Sie sind auf Seite 1von 40

DOI: 10.1111/j.1475-679X.2009.00359.

x
Journal of Accounting Research
Vol. 48 No. 1 March 2010
Printed in U.S.A.

Debt Covenants and Accounting


Conservatism
VA L E R I V. N I K O L A E V ∗

Received 14 January 2008; accepted 30 September 2009

ABSTRACT

Using a sample of over 5,000 debt issues, I test whether firms with more ex-
tensive use of covenants in their public debt contracts exhibit timelier recogni-
tion 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 man-
agerial opportunism, however, only if the accounting system recognizes eco-
nomic losses in earnings in a timely fashion. Thus, the demand for timely loss
recognition should increase with a contract’s reliance on covenants. Consis-
tent with this conjecture, I find evidence that reliance on covenants in public
debt contracts is positively associated with the degree of timely loss recogni-
tion. I also find evidence that the presence of prior private debt mitigates this
relationship.

1. Introduction
I test whether firms that rely on covenants in their public debt contracts
recognize economic losses in earnings in a more timely fashion, that is,
∗ The University of Chicago Booth School of Business. I am indebted to the co-chairs of
my dissertation committee, S.P. Kothari and Laurence van Lent. I thank Douglas Skinner
(the editor) and the anonymous referee for constructive feedback that substantially improved
the paper. I gratefully acknowledge comments from Ray Ball, Sudipta Basu, Jan Bouwens,
Peter Easton, Douglas Hanna, Philip Joos, Christian Leuz, Maarten Pronk, Richard Sansing,
and workshop participants at the annual American Accounting Association and European
Accounting Association meetings, Emory University, MIT, Maastricht University, University of
Antwerp, University of Chicago, University of Manchester, University of Michigan, University
of North Carolina, and Tilburg University. This study was supported by a grant (R 46-570) from
the Netherlands Organization for Scientific Research (NWO).
137
Copyright 
C , University of Chicago on behalf of the Accounting Research Center, 2009
138 V. V. NIKOLAEV

whether these firms are more conservative. Debt contracting is a key eco-
nomic explanation for accounting conservatism (Watts [2003a]). Conser-
vatism mitigates conflicts of interest between shareholders and bondhold-
ers (Ahmed et al. [2002]) and, in particular, facilitates the role covenants
play in transferring control over key managerial decisions to bondholders
whenever the value of their claims is at risk (Ball and Shivakumar [2006]).
Despite a compelling theory of accounting conservatism, however, little em-
pirical evidence exists on how a given firm’s reliance on debt covenants is
related to its degree of accounting conservatism. The public debt market of-
fers a valuable opportunity to examine this relation. Unlike banks, which are
known as delegated monitors (e.g., Diamond [1984]), public bondholders
lack timely inside information, have weaker incentives to monitor manage-
rial actions, and exercise less control over these actions. These differences
imply that public bondholders will have a greater demand for timely loss
recognition than banks or other private lenders.
Debt covenants limit a manager’s ability to opportunistically expropri-
ate wealth from bondholders when a firm approaches economic distress.
Value-expropriating actions include unwarranted distributions to share-
holders, issuance of higher or equal priority debt claims, and investments
in negative net present value (NPV) projects (Jensen and Meckling [1976];
Myers [1977]; Smith and Warner [1979]). Covenants that limit such actions,
however, only become binding if the accounting system recognizes the de-
terioration of a company’s economic performance (or financial position).
Thus covenants are not always able to prevent the expropriation of bond-
holder value. Timely loss recognition is expected to improve the efficiency
of covenants because covenants are more likely to be binding in distress
and thus are more likely to limit opportunistic actions by the management.
Assuming that accounting serves contracting needs (Watts and Zimmerman
[1986]), the use of covenants should, therefore, lead to increased demand
for timely recognition of economic losses in accounting earnings.
What gives managers incentives to meet the demand for timelier recog-
nition of losses? First, a good reputation is crucial to a firm’s access to pub-
lic debt markets and to its ability to reduce the cost of debt (Diamond
[1991]). Second, timely loss recognition is influenced by the threat of litiga-
tion (Basu [1997]; Qiang [2007]). When debt contracts rely on accounting-
based covenants, bondholders are likely to provide higher incentives for
timely loss recognition to the firm’s management and its auditors. Pub-
lic debt contracts often require an auditor to certify compliance with
indenture covenants, which potentially exposes the auditor to a greater
litigation threat. Thus, auditors are likely to be more cautious and ex-
ert a higher degree of conservatism in the presence of accounting-based
covenants.
Important economic differences exist between private (e.g., bank loans)
and public (e.g., bonds) debt. Private lenders such as banks are consid-
ered superior monitors with direct access to internal information (Fama
[1985]; Diamond [1991]). Covenants in private loan agreements, however,
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 139

are not expected to create the same demand for timely loss recognition
as those in public debt contracts, although little research exists on this
topic. First, private debt covenants require that companies maintain cer-
tain financial ratios within a much tighter range as compared to public
debt. As a result, covenant violations and their subsequent renegotiations
are common (Watts and Zimmerman [1986]; DeAngelo, DeAngelo, and
Skinner [1994]; Dichev and Skinner [2002]). The need for renegotiations
substantially increases private debtholder control over the company and
thus reduces scope for managerial opportunism. Second, while public debt
contracts seldom require maintenance of accounting ratios (due to higher
renegotiation costs associated with diffuse ownership), they do employ a
range of negative covenants, which also rely on accounting information.
Managers must meet these covenants before taking certain actions, includ-
ing dividend payouts, acquisitions, investments, issuance of debt, etc. Since
these actions could be used to expropriate bondholder wealth, covenants
limiting such actions (rather than covenants that require maintenance of
financial ratios) create a demand for timely loss recognition. Third, while
private debt usually requires quarterly (or even monthly) compliance with
covenants, public debt contracts normally require only annual compliance
certification (e.g., Kahan and Tuckman [1993], p. 16). Thus, were a firm’s
auditor to overlook the recognition of a loss, management could have a
substantially longer period to act opportunistically before the next compli-
ance is due in the case of public debt. These three distinctions suggest that
public bondholders should be more concerned than private lenders with
the degree of timely recognition of losses.
I use the Mergent Fixed Income Securities Database to retrieve covenants
commonly used in public debt contracts. I construct the index of covenant
use by calculating the total number of covenants present in each contract. I
also construct an index that proxies for the use of accounting in the covenant
section of the contract. Further, depending on their relation with manage-
rial actions, I assign covenants to one of three subgroups: payout-related
restrictions, investments-related restrictions, and financing-related restric-
tions. Within each of these subgroups, I count the number of covenants to
measure how extensively they are used.
Many covenants that restrict managerial actions have ties to accounting in-
formation that are unobservable in the database. However, while the higher
renegotiation costs make relying on covenants in public debt contracts
less attractive than in private credit agreements, accounting information
remains an important component of such contracts (Moody’s [2006]). I
search 8-K filings on Edgar for public indentures and read their covenant
sections. While I do not observe public debt contracts that require mainte-
nance of financial ratios, it is common for public debt contracts to con-
dition various managerial actions on accounting information. Examples
of such restrictions include those on the issuance of additional debt and
equity, payment of dividends, investment, mergers and acquisitions, liens,
leases, and asset sales (see appendix A for an example of a typical covenant
140 V. V. NIKOLAEV

section). 1 As a rule, a contract containing such restrictions uses a few ac-


counting benchmarks to restrict managerial actions. A common accounting
benchmark cumulates 50% of accounting profits less 100% of all losses over
the contract life. This benchmark can be applied to various covenants; but
most often it is used to determine the threshold restricting payment of div-
idends or other spending. Covenants restricting M&A deals or new debt
issuance often include thresholds formulated in terms of fixed-charge cov-
erage ratio, net worth, and leverage. Asset conveyance restrictions, negative
pledge covenants/limitations on liens, as well as limitations on sale-and-
leaseback transactions often require a firm to meet a minimum level of net
tangible assets or are linked to aggregate indebtedness. While not every
covenant listed above has an accounting link, the more complex an inden-
ture’s covenants section, the more likely it is to condition managers’ actions
on accounting information.
Following Basu [1997], I measure timely loss recognition as the degree of
recognition of economic losses over economic gains. My findings show that
firms whose public debt contracts employ more covenants exhibit timelier
recognition of economic losses. These results are both statistically and eco-
nomically significant and apply to both the overall measures of covenants’
use as well as to specific types of covenants. I also find that companies with
more extensive use of covenants exhibit higher levels of timely loss recogni-
tion both before and after the issue. Moreover, I find that companies enter-
ing contracts that use covenants more extensively experience an increase in
timely loss recognition after the issue. Finally, a company’s prior private-debt
issues and their reliance on financial covenants attenuates the relationship
between public debt covenants and timely loss recognition, which suggests
that alternative monitoring mechanisms can substitute for timely loss recog-
nition. The results hold both when I control for firm- and contract-specific
characteristics and when I measure timely loss recognition in an alternative
way. Overall, my findings suggest that the use of covenants in public debt
contracts is associated with increased demand for timely loss recognition.
Few empirical studies examine a direct link between debt contract design
choices and the properties of accounting information (Sloan [2001]; Guay
and Verrecchia [2006]). One exception is Beatty, Weber, and Yu [2008],
who study the use of “income escalators” specified by net-worth covenants. 2
These authors argue that income escalators serve to make a contract more
conservative and find that they are positively related to the degree of ac-
counting conservatism (or suggest they are complementary). Beatty et al.

1 Early evidence in Holthausen and Leftwich [1983] and Leftwich [1983] documents that

many covenants limiting managerial actions (e.g., distributions, financing, and mergers and
acquisitions) are accounting-based or are associated in an indirect fashion with accounting
numbers (Beneish and Press [1993]). While such evidence primarily relates to bank loans,
I find similar evidence in my sample for public debt contracts that rely on these types of
covenants.
2 Income escalators are systematic adjustments that exclude a percentage of positive income

when the current covenant threshold is determined.


DEBT COVENANTS AND ACCOUNTING CONSERVATISM 141

exclusively study income escalators within a single covenant in private lend-


ing agreements. Frankel and Litov [2007] hypothesize that accounting ratios
whose maintenance is required by private credit agreements are more effi-
cient at reducing the agency costs of debt when accounting is conservative.
In a sample of private debt Frankel and Litov do not find systematic evi-
dence to support this hypothesis and conclude that any relation between
covenants and conservatism must be marginal. One possible explanation
for their findings is their focus on private rather than public debt; as I argue
above, it is easier for private debtholders to directly monitor and control
the use of their funds, as well as to discipline managers, and so they are
less likely to be concerned with reporting timeliness. 3 Accordingly, I pro-
vide some evidence that the reliance on private debt and the imposition of
extensive financial covenants in private debt contracts attenuates the rela-
tionship between bond covenants and timely loss recognition.
The present study makes several contributions. First, I expand the liter-
ature on contracting explanations for accounting conservatism (Watts and
Zimmerman [1986]; Ball, Kothari, and Robin [2000]; Watts [2003a, 2003b];
Ball and Shivakumar [2005]; Ball, Robin, and Sadka [2008]). These studies
argue that the debt market influences the degree of accounting conser-
vatism, however, the evidence is largely limited to cross-country and cross-
market examinations. I find that within the same GAAP jurisdiction and
conditional on the presence of debt in a firm’s capital structure, the design
of debt contracts has an incremental effect on reporting incentives. Second,
my results support complementarity between public debt covenants and
timely loss recognition. If, alternatively, contracts can adjust for the lack
of conservatism in accounting by making contractually prespecified adjust-
ments in reported numbers (Leftwich [1983]), the need for timely loss
recognition in earnings can be eliminated (e.g., Schipper [2005], Guay and
Verrecchia [2006]). Here, covenants would be expected to have zero or
even a negative association with timely loss recognition. My results, how-
ever, suggest otherwise and thus should be of interest to standard setters as
the recent move toward neutral accounting can disadvantage bondholders.
Third, the extant literature suggests that conservatism yields gains in con-
tract efficiency intermediated by the use of covenants (Watts [2003], Ball and
Shivakumar [2005]; Ball, Robin, and Sadka [2008]; Zhang [2008]). I doc-
ument the link between timely loss recognition and public debt covenants,
which has not been previously established. Finally, consistent with the cross-
monitoring role of bank debt (Diamond [1984]; Datta, Iskandar-Datta, and
Pattel [1999]), I provide evidence to suggest that the demand for accounting
information differs in the presence of private debt.
The remainder of my paper is organized as follows: Section II reviews
the related literature and develops the main hypotheses; section III outlines

3 In line with this argument, Ball and Shivakumar [2005] find that private firms exhibit

lower levels of timely loss recognition, while Peek, Cuijpers, and Buijink [2009] indicate lower
timely loss recognition in the presence of relationship-based financing.
142 V. V. NIKOLAEV

the research design; section IV describes the data; section V reports results
on the relation between covenants and timely loss recognition; section VI
investigates the effect of private debt; and section VII provides a discussion
and concludes the study.

2. Related Literature and Hypotheses


In this section I discuss the role of bondholder protective covenants and
their relationship with timely loss recognition. I then outline my empirical
predictions and state my hypotheses.

