance-pricing provision, 0 otherwise; and PP&Div_Res = 1 if the contract allows accounting changes to affect contract calculations and contains both an accounting-based performance pricing provision and an accounting-based dividend restriction, 0 otherwise. All other variables are as defined in Model (1). Since all borrowers in our sample have some type of accounting-based covenant, this research design allows us to examine the incremental effect of performance pricing and to differentiate between covenants that are linked to dividend restrictions vs. those that are not. IV. SAMPLE To obtain a sample of firms that have bank debt and also made material voluntary accounting changes, we conduct a keyword search on the Lexis/Nexis database.3 When a firm makes a nonmandated accounting change, the Securities and Exchange Commission
3We

(2)

searchedthe 10-Ks and 10-Qs filed on the Lexis/Nexis database using the phrase"exhibit18" and "Letter re Changein AccountingPrinciples."

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(SEC) requires the firm's independent accountant to issue a "preferability letter" commenting on whether they prefer the new accounting method relative to the prior method. The firm must file these letters with the SEC as exhibit 18 in their annual 10-K or quarterly 10-Q financial statements. To identify firms that change accounting methods, we search all 10-K and 10-Q reports available on Lexis/Nexis from 1995 through 2000 for exhibit 18 disclosures. Then we read each exhibit 18 report to determine whether the firm made a material accounting change. Table 1 describes the results of this sample selection process. This search yields a sample of 296 firms that made accounting changes from January 1, 1995, through June 30, 2000. From these 296 firms, we exclude 48 that made accounting changes that had no effect on income statement or balance sheet accounts (e.g., changes in the format of the income statement, changes in the definition of a cash equivalent, or immaterial changes in accounting methods) and we also exclude two firms whose preferability letters were actually for has mandatory accounting changes. We also excluded five firms that were banks or d banks as significant subsidiaries, because banks' accounting method choices may be affected by regulatory incentives. We then used the debt footnotes to determine the amount and type of debt outstanding, and used the exhibit list at the end of each filing to determine whether the borrower filed a debt contract and, if so, the exact filing that includes that debt contract. Based on this

TABLE 1 Sample Selection Process Borrowers Making Material VoluntaryAccounting Method Changes during 1995-2000 letters"with the SECa Firmsthat filed "preferability Less: Firmsthat made accountingchangesthathad no effect on balancesheet or income
statement accountsb Financial institutions 48 5

296

classifiedas voluntarychanges Firmsthat made mandatory accountingchangesimproperly bankdebt Firmswith no bank debt or with immaterial firmswith materialbank debt that made materialvoluntaryaccountingchanges Nonfinancial Less: thresholdof 10 percentof assets, Firmswith bank debt that exceeds the SEC's materiality but do not reportfiling the debt contractwith the SEC in their 10-K exhibit list Firmsthat indicatedin their 10-K exhibitlist thatbankdebt was filed with the SEC, but we could not find the contracton EDGARC Firmsin our sample
a When a

2 65 176

24 27 125

to accountant firm makes a nonmandated accountingchange,the SEC requiresthe firm'sindependent methodrelativeto the prior of on letter"commenting the preferability the new accounting issue a "preferability method. b Examples includechangesin the formatof the income statement, changesin the definitionof a cash equivalent, methods. or immaterial changesin accounting c whether debtcontracts the on mostof the indicated filingsareavailable globalaccess,we cannotconfirm Although does not allow us to view most of these filings. becauseour subscription were filed or examinefiled contracts

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analysis, we excluded another 65 firms with no bank debt or with immaterial bank debt.4 These adjustments left a sample of 176 nonfinancial firms with material bank debt that also

ie ineexamin the exhibit cindex the of the bank debt with the SEC. More specifically, we e borrower's 10-K filed before and after the accounting change to determine whether the borrower filed the bank debt contract. For each of these 24 firms, no reference to any bank debt contracts appeared in the entire exhibit index. If the exhibit indexes of the 10-Ks filed before and after the accounting change did not mention bank debt, we assume that the borrower never filed it with the SEC.5 In addition, we could not access debt contracts for another 27 firms, even though their exhibit index indicates that they filed bank debt contracts with the SEC.6 Because our study focuses on the effects of debt contract provisions such as covenants, dividend restrictions, and performance pricing on borrowers' voluntary accounting changes, and we do not know whether these debt contracts allowed accounting changes to affect contract calculations, we must exclude these 51 borrowers from the sample. This sample selection process yielded our final sample of 125 firms.7 Although our sample attrition rate is high, we argue that our inferences are unlikely to be an artifact of sample selection bias for two reasons. First, we examine the types of accounting changes made by the firms we exclude, and the effects of these changes on net income, to ensure that our data requirements are not systematically related to our dependent variable. We find these firms' accounting changes are remarkably similar to those made by the sample firms. Of the 51 firms excluded from the sample, 29 (57 percent) made income-increasing accounting changes and 22 (43 percent) made income-decreasing accounting changes, compared to 54 percent increases and 46 percent decreases in our sample firms. The difference between these two groups is not statistically significant. As for the sample firms, the most common accounting changes for the excluded firms were, in order of frequency, for inventory, depreciation/capitalization, and revenue recognition. Thus, we conclude that our data requirements did not result in an endogenous sample selection bias. Second, we compare other characteristics of our sample firms and the excluded firms to ensure that these two groups of firms are not systematically different on other dimensions. Specifically, we compare asset sizes, leverage ratios, and the proportion of borrowers reporting small and large losses before the effect of the accounting changes. None of these
4

