Mandatory accounting change and debt covenant violation: additional evidence from SFAS 150

This study examines whether managers, in response to the liability classification of mandatorily redeemable preferred stock (MRPS) under SFAS 150: Accounting for financial instruments with characteristics of both liabilities and equity, restructure MRPS outstanding to keep debt off the balance sheet and, consequently, avoid increasingly likely debt covenant violation. Findings of this study show an economically and statistically significant association between MRPS restructuring and the likelihood of firms violating leverage covenant constraints, given firms reduce, on average, reported MRPS by USD259,688 for every 1 percentage point increase in leverage covenant tightness. No evidence exists of an association between MRPS restructuring and the presence of a debt covenant constraint that will be tightened by the debt classification of MRPS, or firms’ pre-adoption proximity to covenant violation. Overall, these findings help resolve conflicting evidence on the effectiveness of proxies used in prior studies to capture managers’ concerns about covenant violation due to a mandatory accounting change. JEL classifications: M41.