Asset revaluations and debt contracting

Cotter, Julie (1997). Asset revaluations and debt contracting PhD Thesis, Commerce, University of Queensland.

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n01front.pdf n01front.pdf application/pdf 305.07KB 8
n02chapter1.pdf n02chapter1.pdf application/pdf 78.69KB 1
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Author Cotter, Julie
Thesis Title Asset revaluations and debt contracting
School, Centre or Institute Commerce
Institution University of Queensland
Publication date 1997
Thesis type PhD Thesis
Supervisor Prof. Ian Zimmer
Abstract/Summary The research question investigated is “Do managers of Australian firms use upward asset revaluations to reduce debt contracting costs?” Much work in the accounting choice literature is premised on a relation between debt contracts and accounting policies. In particular, prior research using sample periods from the 1970s and early 1980s, provides evidence that asset revaluations are used to reduce the costs of debt contracting (see Whittred and Chan, 1992; Brown, Izan and Loh, 1992; and Cotter and Zimmer, 1995). However, considerable changes to the institutional setting have occurred in the past decade. These institutional changes include increased regulation of asset revaluations and disclosures, changes in the macroeconomic environment, and changes in the Australian debt market. Particularly, there has been a shift in emphasis from public to private debt. The relationship between asset revaluations and debt contracting is examined in the current setting. Following Watts and Zimmerman’s (1990) suggestion that research into the relationship between firms’ contracts and their accounting policy choices will be improved by the use of more refined measures of contracting variables, the research commences with an investigation of the terms contained in recently issued debt contracts. Accordingly, this thesis contains two phases. Part A comprises an investigation of the covenants and accounting measurement rules typically contained in the recent debt contracts of listed Australian firms, with an emphasis on the role of asset revaluations. Part B then uses the outcomes of this investigation to determine the refined measures of debt contract terms used in testing hypotheses about the current relationship between asset revaluations and debt contracting. Part A establishes the current dominance of bank loan financing, along with a dramatic decline in the use of public debt. Details of the terms typically contained in bank loan agreements, particularly those relating to asset revaluations, are then investigated using a questionnaire survey of senior corporate bankers and analysis of a small sample of actual contracts. Outstanding public debt contracts are also analysed and compared with private debt contracts. The results of this phase of the research indicate that leverage covenants are the most widely used accounting based covenant in the bank loan agreements of listed Australian firms. In addition, interest coverage, current, tangible net worth, and prior charges ratios are all frequently used. Covenants tend to be less restrictive for larger firms than for smaller firms, and more restrictive for mineral producers than for industrial firms. Covenants contained in bank loan agreements tend to be more restrictive than those contained in convertible note trust deeds. In addition to providing important data for part B, the results of this phase of the research address an important gap in our knowledge about the terms contained in recently issued public and private debt contracts of listed Australian firms. Part B develops hypotheses based on the assumption that the costs of revaluing will be incurred when they are expected to be less than reductions in the costs of debt contracting derived from the revaluation. Due consideration is given to the likelihood that at least some of these costs have changed since prior research was conducted. In addition to the arguments presented in prior asset revaluations research, the expected costs of default on debt contracts, and the accounting discretion available to managers, are investigated as determinants of asset revaluation accounting choices. Predictions are made in relation to the likelihood of revaluation, the choice of valuer type, and whether to recognise or merely disclose new valuations of land and buildings. Interestingly, the results of prior research do not replicate in the current setting. Further analysis shows that differences in results are not due to differences in research methods between the current and prior research. In order to further examine the potential impact of changes to the institutional setting, a series of interviews with Chief Financial Officers is undertaken. The conclusion drawn from this additional analysis is that the relatively closer relationship between firms and their bankers has caused many firms to choose footnote disclosure of undervalued assets in preference to recognising an upward asset revaluation in the balance sheet. Overall, the results indicate that, when investigating the relationship between firms’ contracts and their accounting policy choices, a consideration of the way that contracts are negotiated and monitored is potentially more important than the use of refined measures of contract terms.
Keyword asset revaluations
debt covenants

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