made voluntarymaterialchanges in accountingmethods. For each of these 176 borrowers,we systematically searched their debt footnotes, 10-Ks, 10-Qs, 8-Ks, and all their registrationstatementsfiled online to obtain copies of their debt contracts.We identified24 firms whose footnotes indicatethat they have a material bank debt contract,but whose exhibit indexes indicate that they did not file copies

Rule 601 of regulationSK allows borrowers some latitudein filing their debt contracts.Specifically,the SEC to wherethe SEC generallydefinesmateriality requiresborrowers file a copy of a debt contractif it is material, as 10 percent of the firm's assets. See Press and Weintrop(1990) for more discussion of the SEC's filing for We bankdebtif no bankdebtfilings requirements privatedebtcontracts. classifiedfirmsas havingimmaterial were listed in their exhibitindexes and the amountof the bank debt disclosed in theirfootnoteswas less than 10 of theirassets. 5 Wepercent tested the validityof this assumption conductingexhaustiveonline searchesfor debt contractsfor each by of these firms, and we were unableto locate copies of any of the bank debt outstanding the time the firm at madethe accounting online supports assumption the 24 firms the that change.The inabilityto find any contracts neverfiled these debt contracts with the SEC. 6 Althoughmost of the indicatedfilings are availableon the Global Access database,we can neitherconfirm whetherthese 27 firms filed nor can we examine any contractsthese 27 firms might have filed because our to subscription ThomsonFinancialdoes not allow us to view most of these filings. 7 Ourlogit regressions data,reducingthe samplesize to 121 in that analysis. requireadditional

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2003 The AccountingReview,January

characteristics was significantly different between our sample and the excluded borrowers. Furthermore, we confirmed that these characteristics did not differ between the sample and excluded borrowers after partitioning on the accounting changes' effect on net income. Descriptive Statistics Table 2 provides descriptive evidence on our sample firms' accounting method changes.

The sample is split fairly evenly between income-increasingand income-decreasingaccounting changes, with 67 increases and 58 decreases. The most common change is in the method of accounting for inventory, which represents 42 percent of our sample. Of the 53 inventory accounting changes, 41 are changes from LIFO to some other inventory accounting method, 6 are changes from FIFO to LIFO, and 6 are other changes in inventory methods, such as changes in overhead allocation. Changes in capitalization of assets, depreciation, and revenue recognition methods each represent roughly 15 percent of the voluntary accounting changes in our sample. Nearly two thirds of the changes in capitalization reduced income, whereas the split between increases and decreases is fairly even for depreciation changes and changes in revenue recognition as well as for the sample as a whole. V. RESULTS Univariate Analysis Table 3 presents univariate analyses of the direction and (signed) magnitude (scaled by assets before the effect of the change) of the income effect of the accounting method change. Panel A of Table 3 presents the actual and expected (assuming independence) number of income-increasing vs. income-decreasing accounting changes for borrowers whose debt contracts allow voluntary accounting changes to affect calculations vs. those that do not. We find that 75 borrowers have at least one debt contract that allows voluntary changes to affect contract calculations, and 50 of our borrowers do not have any bank debt contracts that allow voluntary accounting changes to affect calculations. The accounting TABLE 2 Method Changes Partitioned by Effect on Income for Borrowers Making Accounting Voluntary Accounting Method Changes during 1995-2000 Typeof AccountingChange to Capitalizing expensingcosts or expensing to capitalizing policies Depreciation Gains on pension assets Goodwill accounting-from LIFO Inventory Inventoryaccounting-from FIFO accounting-Other Inventory Revenuerecognition Other Total 19 18 4 5 41 6 6 14 12 Income-Increasing Income-Decreasing 7 10 4 0 23 4 6 6 7 12 8 0 5 18 2 0 8 5

