[Although costs of default underpin the debt covenant hypothesis, prior research provides limited evidence of their nature, magnitude, and impact on shareholder wealth. We show that announcements of technical default are associated with significant stock price declines. Combining post-default changes in terms of debt contracts with stock returns, we examine whether the consequences arising from renegotiation of lending agreements are priced in the market, and estimate that higher costs of borrowing and new restrictions on firms' opportunities impose wealth losses of 1.4% on shareholders. Leverage measures, frequently used in accounting research as proxies for economic effects of debt contracts, are found to be poor surrogates for default or renegotiation costs.]

[Costs associated with the violation of accounting-based covenants in debt agreements are presumed to be material by both accounting regulators and researchers. The Financial Accounting Standards Board, for example, delayed the implementation of its pronouncement on pension reporting, SFAS No. 87, for two years to allow firms sufficient time to "renegotiate or to obtain waivers of provisions of some legal contracts" (FASB 1985, par. 260). Numerous studies in accounting research hypothesize that it is costly for firms to violate accounting covenants in debt agreements, and this supposition figures in research on such issues as the economic impact of mandated and voluntary accounting changes (see, e.g., Holthausen 1981; Leftwich 1981; Lys 1984) and the determinants of accounting choice (see, e.g., Trombley 1989; Zmijewski and Hagerman 1981). Although research in financial economics has studied some of the costs shareholders bear when there are debt service defaults or bankruptcy filings, the costs associated with technical violation-the violation of covenants other than debt service-have not been documented. This study investigates the costs of technical violation for a sample of 91 firms that violated accounting-based covenants in debt agreements between 1983 and 1987. The sample includes firms for which the technical violation was sufficiently material to merit disclosure. We provide direct evidence of refinancing and restructuring costs by examining changes in terms of debt agreements, and changes in investing and financing decisions. Refinancing costs arise because lenders raise interest rates on loans and notes following violation. We estimate that increased interest costs resulting from violation range between 0.84 and 1.63 percent of the market value of sample firms' equity. Restructuring costs stem from lenders' demands for partial or full repayment. Nearly half the sample firms either refinanced their debt or divested assets within one year of violation, stating that the proceeds were to reduce the outstanding balances of violated debt agreements. We estimate that the costs of restructuring debt represent an average of 0.37 percent of sample firms' market value of equity. We also present some evidence that there are costs associated with modifying operations, although we cannot estimate their magnitude; lenders' repayment demands impose restructuring costs by forcing firms to eliminate profitable investment projects. In addition to these costs, increased lender control is an important effect of technical violation. We observe that lenders add numerous new covenants. Interestingly, few of these are accounting-based, which suggests that only slight adjustments to accounting-based monitoring are required. The majority of new covenants consists of restrictions on investing and financing to prevent further dissipation of assets. We consider whether the costs of technical violation vary according to lender response. We find that the costs are lower for firms that can obtain a waiver than for those that cannot. More important, the evidence suggests that lenders often extract fees and concessions from violators in exchange for granting waivers. This is one of the first studies to substantiate that technical violation of accounting-based covenants is costly. Depending on the assumptions made, the average costs we estimate range between 1.2 and 2 percent of market value of equity; alternatively, the losses represent between 4.4 and 7.3 percent of the outstanding balances of the violated debt agreements. Evidence on the costs of technical violation is relevant to researchers who attribute economic consequences to changes in debt covenant slack and the likelihood of violating accounting-based covenants. Furthermore, by showing that leverage proxies for the magnitude of some of the costs imposed by technical violation, we justify the use of this surrogate in accounting research.]

For a random sample of 83 firms, we show that public and private debt agreements filed at the SEC yield a more comprehensive set of accounting constraints than annual reports or Moody's. For firms with accounting constraints, measures of proximity to leverage, net worth, and working capital constraints are significantly correlated to leverage. We incorporate constraint-related data into Zmijewski and Hagerman's (1981) income strategy model. Both a leverage constraint indicator and leverage are significantly associated with accounting choice. This suggests that leverage is proxying for factors in addition to the existence of accounting-based constraints.

Abstract Industry classification is an important component of the methodological infrastructure of accounting research. Researchers have generally used the Standard Industrial Classification (SIC) system for assigning firms to industries. In 1999, the major statistical agencies of Canada, Mexico, and the United States began implementing the North American Industry Classification System (NAICS). The new scheme changes industry classification by introducing production as the basis for grouping firms, creating 358 new industries, extensively rearranging SIC categories, and establishing uniformity across all NAFTA nations. We examine the implications of the change for accounting research. We first assess NAICS's effectiveness in forming industry groups. Following Guenther and Rosman 1994, we use financial ratio variances to measure intra‐industry homogeneity and find that NAICS offers some improvement over the SIC system in defining manufacturing, transportation, and service industries. We also evaluate whether NAICS might have an impact on empirical research by reproducing part of Lang and Lundholm's 1996 study of information‐transfer and industry effects. Using SIC delineations, they focus on whether industry conditions or the level of competition is the main source of uncertainty resolved by earnings announcements. Across all levels of aggregation, we find inferences are similar using either SIC or NAICS. How‐ever, we also observe that the regression coefficients in Lang and Lundholm's model show smaller intra‐industry dispersion for NAICS, relative to SIC, definitions. Overall, the results suggest that NAICS definitions lead to more cohesive industries. Because of this, researchers may encounter some differences in using NAICS‐industry definitions, rather than SIC, but these will depend on research design and industry composition of the sample.

