Business Finance
Monroe College Cost and Benefits of Business Information Disclosure Summary

Monroe College

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read all 9 articles and prepare a MAX (can be less then 2 pages) of 2-page summary for each article. The summary should follow the following structure:

-Title of Paper

-Objective of paper/ Research question

-Method used to answer the question

-Findings and conclusions

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Costs and benefits of business information disclosure Elliott, Robert K;Jacobson, Peter D Accounting Horizons; Dec 1994; 8, 4; ABI/INFORM Global pg. 80 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. THE ACCOUNTINC REVIEW Vol. 68. No. 2 April 1993 pp. 258-272 Stock Market Effects of the Closeness to Debt Covenant Restrictions Resulting from Capitalization of Leases Samir M. El-Gazzar Pace University SYNOPSIS AND INTRODUCTION: This article examines the association between lessees' market returns and their changes in the tightness of the debt covenant constraints resulting from compliance with SFAS No. 13 (1976). This paper differs from previous research in that it uses covenantbased measures. Similar to Hughes and Ricks (1984) and Schipper and Thompson (1983), it examines cross-sectional stock return dependencies that exist when industry effects cannot be randomized over time. The paper begins by identifying a sample of lessees who retroactively capitalized leases as a result of SFAS No. 13. Actual debt contracts of sample firms are then analyzed to identify accounting-based restrictions, the default value of each restriction, and the definition of the accounting variables used in the covenant. Next, the percentage increase in the tightness of covenant restrictions arising from adopting SFAS No. 13 is calculated.' Finally, cross-sectional tests of the relationship between changes in covenant tightness and changes in security prices that accompanied the events leading to SFAS No. 13 are performed. The analyses reveal several results. First, retroactive capitalization of off-balance sheet leases would have caused significant increases in the tightness of the debt covenant restrictions. Second, affected lessees experienced negative market returns contemporaneously with the disclosure of two of the events that led to the promulgation of SFAS No. 13. However, ' Descriptions of this calculation are presented in section II and in the appendix. I am grateful for the valuable comments of Victor Pastena, Steven Lilien, Victor Bernard (associate editor for this article), and an anonymous referee. I also appreciate comments (on earlier drafts of this paper) from presentations made at Rutgers University, Baruch College, and the AAA annual meeting in Hawaii. The research assistance of Yuki Kim is appreciated. The Author is also associated with Tanta University in Egypt. Submitted June 1989 and May 1991. Accepted October 1992. 258 El-Gazzar—Stock Market Effects of the Closeness to Debt Covenant Restrictions 259 the magnitude of the reduction in market returns is correlated with the impact of SFAS No. 13 on the tightness of debt covenant restrictions. Finally, there appear to be important differences in the structure of debt covenants. Private debt covenants have tighter financial restrictions, while public debt covenants have more nonaccounting-based provisions such as sinking fund, security, and seniority of the debt. Key Words: Lease accounting, Debt covenants. Economic effects. Data Availability: A list of sample firms is available from the autbor. Data from debt contracts used in tbis study will be available for researcb purposes upon completion of a follow-up article. T HE remainder of this article is organized as follows. Section I discusses prior research on lease capitalization. Section II includes the development of hypotheses. A description of the methodology is in section III. Section IV analyzes the results. A stunmary and comments are given in the last section. I. Background and Prior Research Potential Economic Effects of Lease Capitalization SFAS No. 13 (FASB 1976) tightened tbe conditions under which a lease can be classified as an "operating lease." Furthermore, retroactive capitalization was required for off-balance sheet leases meeting the criteria specified in SFAS No. 13. Capitalizing off-balance sheet leases increases assets and liabilities and typically reduces reported income and retained earnings.' These changes increase the likelihood of violating debt covenant restrictions if debt agreements use rolling GAAP. In the due process hearings prior to the issuance of SFAS No. 13, many lessees claimed that capitalizing off-balance sheet leases would cause violations of debt covenants (Abdel-khalik 1981; Nakayama et al. 1981). In fact, El-Gazzar et al. (1986) found that highly-leveraged firms are more likely to use off-balance sheet leasing. However, the results of studies examining the economic effects of lease accounting and disclosure are inconsistent (e.g., Abdel-khalik 1981; Abdel-Khalik et al. 1978; Ro 1978). Previous Research of Technical Default Costs