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

Forthcoming in Management Science

42 Pages Posted: 17 Oct 2015 Last revised: 10 Feb 2019

See all articles by Yun Fan

Yun Fan

University of Oklahoma - Steed School of Accounting

Wayne B. Thomas

University of Oklahoma

Xiaoou Yu

California State University, Long Beach - College of Business Administration; Xiamen University - Institute for Financial and Accounting Studies

Date Written: December 23, 2017

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

Suggested Citation

Fan, Yun and Thomas, Wayne B. and Yu, Xiaoou and Yu, Xiaoou, The Impact of Financial Covenants in Private Loan Contracts on Classification Shifting (December 23, 2017). Forthcoming in Management Science, Available at SSRN: https://ssrn.com/abstract=2675191 or http://dx.doi.org/10.2139/ssrn.2675191

Yun Fan (Contact Author)

University of Oklahoma - Steed School of Accounting ( email )

307 W Brooks
Norman, OK 73019
United States

Wayne B. Thomas

University of Oklahoma ( email )

Michael F. Price College of Business,
307 W Brooks, Rm 212B
Norman, OK 73019
United States
405-325-5789 (Phone)
405-325-7348 (Fax)

Xiaoou Yu

California State University, Long Beach - College of Business Administration ( email )

1250 Bellflower Blvd.
Long Beach, CA 90840
United States

Xiamen University - Institute for Financial and Accounting Studies ( email )

Xiamen, Fujian 361005
China

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