Total Total

125 125

67 67

58 58

on Beatty and Weber-Effects of Debt Contracting AccountingChanges

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TABLE 3 Tests of Independence between Whether Accounting Changes Affect Contract Calculations and the Sign and Magnitude of the Effect of the Accounting Change on Income Panel A: ContingencyTableof Actual and (Expected)Numberof FirmsMakingAccounting between Whether AccountingChangesAffect Contract Changes,Testing Independence for Calculationsand Whether vs. AccountingChangeis Income-Increasing Income-Decreasing AccountingMethod ChangesAffect ContractCalculations Income-increasing accountingchange Income-decreasing accountingchange Total Test of independence 46 (40.2) 29 (34.8) 75 4.51 Chi-square AccountingMethod ChangesDo Not Affect ContractCalculations 21 (26.8) 29 (23.2) 50 p-value0.04

Total 67 58 125

RankSum Testof Independence Distributionof IncomeEffectof Accounting Panel B: Wilcoxon of MethodChangefor Borrowerswith Debt ContractCalculations Affectedor Not Affected by AccountingMethodChanges AccountingMethod ChangesAffect ContractCalculations Actual ranksum Expectedranksum Test of independence 69.42 (63) Z-statistic2.42 AccountingMethod ChangesDo Not Affect ContractCalculations 53.36 (63) p-value 0.008

method change increases income for 61 percent (46/75) of borrowers whose debt contracts allow the changes to affect calculations vs. only 42 percent (21/50) of borrowers whose contracts do not allow voluntary accounting changes to affect the calculations. The Chisquare statistic for independence of these two characteristics is 4.51, which is significant at the 4 percent level. Panel B of Table 3 presents the actual and expected (assuming independence) rank sum of the magnitude of the income effect of the accounting method change for borrowers whose debt contracts allow voluntary accounting changes to affect calculations vs. those that do not. We find that when accounting method changes affect the contract calculations, borrowers make accounting changes that more positively affect income. We perform a Wilcoxon rank sum test of the distribution of the income effect of the accounting change for borrowers with debt contract calculations affected by accounting method changes vs. those without, and reject independence of the distribution of the income effect of the accounting change across these two types of borrowers at the 0.008 level. Table 4 presents the means and standard deviations of our independent variables, partitioned by the direction in which the accounting change affects income, as well as t-statistics for the differences between the means of these two groups. Several of the debtcontracting variables differ significantly between borrowers making income-increasing (vs.

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TABLE 4 Mean and (Standard Deviation) of Independent Variables Partitioned by the Effect of the Accounting Method Change on Income
Predicted Sign of Difference IncomeIncreasing Mean (std. dev.) IncomeDecreasing Mean (std. dev.) Difference Mean (t-statistic)

Variable

Debt Contracting Variables Acc_Change NoPPorDiv_Res PP Div_Res PP&Div_Res One_Lender ControlVariables COMP SMLOSS SMLOSS_NL LGLOSS
+
+ +

0.69 (0.46) 0.09 (0.29) 0.13 (0.34) 0.25 (0.44) 0.21 (0.41) 0.09 (0.29) 0.57 (0.50) 0.18 (0.39) 0.03 (0.39) 0.19 (0.40) 0.02 (0.40)

0.50 (0.50) 0.19 (0.40) 0.07 (0.26) 0.14 (0.44) 0.10 (0.31) 0.17 (0.38) 0.34 (0.48) 0.16 (0.37) 0.12 (0.37) 0.31 (0.47) 0.12 (0.47) 0.16 (0.37) 13.18 (1.83) 0.36 (0.48) 0.18 (0.38) 58

0.19
(2.15)**

+
+

-0.10 (-1.63) 0.06 (1.22) 0.11 (1.65)* 0.11 (1.64)* -0.08 (-1.38) 0.23
(2.53)***

0.02 (0.35) -0.09 (-1.89)* -0.12

-(1.63)* -0.10 (-2.41)***

LGLOSS_ACEO NOL SIZE

+
?

0.12 (0.33) 13.51 (1.89) 0.15 (0.36) 0.08 (0.27) 67

-0.04 (-0.58) 0.33 (1.00) -0.21

(-2.81)***

NLIST ACEO Numberof Firmsa

-0.10 (-1.59)*

(continued on next page)

on Beatty and Weber-Effects of Debt Contracting AccountingChanges

TABLE 4 (continued)

133

***, **, and * Indicate significance at the 1 percent, 5 percent, and 10 percent levels, respectively, for one- or

two-tailedtests as appropriate.
aWe

could not obtain proxy statements for four borrowers, so there are only 121 observations for the COMP,

and LGLOSS_ACEO, ACEOvariables. VariableDefinitions Debt Contracting Variables: = 0 changesto affect calculations, otherwise; ACC_Change 1 if contractallows accounting
NoPPorDiv_Res = 1 if the contract allows accounting changes to affect calculations but contains neither an

PP = Div_Res = PP&Div_Res= One_lender=

dividendrestriction, accounting-based performance pricingprovisionnor an accounting-based 0 otherwise; and 1 if the contractallows accounting changesto affectcalculations containsan accountingbased performancepricing provision but not an accounting-based dividend restriction,0 otherwise; 1 if the contractallows accounting and changesto affect calculations containsan accountingbased dividendbut not an accounting-based performance pricingprovision,0 otherwise; 1 if the contractallows accountingchanges to affect calculationsand containsboth an acdividendrestriction, 0 counting-based performance pricingprovisionand an accounting-based otherwise;and 1 if accountingmethodchanges affect debt contractcalculationsand a single lendermakes the loan, 0 otherwise.