Previous research used financial-statement-based surrogates (mainly debt-to-equity ratio) to examine the extent to which mandated accounting changes affect debt covenants with mixed findings (see for example, Collins et al. 1981; Espahbodi et al. 1991; Leftwich 1981; Lys 1984; Salatka 1989). Notwithstanding the findings of individual studies, Christie (1990) shows that aggregating the results of prior research examining the debt covenant hjrpothesis produces an overall significant explanatory power. The inconsistency and/or inconclusiveness of the results across studies suggest that the debt-to-equity ratio may not be an adequate proxy for the closeness to debt covenant ' Footnote disclosures of most lessees in 1976 financial statements, the year before the effective date of SFAS No. 13, state that capitalizing off-balance sheet leases would cause a decrease in net income and/or retained earnings. 260 The Accounting Review, April 1993 violations. Little research evidence has heen hased on actual deht contracts in examining the economic effects of mandatory accounting changes. For example, Frost and Bernard (1989) use the actual deht contracts of a small sample of oil companies to examine the effects of the SEC rule that mandated write-offs of exploration costs in the first quarter of 1986. They conclude that the write-offs caused significant tightness and even some violations in covenant constraints. However, they show no significant market reaction to the adverse effects on financial statements. Healy and Palepu (1990) use Moody's summaries ahout dividend restrictions to examine whether managers make income-increasing accounting changes to circumvent near violation of a dividend constraint. They conclude that, except for pension accounting, managers did not use income-increasing accounting changes to avoid dividend cuts. II. Development of H;srpotheses A typical deht agreement states the types of restrictions imposed on the horrower during the loan (or hond) term and defines the accounting methods used to measure these restrictions. Covenants that employ financial ratios often restrict the payment of dividends and the issuance of additional deht. In addition, some specify minimum working capital, current ratio, and interest-coverage requirements (Kalay 1982; Smith and Warner 1979). Retroactive capitalization of leases, formerly classified as operating, alters financial ratios used for calculating covenant restrit:tions. In this study, the percentage increase in covenant tightness from capitalizing off-halance sheet leases is measured according to the following equation: PITR«=[(DDVB<,-DDVA«)/(DDVBtf)], (1) where: PITfl(,=percentage increase in the tightness of restriction i (i = 1,2,... ,k) for firm j (j=1,2,... ,N). This also represents the reduction in the slack (distance) to default value of restriction i for firm j, DDVBtf=distance from the default value of restriction i for firm j before capitalizing off-halance sheet leases, and DDVA<,=distance from the default value of restriction i for firm j after capitalizing off-halance sheet leases. Technical Default Hypotheses Lessees with significant increases in the tightness of covenant constraints might incur additional costs as a result of operating under tighter contractual conditions or actual technical default. If lenders do not waive the violations, management could take actions to alleviate these effects. These actions could include issuance of additional equity capital, redemption of outstanding deht, or renegotiation of deht contracts. All of these actions are cosUy in that they alter the mix of investing and financing policies that is hased on other economic analysis. Assuming a nonzero cost of renegotiation or default, affected lessees would incur the cost of either renegotiating terms of the offending deht or operating under tighter contractual conditions. Thus, lessees experiencing a significant increase in the tight- El-Gazzar—Stock Market Effects of the Closeness to Debt Covenant Restrictions 261 ness of covenant constraints are negatively affected by SFAS No. 13. Accordingly, the following hypotheses (in the alternative form) are tested: HI: There is a significant market reaction for affected lessees to the different events in the regulatory process that led to the issuance of SFAS No. 13. H2: The impact of mandating SFAS No. 13 on securities of affected lessees is negatively related to the percentage increase in the tightness of debt covenant restrictions (PITR«). Di^erential Negotiation/De/auJt Cost Hj^othesis The Trust and Indenture Act of 1939 requires that a trustee be appointed for each public debt issue. The trustee is limited in accepting any revision or modification in the debt agreement, which makes it difficult for the manager to renegotiate a defaulted public debt contract, especially if it is widely held. Based on the above rationale, Leftwich (1981) and Collins et al. (1981) predict higher renegotiaion costs for public debt compared to private debt. However, their results do not support the prediction, which may reflect the inadequacy of the surrogates employed or that the