Keywords

income smoothing, debt covenants, earnings monitoring

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.

Original Publication Citation

Demerjian, P., J. Donovan, and M. Lewis-Western. 2020. “Income smoothing and the Usefulness of Earnings for Monitoring in Debt Contracts”, Contemporary Accounting Research 37(2): 857–884.

Document Type

Peer-Reviewed Article

Publication Date

2019

Publisher

Contemporary Accounting Research

Language

English

College

Marriott School of Business

Department

Accountancy

University Standing at Time of Publication

Full Professor

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