Borrower and Lender Perceptions of Accounting Information in Corporate Lending Agreements.

Abstract Economic consequences theories (Watts and Zimmerman 1986) formulate ex ante, that costs of debt covenant violations are significant, while the limited empirical evidence focuses on ex post costs. The expected economic consequences of debt covenant violations are a function of the borrowers' and lenders' perceptions of these violations, although we know of no systematic analysis of the way borrowers and lenders perceive covenant violations and their related costs. We survey borrower and lender perceptions of: (a) the use of accounting information in debt covenants, (b) the economic consequences of debt covenant violations, and (c) the renegotiations following violation. Borrowers include Fortune 500 Companies with public and private debt outstanding. Lenders include the private placement department heads of the top 100 insurance companies and the largest 400 banks. We find debt-to-equity ratio and tangible net worth covenants to be the two covenants most likely to contribute to a technical default in both public and private debt. Furthermore, our evidence supports the assertion made by Smith and Warner (1979) that private debt agreements include more restrictive covenants, resulting in a higher likelihood of violations than in public debt. Ninety-three percent of responding lenders do not perceive violations of accounting-based debt covenants as serious. Both borrowers and lenders indicate a waiver of violations as the most likely consequence. The probability of waiver is perceived to be higher for private than for public debt. Our results also indicate that waivers are perceived to be costly. The cost of waivers is lower for private debt. In choosing accounting methods, borrowers rank debt covenants ahead of compensation contracts and the political environment, although most commonly used, industry convention, and level of reported income are ranked as the top three factors.