Electronic copy available at: http://ssrn.com/abstract=2278946

Mandatory IFRS adoption, fair value accounting and accounting information in debt contracts*

Ray Ball The University of Chicago Booth School of Business

5807 South Woodlawn Avenue Chicago, IL 60637-1610

Tel. (773) 834-5941 ray.ball@chicagobooth.edu

Xi Li Fox School of Business

Temple University Philadelphia, PA 19122

xili@temple.edu

Lakshmanan Shivakumar London Business School

Regents Park London, NW1 4SA

United Kingdom lshivakumar@london.edu

Current Draft: 11 September, 2013

* We appreciate comments received from Hans Christensen, Valeri Nikolaev, Scott Richardson and participants in workshops at London Business School, Manheim University, Temple University, and University of Michigan, and in the University of Minnesota Empirical Conference. We thank Jose Carabias, Stephanie Markman, and Han-Up Park for research assistance. Ball gratefully acknowledges research support from the University of Chicago, Booth School of Business.

Electronic copy available at: http://ssrn.com/abstract=2278946

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Abstract

A significant fall in accounting-based debt covenants and increase in non-accounting covenants follows mandatory IFRS adoption. No such effects are observed in non-adopting countries. Moreover, the changes in covenant usage are associated with measures of the difference between prior domestic GAAP and IFRS, defined in terms of both general and fair value standards. We argue that several aspects of the fair value accounting rules in IFRS are unfavourable to debt contracting. Fair valuing incorporates shocks that are transitory or even reverse before debt maturity, and that would be excluded from covenant definitions (Li, 2010) if not too costly. Fair values also are subjective and manipulable. The IFRS option to fair value the firms own liabilities inhibits leverage covenants, where debts historical face value is relevant. We also argue that accounting covenant use is impacted by the IFRS treatment of convertible debt, method choices given to firms under IFRS, and uncertainty about future IASB rule-making. Overall, IFRS appear to sacrifice debt contracting usefulness for objectives such as complying with an abstract accounting measurement model and incorporating more contemporary information in the financial statements. Keywords: IFRS, Fair value, Debt covenants, Contracting, Accounting

Electronic copy available at: http://ssrn.com/abstract=2278946

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1. Introduction

We study the effect on debt contracting of the mandatory adoption of International

Financial Reporting Standards (IFRS). Compared to the previous rules in adopting countries,

IFRS incorporate a wider range of fair value measurements which, we argue, transformed

financial reporting from the perspective of debt contracting. We report that IFRS adoption is

associated with a decrease in accounting-based debt covenants and an increase in non-

accounting covenants. The changes in covenant use are related to the difference between

IFRS and the debt issuers prior domestic accounting standards generally, and also in the

extent to which IFRS contain more fair value accounting than prior domestic standards.

We propose several ways in which IFRS financial statements are less useful for debt

contracting, four of which involve fair value accounting. First, fair value gains and losses

incorporate transitory shocks to assets cash flows, making current earnings a poorer

predictor of future debt service capacity. This makes earnings a less efficient contracting

variable, particularly for longer-maturity debt (Li, 2010; Christensen and Nikolaev, 2012).

Second, fair value gains and losses include shocks to assets expected returns that are

expected to reverse in full or in part before debt matures. This makes both balance sheet and

earnings variables less efficient in debt contracting, again particularly for longer-maturity

debt.

Third, many fair value amounts are not derived from arms length prices in infinitely

liquid markets, but from subjective estimates ranging from estimated prices in illiquid

markets to discounted present values of future cash flows. Agency costs imply managers

exploit this subjectivity, which in part explains the traditional use of verifiable historical

costs in accounting (Watts and Zimmerman, 1986; Watts 2003). From the viewpoint of

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lenders, financial statements based on unverifiable estimates made by borrowers would not

seem to be an optimal basis for contracting.

Fourth, IFRS gives firms the option to fair value certain financial assets and

liabilities. This might make some sense from the viewpoint of matching asset and liability

measurement bases, but it is inimical to debt contracting. Debt is an agreement to repay

principal and interest, and not an agreement to repay fair value. Transferring decision rights

to lenders conditional on the borrowers credit risk deteriorating requires leverage covenants

that compare asset values with the amount of debt historically incurred, not its fair value. 1

Several additional properties of IFRS introduce uncertainty that is detrimental to debt

contracting. IFRS are principles-based and require substantial managerial judgement in their

application. Moreover, to gain acceptability across diverse political, economic, institutional,

and legal regimes, the IASB has provided managers with substantial choice of accounting

methods, creating additional uncertainty as to firms accounting measurements. Uncertainty

about future IASB rule-making and uncertainty about the immediate and subsequent effects

of IFRS adoption on accounting covenants likely compounded these effects. These

uncertainties add risk to borrowers and lenders, including the risk of extreme outcomes such

as covenants being tripped by rule changes alone (Deloitte, 2011), and thereby reduce the

efficiency of accounting-based covenants relative to alternatives.

First-time adoption is a temporary effect. Similarly, uncertainty surrounding rule-

making could be a temporary effect, or it could be a structural property of the IASB rule-

making process. Nevertheless, we conjecture that mandatory IFRS adoption was associated

with increased uncertainty about the effects of accounting-based debt covenants.

1 Similarly, IFRS accounts for convertible bonds by separating the debt and equity components of their issuance price. The purpose of leverage covenants is to trigger effects when the borrowers capacity to repay is impaired, in which case conversion is unlikely and the instrument is almost entirely debt.

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While there are several logically feasible debt-contracting responses to IFRS

introduction, we argue in the following section that these actions were not chosen voluntarily

under the prior accounting regimes, so they would constitute a less efficient mode of

accounting-based contracting than previously. We also argue that these responses involve

costs, and that some would not be feasible in practice.

We test the hypothesis that mandatory adoption of IFRS is associated with a

reduction in accounting-based debt covenants, using a sample of new debt issues between

1996 and 2010 in twenty IFRS-adopting countries and eight non-IFRS countries. Using a

difference-in-difference specification that controls for firm and debt issue characteristics, we

document a significant decline in both the frequency and intensity of accounting-based

covenants in IFRS-adopting countries after adoption, but not in other countries. The decline

is observed for both income statement covenants and balance sheet covenants. Greater

declines in accounting-based covenants are observed in countries whose pre-IFRS domestic

standards differed more from IFRS, and in countries where the difference involved fair value

accounting. The results are robust with respect to a variety of specifications.

A possible alternative explanation for the post-IFRS decline in accounting covenants

is that IFRS adoption and correlated regulatory changes improved financial transparency, and

this reduced the demand for covenants. We are sceptical of this argument. While increased

transparency could improve debt pricing in both primary and secondary markets, it would not

per se reduce the demand for covenants that transfer decision rights to lenders when violated.

Furthermore, we report two pieces of evidence that do not support this explanation. First, the

post-IFRS decline in accounting-based covenants is unrelated to country-level measures of

enforcement. Second, accounting covenants tend to be replaced by non-accounting

covenants, indicating substitution among (but not reduced demand for) covenants.

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This paper contributes to the literature on economic consequences of IFRS adoption.

To date, studies generally have addressed the equity market and concluded that mandatory

IFRS adoption is beneficial in that context (e.g., Barth, Landsman, and Lang, 2008; Daske,

Hail, Leuz, and Verdi, 2008; Armstrong, Barth, Jagolinzer, and Riedl, 2010; Kim, Tsui, and

Yi, 2011; Landsman, Maydew, and Thornock, 2012). Our evidence suggests a different result

for debt contracting, that financial statements under IFRS are less useful for covenant design.

This constitutes a market test of fair value accounting under IFRS, analogous to

Christensen and Nikolaev (2013).

The paper also contributes to the literature on the use of accounting information in

debt contracting. Several studies have documented that properties of accounting numbers

influence their use in debt contracts. For example, Nikolaev (2010) finds evidence that

accounting covenant use is associated with the degree of timely loss recognition. Costello

and Wittenberg-Moerman (2011) find that accounting-based covenant use falls when internal

control weaknesses impede financial statement reliability. Our study is related to the seminal

Leftwich (1983) study of non-GAAP contracting in private loan agreements, to the recent

Demerjian (2011) evidence that increased fair value accounting in the U.S. has eroded the

use of balance sheet based debt covenants, and also to Christensen and Nikolaev (2012).

