Do debt covenants constrain borrowings prior to violation? Evidence from SFAS 160
Moshe Cohen, Sharon Katz, Sunay Mutlu, and Gil Sadka
The Accounting Review (forthcoming)
Overview Prior evidence shows that leverage is reduced after covenant violations, but we do not know whether leverage is affected before covenants are violated. In December 2007, the US Financial Accounting Standards Board (FASB) issued SFAS 160, which mechanically relaxed certain covenant types. This study uses SFAS 160 as an exogenous, accounting-based shock to debt covenants that relaxed their tightness to examine whether covenants constrain leverage for borrowers that are close to violation, even when they are financially healthy. We find that SFAS 160 increased debt levels in firms that were close to violation and that financially healthy firms drove this increase. We conclude that the likelihood of future covenant violations could impede borrowing. We also find an increase in investment sensitivity to Q after SFAS 160 in firms close to violation, suggesting that the additional debt was used to make legitimate investments. Because SFAS 160 was passed during the financial crisis, generalizing our findings to normal financial periods is difficult.
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