2.1 ROLE OF DEBT COVENANTS


As a company approaches financial distress, bondholders’ vulnerability
to wealth expropriation by management and shareholders increases (Bodie
and Taggert [1978]; Smith, Smithson, and Wilford [1989]; Nash, Netter, and
Poulsen [2003]). Debt overhang (Myers [1977]), asset substitution ( Jensen
and Meckling [1976]), and claim dilution (Smith and Warner [1979]) are
well-known agency problems that financial difficulty exacerbates. Covenants
restrict managers’ ability to invest, pay out dividends, and take on additional
debt and thereby limit actions that potentially hurt bondholders. Covenants
that limit distributions of dividends to shareholders, for example, can effec-
tively force levered firms to reinvest their cash flows, thereby alleviating the
debt overhang problem associated with managers’ unwillingness to under-
take positive NPV projects as the ratio of debt to equity grows. Covenants that
restrict sales of assets or mergers and acquisitions reduce the likelihood of
asset substitution, while restrictions on leases and sales-and-leaseback trans-
actions as well as negative pledge covenants alleviate claim dilution.
Covenants, however, can become binding even for a financially healthy
company, thereby restraining managers’ ability to make decisions that in-
crease firm value. In addition to introducing the significant costs of techni-
cal default and renegotiation (Beneish and Press [1993, 1995]), covenant
restrictions can result in either failure to abandon unproductive assets or
inability to investment in good projects. Thus, firms must trade off the costs
and benefits of using covenants (Smith and Warner [1976]; Begley [1994];
Nash, Netter, and Poulsen [2003]).

2.2 THE ROLE OF TIMELY LOSS RECOGNITION AND THE USE OF COVENANTS
Timely loss recognition can enhance the efficiency of debt contracting in
two ways: (1) by facilitating early transfer of decision rights to bondholders
and (2) by facilitating the signaling role of covenants. I discuss these in turn.
As a component of accounting quality, timely loss recognition (or con-
ditional conservatism) plays an efficiency-enhancing role in contracting
(Watts [2003a]; Ball and Shivakumar [2005]). Early rather than late recog-
nition of economic losses in accounting earnings places a timely constraint
on value-expropriating actions when a firm experiences adverse economic
conditions. Bondholders are more likely to be able to prevent opportunistic
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 143

managerial actions and to mitigate the agency costs of debt if the accounting
incorporates negative economic news in a timely fashion. Covenant thresh-
olds, including those used by negative covenants, are commonly based on
accounting information directly linked to reported earnings, book values
of assets, liabilities, and/or shareholders equity. When a firm approaches
distress, timely loss recognition yields early transfer of control over key firm
decisions to bondholders and thus becomes more important when con-
tracts use covenants. Note, however, that covenants need not necessarily
have strong ties to accounting (although this is an appealing interpreta-
tion) because it is often argued that timely loss recognition alleviates agency
problems in general by, for example, forcing managers to recognize future
losses from unprofitable investments upfront (Ball and Shivakumar [2006]).
Therefore, timely loss recognition can complement covenants by disciplin-
ing management and reducing actions that lead to the expropriation of
bondholder value (e.g., unprofitable risky investments).
The empirical literature examines whether conservatism is beneficial for
debt contracting. Accordingly, economies in which public debt is a rela-
tively more important source of financing exhibit higher levels of timely
loss recognition (Ball, Kothari, and Robin [2000]; Ball, Robin, and Sadka
[2008]). At the firm level, conservatism reduces the cost of debt (Ahmed
et al. [2002]; Zhang [2008]) and the degree of information asymmetry
(Wittenberg-Moerman [2008]), as well as facilitates early transfer of con-
trol rights (Zhang [2008]).
Timely loss recognition can also improve the signaling value of covenants.
Levine and Hughes [2005] demonstrate that a combination of covenants
and conservative reporting is an optimal contracting mechanism. 4 In their
model, a firm seeks debt financing and signs two different contracts, a com-
pensation contract with the manager and a debt contract with lenders. The
compensation contract aims to align managerial incentives. In the absence
of a covenant, firms with a lower risk of default can choose to design their in-
centive compensation schemes suboptimally to signal their type to investors,
thereby engaging in costly distortion of operating decisions. Combining a
debt covenant based on earnings with the conservative measurement of
earnings overcomes the need to incur these signaling costs. Thus, conser-
vatism facilitates contracting on covenants by making it more difficult for the
“low type” firm to mimic the “high type” because lower reported earnings
force the former into early default.
2.3 IS THERE A WAY TO COMMIT TO TIMELIER LOSS RECOGNITION?
While the literature recognizes managerial incentives to manage earn-
ings around covenant thresholds (Watts and Zimmerman [1986]), the evi-
dence is inconclusive (see Fields, Lys, and Vincent [2001] for a discussion).

4 In their stylized model, no distinction is made between conditional and unconditional

conservatism. Nevertheless, because their result is effectively due to the downside risk that
bondholders face, conditional conservatism arguably fits the spirit of the model well.
144 V. V. NIKOLAEV

DeAngelo, DeAngelo, and Skinner [1994] provide evidence that rather than
attempting to portray their firms as less troubled, managers’ accounting
choices acknowledge their firms’ financial troubles, suggesting that counter-
vailing forces (such as the threat of litigation) may offset managerial incen-
tives to manage earnings upward in order to loosen covenants. Note that the
focus here is on economic losses that are already anticipated (or observed)
by the market and thus reflected in share prices, which makes it particularly
difficult for companies’ managers to mask them. Absent accounting-based
contracts, the market should be largely indifferent to the timely recognition
of economic losses that are already known. In contrast, contracting parties
are not indifferent because the degree of their (future) control directly
depends on the timeliness with which losses are recorded in the financial
statements.
I argue that the demand for timely loss recognition is met due to both the
multi-period nature of debt market relationships and auditor pressure for
conservative compliance with covenants. The accounting choices include
timely write-downs and impairments of firm’s assets, and/or other accruals
that recognize adverse economic shocks to future cash flows in the current
period. It is here that accounting exhibits the asymmetric treatment of gains
and losses. 5 While commitment to such treatment is difficult, the economic
incentives at work should discipline the manager and ensure timely loss
recognition.
The first factor that is likely to ensure that companies adhere to conser-
vative accounting policies is reputation. The untimely reporting of losses is
likely to tarnish a firm’s reputation in the credit market (the manager’s rep-
utation will also be affected negatively), which can significantly complicate
its future access to public debt markets (Diamond [1991]). Reputation is a
powerful tool for improving contracting efficiency in credit markets (Fehr,
Brown and Zehnder [2009]), and management has little incentive not to
meet the demand for timely loss recognition, especially when the firm is not
close to violating its covenants.
The second factor promoting timely loss recognition is litigation risk. Au-
ditors face considerable litigation risk when default approaches (Kothari
et al. [1988]; Lys and Watts [1994]; Watts [2006]) and the failure to disclose
all pertinent bad news is known to increase a firm’s legal liability (Skinner
[1997]). In addition, the auditor of a borrowing firm is often required
to provide an annual statement of compliance certifying that no breach
of covenants has taken place (Watts and Zimmerman [1986]). 6 A firm’s

5 For example, companies often recognize earnings gradually as they move toward the com-

pletion of a project. If the company determines that the project will result in a future loss,
GAAP requires recognition of such loss in full in the current period.
6 Consider, for example, the following excerpt from the public debt contract of Baldor

Electric Company: “So long as not contrary to the then current recommendations of the
American Institute of Certified Public Accountants, the year-end financial statements delivered
pursuant to section 4.03 above will be accompanied by a written statement of the Company’s
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 145

failure to recognize adverse economic news increases its litigation risk and
also directly exposes its auditor to such risk. Prior work documents that
client default and increased litigation risk affect audit plans and increase
the issuance of modified opinions (Pratt and Stice [1994]; Krishnan and
Krishnan [1997]). Thus, a debt contract reliance on accounting informa-
tion is likely to increase the degree of conservatism adopted by the auditor.

2.4 MAIN HYPOTHESES


If timely loss recognition indeed facilitates the contracting role of
covenants in resolving a firm’s underlying agency conflicts, a positive as-
sociation between timely loss recognition and debt covenants is expected.
Alternatively, to the extent that covenants adjust accounting numbers to
satisfy bondholders’ needs, no association (or even a negative association)
between covenants and timely loss recognition is implied. This yields the
following hypothesis (stated in the alternative form):
H1: Timely recognition of economic losses increases with the use of debt
covenants in public debt contracts.
The direction of causality between covenants and timely loss recognition
remains an open question: Do conservative firms find it worthwhile to rely
on covenants or do firms that introduce covenants alter the degree to which
they recognize economic losses? Answering this question is difficult because
doing so requires valid instruments that are notoriously difficult to obtain.
As a first step in this direction, I use firms as their own controls and examine
changes in timely loss recognition following debt issues. The arguments
presented earlier suggest that entering a new debt contract that relies on
covenants should further increase the demand for timely loss recognition. 7
Thus, I hypothesize:
H2: Companies that rely on debt covenants more extensively exhibit a
greater increase in timely recognition of economic losses following
debt issue.

3. Research Design
I construct several indices to quantify a public debt contract’s reliance
on covenants. The first index, OVRL, is an overall measure of covenant use
calculated by counting the total number of covenants within a public debt

independent public accountants (who will be a firm of established national reputation) that
in making the examination necessary for certification of such financial statements, nothing
has come to their attention that would lead them to believe that the Company has violated
any provisions of Article 4 or Article 5 (‘Covenants’) hereof in so far as it relates to accounting
matters . . .”
7 I am assuming that an incremental effect still exists if a firm has other existing public debt

issues that also rely on covenants.


146 V. V. NIKOLAEV

contract. In addition, I construct narrower covenant indices by assigning


covenants to the following subgroups: 8
(1) Payout-related restrictions: covenants that restrict dividend payments,
transfers, and distributions to external parties.
(2) Investment-related restrictions: covenants that restrict investments,
merger and acquisition activity, sales or transfers of assets (disinvest-
ments), and sale-and-leaseback transactions.
(3) Financing-related restrictions: covenants that restrict the issuance of se-
nior debt, subordinated debt, collateralized debt, debt of higher pri-
ority, and negative pledge restrictions and limitations on liens and
covenants that limit a firm’s ability to issue preferred or common
stock.
(4) Accounting-related covenants: covenant benchmarks based on minimum
net worth, coverage of interest, and other earnings, as well as leverage
tests and limitations on indebtedness.
(5) Other covenants: covenants that restrict transactions with affiliates,
covenants related to changes in control, cross-default covenants, and
so on. 9
I count covenants within each subgroup: DIV denotes a count of payout
restrictions, INV denotes a count of covenants limiting investment activities
and asset dispositions, FIN denotes a count of covenants limiting financing
activities, and ACC is a count of accounting-related covenants or bench-
marks. I also perform principal component analysis over the five individual
covenant indices, which clearly identifies one main factor, PRIN . For more
details on the covenants used to construct each index, see appendix B.
3.1 EMPIRICAL SPECIFICATIONS
To test the relation between covenants and the degree of timely loss recog-
nition, I follow Basu [1997] and measure accounting conservatism, allowing
the degree of covenant use to influence the effect of “bad news” on earnings.
Specifically, I estimate the following model:
E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 D (Ret t < 0)Ret t
+ β0 Restrict s + β1 D (Ret t < 0)Restrict s + β2 Ret t Restrict s
+ β3 D (Ret t < 0)Ret t Restrict s + εt , (1)

where E t is year t earnings, P t−1 is the market value of equity in the end of
year t − 1, Ret t is the annual return, and D(.) is an indicator function taking
the value of 1 when its argument is true and 0 otherwise. Restrict s denotes
one of the covenant indices (for a debt contract s) described above. Of

8 Since new financing is usually associated with new investments, this allocation is somewhat

arbitrary.
9 While these covenants are significantly correlated with indices based on other subgroups

and are a part of the overall covenant index, I do not perform a separate empirical analysis of
these covenants because of no strong prior about their relation to timely loss recognition.
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 147

primary interest is the coefficient β 3 , which is expected to be positive under


hypothesis H1.
To test hypothesis H2, I augment equation (1) to allow the coefficient β 3
to take different values before and after the issue. The association between
covenants and timely loss recognition thereby can vary in a postissue period.
In particular, I estimate the following regression model:
E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 D (Ret t < 0)Ret t
+ β0 Restrict s + β1 D (Ret t < 0)Restrict s + β2 Ret t Restrict s
+ β3 D (Ret t < 0)Ret t Restrict s + γ0 After t
+ γ1 D (Ret t < 0)Ret t Restrict s After t + εt (2)
where After is a dummy variable that takes the value of 1 in years follow-
ing the debt issue and 0 otherwise, and the other variables are as in equa-
tion (1). Subscript t refers to time period. Under the second hypothesis,
the coefficient γ 1 is expected to be significantly positive. 10 To keep the
model parsimonious, After interacts only with the variable of primary in-
terest; however, the results are robust to interacting the After dummy with
other regressors. 11 Models (1) and (2) are estimated using observations
from within a 10-year window, starting five years prior and ending five years
after the issue. To rule out mechanical relationships, I exclude the year of
the issue from analysis.
3.2 CONTROLLING FOR CONFOUNDING EFFECTS
Of concern here is the possibility that the relationship between covenants
and timely loss recognition is affected by factors omitted from the analysis.
While isolating agency-related conflicts per se is expected to weaken the
relationship under study, it is necessary to control for joint determinants
of timely loss recognition and covenant use. I control for the major firm-
specific and contract-specific characteristics by using the following two-stage