ControlVariables: COMP= 1 if the firm indicatesthat the managers' bonuses dependon financialperformance the and CEOreceiveda bonus in the year priorto the accounting change,0 otherwise; SMLOSS= 1 if the firm's earnings,before the effect of the accountingchange, is between 0 and -1 percentof assets, 0 otherwise; SMLOSS_NL= 1 if the firm's earnings,before the effect of the accountingchange, is between 0 and -1 percentof assets and the firmis not listed on a majorstock exchange,0 otherwise; LGLOSS= 1 if the firm'searnings,beforethe effect of the accounting change,is less than -1 percentof assets, 0 otherwise;
LGLOSS_ACEO = 1 if the firm's earnings, before the effect of the accounting change, is less than -1 percent of

assets and the firm'sCEO changedin the year priorto the accounting change,0 otherwise; NOL = 1 for borrowers have a net operatingloss carryforward make an accounting that and change thathas a tax effect, 0 otherwise; SIZE = the log of the firmsassets beforethe effect of the accounting change; NLIST = 1 for firmsnot listed on a majorstock exchange,0 otherwise;and ACEO= 1 if the firm'sCEO changedin the year priorto the accounting change,0 otherwise.

income-decreasing)accountingchanges. Voluntarychanges in accountingmethods affect

debt contract calculations for 69 percent of the firms that make income-increasing accounting method changes, compared to only 50 percent of those that make income-decreasing changes. Borrowers that make income-increasing accounting method changes are more likely to face dividend restrictions affected by those changes than are borrowers who make income-decreasing accounting changes.

Table 4 also reports that some of our control variables differ significantlybetween borrowerswho make income-increasingvs. income-decreasingchanges. Borrowerswho
pay their executives bonuses based on accounting performance are more likely to make income-increasing accounting method changes. An income-increasing accounting method change is less likely to be made by an unlisted firm that reports a small loss, or by a borrower that reports a large loss, especially if the firm changed its CEO in the year of the accounting change.

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Correlations among Independent Variables Fields et al. (2001) suggest that a limitationof previous accountingchoice studies is
that they typically examine only one potential motive for making accounting choices, without controlling for other possible motives. The correlations among our independent variables reported in Table 5 provide evidence on the extent of the "correlated omitted variable"

problemassociatedwith focusing on a single motive. between our debt-contracting variaIn general, we observe no significantcorrelations
bles (ACC_Change, NoPPorDiv_Res, PP, Div_Res, and One_Lender) and other factors that LGLOSS, LGLOSS_ACEO, NOL, SIZE, NLIST, and ACEO). In particular, whether a debt contract allows accounting method changes to affect contract calculations (ACC_Change) is not significantly correlated with any of the control variables. The second column of Table 5 does show, however, that when accounting changes affect contract calculations

might influence the accounting choice decision (COMP, SMLOSS, SMLOSS_NL,

and no accounting-based performance-pricingor dividend restrictions exist (i.e.,

NoPPorDiv_Res =1), borrowers are less likely to pay their executives a bonus based on accounting performance and are more likely to report large losses. These correlations sug-

gest that it may be importantto control for managementcompensationand incentives to when we test our debt-contracting meet earningsbenchmarks hypotheses. with borrower size. Specifically,larger variablesarecorrelated Manyof ourindependent debt contractsare less likely to bonuses. Meanwhile,largerborrowers' based performance

borrowers are more likely to have accounting-based dividend restrictions that are not combined with performance pricing, and are more likely to pay their executives accounting-

allow accounting changes to affect contract calculations when there are no dividend restrictions or performance pricing. Larger borrowers are also less likely to report a large loss before the effect of the accounting change, or an NOL, and are less likely not to list their shares on a major exchange. Not surprisingly, borrowers with NOLs are more likely to report losses, either large or small; are more likely to experience CEO turnover; and are

less likely to pay their executives a bonus based on accountingperformance.

