Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting

Posted: 9 Jul 2019

See all articles by Peter R. Demerjian

Peter R. Demerjian

School of Accountancy, J. Mack Robinson College of Business, Georgia State University

John Donovan

University of Notre Dame - Department of Accountancy

Melissa F. Lewis-Western

Brigham Young University - Marriott School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: May 14, 2019

Abstract

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 to borrowers with greater income smoothing are more likely to include earnings-based covenants. A structural model that explores the cause of this relationship 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

Demerjian, Peter R. and Donovan, John and Lewis-Western, Melissa Fay, Income Smoothing and the Usefulness of Earnings for Monitoring in Debt Contracting (May 14, 2019). Contemporary Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3415643

Peter R. Demerjian

School of Accountancy, J. Mack Robinson College of Business, Georgia State University ( email )

GA
United States

John Donovan

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States

Melissa Fay Lewis-Western (Contact Author)

Brigham Young University - Marriott School of Business ( email )

Provo, UT 84602
United States
801-703-8426 (Phone)

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