10 One implicit assumption I make in this test is that every new issue that relies on covenants

will have an incremental effect on the demand for conditional conservatism. It is reasonable
to believe that this impact would be lower if a firm already has in its capital structure public
debt that relies on covenants. This, however, should bias my estimates toward zero and thus
work against finding my results.
11 One can also interact After with all the variables present in the baseline model. This, how-
t
ever, can over-parameterize the model. Considerations when determining whether to adhere
to a more parsimonious specification or augment it include the following. First, while inclusion
of the main effects can be desirable, Aiken and West [1991] point out (p. 105) that introducing
into regression unnecessary terms that have no relationship to the criterion in the population
results in lowering, sometimes appreciably, the efficiency of the estimates. Second, Aiken and
West [1991] recognize (p. 97) that inclusion of the lower level interactions and main effects
should be guided by theory (for example it would be appropriate to use length×width, rather
than length and width separately, in a regression where an outcome is based on the area).
Given a lack of theoretical guidance on what specification should be used, I revert to a simpler
specification and recognize the above as a potential caveat. I also check the robustness of the
results with respect to this research design choice and find that the results remain similar when
alternative specifications are used, although the significance levels may decline in some cases.
148 V. V. NIKOLAEV

approach. In the first stage, by performing an OLS regression of covenant


indices on a set of control variables and then saving the residual for use in
the second stage, I orthogonalize the covenant indices with respect to a set
of control variables. 12 The first stage model is:
Restrict t = α0 + α1 log (Assets t−1 ) + α2 Leverage t−1 + α3
Leverage t + α4 BTM t−1
+ α5 ROAt−1 + α6 DivYield t−1 + α7 Loss t−1 + α8 CapInt t−1
+ α9 Z − score t−1 + α10 log (Time) + α11 log (CrRating t )
+ α12 log (Maturityt ) + α13 log (Amount t ) + εt , (3)
where Restrict denotes one of the covenant indices, log(Assets) is a proxy for
size, Leverage is the ratio of long-term debt to assets,
Leverage is the change
in leverage over the year of debt issue, BTM is the book-to-market ratio, ROA
is return on assets, DivYield is the dividend yield, Loss is a dummy for neg-
ative profitability, CapInt is a proxy for capital intensity, Z-score is Altman’s
bankruptcy score, log(Time) is a logarithmic time trend, CrRating is the quan-
tified issue-specific debt rating issued by Moody’s, log(Maturity) is logarithm
of the number of years to maturity, and log(Amount) is the logarithm of the
principal amount (see appendix C for details). Each of these firm charac-
teristics has been shown or is expected to affect the use of covenants and/or
degree of conservatism (see Malitz [1986]; Begley [1994]; Nash, Netter, and
Poulsen [2003]; Watts [2003b]; Bradley and Roberts [2004]; Khan and Watts
[2009]).
In the second stage, I use the unexplained variation in covenant indices,
that is, the residuals from model (3), and re-estimate models (1) and (2).
One can think of these residuals as instrumental variables; like instruments,
while they are correlated with covenant use, by construction they are uncor-
related with other variables that potentially confound the relationship. This
results in a cleaner test of H1 and H2.

4. Data and Sample Construction


The data come from several sources. I base the main tests on the inter-
section of the Mergent Fixed Investment Securities Database (FISD), Com-
pustat, and CRSP. FISD is a comprehensive database of public debt issues
used to obtain covenant and issue-specific information. As discussed earlier,
covenants are assigned to subgroups, and their counts within each subgroup
are used to measure their degree of use. If covenant information is not
available, I exclude the issue from the analysis. Appendix B provides more
details about the individual covenants.
Balance sheet and income statement data are taken from Compustat, and
monthly returns data come from CRSP. I exclude debt issues by financial

12 I use OLS because the main objective of the first-stage regression is to orthogonalize the

covenant indices with respect to control variables. OLS residuals are known to have such a prop-
erty, while the “residuals” from multinomial logit, Poisson, or negative binomial regressions
will not satisfy the orthogonality condition.
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 149

institutions because they are subject to different accounting rules and regu-
lations. To mitigate the influence of extreme observations, I drop 1% of the
earnings at each tail of the population distribution. Earnings, E t , are mea-
sured as income before extraordinary items (Compustat item data18), and
P t− 1 is the end-of-prior-year price (data199) times the number of shares out-
standing (data25). Returns, Ret t , are compounded over the fiscal year using
monthly data. Fiscal-year returns are used to mitigate the concerns raised in
Dietrich, Muller, and Riedl [2007] (see Ryan [2006] for a discussion). Refer
to appendix C or tables’ headers for definitions of control variables used in
equation (3).
Approximately 205,000 debt issues (by 10,900 companies) exist on the
FISD database for the period 1980–2006. The majority of these issues are by
nonindustrial companies (e.g., banks, financial institutions, insurance com-
panies, and so on). Restricting the sample to issues by industrial companies
yields 27,771 issues by 6,158 firms. Only 12,105 of those issues (2,809 compa-
nies) link to Compustat; furthermore, only 7,956 issues (2,466 companies)
have covenant information available. Finally, to equally weight companies, I
retain only one issue per firm per year. This yields the final sample of 5,420
firm-year observations by 2,466 companies (for the period 1980–2006). 13 As
discussed earlier, for each of these debt issues, I include return-earnings ob-
servations from five years prior to and five years after the issue when I apply
the Basu [1997] methodology. This procedure results in 32,716 firm-year
observations. Additional data requirements, such as the presence of non-
missing control variables or the use of Dealscan, further reduce the sample.
I provide details and the exact number of observations used for a particular
test in each table.

4.1 DESCRIPTIVE STATISTICS


Table 1 displays the descriptive statistics for covenant indices. Panel A
displays the frequencies with which different types of covenants are encoun-
tered in public credit agreements. The number of covenants per contract
ranges from 0 to 23. The distribution is somewhat positively skewed, and a
number of public debt contracts appear to employ covenants more exten-
sively than private debt contracts. Presence of multiple covenants is consis-
tent with public debt markets substituting for a lack of control and monitor-
ing of companies’ managers with a more comprehensive set of restrictions
on managerial actions. A range of covenant frequencies is well represented
in the sample. Panel B shows that the mean (median) value of the overall
(OVRL) covenant index is 7.42 (6), with a standard deviation of 4.53. Panel
C shows that all covenant indices exhibit high positive correlations among
themselves; all correlations are statistically significant.

13 To increase the power of the tests, I retain the issue with the maximum number of

covenants.
150 V. V. NIKOLAEV

TABLE 1
Description of Covenant Indices
Panel A: Frequency of Covenant Occurrence
Count of Covenants OVRL DIV INV FIN ACC Other
0 36 3,270 370 1,546 3,214 1,073
1 199 367 42 2,134 257 1,618
2 243 1,683 2,568 875 1,814 860
3 636 100 265 574 100 818
4 714 2,066 206 30 756
5 664 75 70 3 290
6 666 33 14 2 5
7 218 1 1
8 127
9 84
10 137
11 230
12 331
13 340
14 365
15 259
16–23 171

Panel B: Summary Statistics


Statistic OVRL DIV INV FIN ACC
Mean 7.42 0.74 2.73 1.27 0.80
Median 6 0 2 1 0
Standard Dev. 4.53 0.96 1.24 1.19 1.01
Number of Obs. 5,420 5,420 5,420 5,420 5,420

Panel C: Correlation Statistics

OVRL 1
DIV 0.888 1
INV 0.427 0.109 1
FIN 0.834 0.691 0.320 1
ACC 0.873 0.877 0.127 0.662 1

Panel A reports the frequency distribution of covenants present in public debt contracts, based on their
type. OVRL is the overall count of covenant restrictions included in a contract, DIV is a count of payout
restrictions, INV is a count of covenants that limit M&A and investment activities and asset dispositions,
FIN is a count of covenants limiting financing activities, and ACC is a count of accounting-based covenants.
Panel B displays summary statistics while Panel C displays Pearson correlations for different covenant
indices. Data is taken from the Mergent Fixed Income Securities Database. To give all firm-year observations
equal weight, I retain only one debt issue per year. The sample includes industrial debt issues for the period
1980–2006.

5. Covenants and Timely Loss Recognition


5.1 MAIN RESULTS
I begin by estimating regression (1). Table 2 presents the parameter esti-
mates based on the different types of covenant indices. The first specifica-
tion uses the OVRL covenant index. The coefficient α 3 has a positive and
statistically significant value of 0.27, in line with findings in Basu [1997].
This coefficient increases in the OVRL covenant index, as suggested by the
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 151
TABLE 2
Asymmetric Timeliness of Earnings and the Use of Covenants
Variable OVRL PRIN DIV INV FIN ACC
Intercept 0.0687∗∗∗ 0.056∗∗∗ 0.0606∗∗∗ 0.0508∗∗∗ 0.0596∗∗∗ 0.0602∗∗∗
(16.63) (24.43) (27.74) (9.35) (18.86) (27.04)
D(Ret < 0) −0.0077 0.0128∗∗∗ 0.0039 0.0035 0.0054 0.0049
(−1.25) (3.33) (1.13) (0.42) (1.06) (1.42)
Ret −0.014∗∗ −0.0145∗∗∗ −0.0155∗∗∗ −0.0087 −0.0141∗∗∗ −0.015∗∗∗
(−2.16) (−3.67) (−3.45) (−0.98) (−3.11) (−3.36)
D(Ret < 0) ∗ Ret 0.27∗∗∗ 0.3555∗∗∗ 0.3115∗∗∗ 0.3268∗∗∗ 0.3369∗∗∗ 0.3159∗∗∗
(11.7) (23.41) (20.55) (10.31) (18.08) (20.65)
Restrict −0.002∗∗∗ −0.0049∗∗∗ −0.0108∗∗∗ 0.002 −0.0031 −0.0084∗∗∗
(−2.95) (−3.07) (−3.3) (1.17) (−1.29) (−2.75)
D(Ret < 0) ∗ 0.0034∗∗∗ 0.0084∗∗∗ 0.0188∗∗∗ 0.0047 0.0095∗∗ 0.0158∗∗∗
Restrict (3.26) (3.56) (3.73) (1.64) (2.54) (3.32)
Ret ∗ Restrict −0.0001 0.0004 0.0022 −0.0028 −0.0016 0.0007
(−0.13) (0.18) (0.5) (−0.74) (−0.5) (0.18)
D(Ret < 0) ∗ 0.0149∗∗∗ 0.0365∗∗∗ 0.0844∗∗∗ 0.023∗ 0.0422∗∗∗ 0.0775∗∗∗
Ret ∗ Restrict (4.6) (4.99) (5.27) (1.96) (3.41) (5.03)

Adj. R-square 0.143 0.144 0.145 0.137 0.140 0.144


Table 2 displays estimates from the following regression:

E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 D (Ret t < 0)Ret t + β0 Restrict s


+ β1 D (Ret t < 0)Restrict s + β2 Ret t Restrict s + β3 D (Ret t < 0)Ret t Restrict s + εt ,

where E t is year t earnings measured by income before extraordinary items (Compustat item data18),
P t−1 is the market value of equity at year t − 1 (Compustat items data199 ∗ data25), Ret t is the return
from CRSP compounded over the 12 months starting at the beginning of the fiscal year, D(.) is indicator
function, and Restrict s is a covenant restrictiveness index given by the count of covenants of the particular
type included in a debt contract. Types of covenant indices are specified in the first row of the table and
are defined as follows: OVRL is the overall count of covenant restrictions a contract includes, PRIN is the
first principal component based on different types of covenants, DIV is a count of payout restrictions,
INV is a count of covenants that limit M&A and investment activities and asset dispositions, FIN is a
count of covenants that limit financing activities, and ACC is a count of accounting-based covenants. Debt
issues are taken from the Mergent Fixed Income Securities Database. Analysis includes firm-years within
a 10-year window starting five years prior to and ending five years after debt issuance (I exclude the year
of the issue from analysis). To give all firm-year observations equal weight, I retain only one issue per
firm per year. The sample includes industrial debt issues for the period 1980–2006 and amounts to 5,420
debt issues and 32,716 firm-years with nonmissing Compustat data. The standard errors are clustered
by firm; t-statistics are in parentheses. To mitigate the influence of outliers, 1% of scaled Compustat
data is dropped at each tail. ∗ , ∗∗ , ∗∗∗ indicate statistical significance at less than 10%, 5%, and 1%,
respectively.