Regression Analysis Table 6 reportsthe results of our logistic regressions.Model (1), which we use to test
Hypotheses 1 and 2, has explanatory power of 24.3 percent. This model correctly classifies

81.6 percentof the accountingmethod changes as increasingor decreasingincome, comparedto a naive predictionaccuracyrate of 55.4 percentif we assume that all accounting changesincreaseincome. The second model, which we use to test Hypotheses3 and 4, has power at 27.8 percentand correctlyclassifies 84 percentof the slightly higherexplanatory or accountingchanges as either income-increasing income-decreasing.8 in The significantlypositive coefficienton ACC_Change Model (1) indicatesthat borrowers that change accounting methods are more likely to make changes that increase income when the changes affect debt contract calculations. Following Amemiya (1981, 1488), we convert the estimated coefficient to a change in probability by multiplying the

estimatedlogit coefficientby 0.25. Borrowersare 39 percent(1.57 x 0.25) more likely to make income-increasing(ratherthan income-decreasing)accountingchanges when their
8

The sign and magnitude of the effect of the accounting change are the same on both net income and net worth when the firm accounts for changes in accounting methods using either the cumulative effect or prospective method. However, 22 of our sample borrowers use the retroactive approach, where changes in accounting methods have different income statement and net worth effects. Excluding these firms from our analyses does not alter our conclusions.

TABLE 5 Pearson Correlations among Independent Variables (significance levels in parentheses)

ACC_ Change NoPPor DivjRes PP DivRes PP&Div_ One_ Lender COMP Res LG SM SM LOSS LOSS_NL LOSS

ACC_Change NoPPorDiv_Res PP Div-Res PP&Div_Res One_Lender COMP SMLOSS SMLOSS_NL LGLOSS

1.00 0.33 (0.00) 0.28 (0.00) 0.41 (0.00) 0.36 (0.00) 0.31 (0.00) 0.01 (0.94) 0.02 (0.80) 0.04 (0.67) 0.09 (0.31) 1.00 -0.14 (0.13) -0.19 (0.02) -0.17 (0.05) 0.27 (0.00) -0.23 (0.01) 0.01 (0.92) -0.02 (0.82) 0.20 (0.02) 0.19 (0.04) 1.00 -0.17 (0.06) 1.00 1.00 0.03 (0.76) 0.12 (0.1I9) 0.10 (0.29) 0.05 (0.60) 0.00 (0.98) -0.02 (0.85) 1.00 0.03 (0.76) -0.04 (0.63) 1.00 0.05 (0.55) 1.00 0.62 (0.00) 1.00 1.00

-0.15 -0.22 (0.10) (0.01) -0.13 (0.15) -0.00 (0.99) 0.23 (0.00) 0.12 (0.19)

-0.01 -0.06 (0.89) (0.48) 0.11 -0.06 (0.23) (0.49) 0.11 -0.15 (0.23) (0.10) 0.12 -0.13 (0.18) (0.15)

-0.01 -0.01 (0.88) (0.90)

-0.16 -0.26 0.06 -0.09 (0.53) (0.33) (0.01) (0.07) -0.07 0.10 -0.19 -0.12 (0.27) (0.04) (0.20) (0.44)

LGLOSS_ACEO 0.09 (0.34)

0.46 (0.00)

TABLE 5 (continued)
ACC_ NoPPor Change Div-Res PP DivRes PP&DivRes SM LG SM OneLender COMP LOSS LOSS_NL LOSS

NOL SIZE NLIST A~CEO

0.04 (0.67) -0.04 (0.67) -0.02 (0.80) 0.06 (0.51)

0.05 (0.60) -0.24 (0.01) 0.04 (0.64) 0.08 (0.41)

0.09 -0.08 (0.30) (0.37) 0.24 -0.07 (0.43) (0.01) -0.01 -0.10 (0.88) (0.26) 0.11 (0.22) 0.00 (0.98)

0.02 (0.84) -0.04 (0.70) 0.05 (0.56) -0.09 (0.34)

-0.01 -0.18 (0.89) (0.04) -0.39 (0.00) 0.21 (0.02)

0.00 (0.92)

0.16 (0.07)

0.31 (0.00)

0.10 -0.10 (0.29) (0.27) 0.19 (0.04) -0.03 (0.72) 0.49 (0.00) 0.10 (0.27)

-0.22 (0.01)

0.06 -0.16 (0.53) (0.07) 0.16 -0.11 (0.07) (0.72)

0.14 (0.1I1

0.25 (0.01)

Variables are defined in Table 4.

on Beatty and Weber-Effects of Debt Contracting AccountingChanges

137

TABLE 6 Coefficients and (t-statistics) from Logit Regressions of the Sign of the Income Effect of Voluntary Accounting Changes on Debt Contracting and Control Variables Sample of 64 Income-Increasingand 57 Income-DecreasingVoluntary Accounting Method Changes, 1995-2000 Predicted Sign
+

Variable Intercept Debt Contracting Variables

Model (1) Coefficient (t-statistic)

2.36 (1.28)

