Internal Forecast Accuracy and the Preemption of Covenant Violations

• In Event: Debt Covenants

Abstract

Covenant violations that are resolved before the fiscal period end do not have to be reported. Such preemption of covenant violations provides lenders with the option to intervene early and mitigates borrowers’ costs associated with reported violations. Thus, it is important to understand why some firms preempt covenant violations but others do not. We argue that timely preemption requires accurate foresight of the impending violation. Accordingly, we investigate whether accurate internal forecasts, proxied by management forecast accuracy, facilitate the preemption of covenant violations. We find that firms with higher management forecast accuracy are less likely to report covenant violations, more likely to renegotiate timely, and have lower cost of debt. Further analyses show that both the internal control firms rely on to form forecasts and the managerial biases in forming forecasts contribute to these findings. To address endogeneity, we show that an exogenous increase in the management forecast accuracy of small accelerated filers from SOX 404 is associated with a decrease in their reported covenant violations and an increase in timely renegotiation. Our paper is among the first to identify the role of forward-looking accounting information in improving incomplete debt contracts.

Authors

• Ruihao Ke, Southern Methodist University

• Meng Li, University of Michigan

• Joseph Weber, Massachusetts Institute of Technology

• jieying zhang, University of Texas at Dallas