There are several potential policy implications. The contrasting results for debt and

equity users challenge the rationale for general purpose accounting standards. The joint

IASB/FASB Conceptual Framework project (FASB, 2010, OB2) views investors, lenders,

and other creditors and decisions involving buying, selling, or holding equity and debt

instruments and providing or settling loans and other forms of credit as homogeneous. Our

arguments and results imply that for debt contracting purposes it is not optimal to use a

consistent accounting measurement model for all assets and liabilities, as apparently favoured

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by IASB and FASB, and advocated by researchers ranging from Chambers (1966) to Barth

(2013). They also highlight the distinction between recognition and disclosure, of fair values

in particular, since debt contracting is on the basis of the recognized amounts alone.

While it is not in our sample, the policy implications apply to the U.S. as well. U.S.

GAAP has adopted rules that are similar or equivalent to IFRS gradually over several

decades, more recently under a policy of ultimate convergence.2 Consequently, the effects

of the U.S. adopting these rules are dissipated over time and are difficult to identify against

background events. An advantage of our research design is that IFRS adoption occurs

relatively abruptly in our sample countries. In addition, we can exploit measures of the extent

to which countries prior domestic standards differed from IFRS, both generally and in

relation to fair value accounting. The results potentially provide insight into the more

dissipated effects of the U.S. adopting similar or equivalent rules to IFRS over time.

We hasten to add that our arguments and our results do not imply that either IFRS or

fair value accounting should be abandoned. Our more modest conclusion is that IFRS and

fair value accounting have important limitations for debt contracting purposes, the unique

properties of which do not appear to be reflected in the accounting standards. We also

acknowledge that, while both univariate and difference-in-difference analyses indicate a

decline in accounting covenant use after IFRS adoption, the result could have occurred due to

variables for which we have not controlled. Nonetheless, our evidence raises the bar for those

claiming that IFRS or fair value accounting is in some sense ideal.

The remainder of the paper is organized as follows. Section 2 develops testable

hypotheses. Section 3 describes the data and sample selection. Section 4 discusses results.

Section 5 discusses the results for additional analyses. Section 6 provides conclusions. 2 FASB (2013) indicates the convergence process began as early as 1999, was formalized in the Norwalk Agreement with IASB, and involved a joint commitment to using more fair value accounting.

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2. Hypotheses

The adoption of IFRS in many jurisdictions heralded radical changes in their

accounting rules and in the properties of financial statements prepared under the new rules.

This section outlines several ways in which, we conjecture, the changes adversely affected

the use of accounting-based covenants in debt contracting.

2.1 IFRS, fair value accounting, and debt contracting

IFRS adoption brings a strong tilt toward fair value accounting. The IASB has

replaced many traditional historical cost accounting methods with rules that measure assets

and liabilities at their fair values (Ernst and Young, 2005; Ball, 2006). Fair value

measurements are incorporated in IAS 16 (Property, Plant and Equipment), IAS 22 or IFRS 3

(Business Combinations), IAS 36 (Impairment of Assets), IAS 37 (Provisions, Contingent

Liabilities and Contingent Assets), IAS 38 (Intangible Assets), IAS 39 or IFRS 9 (Financial

Instruments: Recognition and Measurement), IAS 40 (Investment Property), IAS 41

(Agriculture), IFRS 2 (Share-based Payment), IFRS 4 (Insurance Contracts), IFRS 5 (Non-

current Assets Held for Sale and Discontinued Operations), and IFRS 13 (Fair Value

Measurement). Fair value is defined as: The price that would be received to sell an asset or

paid to transfer a liability in an orderly transaction between market participants at the

measurement date (IFRS 13, Appendix).

Fair value accounting apparently is founded on premises that all users can make more

informed decisions if (1) the basis of measurement for all assets and liabilities is consistent

(FASB, 2006 P4; FASB, 2008 P4) and (2) that basis is a measure of current market value.

This accords with, and possibly has been strongly influenced by, the classical accounting

literature (e.g., Chambers, 1966). This literature was developed prior to the emergence of

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costly contracting theory, which subsequently has transformed economic thought.3 It

provides no role for contracting on the basis of financial statement information, and for debt

contracting in particular. Thus, in the conceptual framework the IASB and FASB developed

jointly (FASB, 2006, 2008, 2010), there is no reference of any sort to users contracting on the

basis of the financial statements. While on the surface this framework appears to be directed

to the information needs of users, it sketches a supply-focused model of financial reporting.

The supply-based approach is exemplified by the IFRS 9 option to fair value certain

of a firms own liabilities, with the objective of better matching the measurement bases of

assets and liabilities (KPMG, 2010, p.7). This might make sense in the context of an abstract

accounting model that requires consistent measurement methods for all balance sheet

quantities and does not incorporate the uses to which financial statements are put. However,

it ignores the fact that debt contracts inherently imply matching assets with the face value of

debt, as measured by the amortized historical cost model. In other words, this IFRS standard

appears to be based on a supply-driven model of accounting that does not take salient

demand characteristics into consideration.

It is not unreasonable to conclude that IFRS have not been developed with costly

contracting in mind, including debt contracting. In this section, we describe some of the

potential shortcomings of IFRS from a debt contracting perspective, and discuss the costs and

feasibility of attempting to contract around those shortcomings.

2.1.1 Effect of transitory fair value components on income-based covenants

Many IFRS standards require changes in the fair values of certain assets and liabilities

to be reflected in the income statement as unrealized gains or losses. For instance, IFRS

3 Also known as transaction cost economics, its origins lie in Knight (1921), Commons (1931), Coase (1937, 1960) and Debreu (1959). The area later was transformed by Ross (1973), Jensen and Meckling (1976), Holmstrm (1979, 1982), and Williamson (1979, 1981), among many others.

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earnings incorporate gains and losses on investments held for trading purposes (IAS 39), on

biological assets such as animals and crops (IAS 41), on financial instruments (IAS 39, IFRS

9) and, if the option to fair value is chosen, on property, plant and equipment (IAS 16),

investment property (IAS 40), and the firms own qualifying liabilities (IAS 39).

To the extent that assets fair value gains and losses are due to shocks to expected

future cash flows, they are transitory (shocks to discount rates are discussed below) and large

(they are capitalized rather than flow quantities). We therefore expect IFRS to incorporate

substantial transitory components into earnings. Consistent with this expectation, Hung and

Subramanyam (2007) report that, for German voluntary IFRS adopters, IFRS earnings are

more volatile and transitory than previously reported under domestic German standards.

A central role of debt covenants is to act as ex-post trip wires that transfer decision

rights to lenders in states characterized by poor economic performance. We argue that an

earnings variable that incorporates transitory components is a less efficient predictor of future

debt service capacity and hence a less efficient contracting variable for transferring decision

rights to lenders in adverse future states (Li, 2010; Christensen and Nikolaev, 2012).

Consider the following example. A firm acquires assets costing $1000 that generate a

perpetual earnings and free cash flow stream of $100 per period. The discount rate is 10%, so

the fair value of the assets also is $1000. The assets are financed 40% by perpetual debt

paying 5%. At the beginning of a subsequent period, an adverse shock of -$10 occurs to the

cash flow stream. The discount rate is unchanged, so the new fair value of the assets falls to

$900. Future free cash flow of $90 is ample to service periodic interest payments of $20, yet

current-period earnings is -$10 ($90 less a fair value loss of $100). This illustrates how

contracting on an earnings variable inclusive of large capitalized fair value losses can trigger

earnings-based covenants even when debt service is not materially affected. Symmetrically, a

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positive shock to fair value, when capitalized and incorporated in earnings, also makes

current-period earnings a less efficient predictor of future debt service capacity.

One response to mandatory IFRS incorporating more fair value gains and losses in

earnings would be to substitute balance sheet covenants for income statement covenants,

since asset values are not transitive and fair valuing most likely improves balance sheet

predictive power. However, balance sheet covenants were not chosen voluntarily under the

prior accounting regimes, so they presumably provide a less efficient mode of contracting

than previously. For example, firms with substantial unrecorded intangible assets might

otherwise have found it more efficient to contract on earnings/debt rather than earnings/assets

ratios. Furthermore, in following subsections we argue that the usefulness of balance sheets

in debt contracting is impaired by other properties of fair value accounting.

An alternative response would be to contract on the basis of pre-IFRS domestic

standards (frozen GAAP). This would become increasingly problematic over time as the

domestic standards become outdated, so a more efficient response might be to contract only

out of particular IFRS standards. This would incur the costs of preparing and auditing

parallel sets of financial statements, and of maintaining old accounting and audit processes.