coefficient β 3 , and is significantly positive at the 1% level. The magnitude


of β 3 is 0.015, which suggests that adding 10 covenants (i.e., close to two
standard deviations) to a contract yields an economically important 0.15
(or 56% of α 3 ) increase in timely loss recognition. The results based on the
second summary measure covenant use (PRIN ) yield similar inferences.
The separate covenant types—payout, investment, and financing restric-
tions (DIV , INV , FIN , respectively)—also exhibit significantly positive associ-
ations with timely loss recognition. Including a payout restriction (DIV ) has
the strongest effect on timely loss recognition (followed by restrictions on ad-
ditional financing, FIN ). The use of a dividend restriction is associated with
a 0.084 increase in timely loss recognition, which is equivalent to 27%. This
152 V. V. NIKOLAEV

result highlights the importance of conservatism in mitigating bondholder-


shareholder conflicts over dividend policy. Ahmed et al. [2002] find that
when such conflicts are present, companies respond with more conserva-
tive accounting treatment. Finally, timely loss recognition increases in the
accounting-related covenant index (ACC); the coefficient exhibits a high
level of statistical significance. Overall, the evidence supports hypothesis H1
across different types of covenants.
The magnitudes of estimated β 3 coefficients based on the individual
covenant indices are higher than that of the OVRL covenant index. This
implies that the presence of multiple covenants lowers the marginal effect
of an additional covenant on timely loss recognition. Further, it is interesting
to note that the three covenant indices measuring restrictions on managerial
actions have equally strong association with timely loss recognition as com-
pared to the accounting-based covenant index. This suggests that it is not
necessarily the use of accounting per se, but rather its combination with the
restrictions on managerial actions potentially leading to bondholder wealth
expropriation that affect the demand for timely loss recognition.
To shed some light on the direction of causality in the association between
covenants and timely loss recognition, I allow for changes in the degree of
timely loss recognition conditional on a contract’s use of covenants following
a debt issue. Under H2, firms that use covenants more (less) extensively
should exhibit a larger (no significant) increase in timely loss recognition.
To examine this, I estimate model (2).
Table 3 presents the results. The coefficient β 3 now captures the associ-
ation between covenants and timely loss recognition in the years prior to
debt issuance, while the coefficient γ 1 measures the incremental association
between covenants and timely loss recognition in the period following the
issue. Based on the OVRL measure of covenant use, β 3 is equal to 0.008,
which remains statistically significant but lower than its corresponding esti-
mate of 0.015 in table 2. This suggests that the association between the use
of covenants and the degree of timely loss recognition strengthens after the
issue. The estimate of γ 1 , in the case of the OVRL covenant index, equals
0.009 and is statistically significant at less than the 1% level. The total ef-
fect β 3 + γ 1 is 0.017, which implies that the strength of association between
covenants and timely loss recognition in the years after the issue is twice that
in the years before the issue. The PRIN measure also exhibits a stronger as-
sociation with timely loss recognition after the issue. The results based on
payout (DIV ), investment (INV ), financing (FIN ), and accounting-based
(ACC) covenants yield estimates of γ 1 that are highly significant through-
out. Therefore, the evidence is consistent with H2. 14

14 When two or more of covenant indices and their corresponding interactions with other

variables are included in regression at the same time, the estimates of β 3 and γ 1 (i.e., their
analogs in this model) usually lack statistical significance; at the same time being highly signif-
icant when included separately. This implies the presence of a common dimension in these
measures.
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 153
TABLE 3
Asymmetric Timeliness of Earnings Prior to and after Debt Issuance and the Use of Covenants
Variable OVRL PRIN DIV INV FIN ACC
Intercept 0.0747∗∗∗ 0.0645∗∗∗ 0.068∗∗∗ 0.056∗∗∗ 0.067∗∗∗ 0.0676∗∗∗
(17.09) (26.81) (28.67) (10.12) (20.08) (28.12)
D(Ret < 0) −0.005 0.0121∗∗∗ 0.004 0.0053 0.0065 0.005
(−0.81) (3.11) (1.16) (0.64) (1.27) (1.44)
Ret −0.0152∗∗ −0.0156∗∗∗ −0.0167∗∗∗ −0.0096 −0.0152∗∗∗ −0.0161∗∗∗
(−2.32) (−3.9) (−3.66) (−1.08) (−3.32) (−3.57)
D(Ret < 0) ∗ Ret 0.2783∗∗∗ 0.3526∗∗∗ 0.3115∗∗∗ 0.3378∗∗∗ 0.3397∗∗∗ 0.3157∗∗∗
(12.24) (23.02) (20.66) (10.9) (18.34) (20.73)
Restrict −0.002∗∗∗ −0.0049∗∗∗ −0.0108∗∗∗ 0.002 −0.0031 −0.0085∗∗∗
(−2.96) (−3.07) (−3.3) (1.13) (−1.26) (−2.77)
D(Ret < 0) ∗ 0.0027∗∗∗ 0.0072∗∗∗ 0.0163∗∗∗ 0.0032 0.0074∗ 0.0135∗∗∗
Restrict (2.58) (3.04) (3.2) (1.14) (1.96) (2.82)
Ret ∗ Restrict 0 0.0007 0.0026 −0.0027 −0.0013 0.0011
(−0.04) (0.31) (0.61) (−0.71) (−0.4) (0.28)
D(Ret < 0) ∗ Ret ∗ 0.0081∗∗ 0.0223∗∗∗ 0.0524∗∗∗ −0.0005 0.0204 0.0469∗∗∗
Restrict (2.39) (2.64) (2.89) (−0.04) (1.4) (2.72)
After −0.0131∗∗∗ −0.0186∗∗∗ −0.0162∗∗∗ −0.0111∗∗∗ −0.0163∗∗∗ −0.0163∗∗∗
(−5.97) (−9.15) (−7.87) (−4.96) (−7.58) (−7.95)
D(Ret < 0) ∗ Ret ∗ 0.009∗∗∗ 0.0206∗∗ 0.0475∗∗∗ 0.0327∗∗∗ 0.029∗∗∗ 0.0471∗∗∗
Restrict ∗ After (4.25) (2.46) (3.14) (5.49) (2.59) (3.36)

Adj. R-square 0.149 0.148 0.150 0.143 0.143 0.148


Table 3 displays estimates from the following regression:

E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 D (Ret t < 0)Ret t + β0 Restrict s + β1 D (Ret t < 0)Restrict s
+ β2 Ret t Restrict s + β3 D (Ret t < 0)Ret t Restrict s + γ0 After t + γ1 D (Ret t < 0)Ret t After t Restrict s + εt ,

where After t is an indicator variable that takes the value of one in years after a company issues debt and zero
otherwise, E t is year t earnings measured by income before extraordinary items (Compustat item data18),
P t−1 is the market value of equity at year t − 1 (Compustat items data199 ∗ data25), Ret t is the return
from CRSP compounded over the 12 months starting at the beginning of the fiscal year, D(.) is indicator
function, and Restrict s is a covenant restrictiveness index given by a count of covenants of the particular
type included in a debt contract. Types of covenant indices are specified in the first row of the table and
are defined as follows: OVRL is the overall count of covenant restrictions included in a contract, PRIN is
the first principal component based on different types of covenants, DIV is a count of payout restrictions,
INV is a count of covenants limiting M&A and investment activities and asset dispositions, FIN is a count
of covenants limiting financing activities, and ACC is a count of accounting-based covenants. Debt issues
are taken from the Mergent Fixed Income Securities Database. Analysis includes firm-years within a 10-year
window starting five years prior to and ending five years after debt issuance (I exclude the year of the issue
from the analysis). To give all firm-year observations equal weight, I retain only one issue per firm per year.
The sample includes industrial debt issues for the period 1980–2006 and amounts to 5,420 debt issues and
32,716 firm-years with nonmissing Compustat data. The standard errors are clustered by firm; t-statistics are
in parentheses. To mitigate the influence of outliers, 1% of scaled Compustat data is dropped at each tail.
∗ ∗∗ ∗∗∗
, , indicate statistical significance at less than 10%, 5%, and 1%, respectively.

5.2 CONTROLLING FOR CONFOUNDING EFFECTS


Next, I control for a number of confounding effects (see a discussion in
section 3.2) and re-examine H1 and H2. To preserve table space, I combine
covenants that limit key managerial decisions into one index, KDEC, and use
it in subsequent analysis. 15 Specifically, KDEC = DIV + INV + FIN . Table 4

15 The results based on separate covenant indices are very similar.


154

TABLE 4
Descriptive Statistics
Panel A: Summary Statistics
V. V. NIKOLAEV

Variable Mean Median Standard Dev. Number of Obs.


log(Assets) 7.405 7.443 1.644 4,020
BTM 0.425 0.399 0.661 4,020
Leverage 0.303 0.276 0.205 4,020

Leverage 0.056 0.026 0.137 4,020


ROA 0.005 0.045 0.263 4,020
DivYield 0.010 0.001 0.016 4,020
Loss 0.249 0.000 0.432 4,020
CapInt 0.382 0.334 0.245 4,020
Z-score 3.701 2.824 5.331 4,020
log(Time) 3.542 3.584 0.178 4,020
log(CrRating) 2.735 2.833 0.581 4,020
log(Amount) 6.853 6.908 0.496 4,020
log(Maturity) 2.331 2.301 0.577 4,020
(Continued)
T A B L E 4 —Continued
Panel B: Pearson Correlations
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
(1) log(Assets) 1
(2) BTM 0.04 1
(3) Leverage −0.17 −0.19 1
(4)
Leverage −0.33 −0.03 −0.42 1
(5) ROA 0.19 0.08 −0.13 −0.07 1
(6) DivYield 0.34 0.11 −0.13 −0.08 0.12 1
(7) Loss −0.23 −0.10 0.30 0.05 −0.47 −0.24 1
(8) CapInt 0.14 0.05 0.09 −0.07 0.12 0.14 −0.08 1
(9) Z-score −0.14 −0.03 −0.37 0.29 0.04 −0.07 −0.14 −0.19 1
(10) log(Time) 0.19 −0.09 0.09 −0.12 −0.08 −0.20 0.07 −0.15 −0.05 1
(11) log(CrRating) −0.63 −0.01 0.27 0.18 −0.24 −0.40 0.35 −0.20 −0.01 0.13 1
(12) log(Amount) −0.02 0.02 0.00 0.01 0.02 0.00 −0.03 −0.03 0.04 −0.05 −0.05 1
(13) log(Maturity) 0.09 0.02 −0.12 −0.04 0.12 0.14 −0.15 0.10 −0.02 −0.25 −0.17 −0.03
The sample consists of 4,020 public debt issues with nonmissing values for all firm characteristics over the period 1980–2006. Firm level variables are measured at the end of the
fiscal year prior to debt issuance using Compustat data. Debt issues are taken from the Mergent Fixed Income Securities Database. Log (Assets) is the logarithm of a firm’s total assets
(data6), BTM is book-to-market measured as book value of equity (data60) divided by market value (data199 ∗ data25), Leverage is the ratio of long-term debt (data9) to total asset,

Leverage is change in leverage over the year of debt issuance, ROA is return on assets calculated as net income (data172) divided by total assets, DivYield is dividend yield measured
as common dividends (data21) divided by market value of equity, Loss is a dummy variable for negative net income, CapInt is capital intensity measured as a ratio of property, plant,
and equipment (data8) to total assets, Z-score is Altman’s Bankruptcy score, log (Time) is the logarithm of time trend, log (CrRating ) is the logarithm of Moody’s debt ratings taken
from FISD, log (Amount) is the logarithm of the amount of issue, and log (Maturity) is logarithm of the number of months before the issue matures. Moody’s rating is measured by
assigning the value of 1 to the highest credit rating, the value of 2 to the second best credit rating, and so on.
DEBT COVENANTS AND ACCOUNTING CONSERVATISM
155
156 V. V. NIKOLAEV

reports summary statistics for the control variables and their correlations.
The average firm has over 1.5 billion in assets and a leverage of 30%. Over
the year of debt issuance, leverage increases by 5.6% of total assets.
Table 5 displays the estimates from the first-stage regression, given by
equation (3). Covenants correlate in a predictable manner with many firm-
specific characteristics and are generally in line with prior research (e.g.,
Nash, Netter, and Poulsen [2003]). For example, consistent with the view
that covenants are used to respond to elevated agency problems, their use
declines with firm size and increases with book-to-market and leverage. On
the other hand, consistent with the view that covenants impose costs on a
company, they are used less frequently by firms that pay dividends.
Table 6 presents the second stage results based on orthogonalized
covenant indices. Estimates in the first four columns test H1 and are based
on model (1). The slope coefficient on the variable of interest (β 3 ) equals
0.014 (with a t-stat of 3.89) when the OVRL covenant index is used and 0.031
(with a t-stat of 3.79) when the PRIN component is used. The coefficient
β 3 is also positive and statistically significant when constraints on manage-
rial actions, KDEC, and ACC proxy for reliance on covenants. The four
remaining columns present model (2) estimates testing H2. Of primary in-
terest is the coefficient γ 1 in the bottom row of the table. For all four proxies
for reliance on covenants, the coefficient is statistically significant. Overall,
the magnitudes of the estimates of β 3 and γ 1 resemble those in tables 2 and
3. The association between covenants and timely loss recognition predicted
under H1 and H2 still exists when controlling for common firm-specific and
contract-specific characteristics.
5.3 ROBUSTNESS CHECKS
I perform several robustness checks. First, I demonstrate that my results
are robust to alternative model specifications, and then I investigate sample
selection bias.

5.3.1. Alternative Model Specifications. First, instead of performing the two-


stage analysis described in the previous subsection, I control for common
determinants of conditional conservatism in a one-stage regression. Specif-
ically, I augment equations (1) and (2) by adding Size, BTM , and Leverage
along with their respective interactions with Ret, D(Ret < 0), and D(Ret <
0)∗ Ret, which yields a total of 12 additional variables. 16 This approach pre-
cludes adding many control variables because of the likely loss of power;
thus, I use only the above listed three most common determinants of con-
servatism based on prior literature (e.g., Khan and Watts [2007]; LaFond
and Roychowdhury [2008]). 17 Table 7 presents the results. Although the

16 Consistent with prior literature, Size is defined as the logarithm of market capitalization

(Compustat items data24 ∗ data25).


17 I do not follow this one-stage approach as a main test, because it would require introducing

into the model up to 60 correlated regressors.


