The Impact of Financial Covenants in Private Loan Contracts on Classification Shifting

Abstract

This study examines whether firms with private loan contracts that contain debt covenants based on earnings before interest, taxes, depreciation and amortization (EBITDA) are more likely to misclassify core expenses as special items (i.e., classification shift). Misclassifying core expenses as income-decreasing special items allows the firm to increase EBITDA and thereby potentially avoid debt covenant violations. Consistent with our expectation, firms misclassify core expenses as special items when at least one EBITDA-related financial covenant is close to violation. In addition, classification shifting is more prominent when financially distressed firms are close to the violation of at least one EBITDA-related covenant. While prior research on classification shifting focuses primarily on equity market incentives (e.g., meeting analysts’ earnings forecasts), our study extends this research to private loan contracts to highlight that creditors also affect classification shifting. Classification shifting appears to be an additional earnings management technique used by managers to avoid debt covenant violations.

Keywords: Classification shifting, debt contracting, private loans, EBITDA, special items

JEL Classification: M40, M41