Consistent with transitory components rendering earnings a less efficient variable for

debt contracting, Li (2010) shows that borrowers and lenders tend to contract on an earnings

variable that excludes extraordinary items such as gains and losses on discontinued

operations, particularly for longer-maturity debt. However, Li (2010) studies a context in

which GAAP requires firms to report the information needed to contract around transitory

earnings components, and hence the information is independently audited and essentially

costlessly available to users. This is not the case with many fair value gains and losses, so

borrowers would incur the costs of keeping parallel books and having them audited.

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Firms that elect to fair value property, plant and equipment under IAS 16 record gains

and losses due to transitory shocks. If a shock is positive, under IAS 16 39 it is

incorporated in Other Comprehensive Income, not current-period Net Income, unless it is a

reversal of a prior loss (in which case it is booked in Net Income). If a shock is negative, IAS

16 40 incorporates it in current-period Net Income, unless it is a reversal of a prior gain (in

which case it is booked in Other Comprehensive Income). If disclosed, for balance sheet

covenants the shock can be contracted around at low cost by backing out the revaluation

reserve. However, the depreciation charge against future earnings is based on the revalued

amount of the asset, and backing out the effect on current earnings of all past capitalized

transitory gains would be a complex calculation for users to perform themselves, even for a

single asset. It would require information about the assets entire history of booked gain and

losses and a recalculated depreciation schedule. A contractual formula to implement this

calculation for a firm with thousands of assets would be complex and costly to implement.

Consequently, excluding many transitory fair value gains and losses from earnings by

contractual formula is not feasible, so borrowers would need to prepare parallel audited

financial statements or to contract on balance sheet ratios or on EBITDA or cash flow ratios.4

Similar arguments apply to other fair value standards, including IAS 41 on biological assets.

Fair value accounting also introduces debt-irrelevant earnings volatility through

changes in the fair values of assets that essentially hedge existing liabilities, but do not

quality for hedge accounting. Changes in fair values of the liabilities then impact earnings

later than those of the underlying assets, whereas under historical cost accounting they would

be matched at realization.

4 This helps explain the Christensen and Nikolaev (2013) result that few firms exercise the IAS 16 fair value option for property, plant and equipment.

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We conclude that fair value accounting incorporates transitory components in income

statement numbers, thereby reducing the usefulness of these numbers for predicting the

ability of the borrower to service future debt obligations.5 Contracting around this limitation

incurs increased costs under IFRS, so we predict that mandatory IFRS adoption is associated

with a decrease in income statement based covenants.

2.1.2 Effect of discount rate shocks on income and balance sheet covenants

Fair value gains and losses also originate in shocks to discount rates (expected

returns). While cash flow shocks are transitory, the effects of shocks to expected returns on

fair values are expected to reverse over asset lives. For example, if an assets fair value

increases due to an unanticipated fall in discount rates, then the fair value gain is expected to

be offset by lower future returns. To the extent that fair value reversion is expected before

debt matures, the shock is irrelevant for predicting future debt service capacity and hence for

debt contracting because it does not reflect a change in the expected cash available for debt

servicing. This is the case with standards addressing short-term assets such as traded

financial instruments (IAS 39, IFRS 9), which are more relevant for short-term loans. The

problem also applies to any asset or liability that is fair valued at current market price, at

estimate of current market price, or at present value of cash flows using a current discount

rate. The expected fair value reversion makes both book value and accounting income a

poorer predictor of the cash flow that the asset is expected to produce during the life of the

debt contract, and thus a poorer indicator of capacity to meet debt payments.

5 Covenants based on volatile accounting numbers also could be dropped if they induce managers to take sub-optimal risk positions. Lins, Servaes, and Tamayo (2011) document that several firms changed risk management policies when required to fair value their derivatives under SFAS 133 and IAS 39, and that changes were more likely when accounting numbers were used in contracting. DeFond, Hung, Li, and Li (2011) conclude that mandatory IFRS adoption increases the crash risk of banks, which they attribute to increased earnings volatility under fair value accounting.

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The problem also applies to asset impairment standards. IAS 36 56 specifies that the

discount rate used for fair value impairment measurement is the current market rate. The

issue from a debt contracting perspective is that part or all of any impairment due to an

increase in discount rates is expected to reverse before the debt matures. If the maturity of an

impaired asset is less than that of the debt, the fair value reduction is expected to completely

reverse before debt maturity. It would be less efficient to contract on a leverage covenant that

could be violated due to discount rate shocks which do not affect debt service capacity.

While asset impairment is a source of conditionally conservative accounting and likely

contributes to efficient debt contracting, failure to separate discount rate shocks from cash

flow shocks potentially hinders efficiency, particularly for longer-maturity debt.6

2.1.3 Subjectivity in measurement of fair values

Fair value accounting uses prices in actively traded markets if available. If liquid

market prices are not available, as generally is the case with longer-term assets in particular,

fair values are based on subjective estimates derived from valuation comparables, pricing

models, discounted future cash flow estimates, and other techniques. Agency costs imply

managers have the potential and incentives to exploit the subjectivity of these estimates

(Watts and Zimmerman, 1986; Watts, 2003).

Nevertheless, the IASB and FASB joint conceptual framework (IASB, 2010) pays

scant attention to verifiability. It views relevance and faithful representation as the

fundamental qualitative characteristics of accounting information (QC5), and these are

merely enhanced by verifiability (QC4). It elaborates (QC28):

6The comparable U.S. standard (SFAS 121 and SFAS 142) triggers impairment based on undiscounted cash flows. If triggered, impairment is to fair value calculated at the current discount rate. This inconsistency seems nonsensical from an abstract accounting measurement model perspective, but makes more sense from a debt contracting perspective.

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It may not be possible to verify some explanations and forward-looking financial information until a future period, if at all. To help users decide whether they want to use that information, it normally would be necessary to disclose the underlying assumptions, the methods of compiling the information, and other factors and circumstances that support the information.

An FASB staff member explained this joint choice as follows (FASB, 2005):

The Board has required greater use of fair value measurements in financial statements because it perceives that information as more relevant to investors and creditors than historical cost information. . In that regard, the Board does not accept the view that reliability should outweigh relevance for financial statement measures. Due to severe information asymmetry between borrowers and lenders concerning the

borrowers credit risk, we expect the verifiability of accounting measurements to be

especially important in the context of debt contracting. Relative to shareholders, debtholders

can be expected to have a stronger preference for verifiability over informativeness,

especially for good news (e.g., Watts, 2003; Ball, Robin, and Sadka, 2008), which in part

explains the traditional use of conservative historical cost accounting. From the viewpoint of

lenders, financial statements based on unverifiable estimates made by borrowers would not

seem to be an optimal basis for contracting. This provides an additional reason to expect that

IFRS adoption has a negative impact on the use of accounting-based debt covenants.

2.1.4 Option to fair value debt

IAS 39 (revised slightly in IFRS 9) provides firms with an option to fair value certain

of their own liabilities. This does not appear to be optimal from the viewpoint of debt

contracting, the fundamental reason being that debt is an agreement to repay principal and

interest, not to repay fair value.

Leverage covenants transfer some decision rights to lenders when the borrowers

credit risk deteriorates and its ability to service its debt obligations falls. These might include

veto rights on major financing and investment transactions, including dividends and share

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repurchases. Covenant violation also might trigger debt repricing, or the right to be repaid.

Leverage covenants based on balance sheet data involve comparing asset values with the

amount of outstanding debt obligations, not with debt fair values. A disadvantage of the fair

value method is that it reduces the balance sheet amount of debt in tandem with the ability of

the borrower to service it.

Consider a simple example with risk neutral investors requiring an expected return r.

A single-asset firm generates risky future cash flow A(1+r)/(1-p) with probability (1-p), and

zero otherwise. The firm is financed by debt promising to pay principal D and an interest

coupon rate of (1+r)/(1-p) -1. The probability of default on these payments is p. Because the

expected value of the principal and interest payments is D(1+r), the debt is issued at par

value D. At issuance, the balance sheet therefore shows a proportion d=D/A of debt finance.

Immediately after issuance, the default probability rises to p > p. The fair values of the asset and liability fall in tandem to A(1-p)/(1-p) and D(1-p)/(1-p) respectively. A fair valued balance sheet then records an unchanged debt proportion d, independent of the post-issuance

default probability, and thus is useless as a mechanism for triggering transfer of decision

rights to lenders when the borrowers credit risk deteriorates.

