Studies on goodwill impairments and loan covenants

The dissertation investigates three topics concerning the relations between accounting information and capital markets. The first essay examines the relation between share prices and future accounting goodwill impairments. The second essay investigates how expectations of accounting goodwill impairments affect the use of financial covenants in corporate loan contracts. The third essay documents how violations of financial covenants affect corporate financing and investment behavior. Empirical analyses of all three studies are conducted with U.S. data. The main results are obtained using OLS, Tobit, and logistic regression analyses with appropriate robustness checks. The first essay investigates the timeliness and predictability of accounting goodwill impairments. Prior research has documented that firms with market value of equity lower than its book value record goodwill impairments more frequently for the next year than firms with market value of equity greater than its book value. This essay provides a more detailed investigation of how share prices are associated with future accounting goodwill impairments, focusing on the majority of cases where the firms’ market value of equity is greater than its book value. I find that among these cases, stock markets are able to anticipate goodwill impairments recorded for the following four quarters. This anticipation, however, is driven by impairments recorded for the fourth fiscal quarter, for these impairments are less timely than impairments recorded for the other quarters. The second essay documents how the choice of financial covenants in corporate private loan contracts is affected by the contracting parties’ expectations of accounting goodwill impairments. Since covenant violations are costly to both contracting parties, I argue that they deliberately try to avoid using such covenants that could be violated by expected bookings of goodwill impairments. I focus on the use of net worth and tangible net worth covenants and find that when the borrower has a considerable amount of goodwill, the use of tangible net worth covenants is related to future accounting goodwill impairments. The conclusion is that the contracting parties are able to anticipate borrowers’ accounting goodwill impairments and that these expectations affect the choice of financial covenants in the loan contracts. The third essay examines the consequences of loan covenant violations on firm financing and investment behavior. While prior studies have documented individual consequences, we provide an integrated framework where the relative magnitudes of the consequences may be directly compared. We find that, on the financing side, firms increase cash holdings and net debt distributions while modestly reducing equity distributions. These changes together correspond to a net increase in free cash flow. On the investment side, capital expenditures decline but the use of operating leases is not affected, resulting in an increased proportion of operating leases as a means of acquiring tangible fixed assets. Research and development expenses remain largely unchanged, while acquisitions decrease over the subsequent two to three years. The results are consistent with tighter financial discipline, greater creditor oversight, and liquidity preservation, while at the same time maintaining strategic spending on innovation and operational continuity. The thesis contributes to three streams of research literature: one investigating the timeliness and predictability of accounting goodwill impairments, second investigating the design of financial covenants in corporate private loan contracts, and third exploring the consequences of financial covenant violations.