Ningzhong Li

Performance Measures in Earnings-Based Financial Covenants in Debt Contracts

This paper examines how performance measures are defined in major earnings-based financial covenants in loan contracts to shed light on the economic rationales underlying the contractual use of performance measures. I find an earnings-based covenant is typically based on a performance measure close to earnings before interest, tax, amortization, and depreciation expenses (EBITDA). However, my empirical analyses show that EBITDA is less useful in explaining credit risk than earnings before interest and tax expenses (EBIT) and even the bottom-line net income. Thus, measuring credit risk cannot fully explain the choice of accounting performance measures in earnings-based covenants. I conjecture that contracting parties choose an EBITDA-related measure, instead of a measure calculated after depreciation and amortization expenses (e.g., EBIT), to make the performance measure less sensitive to investment activities, which can be controlled through other contractual terms, such as a restriction on capital expenditure, and provide empirical evidence consistent with this conjecture.

Quasi-Indexer Ownership and Corporate Tax-Planning

We test the causal effect of quasi-indexers, traditionally viewed as passive institutional owners, on corporate tax planning by employing the discontinuity in quasi-indexer ownership around the Russell 1000/2000 index cutoff. Russell indices are value-weighted, thus firms assigned to the top of Russell 2000 exhibit much higher quasi-indexer holdings than firms assigned to the bottom of Russell 1000 as a result of the large discontinuity in index weights. Using a regression discontinuity design, we find that the higher quasi-indexer ownership at the top of Russell 2000 is associated with lower GAAP and cash effective tax rates and higher book-tax differences. Further, the greater tax avoidance comes from better federal and state tax planning, not from aggressive tax sheltering activities. Our results are robust to an instrumental variable approach and to various robustness checks. Our evidence contributes to the literature on the impact of ownership structure on tax avoidance and extends the new literature re-examining the assumption that quasi-indexers are passive owners.

Restrictions on Managers’ Outside Employment Opportunities and Asymmetric Disclosure of Bad versus Good News

This study examines the effect of restrictions on managers’ outside employment opportunities on voluntary corporate disclosure. The recognition of the Inevitable Disclosure Doctrine (IDD) by courts in the U.S. states in which the firms are headquartered place greater restrictions on their managers from joining or forming a rival company. We find that on average the IDD adoption increases the asymmetric withholding of bad news. We further show that the IDD adoption increases the asymmetric withholding of bad news relative to good news for firms whose managers are mainly concerned about losing their current job. However, an opposite effect is observed for firms whose managers are mainly interested in seeking promotion elsewhere. Furthermore, these effects are less pronounced for firms subject to greater monitoring of their disclosure policy. These results suggest that managers’ career concerns affect corporate disclosure policy and the effect varies with the type of career concerns.

Major Government Customers and Loan Contract Terms

This study examines how a firm’s business relationship with the U.S. government, in particular, sales to the government, impacts its loan contract terms and how the effect is different from that of major corporate customers. We find that firms with major government customers have a lower number of covenants and are less likely to have performance pricing provisions in their loan contracts than other firms, whereas major corporate customers do not have such impacts. We do not find evidence that major government customers affect the supplier firm’s loan spread, security, or maturity. We conjecture that lenders benefit from the strict monitoring activities of the government customer and reduce the use of covenants and performance pricing in loan contracts when the borrowing firm has a government customer.

Adjustment for Non-Cash Items in Earnings-Based Covenants

This paper examines how non-cash items are adjusted for in the measurement of earnings-based covenants in loan contracts. I first provide descriptive evidence on the forms and frequencies of these adjustments: 15% of covenants subtract “non-cash income,” 36% adds back “other non-cash expenses” (“non-cash expenses” other than depreciation and amortization expenses), and 89% adds back depreciation and amortization expenses. Next, I show evidence that the cross-sectional variations of these adjustments are consistent with concerns about the reliability of these items being a reason for their exclusion: Firms with higher agency costs of debt and lower reputational capital are more likely to exclude these items. Finally, I show that working capital accruals increase the usefulness of earnings in measuring credit risk and that operating cash flows are significantly less associated with credit risk than net income. This finding suggests that the usual inclusion of working capital accruals in the covenant measurement is consistent with contracting parties choosing a performance measure that is more useful in measuring credit risk.