Model (2) Coefficient (t-statistic)

2.92 (1.49)

1.57 Acc_Change NoPPorDiv_Res PP Div_Res PP&Div_Res One_lender ControlVariables COMP SMLOSS SMLOSS_NL LGLOSS LGLOSS_ACEO NOL
+ +

+ + + +
+

(3.19)*** 0.20 (0.26) 2.34 (2.42)*** 1.84 (2.72)***

2.01
(2.52)*** -2.36 (-2.99)*** 1.31 (2.71)*** -2.41 (-2.72)***

1.15 (2.32)*** 1.96 (2.14)** -5.91

(-3.42)***

1.69
+

(1.87)**

-5.13
(-3.23)***

-1.01
(- 1.69)**

-0.96
(- 1.55)*

-2.04
(-1.62)* 1.14

-2.59
(- 1.78)** 1.29 (1.62)* 0.28

(1.49)*
-+

SIZE Pseudo R2 PercentCorrectly Predicted

0.24 (1.74)* 24.3% 81.6

(1.89)*
27.8%

84.0

for ***, **, and * Indicatesignificanceat the 1 percent,5 percent,and 10 percentlevels, respectively, one- or two-tailedtests as appropriate. Variables definedin Table4. are

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debt contracts allow the accounting changes to affect contract calculations.9 This supports our first hypothesis, that debt contracting is an important consideration in borrowers' accounting method change decisions. The significant negative coefficient on One_Lender is consistent with our second hypothesis that borrowers that change accounting methods are less likely to make incomeincreasing accounting changes when the expected costs of technical default are lower, as should be the case when all of their bank debt contracts are from a single lender. Model (2) partitions ACC_Change into four mutually exclusive subgroups to provide evidence on our third hypothesis (that performance pricing provides additional incentives beyond those provided by traditional covenants) and our fourth hypothesis (that the incentives provided by covenants restricting dividend payments, either directly or indirectly, may differ from those provided by other covenants). The significantly positive coefficient on PP indicates that borrowers that make accounting changes are 59 percent (2.34 x 0.25) more likely to make income-increasing accounting method changes when the changes not only affect their covenants, but also affect their interest rates through performance-pricing provisions. This supports our third hypothesis. The coefficient on Div_Res indicates that borrowers are 46 percent (1.84 x 0.25) more likely to make income-increasing (rather than income-decreasing) accounting method changes when the changes affect their dividend restrictions. This is consistent with our fourth hypothesis. The coefficient on PP&Div_Res indicates that borrowers with both performance-pricing and dividend restrictions are 50 percent (2.01 x 0.25) more likely to report income-increasing accounting method changes than are borrowers with neither performance-pricing nor dividend restrictions. However, the coefficient on this variable is not significantly different from the coefficients on PP or on Div_Res. The insignificant coefficient on NoPPorDiv_Res indicates that we find no evidence that borrowers without performance-pricing or dividend restrictions were more likely to report income-increasing accounting method changes. We also find some evidence that management compensation incentives influence the choice between income-increasing and income-decreasing accounting method changes. Specifically, when managers receive accounting-based performance bonuses (COMP) they are more likely to make income-increasing changes. In addition, consistent with a "big bath" story, borrowers with new CEOs who report large losses before the effects of the accounting method changes (LGLOSS_ACEO) are more likely to report income-decreasing accounting changes than income-increasing changes. We also find some evidence that noncontracting motives to manage earnings affect borrowers' decisions to make income-increasing vs. income-decreasing accounting method changes. Specifically, we find borrowers with shares listed on a major exchange expecting to report a small loss prior to the accounting method change (SMLOSS) are more likely to report an income-increasing change, while those not listed on a major exchange are more likely to report an income-decreasing change (SMLOSS_NL). This is consistent with the Beatty, Ke, and Petroni (2002) conclusion that exchange-listed firms are more likely to manage earnings to beat earnings benchmarks than are firms that are not listed on a major exchange. Finally, we find some evidence that external parties affect accounting choices. Specifically, borrowers with NOL carryforwards who make accounting changes affecting taxes
9 The conversion with respectto a particular of factoris obtained takingthe derivative the predicted probability by model that derivative variable.For a linearprobability equalsthe estimatedcoefficient.For a logit independent of model thatderivative probability equalsthe estimatedcoefficientmultipliedby the exponential the predicted of dividedby the squareof 1 plus the exponential the predicted probability.