structure of public debt covenants is less dependent on accounting variables. The validity of these inferences can be clarified by analyzing actual debt agreements using direct measures of closeness to default developed for a sample of actual public and private debt contracts. The public-private dichotomy suggests the following hypothesis (in the alternative form): H3: The correlation between changes in security prices and the increase in tightness of covenant restrictions is stronger for public than for private debt contracts. III. Sample and Methodology Test Events The events that preceded the issuance of SFAS No. 13 by the Financial Accounting Standards fioard (FASB) and the expected market reaction to each are summarized in table 1. Events 1, 2, 3,6, and 7 are considered "bad news" because they provided information indicating eventual capitalization of off-balance sheet leases. Event 4 is considered uncertain because the news indicated ambiguity about whether the FASB would reconsider its prior pro-capitalization. The content of event 5 is mixed. Since The Wall Street Journal (WSJ) article reporting this event states that the FASB is back to the drawing board, it may be interpreted as "good news" in that firms would be allowed more opportunity to lobby against lease capitalization. On the other hand, the article states that members of the FASB insist on retroactive application of the forthcoming rule which would be considered "bad news." The effect of this event, therefore, is not clear and tests of events 4 and 5 are nondirectional tests. Sample Companies included in the AICPA's Accounting Trends and Techniques (ATT) for fiscal year 1976 represent the base sample of this study. ATT provides a breakdown of 600 companies by lease-accounting method. Of these, 300 companies used operating lease accounting, while 41 used capital lease accounting for all of their leases. These The Accounting Review, April 1993 262 Table 1 Summary of the Events Leading up to the Issuance of SFAS No. 13 Event Number Content Expected Market Reaction 1 The Discussion Memorandum luly 10, 1974. The FASB issued a discussion memorandum on accounting for leases and set public hearings for November 18, 1974 in New York. Negative (bad news) 2 The Public Hearings Effects November 25,1974. Opponents of lease-accounting changes fail to convince the FASB of the dangers of tightening lease accounting. Negative (bad news) 3 First Exposure Draft August 29,1975. The FASB exposure draft proposed new rules in the controversial area of lease reporting. Negative [bad news) 4 Issuance of Statement Delayed November 26,1975. Delay of adoption of final rules until next year announced. Uncertain (good news/ bad news) 5 Modifications of the Exposure Draft June 3, 1976. FASB is back to the drawing boards after failing to reach consensus on proposed elimination of retroactive application of new standard. Unspecified changes to draft reported. Uncertain (good news/ bad news) 6 Second Exposure Draft Issued July 28,1976. New rule will apply to existing leases as well as new leases. Negative (bad news) 7 Final Statement Issued December 3, 1976. Major changes implemented in leasing. Negative (bad news) Note: Events are identified by The Wall Street JoumaJ article since the FASB meetings were confidential in the earlier years and only the minutes of the meetings were released to the press on later dates. two groups had chosen to use exclusively one method of accounting for leases before SFAS No. 13. Other ATT listed firms either used a mix of accounting methods for leases or did not provide adequate disclosure. Examination of the annual Feports of the 300 noncapitalizing firms revealed that 113 subsequently restated financial statements.* Another 125 firms did not restate financial statements due to immaterial effects of the change in the lease accounting method. The remaining 62 firms ceased to report as a separate entity in the years following 1976.'' The 41 capitalizers and the 113 restatement companies were further reduced to 23 and 60 by the selection limits reported in table 2.* ' Originally, the FASB granted a long transition period for retroactive application of SFAS No. 13. However, the SEC shortened this period to no later than 1978. The majority of sample firms had adopted SFAS No. 13 retroactively in 1978. * This category represents companies that were delisted for acquisitions, firms that made quasi-reorganization and changed names, and firms that went bankrupt. This number is not unusual since the ATT shows that 83 companies were delisted/substituted mainly because of mergers and acquisitions over the same period Investigated in this study, fiscal years 1977-1979. ' An analysis of sample characteristics, that is not reported here, shows that the sample firms are well-dispersed over the two-digit industry classification. 