Fair Value Accounting and Debt Contracting: Evidence from Adoption of SFAS 159

• Author: PETER R. DEMERJIAN,JOHN DONOVAN,CHAD R. LARSON
• DOI: http://doi.org/10.1111/1475-679X.12126
• Published date: 01 September 2016
• Date: 01 September 2016

DOI: 10.1111/1475-679X.12126

Journal of Accounting Research

Vol. 54 No. 4 September 2016

Printed in U.S.A.

Fair Value Accounting and Debt

Contracting: Evidence from

Adoption of SFAS 159

PETER R. DEMERJIAN,

∗JOHN DONOVAN,

†

AND CHAD R. LARSON

‡

Received 3 November 2014; accepted 19 March 2016

ABSTRACT

We examine how fair value accounting affects debt contract design, specifi-

cally the use and definition of financial covenants in private loan contracts.

Using SFAS 159 adoption as our setting, we find that a small but significant

proportion of loans (14.5%) modify covenant definitions to exclude the ef-

fects of SFAS 159 fair values. Only a limited number of these modifications

exclude assets elected at fair value (less than 7%), while all exclude liabilities

elected at fair value. Notably, we document that covenant definition modifi-

cation is unassociated with ex ante fair value elections. We find that covenant

definition modification positively varies with common incentive problems at-

tributed to fair value accounting and negatively varies with benefits attributed

to fair value accounting. Our results suggest that fair value accounting is not

∗Foster School of Business, University of Washington; †Mendoza College of Business, Uni-

versity of Notre Dame; ‡Bauer College of Business, University of Houston.

Accepted by Christian Leuz. We appreciate the helpful comments and suggestions of

Wendy Baesler, Nicole Cade, John Core, Yiwei Dou, Richard Frankel, Bryan Graden, Kim

Ikuta, Josh Lee, Dawn Matsumoto, Sarah McVay, Zoe-Vonna Palmrose, Bob Resutek, Hojun

Seo, D. Shores, Sara Toynbee, an anonymous reviewer, and workshop participants at the Uni-

versity of Notre Dame, Washington University in St. Louis, University of Washington, the 2014

Lone Star Conference, 2014 Accounting Research Conference at Oklahoma State University,

and AAA 2014 Annual Meeting. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

1041

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

1042 P.R.DEMERJIAN,J.DONOVAN,AND C.R.LARSON

uniformly detrimental for debt contracting and fair value adjustments are in-

cluded when they are most likely to improve performance measurement.

JEL codes: G32; M41

Keywords: fair value accounting; debt contracting; SFAS 159; fair value

liabilities

1. Introduction

Considerable debate exists in the literature regarding the usefulness of

fair values in financial statements.1Proponents argue that fair values pro-

vide timely, value-relevant information to financial statement users (Barth,

Beaver, and Landsman [2001], Barth [2004, 2006]). Opponents deem ex-

pansion of fair values a violation of the age-old principle of conservatism

that requires reliable accounting measurements and, thus, decreases the

usefulness of accounting for contracting (Watts and Zimmerman [1986],

Holthausen and Watts [2001], Watts [2003], Kothari, Ramanna, and Skin-

ner [2010]). In this study, we examine the relationship between fair value

accounting and the design of debt contract covenants written directly on ac-

counting values. Specifically, we study fair values for debt contracting and

observe the revealed preferences of contracting parties to provide evidence

of the usefulness of SFAS 159. More specifically, using SFAS 159 (ASC 825)

as our setting, we examine how increases in fair value accounting affect the

usage and definition of financial covenants in debt contracts.

Despite the importance of fair value expansion, very little direct evidence

exists on the effects of fair values on debt-contracting practice; most prior

studies examine the effects of broad shifts in standards on debt contracting

(Kosi, Pope, and Florou [2010], Demerjian [2011], Ball, Li, and Shivaku-

mar [2015], Florou and Kosi [2015]). These studies leave many important

questions related to fair values and debt contracting unresolved. For ex-

ample, what features of fair value reduce its contracting usefulness? Is it

the lack of reliable measurement and the potential for opportunism intro-

duced by fair value estimates? Are some fair values useful for contracting,

but not others, and, if so, why?

We seek to address these questions by examining debt contracts in the pe-

riod around the adoption of SFAS 159. SFAS 159 has two unique features

that allow us to test hypotheses and draw conclusions that were unreach-

able in previously analyzed settings. First, debt contracts are available and

observable for a large population of firms. This availability allows us to di-

rectly observe any changes in debt contract design before and after SFAS

159 adoption. Second, as we discuss in detail in section 2.2, the cost of ad-

justing SFAS 159 in contracts is very low. Disclosure requirements under

1A significant number of both academic and nonacademic articles concern the history and

expansion of fair value accounting. In Appendix A, we discuss how fair value use in U.S. GAAP,

including the adoption of SFAS 157 and 159, has expanded over time.

FAIR VALUE ACCOUNTING AND DEBT CONTRACTING 1043

SFAS 157 and SFAS 159, which are unique among U.S. standards related

to fair value, lower the costs associated with modification. If adjusting con-

tracts for SFAS 159 was very costly,any obser ved change or lack of change in

contracting practice around the standard would be difficult to interpret, as

it could be a function of either a difference in the usefulness of accounting

due to the standard or the high cost related to adjustment. The low cost of

adjustment related to SFAS 159, however,allows us to disentangle these two

effects and interpret any observed change in contracting as related to fair

value.

We begin our analysis by comparing the net costs and benefits of several

potential contractual responses to the expansion of fair value. We assess

the options to exclude financial covenants affected by fair values, contrac-

tually restrict the election of fair value accounting, modify affected financial

covenant definitions, or make no modifications to financial covenants. We

construct hypotheses based on this analysis and test them by examining

debt contracts before and after adoption of the standard. The premise un-

derlying our research design is that changes in the usefulness of accounting

from the expansion of fair values will alter contracting equilibria and reveal

borrower and lender preferences through changes to debt contract terms.

Using a broad sample of private loan packages in the period surround-

ing SFAS 159 adoption, we find no evidence that the frequency of financial

covenants in debt contracts changed following the expansion of fair value

accounting. Because expanded fair value accounting could affect various

accounting ratios differently, we also examine whether the inclusion of in-

dividual covenants (liquidity, debt, and earnings-based covenants) changed

with the adoption of SFAS 159. Again, we find no evidence that SFAS 159

altered the inclusion of these covenants. Further, we find no evidence that

debt contracts explicitly restrict firms’ elections of fair value use under

SFAS 159. If fair value always reduced the usefulness of accounting infor-

mation for debt contracting and modifying accounting for fair values was

prohibitively costly, we would expect to observe either a decline in the use

of covenants affected by SFAS 159 or explicit restrictions on borrowers’

use of fair value. Our empirical evidence, however, is inconsistent with this

argument.

We next examine what we hypothesize to be the most likely response

to SFAS 159 adoption: modifying financial covenant definitions. We find

that a small but significant number of observations—14.5% of loans initi-

ated from 2008 to 2012—explicitly exclude effects of SFAS 159 from defi-

nitions of accounting-based measures. Notably, the majority of exclusions

apply specifically to liabilities, with only 26 contracts (fewer than 1%) that

feature exclusion of SFAS 159 fair value adjustments related to assets. We

draw two broad conclusions from these results. First, the relatively low fre-

quency of exclusions suggests that debt-contracting parties do not, on aver-

age, consider fair value accounting under SFAS 159 to be particularly dam-

aging to the contracting usefulness of accounting information. Second, the