on Beatty and Weber-Effects of Debt Contracting AccountingChanges

139

are more likely to make income-increasing accounting changes than borrowers without such carryforwards. VI. SENSITIVITY ANALYSIS Signed Magnitude of Income Effect The tests of our hypotheses reported in Table 6 examine the sign of the income effect of the accounting method change but not the magnitude of the effect. In Table 7, we report the results of rank regressions of the signed magnitude of the income effect of the accounting change, scaled by assets before the effect of the change. The results are largely consistent with those from our logistic analyses. As our first hypothesis predicts, borrowers make accounting changes that have more positive effects on income when the accounting changes affect their debt contract calculations. Consistent with our second hypothesis, borrowers make accounting changes that have a less positive effect on income when the accounting changes affect their debt contract calculation, but the costs of covenant violation are lower because all of their bank debt contracts are with a single lender. With respect to our third and fourth hypotheses, borrowers whose bank debt has performance-pricing and dividend restrictions make accounting changes that have a more positive effect on income and, in fact, these appear to be the two most significant debt-contracting factors explaining the magnitude of the income effect. The results on our control variables largely conform to the results from our previous analyses. However, the performance-based executive bonus compensation variable (COMP) is insignificant in our rank regressions. We examine the sensitivity of our rank regression results to two alternative specifications. First, we re-estimate the regressions without ranking the data. After winsorizing the dependent variable for three outliers that fall more than 5 standard deviations from the mean, we obtain results similar to those in Table 7. We also obtain similar results when we re-estimate the rank regressions using the unscaled income effect of the accounting method change as the dependent variable. Debt-Contracting Variables We consider all bank debt contracts when we construct our debt-contracting variables. However, these variables do not incorporate covenants on non-bank debt. Since covenants on non-bank debt typically allow accounting changes to affect contract calculations (see Smith and Warner 1979), we include a dichotomous variable (PUB_COV) equal to 1 for firms with covenants on non-bank debt. When we include PUB_COV as another debtcontracting variable its coefficient is insignificant and our other results remain similar. We also include another variable equal to 1 if the borrower has public debt and accounting changes do not affect bank-debt calculations, 0 otherwise (PUB_COV x [1 - ACC_COV]). Again, the coefficient on this variable is insignificant, indicating that covenants on public debt do not appear to affect whether borrowers' accounting changes are income-increasing vs. income-decreasing, regardless of whether these accounting changes affect bank debt calculations. Our other results remain similar. Our debt-contracting variables capture the average effect of accounting-based covenants on the decision to record an income-increasing vs. an income-decreasing accounting change. However, this relation is likely to differ cross-sectionally, reflecting differences in expected cost of future violations. Since our One_Lender variable measures these differences only indirectly, we considered an alternative (indirect) proxy as an additional debt-contracting variable in our analyses. Following El-Gazaar and Pastena (1991), we consider the number of covenants as a measure of tightness of covenant restrictions. The number of covenants is not significant in our models. This may indicate either that the initial covenant tightness

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TABLE 7 Coefficientsand (t-statistics) from Rank Regressions of the Effect of Voluntary Accounting Changes on the Income Effect of the Accounting Change (Scaled by Assets Before the Effect of the Change) on Contracting and Control Variables Sample of 64 Income-Increasingand 57 Income-DecreasingVoluntaryAccounting Method Changes, 1995-2000 Predicted Sign
+

Variable
Intercept

Model (1) Coefficient (t-statistic)

50.30 (5.79)***

Model (2) Coefficient (t-statistic)

53.14 (5.99)*** ic

Variable Debt Contracting ACC_Chang

+ +
+ +

20.98 (3.21)** 4.57 (0.44)

34.25 (3.27)*** ic

NoPPorDiv_Res
PP Div_Res

26.25
(2.86)*** ic 15.82

PP&Div_Res One_Lender ControlVariables

+
-32.27

(1.70)** (-3.04)**
8.58

-29.57 (-2.63)*** 6.65

(1.02) 32.02 (3.04)*** -47.60 (-2.97)***

COMP SMLOSS SMLOSS_NL

(1.34)* 27.56
(2.62)*** -41.56 (-2.59)**

LGLOSS LGLOSS_ACEO NOL SIZE AdjustedR2

+

-0.95 (0.11)
-20.53

0.64 (0.08)
-20.14 (- 1.43)* 16.42 (1.71)**

(- 1.45)*
17.16 (1.76)** -0.05 (-0.53)

-0.09
(-0.87) 17.8%

15.25%

for ***, **, and * Indicatesignificanceat the 1 percent,5 percent,and 10 percentlevels, respectively, one- or two-tailedtests as appropriate. are Variable definedin Table4.

