This paper investigates the current relationship between asset revaluations and debt contracting. Much work in the accounting choice literature is premised on a relation between debt contracts and accounting policies. In particular, prior research provides evidence that asset revaluations are used to reduce the costs of debt contracting (see Whittred and Chan, 1992; Brown, Izan and Loh, 1992; and Cotter and Zimmer, 1995). Asset revaluations have the potential to reduce the cost of debt contracting by (a) allowing firms to avoid the costs associated with technical default on debt covenants, and (b) signalling available borrowing capacity to lenders.
That is, asset revaluations have the advantages of reducing leverage and providing credible signals of exit values of assets; both of which have the potential to increase borrowing capacity. Reductions in leverage also reduce the probability of technical default on debt covenants, with the probability of default being determined by both current proximity to default on covenants and expectations about future increases in debt levels. Firms therefore have incentives to revalue when increased borrowing capacity allows a reduction in the cost of new debt, and when technical default on debt covenants is probable, especially if default is expected to be costly.
Prior empirical research into debt related determinants of asset revaluations in Australia uses data from the 1970s and early 1980s. Several contextual changes have occurred since then that have the ability to impact on asset revaluations, and in particular, the relationship between asset revaluations and debt contracting. These institutional changes include increased regulation of asset revaluations and disclosures, changes in the macroeconomic environment, and changes in the Australian debt market.
For example, the use of public debt by listed corporations, which has been documented to be associated with asset revaluations in prior research (see Whittred and Chan, 1992), has decreased dramatically in Australia since that sample period; with bank loans being the major source of debt finance for listed Australian firms in the early 1990s. It is therefore timely to re-examine the relationship between asset revaluations and debt contracting, giving due consideration to the changed contextual setting.