The above is a simplified illustration of how fair valuing liabilities reduces, and in the

limit completely eliminates, the effectiveness of balance sheet leverage covenants. While it

might provide better matching of asset and liability measurement bases, to comply with an

abstract accounting measurement model, that model does not incorporate debt contracting

and consequently ignores the fact that debt contracts inherently require mis-matched

measurement bases for assets and debt. In contrast, the amortized historical cost method

measures the present value of the principal and interest amounts contractually owed to

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lenders, calculated at the historical borrowing rate, and thus it provides a current measure of

the firms debt obligations.

An additional problem can arise when borrowers have substantial unrecorded assets.

Consider a firm whose credit is downgraded due to a fall in customer demand or other event

that reduces enterprise value but is not recognized on the balance sheet. The fair value of

liabilities decreases, but there is no offsetting decrease in fair value of assets, perversely

causing balance sheet leverage to decline.

A similar issue arises for bonds with an attached option to convert to equity

exercisable by lenders. IFRS 9 (previously, IAS 32 and IAS 39) requires the separate

components of the issuance price to be valued and recorded as debt and equity. The option is

unlikely to be exercised in the event of default, when the full amount of the debt is repayable,

not just the value of the non-equity component at issuance.

Feasible responses by borrowers and lenders would be to substitute income statement

covenants, to contract on frozen GAAP, to contract on a private set of financial statements

that do not fair value liabilities, or (in the case of convertibles) to define debt as including

their equity component. However, we argue above that the efficiency of these options in debt

contracting is impaired by other factors. Another response would be to contract out of fair

valuing liabilities. This would deny the borrower the IAS 39 option to fair value assets and

liabilities that do not qualify for hedge accounting, and the resulting accounting mismatches

could induce volatility in income statement and balance sheet ratios. All of these responses

induce costs of some sort, so we predict that mandatory IFRS adoption is associated with a

decrease in balance sheet covenants.7

7 In addition, to price risky debt in primary and secondary markets, users need to know historical costs (strike prices), but not fair values (which for pricing purposes are the dependent variable).

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2.2 Debt contracting and other properties of IFRS

This subsection outlines several sources of uncertainty arising from IFRS adoption

that, we propose, inhibit efficient debt contracting.

2.2.1 Uncertainty due to discretion over method choice

IFRS provide managers with substantial choice of accounting methods, apparently to

gain acceptability in a wide range of regimes. For instance, IAS 40 allows firms to report

investment property at either fair value or historical cost. Similarly, IAS 19 gives firms the

option to recognize actuarial gains and losses on post-retirement employee benefits fully in

the income statement or in the statement of comprehensive income, or to partly defer

recognition over time using the corridor approach.8 To lenders, this creates both uncertain

effects on accounting based covenants, as well as risk of managerial opportunism.

2.2.2 Uncertainty due to discretion over method implementation

IFRS are principles-based rules that lay down broad rather than specific requirements

and thus require more management judgement in application. To the lender, this creates

additional uncertainty over the effect of IFRS on accounting covenants, and risk of

managerial opportunism.

2.2.3 Uncertainty about future IASB rule-making

We conjecture that uncertainty about future IASB rule-making added further

uncertainty to the effect of IFRS on accounting covenants. The IASB made frequent changes

to IFRS prior to adoption by many countries in 2005. Figure 1 plots the number of new

standards or amendments to existing standards by year from 1997 to 2012. Changes made

simultaneously to multiple existing standards as a consequence of the issuance of a new

standard are treated as a single change. The frequency of published changes to IFRS 8 The European Commission (2008) reports that, among IFRS-adopting European firms, the choice of accounting for post-retirement employee benefits varies across industries and countries.

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standards substantially increased after the European Unions (EU) 2002 commitment to

adopt them for publicly-listed firms and after the actual adoption in 2005. In addition,

borrowers and lenders face uncertainty about the adoption or modification of individual IFRS

standards in their jurisdictions, the EU in particular.

Frequent revision could be a temporary phenomenon associated with the development

and adoption of the first complete set of IFRS standards in many jurisdictions. Alternatively,

it could be a structural property of the IASB rule-making process and multi-jurisdictional

adoption. The IASB is subject to a wider range of economic and political influences than any

individual countrys standard setting body, so it is reasonable to expect greater uncertainty

about its future actions. Only time will tell.

2.2.4 Uncertain first-time adoption and subsequent effects

The IASB issued IFRS 1 (First-time Adoption of International Financial Reporting

Standards) in June 2003. The standard requires firms reporting for the first time under IFRS

to thoroughly revise their balance sheets prepared under prior domestic rules. This involves

adding, deleting, and remeasuring assets and liabilities to comply with IFRS. Christensen,

Lee, and Walker (2009) argue that IFRS introduction consequently transferred wealth

between debt and equity investors.

Subsequent to first-time adoption, income statements and balance sheets are reported

under IFRS, not prior domestic rules. We argue that, prior to introduction, the first-time and

subsequent effects of IFRS on covenanted accounting ratios, and any attendant wealth

transfers, would have been uncertain. This would have constituted risk to both borrowers and

lenders, including the risk of covenants being tripped by rule changes alone. Subsequent to

adoption, experience with IFRS is likely to have reduced uncertainty about its effects on

accounting covenants, but it is unclear how long this uncertainty would have persisted. We

18

conclude that at least temporary and possibly lingering uncertainty to borrowers and lenders

using accounting covenants surrounded IFRS introduction, thereby reducing their use.

The IASBs governing body acknowledged this issue (IASC Foundation 2002, 22):

The IASB has no general policy of exempting transactions occurring before a specific date from the requirements of new financial reporting standards. When financial statements are used to monitor compliance with contracts and agreements, a new Standard may have consequences that were not foreseen when the contract or agreement was finalised. For example, covenants contained in banking and loan agreements may impose limits on measures shown in a borrowers financial statements. The IASB believes the fact that financial reporting requirements evolve and change over time is well understood and would be known to the parties when they entered into the agreement. It is up to the parties to determine whether the agreement should be insulated from the effects of a future accounting standard, or, if not, the manner in which it might be renegotiated to reflect changes in reporting rather than changes in the underlying financial position. No mention is made of renegotiation costs, which are substantial in the case of public

debt. Changes to accounting rules (and even changes to terminology) can impose covenant

renegotiation costs, redrafting costs, and legal fees.9

2.2.5 Summary

Uncertain future accounting rules and uncertain effects add risk to both borrowers and

lenders, including covenants being tripped by rule changes alone, thereby reducing the

efficiency of accounting-based covenants relative to alternatives. We conjecture that these

effects cause borrowers and lenders to reduce accounting-based covenants.

2.3 Costs of contracting around IFRS standards

It is logically possible for borrowing firms and lenders to contract around these

problems. Logically, they could contract on the basis of pro-forma financial statements

prepared under their countrys pre-IFRS rules (frozen GAAP), or prepared without

applying specific IFRS standards such as IAS 39 on financial assets and liabilities or specific

9 For example, IFRS requires separate disclosure of material items but does not refer to U.K. GAAPs exceptional items or provide an equivalent label. U.K. firms debt covenants that exclude exceptional items (Li, 2010) would require redrafting under IFRS.

19

parts of an IFRS standard such as fair valuing financial liabilities. All such adjustments

involve costs that did not exist prior to mandatory IFRS adoption, and render accounting-

based covenants less efficient relative to alternatives than they were prior to adoption.10

We noted above that, in contrast to the context studied by Li (2010), the information

needed to contract around many fair value measurements is not reported in the financial

statements and hence is not costlessly available to users. Borrowers would need to incur the

costs of keeping parallel books and having them audited. Consistent with this, we observe

frozen GAAP in 1% of cases of in a hand-collected sample, details of which are described

in Section 5.10. Moreover, in this sample, we also rarely observe any adjustments to

covenants for fair value accounting.

Consequently, we expect a substitution away from accounting-based covenants in

favour of alternatives.

2.4 Effect of possible improved transparency under IFRS

The arguments in the previous sub-sections lead us to the unambiguous expectation

that both income statement and balance sheet covenants would decline under IFRS, due to

both its emphasis on fair value reporting as well as due to the frequent changes to IFRS

standards. However, IFRS could also affect debt covenants through its effect on firms

financial transparency, although the effect of financial transparency on debt covenants is

ambiguous as discussed below.

