Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting
58 Pages Posted: 11 Mar 2016 Last revised: 9 Nov 2018
Date Written: November 8, 2018
We investigate whether income smoothing affects the usefulness of earnings for contracting through the monitoring role of earnings-based debt covenants. First, we examine initial contract design and predict that income smoothing will increase (decrease) the use of earnings-based covenants if income smoothing improves (reduces) the usefulness of earnings to monitor borrowers. We find that private debt contracts for borrowers with greater income smoothing are more likely to include earnings-based covenants. A structural model exploring the cause of this relation provides evidence that smoothing improves the ability of earnings to reflect credit risk. Second, we examine technical default following contract inception. We find that income smoothing is associated with a lower likelihood of spurious technical default (when the borrower’s economic performance has not declined but the loan nevertheless enters technical default). In contrast, we find no association between income smoothing and performance technical default (when the borrower’s economic performance has declined). Collectively, this evidence is consistent with income smoothing improving the effectiveness of earnings-based information in monitoring borrowers.
Keywords: Income Smoothing, Debt Contracting, Financial Covenants, Technical Default
JEL Classification: G30, M40, M41, M43
Suggested Citation: Suggested Citation