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Accruals, Financial Distress, and Debt Covenants

This paper examines whether commercial lenders incorporate the information about financial distress contained in accruals into debt covenants. It documents that, controlling for earnings, accruals provide incremental information over standard variables used in models for predicting financial distress. It further shows that firms with extreme accruals are more likely to become distressed than firms with moderate accruals. This paper also examines one possible use of the information in accruals by commercial lenders.

Results indicate that lenders do not fully consider the relation between accruals and financial distress when setting the initial tightness of debt covenants. As expected, debt covenants are set more tightly for borrowing firms with low accruals, regardless of the level of earnings. However, tests reveal that debt covenants for firms with high accruals are set more loosely than firms with moderate accruals. Because the initial tightness of debt covenants is not consistent with the information in accruals about financial distress, this result adds to prior literature that suggests that sophisticated users of accounting information do not fully utilize the information in accruals.

Prior research on the information in accruals has shown that high accruals are associated with declining future performance. Sloan (1996) finds that earnings consisting primarily of accounting accruals are less persistent than earnings predominantly made up of cash flows. His results indicate that the performance of firms with extreme accruals tends to mean-revert more quickly than firms with moderate levels of accruals. This result indicates that firms with high accruals will experience lower earnings performance in the future.

Other studies have documented the relation between high accruals and future unfavorable events. Changing auditors is generally regarded as a negative signal about firm performance (Schwartz and Menon, 1985; Johnson and Lys, 1990; Schwartz and Soo, 1995, 1996), and DeFond and Subramanyam (1998) find that firms with high accruals are more likely to change auditors. Dechow, Sloan and Sweeney (1996) find that firms with high accruals are more likely to be subject to SEC enforcement actions for violations of generally accepted accounting principles. High accruals have also been associated with management's attempts to manipulate earnings to avoid problems such as debt covenant violations (Dichev and Skinner, 2002; DeFond and Jiambalvo, 1994).

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Accruals, Financial Distress, and Debt Covenants