IFRS often is viewed as significantly improving financial transparency. Moreover, the

increased reporting of fair values under IFRS increases the information content of financial

statements, which could potentially make the IFRS adoption lead to greater accounting

covenant use. These arguments are supported by the findings in Wu and Zhang (2009) and 10 Kvaal and Nobes (2010) report that, when allowed under IFRS, many firms continue to use their countrys pre-adoption domestic standards. This is consistent with firms attempting to reduce IFRS adoption costs.

20

Ozkan, Singer, and You (2012) that firms rely more on accounting earnings to make internal

evaluation decisions.

However, the theoretical model in Demerjian (2012) suggests that the demand for

covenants will decrease when financial transparency improves and lenders have clearer

information about the borrowers. Demerjian (2012) presents a model where lenders face

uncertainty about borrowers prior to contracting and shows that borrowers can mitigate this

concern by allowing lenders to use covenants as trip-wires that allow lenders to renegotiate in

the future when new information is received. In his model, the need for covenants is lowered

when information uncertainty is reduced through higher-quality financial reporting. Along

similar lines, Kim, Tsui, and Yi (2011) argue that banks are less likely to impose covenants

on borrowers using IFRS than those using domestic GAAP, because greater financial

transparency of IFRS reduces the demand for ex-post monitoring and recontracting. They

find support for their arguments in a sample of voluntary IFRS adopters. Thus the effect of

IFRS adoption on the use of accounting numbers in debt contracting is ambiguous.

2.5 Hypothesis

The above arguments lead us to the following hypothesis:

H1: Accounting-based covenant use in debt contracts falls after IFRS adoption.

3. Data and Sample Selection

Our primary data set combines multiple sources to compile a relatively large sample

of new debt issues made between 1996 and 2010 by firms in 28 countries. The information

on public bond issuance is obtained from Mergent FISD, Capital IQ, SDC Thomson One,

and Bloomberg. The information on private loan issuance is obtained from DealScan and

21

SDC Thomson One.11 We match borrowers from these databases with Compustat Global

data using available company identifiers provided by Excel Company ID, Cusip, Sedol, ISIN,

Ticker, and CIK. For borrowers that cannot be matched by these identifiers, we manually

match by borrower name and country.12 We merge each debt issue with the borrowers

accounting information on Compustat Global in the fiscal year immediately before the

issuance date. Countries that mandated IFRS in 2005 are the treatment sample. Following

Landsman, Maydew, and Thornock (2012), countries that retained their domestic accounting

standards during the sample period are the control sample.13 U.S. firms are excluded from the

control group because they attract more coverage by the data vendors, their disproportionate

representation could unduly influence the results, and because the IASB/FASB convergence

project pollutes the U.S. as a control.14

We require non-missing information on issue date, debt amount, yield spread,

covenants, and maturity. We exclude debt issues with no covenants recorded by the data

providers.15 This results in a sample of 5,134 debt issues. We further exclude firm-year

11 To construct the bond sample, we start with Mergent FISD and augment the dataset with (in order) Capital IQ, Bloomberg, and SDC, taking care to exclude duplication. To construct the loan sample, we start with DealScan and augment the dataset with SDC, again excluding duplication. Consistent with prior literature, we consider each loan facility as a separate observation, because loan features, such as yield spread, maturity, and offering amount, vary across facilities (Qian and Strahan, 2007; Kim, Tsui, and Yi, 2011). When excluding duplicate observations, if different data sources provide different numbers of accounting covenants, we keep the data source with the highest number to mitigate the concern that a particular data provider may understate covenant intensity. For example, Nini, Smith, and Sufi (2009) observe that DealScan under-reports the use of capital expenditure restrictions in loan contracts. 12 For borrowers in Mergent FISD, we use Cusip, Sedol, Ticker, and borrower name and country for matching. For borrowers in Capital IQ, we use the Excel Company ID-Gvkey link table provided by Capital IQ. For borrowers in SDC, we use CIK, Cusip, Sedol, and borrower name and country for matching. For borrowers in Bloomberg, we use ISIN for matching. For borrowers in DealScan, we manually match by borrower name and country. 13 The sample period in Landsman, Maydew, and Thornock (2012) ends in 2007. To make sure that there is no shift in the accounting regime after 2007 in our control sample, we manually check updates on each countrys accounting standards from the IAS Plus website at www.iasplus.com. New Zealand adopted IFRS in 2007 and therefore has been excluded from the control sample. 14 We ignore any pre-IFRS convergence of countries standards to IFRS, possibly under-estimating the true effects of IFRS adoption. 15 Only 10% of international debt issues have at least one recorded covenant. We exclude the remainder because our data providers suggest this is likely to be caused by them failing to collect covenant information, rather than

22

observations in the control sample of non-IFRS countries that voluntarily used IFRS (10

observations). We also exclude firm-years in the treatment sample of IFRS-adopting

countries that did not use IFRS for fiscal years ending in or after December, 2005 (173

observations) or did not use local accounting standards previously (252 observations).16 We

exclude firm-years that do not disclose the accounting standards used (14 observations).

Further, following Qian and Strahan (2007) and Kim, Tsui, and Yi (2011), we

exclude debt issued by firms in financial industries (SIC 6), as these firms face different

regulatory, financial reporting, and debt contracting issues. Lastly, we drop observations that

do not have enough data to calculate the variables used in our regressions. The final sample

comprises 3,037 observations, including 1,362 debt issues from 20 IFRS adoption countries

(treatment sample) and 1,675 debt issues from eight non-IFRS adoption countries (control

sample).

A potential concern is that our results could be due to an unobservable change in the

way the data providers cover debt issues or classify covenants. This seems unlikely, since

(for it to show up in our diff-in-diff tests) the change would need to occur at the time of IFRS

adoption, in IFRS-adopting countries but not in non-adopting counties, and independent of

the firm, industry, and debt issue characteristics for which we control.

We also report results from a secondary sample constructed from hand-collected

prospectus data for 758 public bond issues, 616 of which are in IFRS countries and 142 are in

non-IFRS countries. It is less representative than the primary sample, in that private loan

agreements are not publicly available for non-U.S. firms, but produces similar results.

covenant-free debt. Excluding issues without covenants also is consistent with prior literature (e.g., Demerjian, 2011; Christensen and Nikolaev, 2012). While this excludes debt issues that actually are covenant-free, our data providers and extant research suggest that covenant-free debt was relatively rare during the sample period. 16 Firms in the treatment sample that do not use IFRS after the mandatory adoption date might be exempted, for example being allowed to follow U.S. GAAP. These observations are removed to create a cleaner comparison between local GAAP in pre-adoption period and IFRS in post-adoption period.

23

Table 1 reports the distribution of the primary sample of debt issues by country.

Within the treatment group, 52% of the observations are from the U.K. and France, while

within the control group, 63% of the observations are from Japan and Taiwan.

4. Empirical Research Design and Results

4.1 Accounting covenant use pre- and post-IFRS (H1)

We use the following difference-in-difference models to examine the change in

accounting covenant use around mandatory IFRS adoption, where debt issued in non-IFRS

mandation countries is the control sample:

Pr(D_ACov=1) = 1 Post+ 2 IFRS+ 3 PostIFRS +Control Variables (1) Log(1+Num_ACov) = 1 Post+ 2 IFRS+ 3 PostIFRS +Control Variables (2)

Post is a dummy variable equal to one for fiscal years ending in or after December, 2005.

IFRS is a dummy variable indicating that the debt is issued by a firm in an IFRS-mandating

country. D_ACov and Num_ACov measure accounting covenant use. Equation (1) is a Probit

model examining the frequency of including accounting covenants in debt contracts. D_ACov

is a dummy variable defined as one if the debt contract contains at least one accounting-

based covenant, and zero otherwise.17 Equation (2) is an OLS model examining the intensity

of accounting covenant use. Num_ACov is the logarithm of one plus the count of the total

number of accounting-based covenants.18 In both models, a negative (positive) 3 indicates a decline (increase) in the use of accounting covenants after mandatory IFRS adoption.19

17 For public bonds, we follow Nikolaev (2010) and identify declining net worth, indebtedness, leverage test, maintenance net worth, net earnings test, and fixed charge coverage covenants as accounting-based. For private loans, we follow Demerjian (2011) and Christensen and Nikolaev (2012) and identify interest coverage, fixed charge coverage, debt-to-earnings, leverage, net worth, and current ratio covenants as accounting-based. 18 The log transformation is consistent with prior literature such as Becker and Strmberg (2012). 19 We do not predict the sign of 1 or 2, as there is no prior literature on the determinants of accounting covenant use in a cross-country setting.

