The Effect of Debt Covenant Violation on the Use of Off-Balance-Sheet Operating Lease and Long-Term Debt
Posted: 2 May 2015
Date Written: April 30, 2015
Under current U.S. lease accounting standards, operating leases are considered off-balance-sheet (OBS) financing, thus allowing firms to use an operating lease as hidden debt. We show that firms’ leverage, debt covenant violations, and tight covenant slacks have a large impact on the use of corporate OBS operating leases as well as long-term debt. Our results show that high risk profile firms in terms of their debt financing, characterized as those who have high leverage, or have violated their debt covenants, or are close to covenant violations, on average significantly reduce the use of OBS operating leases. However, for these high risk profile firms who have their business operating in industries where OBS leases are widely used, they significantly increase the use of OBS operating leases. In other words, our results indicate that firms, who belong to industries where operating leases are heavily used, use OBS leases as a substitute (an alternative source of financing) to long-term debt in their financing activities when their debt financing condition is weakened. We find that this significant increase in OBS operating leases is even more prominent during the economic recession periods. Our findings of the use of OBS leases following debt covenant violations or when being close to violations, provide incremental evidence to the finance and accounting literature that has documented the significant impact of moral hazard and incentive conflicts between firms and their creditors on their debt financing policy.
Keywords: debt covenant violation, lease, off-balance-sheet financing
JEL Classification: M41
Suggested Citation: Suggested Citation