DEBT COVENANTS AND ACCOUNTING CONSERVATISM 157
TABLE 5
Determinants of Covenant Use (First Stage)
Variable OVRL PRIN DIV INV FIN ACC
Intercept −9.0506∗∗∗ −4.9319∗∗∗ −0.0494 −1.5132∗∗ −0.9173∗∗ −1.217∗∗∗
(−4.62) (−6) (−0.13) (−2.12) (−2) (−2.95)
Log(Assets) −0.5849∗∗∗ −0.3096∗∗∗ −0.1277∗∗∗ −0.0163 −0.0983∗∗∗ −0.113∗∗∗
(−8.16) (−10.84) (−8.97) (−0.56) (−5.16) (−7.01)
BTM 0.7233∗∗∗ 0.3189∗∗∗ 0.1421∗∗∗ 0.0653∗ 0.1668∗∗∗ 0.1215∗∗∗
(4.99) (5.01) (5.1) (1.84) (4.18) (3.88)
Leverage 7.5913∗∗∗ 3.367∗∗∗ 1.6297∗∗∗ 0.2513 1.9886∗∗∗ 1.6336∗∗∗
(13.13) (13.58) (14.04) (1.61) (12.5) (13.02)

Leverage 3.7076∗∗∗ 1.6347∗∗∗ 0.845∗∗∗ 0.2126 1.0024∗∗∗ 0.8974∗∗∗


(5.41) (5.58) (6.25) (1.23) (5.48) (5.99)
ROA 0.6443∗∗ 0.3269∗∗ 0.1817∗∗∗ 0.0246 0.1442∗∗ 0.1416∗∗
(2.1) (2.54) (3) (0.28) (2.1) (2.33)
Loss 0.2357 0.0982 0.08∗ 0.0442 −0.0004 0.06
(1.11) (1.1) (1.9) (0.74) (−0.01) (1.35)
CapInt 1.322∗∗∗ 0.6303∗∗∗ 0.2455∗∗∗ 0.0662 0.3231∗∗∗ 0.3302∗∗∗
(3.37) (3.8) (3.1) (0.48) (3.1) (3.86)
DivYield −9.3377∗ −5.4336∗∗ −3.7658∗∗∗ 4.6337∗∗ 1.0318 −3.5904∗∗∗
(−1.73) (−2.36) (−3.33) (2.17) (0.74) (−3.08)
Z-score −0.0556∗∗∗ −0.0245∗∗∗ −0.0122∗∗∗ −0.0119∗∗∗ −0.0148∗∗∗ −0.0141∗∗∗
(−4.18) (−4.2) (−4.45) (−3.25) (−4.46) (−5.04)
Log(Trend) 5.7157∗∗∗ 2.026∗∗∗ 0.3975∗∗∗ 1.7263∗∗∗ 0.9643∗∗∗ 0.7178∗∗∗
(13.27) (11.33) (4.46) (10.85) (8.49) (7.59)
Log(CrRating) −0.9813∗∗∗ −0.2609∗∗∗ −0.0058 −0.774∗∗∗ −0.4586∗∗∗ −0.018
(−5.29) (−4.12) (−0.19) (−6.55) (−9.3) (−0.54)
Log(Amount) 0.1889 0.0683 −0.0135 0.0609 0.0334 −0.0057
(1.24) (1.04) (−0.49) (1.4) (0.94) (−0.18)
Log(Maturity) −0.7506∗∗∗ −0.3348∗∗∗ −0.1509∗∗∗ −0.0791∗∗ −0.1869∗∗∗ −0.1759∗∗∗
(−7.13) (−8) (−7.83) (−2.06) (−7.14) (−7.89)

Adj. R-square 0.238 0.271 0.279 0.170 0.164 0.255


Table 5 displays the estimates from the regression of covenant indices on firm-specific characteristics.
The dependent variable is covenant index, that is, a count of covenants of a particular type contained in an
indenture agreement. The types of covenant indices are specified in the first row and are as follows: OVRL
is the overall count of covenant restrictions included in a contract, PRIN is the first principal component
based on the main groups of covenant restrictions, DIV is a count of payout restrictions, INV is a count
of covenants limiting M&A and investment activities and asset dispositions, FIN is a count of covenants
limiting financing activities, and ACC is a count of accounting-based covenants. The explanatory variables
are measured at the end of the fiscal year prior to debt issuance using Compustat data. Log (Assets) is
the logarithm of total assets (data6), BTM is book-to-market measured as book value of equity (data60)
divided by its market value (data199 ∗ data25), Leverage is a ratio of long-term debt (data9) to total assets,

Leverage is change in leverage over the year of debt issuance, ROA is net income (data172) divided by
total assets, Loss is a dummy variable for negative net income, CapInt is capital intensity measured as a ratio
of property, plant, and equipment (data8) to total assets, DivYield is dividend yield measured as common
dividends (data21) divided by market value of equity, Z-score is Altman’s Bankruptcy score, log (Trend) is the
logarithm of time trend, log(Maturity) is the logarithm of the number of months before the issue matures,
log (Amount) is the logarithm of the amount of issue, and log (CrRating ) is logarithm of Moody’s debt ratings
taken from FISD. Moody’s rating is measured by assigning the value of 1 to the highest credit rating, the
value of 2 to the second best credit rating, and so on. Debt issues are taken from the Mergent Fixed Income
Securities Database. The sample consists of 4,020 debt issues with nonmissing firm characteristics over the
period 1980–2006, which includes only issues by industrial firms. Only covenants that occur in more than
1% of debt issues in the population are used. To give all firm-year observations equal weight, I retain one
debt issue per firm per year. The standard errors are clustered by firm; t-statistics are in parentheses. To
mitigate the influence of outliers, 1% of scaled Compustat data is dropped at each tail. ∗ , ∗ ∗ , ∗ ∗ ∗ indicate
statistical significance at less than 10%, 5%, and 1%, respectively.
158

TABLE 6
Covenants and Timely Loss Recognition Controlling for Other Factors (Second Stage)
Variable OVRL PRIN KDEC ACC OVRL PRIN KDEC ACC
Intercept 0.0529∗∗∗ 0.0529∗∗∗ 0.0531∗∗∗ 0.0528∗∗∗ 0.0616∗∗∗ 0.0616∗∗∗ 0.0617∗∗∗ 0.0615∗∗∗
V. V. NIKOLAEV

(23.6) (23.43) (23.85) (23.47) (25.86) (25.74) (26.06) (25.82)


D(Ret < 0) 0.016∗∗∗ 0.0162∗∗∗ 0.0158∗∗∗ 0.0164∗∗∗ 0.0151∗∗∗ 0.0153∗∗∗ 0.0151∗∗∗ 0.0157∗∗∗
(3.74) (3.78) (3.71) (3.81) (3.49) (3.55) (3.5) (3.65)
Ret −0.0151∗∗∗ −0.0149∗∗∗ −0.0155∗∗∗ −0.0147∗∗∗ −0.0161∗∗∗ −0.0159∗∗∗ −0.0165∗∗∗ −0.0158∗∗∗
(−3.5) (−3.46) (−3.55) (−3.46) (−3.72) (−3.69) (−3.77) (−3.7)
D(Ret < 0) ∗ Ret 0.3784∗∗∗ 0.3788∗∗∗ 0.3791∗∗∗ 0.3794∗∗∗ 0.3736∗∗∗ 0.3744∗∗∗ 0.3751∗∗∗ 0.3761∗∗∗
(22.21) (22.09) (22.24) (22.16) (21.74) (21.77) (21.76) (21.99)
Restrict −0.0003 −0.0004 −0.0008 −0.0014 −0.0003 −0.0004 −0.0009 −0.0016
(−0.41) (−0.23) (−0.72) (−0.53) (−0.41) (−0.24) (−0.74) (−0.58)
D(Ret < 0) ∗ Restrict 0.0028∗∗ 0.007∗∗∗ 0.0049∗∗∗ 0.0124∗∗ 0.0025∗∗ 0.0063∗∗ 0.0045∗∗ 0.0114∗∗
(2.49) (2.65) (2.82) (2.41) (2.24) (2.4) (2.54) (2.22)
Ret ∗ Restrict 0.0009 0.0028 0.0007 0.007∗ 0.001 0.003 0.0009 0.0073∗
(0.92) (1.26) (0.39) (1.69) (1) (1.35) (0.49) (1.76)
D(Ret < 0) ∗ Ret ∗ 0.0135∗∗∗ 0.0308∗∗∗ 0.0234∗∗∗ 0.0568∗∗∗ 0.0074∗∗ 0.0168∗∗ 0.0143∗∗ 0.0316∗
Restrict (3.89) (3.79) (4) (3.23) (2.06) (2) (2.19) (1.71)
(Continued)
T A B L E 6 —Continued
Variable OVRL PRIN KDEC ACC OVRL PRIN KDEC ACC
After −0.0192∗∗∗ −0.0194∗∗∗ −0.0192∗∗∗ −0.0195∗∗∗
(−8.79) (−8.84) (−8.77) (−8.85)
D(Ret < 0) ∗ Ret ∗ 0.0107∗∗ 0.025∗∗ 0.0146∗∗ 0.0462∗∗
Restrict ∗ After (2.44) (2.39) (1.99) (2.33)

Adj. R-square 0.137 0.137 0.138 0.137 14.2 0.142 0.142 0.141
The table displays estimates from the following regression:

E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 D (Ret t < 0)Ret t + β0 Restrict s + β1 D (Ret t < 0)Restrict s + β2 Ret t Restrict s + β3 D (Ret t < 0)Ret t Restrict s + γ0 After t
+ γ1 D (Ret t < 0)Ret t Restrict s After t + εt ,

where E t is year t earnings, measured by income before extraordinary items (Compustat item data18), P t−1 is the market value of equity at year t − 1 (Compustat items data199 ∗
data25), Ret t is the return from CRSP compounded over the 12 months starting at the beginning of the fiscal year, D(.) is indicator function, After t is an indicator variable taking
the value of one in years after a company issues debt. Restrict s labels the orthogonalized covenant index from the first stage: I construct the covenant indices by counting covenants
of the particular type; subsequently, I orthogonalize these indices by regressing each of them on the firm characteristics and saving the residual (see table 5). Types of covenant
indices are specified in the first row of the table and are defined as follows: OVRL is the overall count of covenant restrictions included in a contract, PRIN is the first principal
component based on different types of covenants, KDEC is the sum of DIV , FIN , and INV , where DIV is a count of payout restrictions, INV is a count of covenants limiting M&A
and investment activities and asset dispositions, and FIN is a count of covenants limiting financing activities; ACC is a count of accounting-based covenants. Debt issues are taken
from the Mergent Fixed Income Securities Database. Analysis includes firm-years within a 10-year window starting five years prior to and ending five years after debt issuance (I
exclude the year of the issue from the analysis). To give all firm-year observations equal weight, I retain only one issue per firm per year. The sample includes industrial debt issues
for the period 1980–2006 and amounts to 4,020 debt issues and 29,185 firm-years with nonmissing Compustat data. The standard errors are clustered by firm; t-statistics are in
parentheses. To mitigate the influence of outliers, 1% of scaled Compustat data is dropped at each tail. ∗ , ∗ ∗ , ∗ ∗ ∗ indicate statistical significance at less than 10%, 5%, and 1%, respectively.
DEBT COVENANTS AND ACCOUNTING CONSERVATISM
159
TABLE 7
Asymmetric Timeliness of Earnings and the Use of Covenants: An Alternative Specification
160

Variable OVRL PRIN KDEC ACC OVRL PRIN KDEC ACC


Intercept 0.0571∗∗∗ 0.0525∗∗∗ 0.0551∗∗∗ 0.0524∗∗∗ 0.0542∗∗∗ 0.0484∗∗∗ 0.0525∗∗∗ 0.0486∗∗∗
(3.45) (3.28) (3.46) (3.19) (3.26) (3.01) (3.28) (2.95)
Size 0.0037∗∗ 0.0039∗∗ 0.004∗∗∗ 0.004∗∗ 0.0045∗∗∗ 0.005∗∗∗ 0.0047∗∗∗ 0.0049∗∗∗
(2.51) (2.55) (2.67) (2.56) (2.94) (3.18) (3.11) (3.1)
Size ∗ Ret 0.0027 0.003 0.0026 0.0031 0.0026 0.0028 0.0025 0.003
(1.36) (1.48) (1.29) (1.55) (1.31) (1.41) (1.24) (1.48)
V. V. NIKOLAEV

