The Impact of Financial Covenants in Private Loan Contracts on Classification Shifting

Yun Fan (), Wayne B. Thomas () and Xiaoou Yu ()
Additional contact information
Yun Fan: College of Business, University of Texas at Arlington, Arlington, Texas 76010
Wayne B. Thomas: John T. Steed School of Accounting, Michael F. Price College of Business, University of Oklahoma, Norman, Oklahoma 73019
Xiaoou Yu: Institute for Financial and Accounting Studies, Xiamen University, 361000 Xiamen, China

Management Science, 2019, vol. 65, issue 8, 3637-3653

Abstract: This study examines whether firms with private loan contracts that contain debt covenants based on earnings before interest, taxes, depreciation, and amortization (EBITDA) are more likely to misclassify core expenses as special items (i.e., classification shift). Misclassifying core expenses as income-decreasing special items allows the firm to increase EBITDA and thereby potentially avoid debt covenant violations. Consistent with our expectation, firms misclassify core expenses as special items when at least one EBITDA-related financial covenant is close to being violated. In addition, classification shifting is more prominent when financially distressed firms are close to violating at least one EBITDA-related covenant. Whereas prior research on classification shifting focuses primarily on equity market incentives (e.g., meeting analysts’ earnings forecasts), our study extends this research to private loan contracts to highlight that creditors also affect classification shifting. Classification shifting appears to be an additional earnings management technique used by managers to avoid debt covenant violations.

Keywords: classification shifting; debt covenant; private loans; EBITDA; special items (search for similar items in EconPapers)
Date: 2019
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

Downloads: (external link)
https://doi.org/10.1287/mnsc.2018.3110 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:65:y:2019:i:8:p:3637-3653

Access Statistics for this article

More articles in Management Science from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().