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Debt Covenants and Accounting Conservatism: Complements or Substitutes?
Valeri Nikolaev,
University Of Chicago
ABSTRACT. Using a sample of more than 3,000 debt issues, I examine whether firms with more covenant restrictions in their public debt contracts exhibit more timely recognition of economic losses in earnings. Covenants limit the manager’s ability to take actions leading to bondholder wealth expropriation by governing the transfer of control rights from shareholders to bondholders when a firm approaches financial distress. Given most covenants become binding when accounting performance deteriorates, I argue that covenants are more valuable in constraining managerial opportunism if the accounting system generates timely signals of a firm’s economic health. Consistent with this conjecture I find evidence that reliance on covenants in lending agreements is positively associated with the demand for timely loss recognition. In particular, firms with the most restrictive debt contracts are twice as timely in recognizing economic losses as firms with the least restrictive debt contracts.
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