Accounting Seminar（2016-11）

Topic:Internal Forecast Accuracy and the Preemption of Covenant Violations

Speaker:Jieying Zhang, University of Texas at Dallas

Time:Friday,June 17, 10:00-11:30

Place:Room219, Guanghua Building 1

Abstract:

Covenant violations that are resolved before the fiscal period end do not have to be reported. Suchpreemption of covenant violations provides lenders with the option to intervene early and mitigatesborrowers’ costs associated with reported violations. Thus, it is important to understand why somefirms preempt covenant violations but others do not. We argue that timely preemption requiresaccurate foresight of the impending violation. Accordingly, we investigate whether accurateinternal forecasts, proxied by management forecast accuracy, facilitate the preemption of covenantviolations. We find that firms with higher management forecast accuracy are less likely to reportcovenant violations, more likely to renegotiate timely, and have lower cost of debt. Furtheranalyses show that both the internal control firms rely on to form forecasts and the managerialbiases in forming forecasts contribute to these findings. To addressendogeneity, we show that anexogenous increase in the management forecast accuracy of small accelerated filers from SOX404 is associated with a decrease in their reported covenant violations and an increase in timelyrenegotiation. Our paper is among the first to identify the role of forward-looking accountinginformation in improving incomplete debt contracts.

Introduction: