Do Debt Covenants Constrain Borrowings Prior to Violation? Evidence from SFAS 160

51 Pages Posted: 12 Jul 2012 Last revised: 19 Apr 2019

See all articles by Moshe Cohen

Moshe Cohen

Columbia Business School

Sharon P. Katz

INSEAD

Sunay Mutlu

Kennesaw State University - Michael J. Coles College of Business

Gil Sadka

University of Texas at Dallas

Date Written: June 12, 2018

Abstract

Prior evidence shows a reduction in leverage after covenant violations, but we do not know whether covenants affect leverage before they are violated. In this study, we use an exogenous accounting-based shock to debt covenants that relaxed covenant tightness (SFAS 160) and examine whether covenants constrain leverage for borrowers that are close to violation, even when the borrower is financially healthy. We find that SFAS 160 increased debt levels in firms that were close to violation. This increase in debt was driven by financially healthy firms, suggesting that the likelihood of future covenant violations could impede borrowing by firms. We also find an increase in investment sensitivity to Q after SFAS 160 in firms close to violation, suggesting the additional debt was used to make legitimate investments. Because SFAS 160 was passed in the midst of the financial crisis, it is difficult to generalize our findings to more normal financial periods.

Keywords: Debt, covenants, financial constraints, leverage, investments, default

JEL Classification: G01, G30, G31, G33, M21, M41

Suggested Citation

Cohen, Moshe and Katz, Sharon P. and Mutlu, Sunay and Sadka, Gil, Do Debt Covenants Constrain Borrowings Prior to Violation? Evidence from SFAS 160 (June 12, 2018). The Accounting Review, Vol. 94, No. 2, pp. 133–156, March 2019. Available at SSRN: https://ssrn.com/abstract=2102878 or http://dx.doi.org/10.2139/ssrn.2102878

Moshe Cohen

Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States
(212) 854-1486 (Phone)

Sharon P. Katz (Contact Author)

INSEAD ( email )

Boulevard de Constance
CEDEP No. 11
F-7705 Fontainebleau Cedex, 77305
France

Sunay Mutlu

Kennesaw State University - Michael J. Coles College of Business ( email )

1000 Chastain Road
Kennesaw, GA 30144
United States

Gil Sadka

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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