Size ∗ D(Ret < 0) −0.0035 −0.0028 −0.0046 −0.0025 −0.0033 −0.0031 −0.0042 −0.0026
(−1.17) (−0.94) (−1.53) (−0.82) (−1.12) (−1.02) (−1.42) (−0.85)
Size ∗ D(Ret < 0) ∗ −0.0653∗∗∗ −0.0642∗∗∗ −0.0672∗∗∗ −0.0632∗∗∗ −0.0645∗∗∗ −0.0634∗∗∗ −0.066∗∗∗ −0.062∗∗∗
Ret (−6.46) (−6.3) (−6.63) (−6.22) (−6.45) (−6.27) (−6.6) (−6.16)
BTM −0.0152 −0.0153 −0.0152 −0.0154 −0.0146 −0.0145 −0.0146 −0.0147
(−1.35) (−1.36) (−1.34) (−1.36) (−1.3) (−1.29) (−1.3) (−1.3)
BTM ∗ Ret 0.0061 0.0061 0.0061 0.0061 0.0061 0.006 0.006 0.0061
(1.11) (1.11) (1.1) (1.12) (1.11) (1.1) (1.09) (1.11)
BTM ∗ D(Ret < 0) 0.0326 0.0326 0.0324 0.0323 0.0337 0.0335 0.0334 0.0331
(1.53) (1.52) (1.51) (1.51) (1.58) (1.57) (1.57) (1.55)
BTM ∗ D(Ret < 0) ∗ 0.1518∗∗∗ 0.1523∗∗∗ 0.1515∗∗∗ 0.1517∗∗∗ 0.1516∗∗∗ 0.1535∗∗∗ 0.1514∗∗∗ 0.1521∗∗∗
Ret (3.18) (3.18) (3.17) (3.17) (3.2) (3.22) (3.19) (3.2)
Lev −0.0697∗∗∗ −0.0709∗∗∗ −0.0709∗∗∗ −0.0713∗∗∗ −0.0625∗∗∗ −0.0613∗∗∗ −0.0636∗∗∗ −0.0629∗∗∗
(−4.51) (−4.58) (−4.56) (−4.64) (−4.02) (−3.95) (−4.06) (−4.08)
Lev ∗ Ret −0.0234 −0.0271∗ −0.0229 −0.0285∗ −0.0237 −0.0275∗ −0.0233 −0.0287∗
(−1.49) (−1.74) (−1.47) (−1.85) (−1.51) (−1.77) (−1.49) (−1.87)
Lev ∗ D(Ret < 0) 0.0176 0.0167 0.0219 0.0146 0.0161 0.0154 0.0208 0.0129
(0.6) (0.56) (0.74) (0.5) (0.55) (0.52) (0.71) (0.44)
Lev ∗ D(Ret < 0) ∗ 0.1626∗∗ 0.1724∗∗ 0.171∗∗ 0.1671∗∗ 0.1246 0.1604∗∗ 0.1394∗ 0.141∗
Ret (2.15) (2.24) (2.27) (2.21) (1.63) (2.1) (1.84) (1.85)
D(Ret < 0) 0.0107 0.0264∗∗∗ 0.0136 0.018∗ 0.0126 0.0269∗∗∗ 0.0152 0.019∗∗
(0.99) (2.96) (1.33) (1.92) (1.18) (3.02) (1.49) (2.04)
(Continued)
T A B L E 7 —Continued
Variable OVRL PRIN KDEC ACC OVRL PRIN KDEC ACC
Ret −0.0148∗∗ −0.0104∗∗ −0.0145∗∗ −0.0138∗∗∗ −0.0152∗∗ −0.0106∗∗ −0.0149∗∗ −0.014∗∗∗
(−2.2) (−2.42) (−2.21) (−2.83) (−2.25) (−2.46) (−2.26) (−2.87)
D(Ret < 0) ∗ Ret 0.4861∗∗∗ 0.5199∗∗∗ 0.4909∗∗∗ 0.5029∗∗∗ 0.4905∗∗∗ 0.5167∗∗∗ 0.497∗∗∗ 0.5018∗∗∗
(13.12) (16.63) (13.59) (15.34) (13.44) (16.57) (13.98) (15.39)
Restrict −0.0006 −0.0007 −0.0007 −0.0005 −0.0006 −0.0007 −0.0008 −0.0004
(−0.94) (−0.48) (−0.73) (−0.33) (−0.94) (−0.42) (−0.8) (−0.27)
D(Ret < 0) ∗ Restrict 0.0028∗∗∗ 0.0071∗∗∗ 0.0042∗∗∗ 0.0079∗∗∗ 0.0024∗∗ 0.0059∗∗∗ 0.0035∗∗ 0.0069∗∗∗
(2.9) (3.13) (2.66) (3.18) (2.41) (2.6) (2.18) (2.76)
Ret ∗ Restrict 0.0007 0.0027 0.0012 0.0033 0.0008 0.0027 0.0013 0.0033
(0.79) (1.23) (0.74) (1.5) (0.82) (1.27) (0.79) (1.52)
D(Ret < 0) ∗ Ret ∗ 0.0061∗ 0.0123∗ 0.0094∗ 0.0146∗ 0.0016 −0.0016 0.0016 0.0035
Restrict (1.95) (1.7) (1.83) (1.8) (0.5) (−0.19) (0.3) (0.39)
After −0.0111∗∗∗ −0.0153∗∗∗ −0.0111∗∗∗ −0.0136∗∗∗
(−5.03) (−7.25) (−4.94) (−6.48)
D(Ret < 0) ∗ Ret ∗ 0.0073∗∗∗ 0.0226∗∗∗ 0.0116∗∗∗ 0.0198∗∗∗
Restrict ∗ After (3.44) (2.81) (3.28) (2.69)
Adj. R-square 0.184 0.184 0.183 0.184 0.188 0.187 0.187 0.188

E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 D (Ret t < 0)Ret t + δ0 Si ze t + δ1 Si ze t D (Ret t < 0) + δ2 Si ze t Ret t + δ3 Si ze t D (Ret t < 0)Ret t
+ λ0 BT Mt + λ1 BT Mt D (Ret t < 0) + λ2 BT Mt Ret t + λ3 BT Mt D (Ret t < 0)Ret t + κ0 Le vt + κ1 Le vt D (Ret t < 0) + κ2 Le vt Ret t + κ3 Le vt D (Ret t < 0)Ret t
+ β0 Restrict s + β1 D (Ret t < 0)Restrict s + β2 Ret t Restrict s + β3 D (Ret t < 0)Ret t Restrict s + γ0 After t + γ1 D (Ret t < 0)Ret t Restrict s After t + εt ,

After t is an indicator variable taking a value of one in years after a company issues debt, E t is year t earnings measured by income before extraordinary items (Compustat item data18),
P t−1 is the market value of equity at year t − 1 (Compustat items data199 ∗ data25), Ret t is the return from CRSP compounded over the 12 months starting at the beginning of the
fiscal year, D(.) is indicator function, and Restrict s is a covenant restrictiveness index given by a count of covenants of the particular type included in a debt contract. Types of covenant
indices are specified in the first row of the table and are defined as follows: OVRL is the overall count of covenant restrictions included in a contract, PRIN is the first principal
component based on different types of covenants, KDEC is the sum of DIV , FIN , and INV , where DIV is a count of payout restrictions, INV is a count of covenants limiting M&A
DEBT COVENANTS AND ACCOUNTING CONSERVATISM

and investment activities and asset dispositions, and FIN is a count of covenants limiting financing activities; ACC is a count of accounting-based covenants. Size is measured by the
logarithm of market capitalization (data199 ∗ data25), BTM is book-to-market ratio (data60/data199 ∗ data25), and Lev is long-term debt divided by total assets (data9/data6). Debt
issues are taken from the Mergent Fixed Income Securities Database. Analysis includes firm-years within a 10-year window starting five years prior to and ending five years after debt
issuance (I exclude the year of the issue from the analysis). To give all firm-year observations equal weight, I retain only one issue per firm per year. The sample includes industrial debt
issues for the period 1980–2006 and amounts to 5,420 debt issues and 32,716 firm-years with nonmissing Compustat data. The standard errors are clustered by firm; t-statistics are in
161

parentheses. To mitigate the influence of outliers, 1% of scaled Compustat data is dropped at each tail. ∗ , ∗ ∗ , ∗ ∗ ∗ indicate statistical significance at less than 10%, 5%, and 1%, respectively.
162 V. V. NIKOLAEV

levels of statistical significance weaken (which is expected given substan-


tially larger number of parameters and mechanical correlations among the
variables), the estimated coefficients β 3 in model (1) and γ 1 in model (2)
remain statistically and economically significant, which confirms my prior
results.
Second, to investigate the robustness of estimated coefficients on high
order interaction terms, I transform each covenant index into a binary vari-
able that takes a value of 1 if the value of this index is greater or equal to its
median, and 0 otherwise, and I re-estimate models (1) and (2). Such analysis
informs on whether the empirical results are driven by relatively few obser-
vations in the tails. While limiting the variation in the independent variable
is unlikely to add power to the specification, the results remain very similar
to those reported in the paper.

5.3.2. The Ball and Shivakumar Measure of Timely Loss Recognition. Ball and
Shivakumar [2006] propose an alternative way to measure asymmetric time-
liness in the absence of market returns. They note that accruals recognize
revisions in expectations about future cash flows asymmetrically (which they
exploit to evaluate timely loss recognition); that is, while they do so for eco-
nomic losses, economic gains are usually accounted for when realized. Using
their methodology, I find that, controlling for other factors, the estimate of
timely loss recognition increases with the use of covenants (H1). I also find
support for H2. Results are available upon request.

5.3.3. Sample Selection Bias. Because covenant information is unavailable


for a number of debt issues in the database (possibly owing to the absence
of a covenants section in the given contract), a selection issue may arise. I
address this issue using the approach in Heckman [1979]. First, I model the
probability of covenant information being available. I then control for the
inverse of Mill’s ratio in equation (3). 18 To ensure that equation (3) is well
identified, I use additional instruments in the first-stage regression. 19 I use
variables potentially correlated with the inclusion of covenants: Convertible
indicates the presence of a conversion option; Putable indicates the presence
of a put option; Redeemable indicates the presence of a call option; and
AssetBacked indicates that certain assets back the issue. The coefficient on
the inverse of Mill’s ratio is negative and statistically significant. Finally, I re-
estimate equations (1) and (2) using a selection-corrected set of covenant
indices (based on the residuals from equation (3)) and determine that my
findings do not change.

18 OLS residuals in this equation are uncorrelated with the nonrandom selection process,

and thus subsequent tests based on these residuals should not be biased.
19 Otherwise the model is identified purely by the nonlinearity of the inverse Mill’s ratio,

which yields unreliable inferences.


DEBT COVENANTS AND ACCOUNTING CONSERVATISM 163

6. Private Debt and Timely Loss Recognition


In this section, I explore the effect of private debt on the link between
covenants and timely loss recognition. I posit that the demand for timely
loss recognition varies with the presence of private versus public debt ow-
ing to the different mechanisms that resolve debt-related agency problems
in these forms of debt. Unlike public bondholders, who rely mainly on
financial reports, private lenders often rely on direct inside information,
which facilitates monitoring (Fama [1985]; Diamond [1991]). In addition,
private lenders’ have stronger incentives to monitor due to the lesser free-
rider problem associated with dispersed ownership. They also rely on much
tighter financial covenants serving as tip-wires (Berlin and Mester [1992];
Rajan and Winton [1995]). In practice, this results in frequent transfers of
control followed by one-sided renegotiations in which private debtholders
selectively relax covenants in exchange for some additional consideration
(Dichev and Skinner [2002]; Garleanu and Zwiebel [2009]). I expect that
the likelihood of public bondholder wealth being expropriated decreases
with the degree of monitoring by private lenders. The amount of private
lender monitoring is likely to be proportional to the amount lent. There-
fore, I expect that the demand for timely loss recognition decreases with
the extent a company relies on private debt. This gives rise to the following
hypothesis:
H3: The relationship between covenants in public debt contracts and
timely recognition of economic losses weakens as a company’s re-
liance on private debt increases.
A related empirical prediction concerns the use of financial ratios in
private lending agreements. I expect that the amount of control and mon-
itoring that private debtholders exercise over a company is proportional
to the number of financial covenants these bondholders impose. The abil-
ity to monitor and discipline the management is likely to be higher in the
presence of tight financial covenants, which in turn should decrease public
bondholders’ demand for timely loss recognition. Hence I hypothesize:
H4: The relationship between covenants in public debt contracts and
timely recognition of economic losses weakens as the number of
financial covenants present in coexisting private credit agreements
increases.
Using Dealscan data, I take the most recent private debt issues issued within
the three years prior to each public debt issue in my sample (I also use a
five-year window as a sensitivity check). 20 If no issues are found within this
period, the monitoring effect of private debt is assumed to be zero. Since
Dealscan data relies on SEC filings, and since I require a three-year window to

20 Matched with Compustat using ticker; when the latter is missing, loans are hand-matched

by company name.
164 V. V. NIKOLAEV

measure private debt variables, the sample of public debt is further restricted
to the period after 1996.
To test hypotheses H3 and H4, I estimate the model,
E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 Ret t D (Ret t < 0)
+ β0 Restrict s + β1 D (Ret t < 0)Restrict s + β2 Ret t Restrict s
+ β3 D (Ret t < 0)Ret t Restrict s + γ0 DealAmt t− + δ0 FinCoven t−
+ γ1 D (Ret t < 0)Ret t Restrict s DealAmt t−
+ δ1 D (Ret t < 0)Ret t Restrict s FinCoven t− + εt , (4)
where DealAmt t− proxies for reliance on prior private debt, and FinCoven
is the number of financial covenants present in the prior private credit
agreement. As argued above, both of these characteristics are associated with
the higher degree of bank monitoring. To keep the model parsimonious
(as discussed earlier), I interact only DealAmt and FinCoven with the main
variable of interest; my findings, however, are not sensitive to this research
design choice.
Table 8 presents the results. Of interest here are the coefficients γ1 and
δ1 . In line with hypotheses H3 and H4, both coefficients are negative and
statistically significant across all four specifications. This finding suggests
that (irrespective of how we measure the reliance on public debt covenants)
the association between public debt covenants and timely loss recognition
is attenuated by the extent to which companies rely on private debt or
its covenants. Overall, the evidence is consistent with private debt markets
exhibiting a lower demand for timely loss recognition than public debt
markets. Also, the results suggest that alternative monitoring mechanisms
alter public bondholder demand for timeliness of financial reporting.

