Financial statements are supposed to provide useful information to a wide variety of users: equity analysts, investors, creditors, even prospective employees wanting to make sure they’re not about to board a sinking ship. But corporate boards don’t have fiduciary obligations to all of those different groups, and it turns out that this shows up in how they present themselves.

Financial statements corp-governance

“The likelihood that firms will manipulate their reporting to circumvent debt covenants is higher when directors owe fiduciary duties only to equity holders, rather than when they owe fiduciary duties also to creditors,” write Tel Aviv University professor Shai Levi, Fordham University and The Hebrew University associate professor Benjamin Segal, and Singapore Management University associate professor Dan Segal.

Financial statements: Focusing on structured debt issuance

To answer the question of how fiduciary obligations affect financial statements, the researchers focused on Delaware companies before and after a 1991 ruling in Credit Lyonnais v. Pathe Communications that increased boards’ obligations to creditors if a company is close to insolvency and the issuance of mandatory redeemable preferred shares that in many ways behave like debt (the deadline for the mandatory redemption is effectively its maturity), but without counting against debt covenant limits.

When managers manipulate financial reports to circumvent these debt covenants, they transfer wealth from creditors to shareholders,” they write.

After the 1991 ruling, the issuance of this type of structured debt dropped among Delaware companies close to insolvency, but it remained steady for US firms located outside Delaware and Delaware companies with low gearing. While this is only one data point for a pretty general claim, it suggests that boards really do respond to changing legal expectations. Unsurprisingly, boards with a higher mix of independent were more likely than the average to reduce this type of structured debt issuance.

Financial statements: The changing distribution of covenant slack

Levi, Segal, and Segal also looked at covenant slack, the difference between the maximum level of debt-to-cash allowed under the covenant and the amount reported in a company’s financial statement.

The distribution of corporate slack for non-Delaware companies is concentrated at slightly more than 0 (where the company would be exactly at the maximum debt-to-cash level) with a noticeable fall off just below zero. This could be interpreted as management working to keep gearing as high as possible without going over, but the effect disappears in high-geared Delaware companies after 1991.

“Managers usually have limited ability to manipulate their firms’ financials, and they use it when the true performance is just below the covenant limit, in order to report numbers that meet the threshold and avoid violation,” they write.