Tightening the Noose: The Impact of FIN 48 on Corporate Borrowers
Posted: 13 Feb 2013
Date Written: February 6, 2013
We investigate the interaction of debt covenants and tax reporting upon the adoption of a financial accounting standard that codifies disclosures for income tax risks, 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 market. While FIN 48 generally results in firms reducing equity, we find that firms close to net worth covenants are more likely to reduce equity, but tend to make smaller (less negative) adjustments, consistent with prior research that shows firms try to avoid costly covenant violations. For firms near net worth debt covenant violation, the act of decreasing equity upon FIN 48 adoption leads to an average increase in cost of debt of 43 basis points. Our results suggest that the market anticipated potential debt impacts associated with FIN 48 as the cumulative abnormal return at the FIN 48 exposure draft release date is negative only for firms with large book-tax differences (more tax aggressive firms) that are also close to debt covenant violation.
Suggested Citation: Suggested Citation