263 El-Gazzar—Stock Market Effects of the Closeness to Debt Covenant Restrictions Table 2 Final Sample Selection Process Control Sample: All Leases Capitalized Experimental Sample: Operating Leases/ Restated Retroactively 41 113 Initial sample Minus: Companies with dividends or earnings announcements Companies not available on CRSP daily stock return 3 14 14 22 Companies for which no debt contracts found NA 14 1 3 23 60 Companies with reorganization or bankruptcy activities d samDle NA=Not Applicable Debt Contracts: Cross-Sectional Test Sample Debt contracts were needed only for the experimental group on which crosssectional tests were performed. Debt contracts that existed before November 30,1976 were obtained from statements of debt registrations, filed prospectus reports, and 10-K filings of 1980 and 1981 that contain detailed contracts for the 1976 debt." This study uses the most restrictive covenants of known contracts.' To the extent that test events are on different dates, the number of contracts (sample size) for each event is different, reflecting issuance of new contracts or settlement of old ones. Both the market and the cross-sectional tests are conducted for the cumulative effect of all events using all available debt contracts. Coding and Analysis of Deht Agreements Coding of debt contracts is summarized in table 3. For the sample including all debt agreements, the most binding contract is used. Accounting-based restrictions contain 47 restrictions on issuing additional debt and 42 on payment of dividends. Twelve contracts require maintenance of certain levels of working capital, while seven contracts require maintenance of a minimum current ratio and four contracts have restrictions on fixed-charges coverage. The coding of public and private debt contracts reveals few differences in the use of accounting-based covenants. ' The Form 10-Ks for 1980 and 1981 represent a special source of debt agreements because many firms attached copies of debt contracts as exhibits to financial statements in compliance with the SEC integrated disclosure act of 1980. ' Lack of the most restrictive debt contracts produces bias against finding significant correlation between the tightness of covenant restrictions and the market returns associated with SFAS No. 13. Since the results show significant correlations, no further effort is necessary to identify those contracts. The Accounting Review, AprU 1993 264 oc o Q s >1 I 01 eo a 11 K £1 2. eg I Ic o cc "5- o o CO !§ §1 3- # o I eg I CO m rg ? 1^ O rj Ii & 2. 12, & .2 u ^1 g§ tn eM g§ -> o a o CO CO U 3 g •si si 111 g.D Cd • rM CO CO •KG G .H O m O m Is is I CO J J ' S 1 £I S g Hill nil »- g 3 " ^ C Q 0) — o- C52 as SB SE ^ j2 iS CO *2 CO ••-' u u ;3 u 3 •§2 2 ^ •3 u o o =s 2 ^ o 111! iiii II II II ccoccc El-Gazzar—Stock Market Effects of the Closeness to Debt Covenant Restrictions 265 Table 4 Calculated Percentage Increase in the Tightness of Covenant Restrictions Cross-SectionaJ Distribution Statistics Mean S.D. 25% 50% 75% 100% All Debt Agreements PITHl PITR2 PITR3 43.1 18.3 7.9 29.9 18.9 2.3 25.9 8.2 0.0 45.4 20.3 0.0 68.6 37.8 11.5 92.4 77.2 65.0 Private Debt Agreements PITHl PITR2 PITR3 54.1 21.5 NM 30.0 22.0 NM 31.0 4.4 NM 61.0 19.4 NM 76.1 42.8 NM 92.4 77.2 NM Public Debt Agreements PITHl PITH2 PITH3 37.2 15.6 NM 25.4 16.0 NM 0.0 9.8 NM 34.7 13.2 NM 37.3 18.8 NM 79.5 67.3 NM Variable Diffe ...
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Summary of Articles
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Article#1: Cost and benefits of business information disclosure
The objective of this article is to summarize the only information of profit making cost
and benefits of disclosure. This means any non-profiting entities are excluded. Issues arise when
disclosure of has a relationship with effective functioning and goals in charitable and democracy
undertakings. Disclosure varies from none to complete. Parties are positively or negatively
affected by any disclosure in costs and benefits. Therefore, the suitable place to start on
considering costs and benefits is identification of their nature and range and exploring their
Costs and benefits in this article have been classified by interests. These interests are
entities, investors and national. Assumptions that are made in this article need to be understood
clearly for one to follow and understand what is being addressed. Informative disclosure used in
this article is ideal in illustrating the benefits and costs of disclosure. When investigating benefits
and costs of misleading and frivolous disclosure, it is not and enterprise of disclosure which is
Let’s look on the interests which are the methods used in this article in the disclosure of
the information on the costs and benefits. Entities interests is one of the three methods used.
Entities in this article are treated as the employees and owners. Both of these two entities share a
power of influence on interest in maximization of long-term cash flow. What is in the interest of
the entity is need to be in interests of all the entities in the subset which is represented by an
industry. Benefits of the entities are felt when disclosure leads to low capital cost. This is
accomplished by helping creditors and investors in understanding economic risk associated with
investment. Disclosing information is a route in which investors use in arriving to capital transfer