24

The above specification does not allow the regression coefficients on control

variables to differ across treatment and control countries and/or across different time periods.

To control for the effects of institutional differences across IFRS and non-IFRS countries as

well as for the effects of changes in firm-level measures upon IFRS adoption, we extended

the specification to allow the regression coefficients to vary both between IFRS and non-

IFRS countries as well as between pre- and post-IFRS periods. These modifications leave

our conclusions unchanged (results untabulated).

We further classify accounting covenants into those based on income statement

numbers, such as debt-to-earnings, interest coverage, and fixed charge coverage covenants,

and those based on balance sheet numbers, such as indebtedness, current ratio, leverage, and

net worth covenants. The classifications are mutually exclusive. Although a debt-to-earnings

covenant employs both income statement and balance sheet numbers, we classify it as an

income statement covenant following prior literature (Demerjian, 2011; Christensen and

Nikolaev, 2012). D_ACov_IS is a dummy variable indicating that the debt contract contains

at least one income statement covenant. Num_ACov_IS is the total number of income

statement covenants. D_ACov_BS is a dummy variable indicating that the debt contract

contains at least one balance sheet covenant. Num_ACov_BS is the total number of balance

sheet covenants.

We control for firm, debt, industry, and country characteristics that might shape the

use of accounting covenants in debt contracts. Because smaller firms, higher-growth firms, as

well as those with fewer tangible assets and lower profitability face higher agency costs of

debt and hence greater demand for covenants, we control for firm size (logarithm of market

value of equity), market-to-book ratio (market value of equity divided by book value of

equity), asset tangibility (net PP&E divided by total assets), and profitability (EBITDA

25

divided by total assets). We also include leverage (total debt divided by total assets) as a

control variable, since leverage could exacerbate the agency cost of debt. However, leverage

could also reflect the firm having other debt contracts with covenants and prior lending

relationships, which could reduce the need for debt covenants in newly issued debt.20 In the

latter case, we would expect a negative relation between leverage and the use of accounting

covenants. The regressions also include a dummy for the availability of U.S. filings, since

borrowers with public debt or equity traded in the U.S. might be subject to different financial

reporting incentives and face different agency costs.21

To control for debt-level determinants of covenant usage, we include debt size

(borrowing amount), maturity (number of months to maturity), yield spread (offering yield to

maturity over benchmark risk-free rate)22, an indicator for secured debt, an indicator for the

availability of credit ratings, and an indicator for investment grade.23 Since debt issued by the

same firm may have different contractual features, we conduct our regression analysis at the

debt level, but cluster standard errors by both firm and calendar year of issuance to control

for potential correlations across observations within the same firm and year.24

20 For example, Yi (2005) shows that the number of covenants in a loan contract decreases as the intensity of the lending relationship increases. Beatty, Liao, and Weber (2012) find that public bondholders may choose to delegate monitoring of borrowers to existing senior creditors. 21 For example, Ball, Hail, and Vasvari (2013) find that public bonds issued by foreign firms cross-listed in the U.S. have lower interest rates. In untabulated robustness analysis, we also include a dummy variable for the availability of London Stock Exchange filings, and our conclusions are unchanged. 22 For public bonds, the proxy for the benchmark risk-free rate is the three-month LIBOR (interbank) rate at the country where the issuing firm is domiciled, obtained from Datastream. If the LIBOR rate for a country or year is not available, we use the local Treasury bill or government bond rate obtained from IMF. For private loans, consistent with prior literature, we directly use the variable all-in-drawn as a proxy for yield spread. Our results are not sensitive to the choice of the benchmark risk-free rate. 23 We use the average credit rating of the debt issue provided by three rating agencies, Standard & Poor, Moodys, and Fitch. If a rating is not available, we use the average rating for the issuer within one year of the issuance date. Credit ratings of BBB or above for Standard & Poor and Fitch and Baa or above for Moodys are identified as investment grade. As some of these debt characteristics are potentially simultaneously determined with covenant usage, in the robustness section, we evaluate the sensitivity of the results by using IV regressions to address the endogeneity of other debt features. 24 We get very similar and sometimes larger t-statistics if we cluster standard errors only at the firm level, as is common in studies of IFRS adoption effects in capital markets (e.g. Daske, Hail, Leuz, and Verdi, 2008;

26

Country-level controls include legal origin (Civil Law), creditor rights index (Cred

Rghts), and the importance of a countrys private debt market (PrivDebt Mkt). These

variables are motivated by prior literature and are used as proxies for the level of legal

protection that lenders enjoy and the development of the debt market in each country. We

also include industry (2-digit SIC) fixed effects to control for industry-specific factors that

affect accounting covenant use. All non-ratio accounting variables are converted from local

currencies to US dollars using the exchange rate at the fiscal year end. For debt denominated

in currencies other than US dollars, the borrowing amount is converted into US dollars using

the exchange rate at the issue date. All continuous variables are Winsorized at their 1 and 99

percentage levels.

4.1.1 Sample statistics

Table 1 reports by country the sample frequency of debt issues with accounting

covenants (the mean of D_ACov) and the intensity of use, defined as the average number of

accounting covenants (the mean of Num_ACov). There is large variation in use across

countries. Among IFRS-adoption countries, more than 70% of debt issued by firms in South

Africa, Philippines, and Greece contains accounting covenants, while no debt issued in

Austria, Portugal, or Switzerland contains any accounting covenants. Among non-IFRS-

adoption countries, more than 98% of debt issued by firms in Taiwan contains accounting

covenants, with the average debt contract containing three, while only less than 3% of debt

issued by Japanese companies includes any accounting covenants. Table 1 also reports

country indexes of legal protection and debt market development.

Table 2 and Figure 2 report accounting covenant use by calendar year of debt

issuance. Panels A and B plot the frequency and average number of accounting covenants, Landsman, Maydew, and Thornock, 2012). In following analyses, we report t-statistics with both firm and year clustering, except when specified in Tables 7 and 10.

27

respectively. In Figure 2, the dotted line represents IFRS countries and the solid line

represents non-IFRS countries. The vertical lines indicate the time of IFRS adoption,

December 2005, and the start of recent financial crisis, July 2007.

Prior to 2006, accounting covenant use in IFRS countries and non-IFRS countries

appears comparable. Figure 2 indicates the use frequency is volatile during that period, which

we attribute to tiny sample sizes (Table 2 shows that neither the treatment nor the control

sample exceeds 70 issues per year prior to 2003). Subsequently, the usage rates diverge. For

both the frequency and intensity of accounting-based covenant use in debt issuances, we

observe a significant decline in IFRS-adoption countries in 2006, a further decline in 2007,

and a relatively flat trend after 2007. This evidence is consistent with the hypothesis that debt

issued by firms using IFRS contains fewer accounting covenants than debt issued by firms

using domestic GAAP.25

From Table 2 Panel A, we note that the drop in accounting covenants for debt issued

in IFRS mandating countries occurs for both income statement covenants (D_ACov_IS and

Num_ACov_IS) and balance sheet covenants (D_ACov_BS and Num_ACov_BS). The

frequency (intensity) declines from 28.4% (0.466) in 2005 to 10.5% (0.200) in 2006 for

income statement covenants and from 27.3% (0.352) to 7.6% (0.086) for balance sheet

covenants. In contrast to IFRS countries, Table 2, Panel B shows no clear trend in any

measure of accounting covenant use after 2005 for firms in non-IFRS countries.26

Table 3, Panels A and B report summary statistics of the regression variables for both

treatment and control samples aggregated over all years in the pre- and post-adoption 25 The correlation of average D_ACov (Num_ACov) between IFRS countries and non-IFRS countries in the figure is 0.003 (0.44) from 1996 to 2005 and -0.50 (-0.56) from 2006 to 2010. 26 We replicate the analysis separately for U.S. firms. Consistent with Demerjian (2011) and Christensen and Nikolaev (2012), we find a decline in balance sheet covenant use between 1996 and 2007, followed by a partial reversal of this trend in the 2007-2010 period. Further, as in the above studies, income statement covenant use was relatively constant over the 1996-2010 period for private loans. However, when we extend the analysis to public bonds, we find a decline in income statement covenant use after the onset of the financial crisis in 2007.