7. Discussion and Concluding Remarks


I test whether covenants that protect bondholders in public debt contracts
are associated with the timely recognition of economic losses in accounting
earnings. Covenants transfer decision power from shareholders to bond-
holders when a company moves toward distress, limiting a manager’s ability
to expropriate bondholder wealth. Covenants are expected to be more ef-
fective in preventing agency costs of debt when a firm’s accounting system
generates timely signals of the firm’s economic health. Therefore, the use
of covenants creates a demand for timely loss recognition.
My analysis demonstrates that the more a company relies on protective
covenants in its public indentures, the greater its degree of timely loss recog-
nition. I also find that firms whose debt contracts use covenants extensively
exhibit a significant increase in timely loss recognition in the years after
the debt issues. This suggests that a reliance on covenants promotes timely
loss recognition. Further, the relationship between covenants and timely
loss recognition weakens in the presence of private debt, as is consistent
with the lower demand for reporting timeliness in this market. The results
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 165
TABLE 8
Private Debt, Asymmetric Timeliness of Earnings, and the Use of Covenants
Variable OVRL PRIN KDEC ACC
Intercept −0.0678∗ −0.1129∗∗∗ −0.0563 −0.0951∗∗∗
(−1.9) (−3.32) (−1.59) (−2.72)
D(Ret < 0) −0.0099 0.0179∗∗∗ −0.0101 0.0098∗
(−1.12) (3.04) (−0.94) (1.84)
Ret −0.0027 −0.0015 −0.0018 −0.0025
(−0.4) (−0.33) (−0.28) (−0.49)
D(Ret < 0) ∗ Ret 0.1735∗∗∗ 0.3082∗∗∗ 0.1951∗∗∗ 0.2601∗∗∗
(5.06) (13.42) (5.52) (11.06)
Restrict −0.0005 −0.0008 −0.0005 −0.0008
(−0.59) (−0.47) (−0.35) (−0.23)
D(Ret < 0) ∗ Restrict 0.0043∗∗∗ 0.0102∗∗∗ 0.0069∗∗∗ 0.0175∗∗∗
(3.18) (3.55) (2.94) (3.03)
Ret ∗ Restrict 0.0002 0.0012 0.0000 0.0018
(0.21) (0.59) (0.02) (0.43)
D(Ret < 0) ∗ Ret ∗ Restrict 0.086∗∗∗ 0.2249∗∗∗ 0.1646∗∗∗ 0.3796∗∗
(3.14) (2.59) (3.77) (2.37)
DealAmt 0.0063∗∗∗ 0.0084∗∗∗ 0.0057∗∗∗ 0.0075∗∗∗
(3.54) (4.86) (3.16) (4.28)
FinCoven −0.0024 −0.0018 −0.0028∗ −0.0022
(−1.49) (−1.18) (−1.73) (−1.42)
D(Ret < 0) ∗ Ret ∗ Restrict ∗ −0.0032∗∗ −0.0087∗ −0.0067∗∗∗ −0.0139∗
DealAmt (−2.31) (−1.92) (−3.04) (−1.69)
D(Ret < 0) ∗ Ret ∗ Restrict ∗ −0.0014∗∗ −0.0052∗ −0.0025∗∗ −0.0091∗
FinCoven (−1.96) (−1.8) (−2.06) (−1.82)

Adj. R-square 0.151 0.150 0.149 0.151


The table displays estimates from the following regression:

E t /Pt−1 = α0 + α1 D (Ret t < 0) + α2 Ret t + α3 D (Ret t < 0)Ret t + β0 Restrict s


+ β1 D (Ret t < 0)Restrict s + β2 Ret t Restrict s + β3 D (Ret t < 0)Ret t Restrict s + γ0 DealAmt t−1
+ δ0 FinCoven t−1 + γ1 D (Ret t < 0)Ret t Restrict s DealAmt t−1
+ δ1 D (Ret t < 0)Ret t Restrict s FinCoven t−1 + εt ,

where E t is earnings in year t measured by income before extraordinary items (Compustat item data18),
P t−1 is the market value of equity at year t − 1 (Compustat items data199 ∗ data25), Ret t is the return from
CRSP compounded over the 12 months starting at the beginning of the fiscal year, D(.) is indicator function,
and Restrict s is a covenant restrictiveness index given by a count of covenants of the particular type included
in a debt contract. Types of covenant indices are specified in the first row of the table and are defined as
follows: OVRL is the overall count of covenants included in a contract, PRIN is the first principal component
based on differnt types of covenants, KDEC is the sum of DIV , FIN , and INV , where DIV is a count of payout
restrictions, INV is a count of covenants limiting M&A and investment activities and asset dispositions, and
FIN is a count of covenants limiting financing activities; ACC is a count of accounting-based covenants.
DealAmt is the logarithm of the amount of prior private debt issue, and FinCoven is the number of covenants
in a prior debt issue (if no prior issue is found, these variables are set to zero). Public debt issues are taken
from the Mergent Fixed Income Securities Database; private debt comes from Dealscan. I merge Dealscan
with FISD by taking the most recent debt issue within the three years prior to a public debt issue. Analysis
includes firm-years within a 10-year window starting five years prior to and ending five years after public debt
issuance (I exclude the year of the issue from the analysis). To give all firm-year observations equal weight, I
retain only one issue per firm per year. The sample includes industrial debt issues for the period 1990–2006
and amounts to 18,764 firm-years with nonmissing Compustat data. The standard errors are clustered by
firm; t-statistics are in parentheses. To mitigate the influence of outliers 1% of scaled Compustat data is
dropped at each tail. ∗ , ∗∗ , ∗∗∗ indicate statistical significance at 10%, 5%, and 1%, respectively.
166 V. V. NIKOLAEV

hold both for overall proxies of covenant use and for individual types of
covenants. The results are also robust to two alternative measures of earn-
ings timeliness as well as to controlling for firm-specific and issue-specific
characteristics. Jointly, these findings speak to the importance for debt con-
tracting of timely recognition of economic losses in earnings.
The above findings contribute to the debate on how debt contracts satisfy
the need for timely loss recognition (e.g., Guay and Verrecchia [2006]).
Consistent with Beatty et al. [2008], who find that the demand for account-
ing conservatism is not fully met through conservative contractual adjust-
ments, my evidence suggests that the use of covenants—along with any
attendant adjustments to accounting information—does not substitute for
timely loss recognition. Rather, including covenants creates a demand for
timely loss recognition; otherwise, no or even a negative association be-
tween covenants and timely loss recognition would be expected. This find-
ing may be explained as follows: First, while debt contracts can specify ad-
justments to accounting information (Leftwich [1983]), the information
used in such adjustments is nevertheless backed out from GAAP numbers
that are already affected by conservative accounting practices; and second,
because specifying a complete and exhaustive set of adjustments is costly
(Holthausen and Leftwich [1983]), conservative accounting remains in
demand.
Two main caveats are in order. First, judging whether the link between
covenants and accounting information is sufficiently strong to explain the
relation I document is difficult, and one should bear in mind an alterna-
tive interpretation. Because the benefits of timely loss recognition are not
limited to cases of distress (Watts [2003a]), timely loss recognition and
debt covenants both represent mechanisms used to reduce a firm’s un-
derlying agency problems, and hence they may simply complement each
other. Timely loss recognition is known to alleviate, for example, a firm
management’s orientation toward the short-, rather than the long-, term as
well as to prevent management from pursuing negative NPV investments
(Ball and Shivakumar [2005]). Were bondholders to exhibit a preference
for using both instruments simultaneously, a positive relationship between
covenants and timely loss recognition could obtain. Second, I only mea-
sure the number of covenants contained in a given debt contract. Owing to
data limitations, I cannot measure the tightness with which these covenants
are imposed. Therefore, the extent to which covenant use correlates with
covenant tightness can make the results more, or less, attributable to the
inclusion of covenants per se.
Despite the limitations, the documented association between covenants
and timely loss recognition should be of interest to both theorists and em-
pirical researchers who study the interactions between conservatism and
optimal contract design, as well as to standard setters, because it suggests
that contracts cannot fully satisfy the demand for conservatism via a set of
conservative adjustments to general purpose financial statements based on
GAAP.
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 167

APPENDIX A

Use of Accounting Numbers in Public Debt Contracts: An Example


LYONDELL CHEMICAL COMPANY,
INDENTURE, dated as of June 1, 2007
6.875% Senior Notes Due 2017
The following are excerpts from the Covenants section of the indenture:

Section 4.06. Limitation on Indebtedness.


(a) On or after the Issue Date:
the Company will not, and will not permit any of its Restricted Sub-
sidiaries to . . .“incur” any Indebtedness (including Acquired Debt);
(ii) the Company will not, and will not permit any of its Restricted
Subsidiaries to, issue any Disqualified Stock (including Ac-
quired Disqualified Stock); and
(iii) the Company will not permit any of its Restricted Subsidiaries
that are not Subsidiary Guarantors to issue any shares of
Preferred Stock (including Acquired Preferred Stock);
provided, however, that the Company and the Subsidiary Guarantors may in-
cur Indebtedness (including Acquired Debt) and the Company and the
Subsidiary Guarantors may issue shares of Disqualified Stock (including
Acquired Disqualified Stock) if the Fixed Charge Coverage Ratio for the
Company’s most recently ended four full fiscal quarters for which earn-
ings have been publicly disclosed immediately preceding the date on which
such additional Indebtedness is incurred or such Disqualified Stock is issued
would have been at least 2.0–1 , determined on a pro forma basis (including
a pro forma application of the net proceeds therefrom . . .
(b) The foregoing provisions will not apply to:
(i) the incurrence by the Company of Indebtedness pursuant to
the Existing Credit Facility (and by its Subsidiaries of Guar-
antees thereof) in an aggregate principal amount at any time
outstanding not to exceed an amount equal to the greater of
(i) $3.6 billion and (ii) 38.0% of Consolidated Net Tangible
Assets of the Company determined as of the date of the incur-
rence of such Indebtedness after giving pro forma effect to such
incurrence and the application of the proceeds therefrom;
(ix) the incurrence by the Company or any Restricted Subsidiary
of Indebtedness or the issuance by any Restricted Subsidiary
of Preferred Stock in an aggregate principal amount (or ac-
creted value or liquidation preference, as applicable) at any
time outstanding and incurred or issued in reliance on this
clause (ix) not to exceed the greater of (i) $200.0 million and
(ii) 2.0% of Consolidated Net Tangible Assets of the Company
at the date of such incurrence or issuance, as the case may be;
168 V. V. NIKOLAEV

(x) the issuance by any Finance Subsidiary of Preferred Stock with


an aggregate liquidation preference not exceeding the amount
of Indebtedness of the Company held by such Finance Sub-
sidiary; provided that the Fixed Charge Coverage Ratio for the
Company’s most recently ended four full fiscal quarters for
which earnings have been publicly disclosed immediately pre-
ceding the date on which such Preferred Stock is issued would
have been at least 2.0–1, determined on a pro forma basis (in-
cluding a pro forma application of the net proceeds therefrom)
as if such Preferred Stock had been issued at the beginning of
such four-quarter period;

Section 4.07. Limitation on Restricted Payments.


(a) The Company will not, and will not permit any of its Restricted Sub-
sidiaries to, directly or indirectly:
(i) declare or pay any dividend or make any distribution . . .
(ii) purchase, redeem or otherwise acquire or retire for value any
Equity Interests . . .
(iii) make any principal payment on, or purchase, redeem, defease
or otherwise acquire or retire for value, prior to the Stated Ma-
turity thereof, any Indebtedness (“Subordinated Debt”) . . .
(iv) make any Restricted Investment (all such payments and other
actions set forth in clauses (i) through (iv) above being collec-
tively referred to as “Restricted Payments”);
unless, at the time of and after giving effect to such Restricted
Payment . . .
(b) the Company would, at the time of such Restricted Payment and af-
ter giving pro forma effect thereto as if such Restricted Payment had
been made at the beginning of the most recently ended four full
fiscal quarters for which earnings have been publicly disclosed im-
mediately preceding the date of such Restricted Payment, have been
permitted to incur at least $1.00 of additional Indebtedness pursuant
to the Fixed Charge Coverage Ratio test set forth in section 4.06(a);
and
(c) such Restricted Payment, together with the aggregate of all other
Restricted Payments made by the Company and its Restricted Sub-
sidiaries . . . and 50% of any Restricted Payments permitted by section
4.07(b)(vii) is less than or equal to the sum, without duplication, of:
(i) 50% of the Consolidated Net Income of the Company for the
period (taken as one accounting period) beginning on July 1,
2006 to the end of the Company’s most recently ended fiscal
quarter for which earnings have been publicly disclosed at the
time of such Restricted Payment (or, if such Consolidated Net
Income for such period is a deficit, less 100% of such deficit),
plus . . .
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 169

(xvi) Restricted Payments of the type described in section 4.07(a)(ii)


and section 4.07(a)(iii) in an aggregate amount not to exceed
$500 million; provided that after giving pro forma effect thereto
as if such Restricted Payment had been made at the beginning
of the most recently ended four-full-fiscal-quarter period
for which earnings have been publicly disclosed immedi-
ately preceding the date of such Restricted Payment, the
Company’sConsolidatedLeverageRatiowouldhavebeenless
than 2.5–1.0 .

Section 4.10. Limitation on Affiliate Transactions.


(a) The Company will not, and will not permit any of its Restricted Sub-
sidiaries to, sell, lease, transfer or otherwise dispose of any of its prop-
erties or assets to, or purchase any property or assets from, or enter
into or make any contract, agreement, understanding, loan, advance
or Guarantee with, or for the benefit of, any Affiliate of the Company
(each of the foregoing, an “Affiliate Transaction”), unless:
(ii) transactions between or among the Company and/or its Re-
stricted Subsidiaries;
(iii) any Restricted Payment permitted by section 4.07 and any
Permitted Investment ;

Section 4.15. Limitation on Sale and Leaseback Transactions.