on Beatty and Weber-Effects of Debt Contracting AccountingChanges

141

is not an important determinant of the subsequent accounting choice decision, or that the number of covenants is not a good proxy for covenant tightness. VII. CONCLUSIONS Fields et al. (2001, 301) argue that "research on accounting choice addresses the fundamental question of whether accounting matters." However, they also state that "the evidence on whether accounting choices are motivated by debt covenant concerns is inconclusive." By analyzing contract-specific details, we provide sharper evidence on the importance of debt contracts in borrowers' accounting choices. Specifically, our tests capitalize on the facts that (1) many recent debt contracts do not allow borrowers to use voluntary accounting method changes to affect contract calculations, (2) debt contracts often include performance pricing features as well as debt covenants, and (3) debt contracting decisions may affect accounting choices of borrowers who are not approaching covenant violations. We find that borrowers that make accounting method changes are more likely to make income-increasing changes when their debt contracts allow these changes to affect contract calculations. This increase in likelihood of an income-increasing accounting change is lower when the borrower expects costs of technical violation to be lower because all of the borrower's bank debt is from a single lender. These results, which hold even after controlling for other motives for changing accounting methods (such as executive compensation incentives, incentives to meet earnings benchmarks, and incentives to reduce taxes), suggest that debt contracts influence borrowers' accounting choices. We also find that borrowers that voluntarily change their accounting methods are more likely to make income-increasing changes if their debt contracts include accounting-based performance-pricing or dividend restrictions. These results suggest that incentives to lower interest rates through performance pricing or to retain dividend payment flexibility influence borrowers' accounting method choices, thereby providing indirect evidence addressing the Fields et al. (2001) fundamental questions of whether, under what circumstances, and how accounting choice matters. Our focus on contract-specific details for borrowers who need not be approaching covenant violations creates two important data limitations. First, our tests do not include borrowers that do not file their bank debt contracts with the SEC because contract-specific information is unavailable for these borrowers. This could affect the generalizability of our results if the relation between debt contracting and accounting choice differs for these borrowers. To mitigate this concern we provide evidence that these borrowers made voluntary accounting changes that are similar to those made by our sample borrowers. In addition, we document that the excluded borrowers and sample borrowers are similar along a number of dimensions including firm size, income before the accounting change, and leverage. Second, we cannot directly test whether an accounting change (1) reduced the interest rate charged on the loan based on the performance pricing grid, (2) increased the borrower's flexibility to pay dividends, or (3) reduced the likelihood the borrower would violate a covenant. Since our sample includes borrowers that may be making accounting changes not only to affect the current debt contracting calculations, but also future calculations, we would need to estimate the effect of their accounting change on the interest rate, dividends paid, and covenant violations both in the quarter of the accounting change, and in all future quarters that could be affected by the accounting change as well. Since most borrowers have equity-based covenants and dividend restrictions, this means an accounting change would affect all future calculations until the debt matures. In addition, it is difficult to develop such estimates using only publicly available current period data. For example, when

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The AccountingReview,January 2003

we use balance sheet data available in the financial statements, the ratios we calculate are not equal to the ratios used in the debt contracts. For all these reasons, we leave it to future research to quantify the effects of borrowers' voluntary changes in accounting methods on their interest rates, dividend payments, and probability of covenant violations. REFERENCES Amemiya, T. 1981. Qualitativeresponsemodel: A survey.Journalof EconomicLiterature19 (December):1483-1586. pricing in privatedebt contracts.Working Asquith,P., A. Beatty, and J. Weber.2002. Performance MA. Instituteof Technology,Cambridge, paper,Massachusetts of performBeatty,A., I. Dichev, and J. Weber.2002. The role and characteristics accounting-based ance pricingin privatedebt contracts.Workingpaper,Universityof Michigan,Ann Arbor,MI. to , B. Ke, and K. Petroni.2002. Earnings management avoidearningsdeclinesacrosspublicly , K. Ramesh, and J. Weber.2002. The importanceof accountingchanges in debt contracts: The cost of flexibilityin covenantcalculations. Journalof Accountingand Economics33 (June): 205-227. debt Beneish,D., and E. Press. 1993. Costs of technicalviolationof accounting-based covenants.The to D., Burgstahler, and I. Dichev. 1997. Earningsmanagement avoid earningsdecreasesand losses. evidence on the debt covenanthypothesis.Journalof Dichev, I., and D. Skinner.2002. Large-sample El-Gazaar,S., and V. Pastena. 1991. Factors affecting the scope and initial tightness of covenant Research8 (Fall): 132-151. restrictions privatelendingagreements. in Accounting Contemporary Fields, T., T. Lys, and L. Vincent. 2001. Empiricalresearchon accountingchoice. Journal of Acdividend covenants.Journal of Healy, P., and K. Palepu. 1990. Effectivenessof accounting-based Mohrman,M. 1996. The use of fixed GAAP provisionsin debt contracts.AccountingHorizons 10 78-91. (September): in constraints publicand privatedebt agreements: Press,E., and J. Weintrop.1990. Accounting-based Their associationwith leverage and impact on accountingchoice. Journal of Accountingand An 1979. On financialcontracting: analysisof bond covenants.Journalof Smith, C., and J. Warner.
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