28

periods, respectively. In IFRS-adopting countries, there are accounting covenants in 46.5%

of debt issued in the pre-adoption period, but only 12.1% in the post-adoption period. The

difference is statistically significant. The average number of accounting covenants

(Num_ACov) declines from 0.899 to 0.194 around IFRS adoption. This decline of over 70%

in covenant intensity is economically and statistically significant. In comparison, a decline is

not observed for debt issued in non-IFRS countries. In these countries, average D_ACov in

the pre- and post-adoption periods is almost unchanged at 44.2% versus 41.5%, and average

Num_ACov is slightly higher in the post-adoption period (1.124 versus 1.021). These

statistics indicate that the decline around IFRS adoption is not part of a global trend.

The last columns of Table 3 Panel A report mean difference-in-difference statistics,

comparing the change in covenant usage around 2005 between IFRS and non-IFRS

countries. The mean difference-in-difference values for D_ACov and for Num_ACov are -

0.317 (t-stat = -8.71) and -0.807 (t-stat = -8.81). These univariate results provide preliminary

evidence that IFRS adoption leads to a decline in both the frequency and intensity of usage of

accounting covenants in debt contracts.

4.1.2 Regression models

Table 4 reports multivariate regression results for Equations (1) and (2). Consistent

with the prediction that accounting covenant use declines after mandatory IFRS adoption, the

coefficients on PostIFRS are negative and significant in all model specifications in Panel A,

irrespective of controls for firm, industry, debt, and country specific determinants of

accounting covenant use. Columns (1) and (2) present results without debt-level controls,

some of which could be endogenous to covenant use. However, comparing the results in

column (2) with those when controls are included in column (3) shows that the coefficient on

PostIFRS declines slightly but is not very sensitive to the inclusion or exclusion of debt-

29

level determinants. The coefficients on PostIFRS also are economically significant. For

example, in column (3) the untabulated marginal effect of PostIFRS is -0.267, indicating

that debt issued by firms in IFRS countries is estimated as 26.7% less likely to contain any

accounting covenants in the post-adoption period relative to that issued by firms in non-IFRS

countries. We address endogeneity further in the robustness section.

The coefficients on the firm and debt control variables generally are consistent with

prior literature. The negative coefficient on firm size and positive coefficient on market-to-

book ratio are consistent with small and high growth firms facing higher agency costs of debt

and therefore using more accounting covenants. The negative coefficients on leverage

suggest that newly issued debt is less likely to include accounting covenants when the

borrower has more debt outstanding, consistent with existing lending relationships and

monitoring by existing lenders reducing the need for covenants. Among debt-level control

variables, the coefficients on the secured debt indicator and yield spread are significantly

positive, and those on the investment grade indicator and maturity are significantly negative.

While these are consistent with higher yield spreads/credit ratings reflecting greater/lower

agency cots of debt and the demand for monitoring being lower/higher for shorter maturity

debt/secured debt, we are careful not to draw strong inferences on these coefficients due to

potential endogenous effects. Finally, with regards to the country-level variables, we find

negative coefficients on PrivDebt Mkt and positive coefficients on Civil Law, indicating that

debt issued by firms located in countries with more developed debt markets and stronger

legal protection contain fewer accounting covenants. A pseudo R2 of 7.0% in column (1) and

an adjusted R2 of 8.5% in column (4) suggest that indicators for IFRS adoption alone explain

a significant amount of variation in the use of accounting covenants.

To address the concern that the results might be driven by different sample

30

composition in the pre- and post-adoption periods, we repeat the above analysis by using a

constant sample, in which a firm is kept in the sample only if it issues debt in both the pre-

and post-adoption periods. This reduces the sample size to 1,383 observations. Nevertheless,

the results in Table 4 Panel B show that the main conclusions hold unchanged. The

coefficients on PostIFRS are negative and significant in all model specifications and are

comparable to those reported in Panel A, suggesting that differences in the types of firms

raising debt between the pre- and post-IFRS periods are not sufficient to explain our results.

Table 4 Panel C reports that both income statement and balance sheet covenants

exhibit significant decreases after mandatory IFRS adoption.27 The coefficient on PostIFRS

is -1.241 (t-stat = -7.65) for income-statement covenants and -0.621 (t-stat = -4.29) for

balance sheet covenants in the Probit regressions. The untabulated marginal effects of

PostIFRS estimate that debt issued by firms in IFRS countries is 15.7% less likely to

contain any income statement covenants and 15.6% less likely to contain any balance sheet

covenants in the post-adoption period, relative to debt issued by firms in non-IFRS countries.

The coefficients on the control variables are also qualitatively similar to those reported in

Panel A. The decline in covenant use after mandatory IFRS adoption is observed in both

income statement and balance sheet variables, consistent with our predictions.

Defining accounting covenants to exclude those using cash flow numbers does not

alter the conclusions.28 Only 17 observations, or 0.6% of the sample, are influenced by this

redefinition. Consequently, the results reported in columns titled Ex. Cash Flow in Panel C

are very similar to those reported in Panel A.

27 In this panel and all subsequent tables, we report only regressions with all controls including debt-level variables. The conclusions are unaffected if debt-level control variables are excluded. 28 Cash flow covenants are those using cash interest coverage and debt-to-cash-flow ratios. Although the debt numbers could be affected by IFRS and more specifically by fair value accounting requirements, we excluded these ratios from this test to be conservative.

31

4.2 Effect of the difference between IFRS and prior domestic standards

If the observed covenant changes are caused by IFRS adoption, they should increase

with the degree to which IFRS alters a countrys accounting standards. To test this

implication, we create two indexes of the distance between prior domestic GAAP and IFRS.

The first index is constructed from the item scores obtained from Bae, Tan, and Welker

(2008, Table 1) who list 21 key accounting variables based on the Nobes (2001) GAAP 2001

Survey, and assign a score of 1 for each item that does not conform to International

Accountings Standards (IAS), the predecessor of IFRS.29 The first index is the sum of the

scores on those items that directly affect financial statement numbers, excluding items that

relate only to non-numerical disclosure requirements.30 This index is labelled Bae Acct.

The second index is a self-constructed measure capturing the difference between local GAAP

and IFRS in terms of fair value accounting in particular. We construct this index by

following a similar approach used in Bae, Tan, and Welker (2008). Using Nobes (2001)

survey, we identify the differences between local GAAP and the following seven IFRS

applications of fair value accounting: IAS 16 (Property, Plant and Equipment), IAS 22

(Business Combinations), IAS 36 (Impairment of Assets), IAS 37 (Provisions, Contingent

Liabilities and Contingent Assets), IAS 38 (Intangible Assets), IAS 39 (Financial

Instruments), and IAS 40 (Investment Property). For each accounting item, countries that do

29 Nobes (2001) survey is based on accounting standards that were effective on Dec. 31, 2001 and so ignores differences between IAS and national accounting rules emerging from subsequent revisions to standards. Also, the survey ignores differences that might arise from IAS permitting alternative policies, but national rules allowing only one of those alternatives or providing more detailed or more restrictive standards. 30 Items excluded from Bae, Tan, and Welker (2008) are Item 1 (IAS No. 1.7: Do not require a primary statement of changes in equity), Item 3 (IAS No. 14: Require no or very limited segment reporting), Item 7 (IAS No. 2.36: Do not require disclosure of FIFO inventory cost when LIFO is used), Item 9 (IAS No. 24: Have no or very limited disclosure requirements for related-party transactions), Item 11 (IAS No. 32.77: Do not require the disclosure of the fair value of financial assets and liabilities), Item 12 (IAS No. 35: Do not have rules outlining the treatment of discontinued operations), and Item 19 (IAS No. 7: Do not require a statement of cash flow). The above items are listed in Nobes (2001) in the section titled There are no specific rules requiring disclosures of.

32

not conform to IAS receive a score of 1, and all other countries receive a score of 0.31 The

index is calculated as the aggregate score of the seven items. This index is labelled FV.

Higher index values indicate greater differences between prior domestic GAAP and IFRS.32

Table 1 reports the values of the indexes for countries in the treatment sample. The

sample medians for the Bae Acct and FV indexes are 7 and 4, respectively. Values cannot be

computed for non-IFRS countries, so analyses based on these indexes are restricted to firms

in IFRS countries.

The association between post-IFRS change in accounting covenant use and difference

between local GAAP and IFRS is estimated from the following model:

Pr(D_ACov=1) = 1 Post+ 2 Index+ 3 PostIndex+Control Variables (3) Log(1+Num_ACov) = 1 Post+ 2 IFRS+ 3 PostIndex +Control Variables (4) Index is defined as Bae Acct or FV and other variables are defined as before. Because the

indexes are count variables, we normalize their values between 0 and 1 to facilitate

interpretation of the regression coefficients.