economic risk. The cost incurred when disclosing and developing disclosure is payed for by the
owner alone. Litigation arises when allegations of information disclosure are insufficient or the
disclosure is misleading.
The category of non-owner investors interest will refer to creditors and investors in the
market place who can invest in entity. This will exclude all the owners both the potential and
entity owners. These non-owner investors get their benefits when the risk is low in making errors
in resource allocation. Lower information risks will generate to other interests’ benefits if these
risks are occurring to non-owner investor. Potential owners will obtain disclosure benefits
without risks making them free riders.
The last interest is the national interest in which is questioned by many on weighed of
and evaluation its disclosure in cost and benefits for neutralization of accounting. In the national
interest disclosure will contribute to low capital cost. Non- underestimated capital allocation
which is effective is associated with national interest. This effective allocation will include more
but not limited to financial capital and human capital.
In conclusion, considering benefits and costs will include their future change.
Contribution of perspective net cost and benefits in long term is an objective in this
consideration. The major considerations and are the three interests discussed in this article. Some
of the findings disclosed in this article is that find that cost will change with time in response to
information disclosure. Optimal level in disclosure will increase in future for the public
companies unless capabilities of competitive advantage of competitors are imposed. For the
national interest increase in disclosure optimal level will cause long term benefits.



Article#2: stock market effect of the closeness to debt covenant restriction resulting from
capitalization of leases
The objective of this article is examination of how lessees in market returns associate with
the changes in the debt covenant tightness. This article uses covenant based course of action. The
action will examine cross-section stock returns that exist when effect in an industry cannot be
randomized with time. Debt covenants which are private have financial restrictions which are
tighter while the public debt covenants contain more provisions which ae non-accounting-based
which include security, sinking fund, and seniority debt.
SFAS No.13 (FASB 1976) secured the conditions for classification of lease by tightening
them as operating lease. To meet the criteria of SFAS No 13, retroactive capitalization became a
requirement for off-balance leases sheet. If the debt agreement is likely to use GAAP, the changes
of off-balance leases sheet increases likelihood to violation of debt covenant restriction. Some of
previous research on the extend on which change in mandated accounting affect debt covenant
found that grouping of results of previous researches on debt covenant will give the overall
significant power in explanatory.
In the answering of this question on this article several researches are looked in and
evaluated. The inconclusiveness and inconsistency of these research results give a suggestion that
the debt to equity ratio is like to not an adequate representative for closeness to viola...

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