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Sreedhar Bharath
  Sreedhar Bharath

Accounting Quality Affects Debt Contracts

3/2/2006 --

Firms with good accounting quality are able to obtain lower interest rates in the debt market and to negotiate better maturity and collateral terms for bank loans.

ANN ARBOR, Mich.—Good accounting practices pay off, especially when companies seek to raise new capital through debt financing, says a University of Michigan business professor.

According to Sreedhar Bharath, assistant professor of finance at Michigan’s Ross School of Business, the accounting quality of borrowers—as reflected in their discretionary accounting choices—influences the design of debt contracts in the private and public debt markets.

Bharath suggests that firms demonstrating sound accounting decisions are able to obtain lower interest rates from both private and public lenders and to negotiate more favorable maturity and collateral terms with banks.

On the other hand, companies with poor accounting quality—characterized by abnormally large operating accruals—are penalized by lenders, who find it harder to discern the borrowers’ true economic performance. Both banks and the bond market are more likely to charge higher borrowing rates, and bank loans are more apt to have shorter maturities and greater collateral requirements.

"Our findings show that borrowers’ accounting quality has a significant economic impact on loan-contract terms," Bharath said. "We also see evidence that the relation of accounting quality and contract features differs markedly for bank loans and public bonds."

Banks, he says, have greater capabilities and incentives to customize loan contracts, so accounting quality impacts both the price as well as non-price loan terms. In the case of public bonds, accounting quality impacts price alone, but the impact is more pronounced than with bank loans, in part because bondholders have less access to information about firms, greater difficulty in monitoring borrowers and higher renegotiation costs.

In the study, Bharath and colleagues Jayanthi Sunder and Shyam Sunder of Northwestern University, investigate 5,834 loans obtained by 2,518 firms and 3,495 bonds issued by 723 firms from 1988 to 2001. They examine contract terms at the time of the debt origination, after controlling for default risk and firm and loan characteristics.

To measure accounting quality, the researchers use accruals-based metrics that compare a firm’s operating accruals to those of its industry peers. Operating accruals, which can be interpreted as a measure of relative lack of information about the firm’s future profitability and cash flows, may be either income-increasing or income-decreasing.

The researchers report that firms with poor accounting quality end up paying 20 basis points more for bank debt, moving from the lowest to highest quintile of accounting quality. This amounts to an incremental interest cost of about 12 percent over the median interest spread charged on bank loans in the sample. Similarly, the study shows that as operating accruals move from the lowest to the highest quintile, the maturity of loans granted declines by nearly 7 percent (an average one-month reduction) and the probability of having to provide collateral increases by 10 percentage points.

For public bonds, research results reveal that firms with poor accounting quality again face significantly higher interest costs of nearly 32 basis points (representing a 33 percent increase over the median interest spread for all public bonds in the sample), moving from the lowest to the highest quintile in operating accruals. These findings coincide with the notion that bondholders prefer to incorporate all the effects of accounting quality into the interest cost since monitoring and renegtiating of non-price maturity and collateral terms are unfeasible.

When Bharath and his co-authors re-estimate their results to allow for the simultaneous determination of all loan terms, they find that the interest costs for firms with poor accounting quality are 13 percent to 37 percent higher than the corresponding single-equation estimates. This works out to interest spreads that are 27 basis points higher for bank loans and 37 basis points higher for public bonds.

"This underscores the importance of considering the jointness of contract terms when estimating the impact of accounting quality," Bharath said.

According to the findings, borrowers face higher interest spreads and more stringent non-price terms for bank loans when they have a greater magnitude of abnormal operating accruals, regardless of whether those are positive or negative. In the case of public bonds, only interest spreads are affected. There is no evidence, however, that the accounting quality of the borrower impacts a firm’s choice to access the private or public debt market.

Written by Claudia Capos

For more information, contact:
Bernie DeGroat
Phone: (734) 936-1015 or 647-1847