Regression results are reported in Table 5. The coefficients on PostIndex are

negative and significant in all model specifications, suggesting that the decrease in

accounting covenant use in the post-adoption period is increasing in the difference between

prior domestic GAAP and IFRS. For the Probit regressions, the untabulated marginal effect

of PostIndex is -0.329 (-0.266) when Bae Acct (FV) is used as the index, indicating that

31 Countries in our treatment sample that receive 1 for IAS 16 include Greece, Italy, Netherlands, Philippines, Portugal, Spain, and Sweden; countries that receive 1 for IAS 22 include Austria, Belgium, Denmark, Germany, Philippines, and Spain; countries that receive 1 for IAS 36 include all countries in our treatment sample except Australia, Hong Kong, Ireland, Netherlands, South Africa, and UK; countries that receive 1 for IAS 37 include all countries in our treatment sample except Hong Kong, Ireland, South Africa, and UK; countries that receive 1 for IAS 38 include Australia, Belgium, Denmark, France, Germany, Norway, Portugal, and Spain; all countries in our treatment sample receive 1 for IAS 39; countries that receive 1 for IAS 40 include Australia, France, Greece, Hong Kong, Ireland, Netherlands, South Africa, Sweden, and Switzerland. 32 The indexes do not take into account changes in domestic accounting standards after 2001. After the vote in 2002 by the European Union to adopt IFRS, many IFRS-adoption countries in our sample changed their domestic accounting standards to ease the transition to IFRS.

33

debt issued by firms in countries with highest Bae Acct (FV) index is 32.9% (26.6%) less

likely to contain any accounting covenants in the post-adoption period relative to that issued

by firms in countries with the lowest index. The coefficients on the control variables are

qualitatively similar to those reported in Table 4, except that the Civil Law variable is

statistically insignificant in the current table.

5. Additional Analyses

5.1 Loans versus bonds

Public bond contracts and syndicated bank loans differ in borrowing incentives,

monitoring, and contractual features generally. Syndicated bank lenders can monitor

borrowers and renegotiate loans at lower cost than public bondholders, due to concentrated

loan ownership, financial expertise, and access to private information. Thus, bank loans

typically have a larger number of tightly set accounting covenants that are more frequently

violated and renegotiated (Nini, Smith, and Sufi, 2012). Public bondholders typically do not

have access to private information, and their dispersed ownership makes renegotiation more

costly. Thus, bond contracts typically have fewer accounting covenants, which when used are

often more loosely set. In addition, public bonds often are subordinated and contain callable

and/or convertible features, while syndicated bank loans often involve revolving credit or

include performance pricing. Because of their greater reliance on accounting covenants, we

expect IFRS adoption to have a greater impact on loans than bonds.

Separate regression results for public bond and private loan samples are reported in

Table 6, using both Equations (1) and (3). We also test the difference in coefficients between

34

the two types of debt.33 In the difference-in-difference regressions, the coefficient on

PostIFRS is negative and significant for loans but negative and insignificant for bonds. The

difference between the loan and bond coefficients also is negative and significant. The

decline in accounting covenant use following mandatory IFRS adoption thus appears more

pronounced for loans than for bonds, consistent with loans being more reliant on accounting

covenants and more affected by the accounting change. As expected, the coefficients on the

control variables also differ between the loan and bond samples.

In the cross-sectional regressions, reported in the columns titled Bae Acct and FV

in Table 6, the coefficients on PostIndex are significantly negative for both indexes of the

difference between local GAAP and IFRS in the loan regression and significantly negative in

the bond regression using the Bae Acct index. The coefficient magnitudes are considerably

larger in the loan regressions and the differences are significant.34

5.2 Country and year fixed effects

One concern is that our specifications might omit country characteristics that are

correlated with both IFRS adoption and accounting-based covenants. The country-level

control variables ameliorate this concern, but nevertheless we examine the sensitivity of the

results to including country fixed effects that absorb all time-invariant differences across

countries. We also include year fixed effects to control for potential time-specific effects in

debt contracting, including trends. Further, we check the robustness of the results to

computing standard errors based on clustering observations at both the country and year

levels. This is a conservative approach as clustering by country and year lowers degrees of

freedom and power.

33 We do not include loan specific controls, such as indicators for revolving credit, term loan, performance pricing, or bond specific controls such as indicators for subordinated bond, callable bond, and convertible bond. In untabulated results, we get qualitatively similar results when including them. 34 In the bond regressions, the dummy variable D_Secured is dropped due to multicollinearity.

35

The results, reported in Table 7, show that our main results are unaffected by these

changes.35 Specifically, the coefficients on PostIFRS and PostIndex continue to be

negative and significant.

5.3 Other covenants

Demerjian (2012) suggests that covenants are a mechanism that allows lenders and

borrowers to contract even when lenders do not have certain information about borrowers

prior to contracting. The covenants force borrowers to renegotiate with lenders at a future

date when new information is received. This argument predicts that the demand for

covenants increases in the lenders ex-ante uncertainty about the borrower. If IFRS adoption

improved financial transparency and thereby lowered the ex-ante uncertainty about

borrowers, this argument could explain the observed decline in accounting covenants after

IFRS adoption. It thus is an alternative to our hypothesis that IFRS adoption makes

accounting numbers less relevant for debt contracting.

A differentiating test is as follows. Our hypothesis predicts a substitution away from

accounting-based covenants to non-accounting covenants, implying an increase in non-

accounting covenant use following IFRS adoption. The hypothesis that IFRS improved

transparency predicts a reduced demand for all covenants, non-accounting included (if

anything, it predicts a substitution toward IFRS-based accounting covenants). To test this

prediction, we identify four common types of non-accounting covenants based on their

functionality: investment restrictions, asset sale restrictions, equity issue restrictions, and

debt issue restrictions. Although dividend restrictions also are frequently observed in debt

covenants, we do not consider these as a non-accounting covenant, as they typically are

based on the amount of accounting earnings or retained earnings (Healy and Palepu, 1990).

35 IFRS and Post dummies are not included by themselves in these regressions as their effects are subsumed by country fixed effects and year fixed effects, respectively.

36

Nonetheless, for completeness we also report the effect of IFRS adoption on dividend

restrictions. The covenant classifications are based on Bratton (2006).

Table 8 reports results. In the first five columns of Table 8, Panel A, the dependent

variable is defined as one if the debt contract has at least one covenant of the specified type,

and zero otherwise.36 The results indicate that investment restrictions and equity issue

restrictions increase after IFRS adoption, while dividend and debt issue restrictions remain

unchanged and asset sale restrictions decrease.37 An Ordered Logit regression where the

dependent variable is Four_NACov, the sum of the four dummies defined above (dividend

restrictions excluded) confirms these results. These results are not consistent with the

alternative hypothesis that improved financial transparency from IFRS adoption mitigates the

need for debt covenants.

We also examine covenants that are specific to bonds or loans and find that private

loan contracts are more likely to use prepayment restrictions while public bond contracts are

more likely to use merger restrictions after IFRS adoption. The coefficients on PostIFRS

are insignificant when dummies for cross-default covenants on bonds or prior claim

restrictions on bonds are the dependent variables. 38

The last two columns of Table 8, Panel A, present results from OLS regressions of

the ratio of accounting covenants to non-accounting covenants, where non-accounting

covenants are either Four_NACov or computed as the total number of covenants minus the

number of accounting covenants. If both covenant types declined proportionally after IFRS

adoption, these ratios would not differ between the pre- and post-IFRS adoption periods. 36 The sample size is smaller for investment restriction, equity issue restriction, debt issue restriction, and four-type Ordered Logit regressions due to missing information on these covenant types for some of the data sources. 37 One reason for the decline in asset sale restrictions could be that these restrictions often rely on accounting numbers (viz., net worth) to define whether an asset sale is substantial or not. These covenants tend to permit sales of assets not exceeding a set percentage of net worth or total assets. 38 The sample size is smaller for cross-default covenants for the bond sample, as some of the data sources do not have information on this covenant type.

37

Irrespective of the proxy for non-accounting covenants, the results document a negative

coefficient on POSTIFRS, implying that after IFRS adoption, fewer accounting covenants

relative to non-accounting covenants were being employed in debt contracts.

Table 8, Panel B examines the effect as a function of countries prior domestic