Abstract. This paper contrasts technical default, debt service default and bankruptcy, and establishes that the valuation effects of their announcements are significant and increasingly severe. We show the events are interrelated. Specifically, we show that technical default is a timely warning of further distress insofar as adverse stock price effects of debt service default are mitigated if preceded by technical default. We find this arises in part because technical default increases the likelihood of further distress. The extent of the mitigation suggests reduced costs of future distress, likely because technical default triggers the early exercise of contractual rights that allow lenders to increase control over the firm. We also evaluate explanations of why debt service default and bankruptcy occur without firms first reporting technical default. Our analysis is based on the small sample of firms for which we can ascertain the terms of debt covenant constraints. Given this limitation, we find that it is not because debt agreements are written with too much covenant slack, nor do we observe material cases of nonreporting of covenant defaults. We conclude that covenants do not always provide warnings of future difficulties. Résumé. Les auteurs établissent la différence entre le manquement technique, le manquement au service de la dette et la faillite et font la preuve que les conséquences de ces indicateurs sur l'évaluation des entreprises sont appréciables et de plus en plus sérieuses. Ils démontrent que ces événements sont reliés entre eux et, plus précisément, que le manquement technique est un avertissement hâtif d'autres difficultés, dans la mesure où les conséquences néfastes du manquement au service de la dette sur le cours des actions sont atténuées si ledit manquement est précédé par un manquement technique. Les auteurs en viennent à la conclusion que cette situation se produit en partie parce que le manquement technique augmente la probabilité d'autres difficultés. L'ampleur de cette atténuation permet de supposer une réduction des coûts associés aux autres difficultés, sans doute parce que le manquement technique déclenche l'exercice anticipé des droits contractuels qui permettent aux bailleurs de fonds de resserrer le contrôle qu'ils exercent sur l'entreprise. Les auteurs évaluent également les facteurs qui expliquent pourquoi une entreprise peut manquer au service de la dette et faire faillite sans faire d'abord état d'un manquement technique. Leur analyse se fonde sur un petit échantillon d'entreprises à l'égard desquelles il est possible de s'assurer des conditions relatives aux contraintes imposées par les clauses restrictives des contrats de prêt. Compte tenu de cette limitation, les auteurs concluent que ce genre de situation n'est pas attribuable au fait que les contrats de prêt comportent des clauses trop permissives et n'observent pas non plus de cas probants de non‐divulgation d'information relative au manquement aux clauses restrictives. Ils en déduisent que les clauses restrictives ne préviennent pas toujours les difficultés futures.

Abstract Examines whether the consequences arising from renegotiation of lending agreements are priced in the market. Technical default; Wealth losses from higher costs of borrowing and restrictions on firms' opportunities; Stock price declines; Debt covenant violation.

Abstract Costs associated with the violation of accounting-based covenants in debt agreements are presumed to be material by both accounting regulators and researchers. The Financial Accounting Standards Board, for example, delayed the implementation of its pronouncement on pension reporting, SFAS No. 87, for two years to allow firms sufficient time to "renegotiate or to obtain waivers of provisions of some legal contracts" (FASB 1985, par. 260). Numerous studies in ace counting research hypothesize that it is costly for firms to violate accounting covenants in debt agreements, and this supposition figures in research on such issues as the economic impact of mandated and voluntary accounting changes (see, e.g., Holthausen 1981; Leftwich 1981; Lys 1984) and the determinants of accounting choice (see, e.g., Trombley 1989; Zmijewski and Hagerman 1981). Although research in financial economics has studied some of the costs shareholders bear when there are debt service defaults or bankruptcy filings, the costs associated with technical violation-the violation of covenants other than debt service-have not been documented. This study investigates the costs of technical violation for a sample of 91 firms that violated accounting-based covenants in debt agreements between 1983 and 1987. The sample includes firms for which the technical violation was sufficiently material to merit disclosure. We provide direct evidence of refinancing and restructuring costs by examining changes in terms of debt agreements, and changes in investing and financing decisions. Refinancing costs arise because lenders raise interest rates on loans and notes following violation. We estimate that increased interest costs resulting from violation range between 0.84 and 1.63 percent of the market value of sample firms' equity. Restructuring costs stem from lenders' demands for partial or full repayment. Nearly half the sample firms either refinanced their debt or divested assets within one year of violation, stating that the proceeds were to reduce the outstanding balances of violated debt agreements. We estimate that the costs of restructuring debt represent an average of 0.37 percent of sample firms' market value of equity. We also present some evidence that there are costs associated with modifying operations, although we cannot estimate their magnitude; lenders' repayment demands impose restructuring costs by forcing firms to eliminate profitable investment projects. In addition to these costs, increased lender control is an important effect of technical violation. We observe that lenders add numerous new covenants. Interestingly, few of these are accounting-based, which suggests that only slight adjustments to accounting-based monitoring are required. The majority of new covenants consists of restrictions on investing and financing to prevent further dissipation of assets. We consider whether the costs of technical violation vary according to lender response. We find that the costs are lower for firms that can obtain a waiver than for those that cannot. More important, the evidence suggests that lenders often extract fees and concessions from violators in exchange for granting waivers. This is one of the first studies to substantiate that technical violation of accounting-based covenants is costly. Depending on the assumptions made, the average costs we estimate range between 1.2 and 2 percent of market value of equity; alternatively, the losses represent between 4.4 and 7.3 percent of the outstanding balances of the violated debt agreements. Evidence on the costs of technical violation is relevant to researchers who attribute economic consequences to changes in debt covenant slack and the likelihood of violating accounting-based covenants. Furthermore, by showing that leverage proxies for the magnitude of some of the costs imposed by technical violation, we justify the use of this surrogate in accounting research.