Accounting Research About Small-Company Debt Resonates in Tough Economic Times

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In a time of international economic crisis, like the one caused by the COVID-19 pandemic, a corporation’s debt burden can make the difference between survival and collapse.

Accounting professors David P. Weber and Yanhua Sunny Yang‘s research, appearing in the March/April issue of the prestigious publication The Accounting Review, sheds light on accounting regulations that seem to inadvertently foster increased debt among smaller firms.

For some years, growing corporate debt has evoked concern among financial observers. The financial burden may, in part, be the result of low interest rates, but regulatory factors have been implicated as well. Weber and Yang investigated federal accounting regulations that may have had the unintended effect of encouraging indebtedness among small firms.

Those regulations are Section 404 of the Sarbanes-Oxley act (SOX 404) and an exemption that permits small firms to avoid an expensive requirement of this provision. The exemption considerably increases the likelihood that small firms qualifying for it will fund growth by incurring debt rather than by selling common stock. SOX 404, a response to corporate accounting scandals circa 2000, mandates large firms to meet expensive corporate management and auditing requirements related to internal controls. Smaller firms can qualify for exemptions to the audit requirements for internal controls. The exemption applies to firms with public float (the value of company shares held by the public at large) of less than $75 million.

But, the UConn researchers said, the exemption can impact the financial choices of firms near the exemption threshold, making common equity more costly and additional debt relatively less so.

“Certainly one potential cost of taking on more debt than would otherwise be optimal is the increased risk of financial stress in the event of a negative economic shock, such as the current coronavirus situation,” Weber said.

Yang and Weber analyzed 1,095 small public firms, over a 15-year span, and discovered strikingly different patterns in raising capital between those slightly above the SOX-mandated threshold and those slightly below it. Before SOX, both groups were equally likely to issue common stock as a means of external financing. But after SOX, the below-threshold firms were, on average, 19.4 percent less likely to issue common stocks than those above the threshold.

“The study’s value, we believe, is in alerting regulators to a heretofore unrecognized, though important, effect of SOX 404 and, more generally, of basing regulatory exemptions on equity values,” Weber said. Although the study does not prescribe an optimal exemption threshold, it may be informative to policy makers who weigh the balance between regulatory burdens and investor protection.

Indeed, the SEC recently adopted new rules that, going forward, will expand the exemption to firms with revenues less than $100 million. “It will be interesting to see if this new provision affects regulatory avoidance in the future,” Yang said.