Debt Contracts and FAS No. 19: A Test of the Debt Covenant Hypothesis.

Abstract The objective of this study is to evaluate the debt covenant hypothesis by using the details of lending agreements at the time of the FAS No. 19 Exposure Draft If adopted, FAS No. 19 would have eliminated the use of the full-cost method for firms involved in oil and gas exploration. Several studies found a significant difference between the abnormal returns of full-cost and successful-efforts firms in response to the release of the FAS No. 19 Exposure Draft (Collins and Dent 1979; Lev 1979; Lys 1984), and this has been hypothesized to result from possible effects on accounting-based covenants in debt contracts. However, empirical tests were indirect in that variables of financial leverage were used as proxies for debt covenant effects. According to the debt covenant hypothesis, firms choose accounting methods to maximize slack in debt covenant constraints. Mandatory changes in accounting methods might bring some firms closer to violating their debt covenants. Borrowing firms, however, can anticipate the possibility of such regulatory change and protect themselves, for example, by completely specifying the accounting methods that will be used to deter- mine covenant compliance, regardless of subsequent changes to generally accepted accounting principles. When outstanding debt contracts are so structured, the probability of default on accounting-based covenants could be unaffected by GAAP changes. Financial leverage variables fail to distinguish between firms with and without such protection. Using exhibits to SEC filings, I examined 83 debt contracts in effect in 1977 for each firm in a sample of 35 full-cost firms. I identified 13 firms that had at least one covenant that would have been affected by FAS No. 19. Portfolio tests indicated that these 13 firms drive the difference between the returns of full-cost and successful-efforts firms in the full sample. An alternate set of portfolios based on leverage as a proxy for debt covenant effects showed no relation to those based on actual debt contracts and also failed to explain the stock price response to the Exposure Draft release.