Debt Covenants and Accounting Conservatism

Valeri V. Nikolaev

468 citations0/0 files storedJournal of Accounting Research

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Auditing, Earnings Management, Governance Corporate Finance and Governance Accounting Theory and Financial Reporting

Abstract

ABSTRACT Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision‐making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers’ abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if the accounting system recognizes economic losses in earnings in a timely fashion. Thus, the demand for timely loss recognition should increase with a contract's reliance on covenants. Consistent with this conjecture, I find evidence that reliance on covenants in public debt contracts is positively associated with the degree of timely loss recognition. I also find evidence that the presence of prior private debt mitigates this relationship.

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References

1976Theory of the firm: Managerial behavior, agency costs and ownership structure 1977Determinants of corporate borrowing 1984Financial Intermediation and Delegated Monitoring 1985Positive Accounting Theory 1997The conservatism principle and the asymmetric timeliness of earnings1 1991Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt 2000The effect of international institutional factors on properties of accounting earnings 1979On financial contracting

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