Melissa Fay Lewis-Western

Historical Cost Measurement and the Use of DuPont Analysis by Market Participants

We investigate a possible weakness of measuring assets using historical cost. Our results suggest that an economically significant portion of the return on net operating assets reported by firms with older assets is an artifact of historical cost accounting rather than superior economic performance. We document that this feature of historical cost accounting lowers the comparability and value-relevance of accounting-based rates of return. Results are concentrated in firms with high proportions of PPE, and alternative explanations due to variation in the age of the firm, managerial ability and competitive advantages are not supported by the data. Our results have implications for the ongoing debate on the appropriate measurement techniques for assets.

Income Smoothing and Debt Covenants: Evidence from Technical Default

We investigate whether income smoothing affects the usefulness of earnings for contracting through the monitoring role of earnings-based debt covenants. First, we examine initial contract design and predict that income smoothing will increase (decrease) the use of earnings-based covenants if income smoothing improves (reduces) the usefulness of earnings to monitor borrowers. We find that private debt contracts for borrowers with greater income smoothing are more likely to include earnings-based covenants. A structural model exploring the cause of this relation provides evidence that smoothing improves the ability of earnings to reflect credit risk. Second, we examine technical default following contract inception. We find that income smoothing is associated with a lower likelihood of spurious technical default (when the borrower’s economic performance has not declined but the loan nevertheless enters technical default). In contrast, we find no association between income smoothing and performance technical default (when the borrower’s economic performance has declined). Collectively, this evidence is consistent with income smoothing improving the effectiveness of earnings-based information in monitoring borrowers.