Ebook Financial Accounting Characteristics and Debt Covenants
We estimate the relation between financial accounting characteristics and firms’ use of accounting-based covenants in lending agreements and the amount of covenant slack in these agreements. The financial accounting characteristics studied are the magnitude of prior discretionary accruals and asymmetric timeliness.
We find the use of accounting-based covenants is not clearly associated with the asymmetric timeliness of earnings whether asymmetric timeliness is measured according to the techniques of Basu (1997) or Ball and Shivakumar (2006). Neither is the use of accounting-based covenants significantly associated with the absolute value of discretionary accruals. Furthermore, we do not find a consistent relation between asymmetric timeliness or absolute discretionary accruals on the one hand and covenant slack on the other.
Research suggests that accounting-based covenants are effective at limiting bondholder/stockholder conflicts (e.g., Healy and Palepu, 1990, and Billett, King, and Mauer, 2006) and that the characteristics of accounting-based covenants are consistent with contracting-efficiency considerations (e.g., Leftwich, 1983 and Asquith, Beatty, Weber, 2005). Researchers also provide evidence that debt contracting incentives shape financial reporting characteristics (Ball, Kothari, and Robin, 2000 and Bushman and Piotroski, 2005) and that financial reporting characteristics are related to debt pricing (Moerman, 2006, and Bharath et al., 2004).
Taken together these studies imply that accounting characteristics have contracting efficiency implications because they alter the effectiveness of bond covenants. We argue that a treatment is more likely to be used when it is more effective. Therefore, if a given accounting characteristic (e.g. lower discretionary accruals) increases the efficiency of accounting-based covenants we will be more likely to observe the use of accounting-based covenants when that characteristic is present. We use this logic to draw inferences from the correlation between accounting based covenant use and a given set of financial reporting characteristics.
Debt covenants reduce shareholder moral hazard by providing bondholders with additional rights prior to severe financial distress. The level of covenant slack reflects the trade-off between the benefits of a protective trip-wire and the costs of renegotiation. If untimely and unreliable accounting reduce the ability of accounting covenants to function as an advanced warning device and lenders reduce slack in an attempt to counteract this deficiency, then we expect covenant slack to be reduced as accounting becomes less timely and less reliable. Therefore, we examine the relation between covenant slack and proxies for these accounting characteristics.
The accounting characteristics we study are discretionary accruals and ‘bad news’ sensitivity. These characteristics have been associated with the timeliness and reliability of financial reports. Researchers have attempted to link these characteristics with contracting efficiency. Existing work focuses on the relation between these characteristics and borrowing costs (Ahmed et al., 2002, and Bharath et al, 2004) and covenant violations (Zhang, 2004). While these papers look for effects given contracts are in place, we examine factors associated with the ex-ante choice of covenants.
Using the Loan Pricing Corporation’s Dealscan database, we identify private lending agreements in a given year that contain accounting-based covenants. Accounting-based covenants include requirements to maintain a given interest coverage ratio, current ratio, net worth, etc. We then examine the relation between prior ‘bad news’ sensitivity and discretionary accrual magnitude and the use of accounting covenants in the current period. We hypothesize that if these characteristics are associated with accounting-covenant efficiency, they should be related to the use of accounting covenants and the amount of covenant slack.
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