The Company will not, and will not permit any of its Restricted Sub-
sidiaries to, enter into any Sale and Leaseback Transaction; provided that
the Company or any Restricted Subsidiary may enter into a Sale and Lease-
back Transaction if: (a) the Company or such Restricted Subsidiary, as the
case may be, could have (i) incurred Indebtedness in an amount equal
to the Attributable Debt relating to such Sale and Leaseback Transaction
pursuant to section 4.06 (whether or not such covenant has ceased to be
otherwise in effect pursuant to section 4.18) (in which case it shall be
deemed to have been incurred thereunder) and (ii) incurred a Lien to
secure such Indebtedness pursuant to section 4.11 without securing the
Notes; and (b) the gross cash proceeds of such Sale and Leaseback Transac-
tion are at least equal to the fair market value (as conclusively determined
by the Board of Directors) of the property that is the subject of such Sale
and Leaseback Transaction.

Section 5.01. Consolidation, Merger or Sale of Assets by the Company.


(a) The Company may not consolidate or merge with or into (whether or
not the Company is the surviving corporation), or sell, assign, transfer,
conveyor otherwise dispose of all or substantially all its assets in one or
more related transactions, to another corporation, Person or entity
unless:
170 V. V. NIKOLAEV

(A) the Company or the entity or person formed by or surviving


any such consolidation or merger (if other than the Com-
pany), or to which such sale, assignment, transfer, lease, con-
veyance or other disposition shall have been made, will have
a Consolidated Net Worth immediately after the transaction
equal to or greater than the Consolidated Net Worth of the Com-
pany immediately preceding the transaction, or
(B) except with respect to a consolidation or merger of the Company
with or into a Person that has no outstanding Indebtedness,
either (I) at the time of such transaction and after giving pro
forma effect thereto as if such transaction had occurred at the
beginning of the applicable four-quarter period, the Company
or the entity or Person formed by or surviving any such consoli-
dation or merger (if other than the Company), or to which such
sale, assignment, transfer, lease, conveyance or other disposition
shall have been made, will be permitted to incur at least
$1.00 ofadditional Indebtedness pursuant to the Fixed Charge
Coverage Ratio test set forth in section 4.06(a) or (II) the Fixed
Charge Coverage Ratio at the time of such transaction and
after giving pro forma effect thereto as if such transaction had
occurred at the beginning of the applicable four-quarter period
will be equal to or greater than it was immediately before such
transaction;

APPENDIX B

List of Covenants
Payout-related covenant restrictions (DIV )
1. Restrictions on payments made to shareholders or other entities; pay-
ments may be limited to a certain percentage of net income or some
other ratio (dividends related payments).
2. Restrictions on an issuer’s freedom to make payments (other than
dividend-related payments) to shareholders and others (restricted
payments).
3. Restrictions on a subsidiary’s payment of dividends to a certain per-
centage of net income or some other ratio (su dividends related
payments).
Investment-related covenant restrictions (INV )
1. Restrictions on consolidations or mergers between an issuer and other
entities (consolidation merger).
2. Restrictions on an issuer’s investment policy in an effort to prevent
risky investments (investments).
3. Restrictions on subsidiaries’ investments (su investments
unrestricted subs).
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 171

4. Restrictions on the ability of an issuer to sell assets or restrictions on


the issuer’s use of the proceeds from the sale of assets (sale assets).
5. Restrictions on the use of proceeds from the sale of a subsidiary’s
assets to reduce debt (su sale xfer assets unrestricted).
6. Restrictions on the type or amount of property used in a sale leaseback
transaction and on the use of proceeds from a sale (sales leaseback).
7. Restrictions on subsidiaries from selling leaseback assets that provide
security for the debtholder (su sales leaseback).
Financing-related covenant restrictions (FIN )
1. Restrictions on the amount of senior debt an issuer may issue in the
future (senior debt issuance).
2. Restrictions on the issuance of junior or subordinated debt
(subordinated debt issuance).
3. Restrictions on subsidiaries issuing additional funded debt (su
funded debt).
4. Restrictions on issuing additional common stock (stock
issuance issuer).
5. Restrictions from transferring, selling, or disposing of the issuer’s
own common stock or the common stock of a subsidiary (stock
transfer sale disp).
6. Restrictions on issuing additional common stock in restricted sub-
sidiaries (su stock issuance).
7. Restrictions on subsidiaries’ ability to issue preferred stock (su
preferred stock issuance).
8. Restrictions on issuing secured debt unless the new issue secures the
current issue on a pari passu basis (negative pledge covenant).
9. Requirement that in the case of default, the bondholders have the le-
gal right to sell mortgaged property to satisfy their unpaid obligations
(liens).
10. Restrictions on subsidiaries from acquiring liens on their property
(su liens).
Accounting-related covenants and benchmarks (ACC)
1. If an issuer’s net worth falls below a minimum level, certain bond
provisions are triggered (declining net worth).
2. Limits on the absolute dollar amount of debt outstanding or the per-
centage total capital (indebtedness).
3. Limits on total indebtedness of subsidiaries (su indebtedness).
4. Leverage test: restricts total-indebtedness of the issuer.
5. Subsidiary leverage test: restricts total-indebtedness of the subsidiary.
6. Net worth test: issuer must maintain a minimum specified net worth
(maintenance net worth).
7. Net earnings test: issuer must have achieved or maintained certain
profitability levels, usually in connection with additional debt issuance
(net earnings test issuance).
172 V. V. NIKOLAEV

8. Fixed charge coverage: issuer is required to have a ratio of earn-


ings available for fixed charges, of at least a minimum specified level
(fixed charge coverage).
9. Subsidiary fixed charge coverage: subsidiaries are required to have a
ratio of earnings available for fixed charges, of at least a minimum
specified level (fixed charge coverage).
Other Covenants (OTHR)
1. A bondholder protective covenant that activates an event of default
in their issue if a default event has occurred under any other debt of
the company (cross default).
2. A bondholder protective covenant that allows the holder to accelerate
their debt if any other debt of the organization has been accelerated
due to a default event (cross acceleration).
3. A covenant whereby upon a change of control in the issuer, bondhold-
ers have the option of selling the issue back to the issuer (change
control put provisions).
4. A covenant whereby a decline in the credit rating of the issuer
(or issue) triggers a bondholder put provision (rating decline
trigger put).
5. Restrictions on an issuer’s business dealings with its subsidiaries
(transaction affiliates).
6. Restrictions on a subsidiary issuing guarantees for the payment of
interest and/or principal of certain debt obligations (su subsidiary
guarantee).
7. A covenant that indicates whether restricted subsidiaries may be re-
classified as unrestricted subsidiaries (su subsidiary redesignation).

APPENDIX C

Definitions of Control Variables


Below are the definitions of control variables used in equation (3). Control
variables based on Compustat are winsorized at the 1st and 99th percentiles
to maximize the number of observations for the first-stage analysis.
log (Assets) = the natural logarithm of total assets (data6);
ROA = income before extraordinary items (data18) divided by total assets
(data6);
DivYield = dividends (data21) divided by end-of-year market value
(data199 times data25);
Leverage = long-term debt (data9) divided by total assets (data6);
BTM = book value of equity (data60) divided by market value (data199
times data25);
Loss = a dummy for negative net income;
CapInt = property, plant, and equipment (data8) divided by total assets;
log(Time) = the natural logarithm of time trend;
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 173

log(CrRating) = the natural logarithm of issue-specific debt rating assigned


by Moody’s. Rating is constructed by assigning the value of 1 to “Aaa” rated
debt, value of 2 to “Aa” rated debt, and so on, with the lowest value attached
to nonrated debt.
log(Maturity) = the natural logarithm of years to maturity;
log(Amount) = the natural logarithm of the principal amount.

REFERENCES

AHMED, A.; B. BILLINGS; R. MORTON; AND M. HARRIS. “The Role of Accounting Conservatism
in Mitigating Bondholder-Shareholder Conflicts over Dividend Policy and in Reducing Debt
Costs.” The Accounting Review 77 (2002): 867–90.
AIKEN, L., AND S. WEST. Multiple Regression: Testing and Interpreting Interactions. Thousand Oaks,
CA: Sage Publications (1991).
BALL, R.; S. KOTHARI; AND A. ROBIN. “The Effect of International Institutional Factors on
Properties of Accounting Earnings.” Journal of Accounting & Economics 29 (2000): 1–51.
BALL, R.; A. ROBIN; AND G. SADKA. “Is Financial Reporting Shaped by Equity Markets or by
Debt Markets? An International Study of Timeliness and Conservatism.” Review of Accounting
Studies 13 (2008): 168–205.
BALL, R., AND L. SHIVAKUMAR. “Earnings Quality in UK Private Firms: Comparative Loss Recog-
nition Timeliness.” Journal of Accounting & Economics 39 (2005): 83–128.
BALL, R., AND L. SHIVAKUMAR. “The Role of Accruals in Asymmetrically Timely Gain and Loss
Recognition.” Journal of Accounting Research 44 (2006): 207–42.
BASU, S. “The Conservatism Principle and Asymmetric Timeliness of Earnings.” Journal of Ac-
counting & Economics 24 (1997): 3–37.
BEATTY, A.; J. WEBER; AND J. YU. “Conservatism and Debt.” Journal of Accounting & Economics 45
(2008): 154–74.
BEGLEY, J. “Restrictive Covenants Included in Public Debt Agreements: An Empirical Investi-
gation.” Working paper, University of British Columbia, 1994.
BENEISH, M., AND E. PRESS. “Cost of Technical Violation of Accounting-Based Debt Covenants.”
The Accounting Review 68 (1993): 233–57.
BERLIN, M., AND L. MESTER. “Debt Covenants and Renegotiation.” Journal of Financial Interme-
diation 2 (1992): 95–133.
BODIE, Z., AND R. TAGGERT. “Future Investment and the Value of the Call Provision on a Bond.”
Journal of Finance 33 (1978): 1187–1200.
BRADLEY, M., AND M. ROBERTS. “The Structure and Pricing of Corporate Debt Covenants.”
Working paper, Duke University, 2004.
DATTA, S.; M. ISKANDAR-DATTA; AND A. PATEL. “Bank Monitoring and the Pricing of Corporate
Public Debt.” Journal of Financial Economics 51 (1999): 435–49.
DEANGELO, H.; L. DEANGELO; AND D. SKINNER. “Accounting Choice in Troubled Companies.”
Journal of Accounting & Economics 17 (1994): 113–43.
DIAMOND, D. “Financial Intermediation and Delegated Monitoring.” Review of Economic Studies
51 (1984): 393–414.
DIAMOND, D. “Monitoring and Reputation: The Choice between Bank Loans and Directly
Placed Debt.” Journal of Political Economy 99 (1991): 689.
DICHEV, I., AND D. SKINNER. “Large-Sample Evidence on the Debt Covenant Hypothesis.” Journal
of Accounting Research 40 (2002): 1091–1123.
DIETRICH, D.; K. MULLER; AND E. RIEDL. “Asymmetric Timeliness Tests of Accounting Conser-
vatism.” Review of Accounting Studies 12 (2007): 95–124.
FAMA, E. “What’s Different about Banks?” Journal of Monetary Economics 15 (1985): 29–39.
FEHR, E.; M. BROWN; AND C. ZEHNDER. “On Reputation: A Microfoundation of Contract En-
forcement and Price Rigidity.” The Economic Journal 119 (2009): 333–53.
174 V. V. NIKOLAEV

FIELDS, T.; T. LYS; AND L. VINCENT. “Empirical Research on Accounting Choice.” Journal of
Accounting & Economics 31 (2001): 255–307.
FRANKEL, R., AND L. LITOV. “Financial Accounting Characteristics and Debt Covenants.” Work-
ing paper, Washington University in St. Louis, 2007.
GARLEANU, N., AND J. ZWIEBEL. “Design and Renegotiation of Debt Covenants.” Review of Finan-
cial Studies 22 (2009): 749–81.
GUAY, W., AND R. VERRECCHIA. “Discussion of an Economic Framework for Conservative Ac-
counting and Bushman and Piortoski (2006).” Journal of Accounting & Economics 42 (2006):
149–65.
HECKMAN, J. “Sample Selection Bias as a Specification Error.” Econometrica 47 (1979): 153–
61.
HOLTHAUSEN, R., AND R. LEFTWICH. “The Economic Consequences of Accounting Choice:
Implications of Costly Contracting and Monitoring.” Journal of Accounting & Economics 39
(1983): 295–327.
JENSEN, M., AND W. MECKLING. “Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure.” Journal of Financial Economics 3 (1976): 305–60.
KAHAN, M., AND B. TUCKMAN, “Private vs. Public Lending: Evidence from Covenants,” Unpub-
lished working paper, Anderson Graduate School of Management, UCLA, 1993.
KHAN, M., AND R. WATTS. “Estimation and Empirical Properties of a Firm-Year Measure of
Accounting Conservatism.” MIT Sloan School Research Paper No. 4640, 2009.
KOTHARI, S.; T. LYS; C. SMITH; AND R. WATTS. “Auditor Liability and Information Disclosure.”
Journal of Accounting, Auditing, and Finance 3 (1988): 307–39.
KRISHNAN, J., AND J. KRISHNAN. “Litigation Risk and Auditor Resignations.” The Accounting
Review 72 (1997): 539–60.
LAFOND, R., AND S. ROYCHOWDHURY. “Managerial Ownership and Accounting Conservatism.”
Journal of Accounting Research 46 (2008): 101–35.
LEFTWICH, R. “Accounting Information in Private Markets: Evidence from Private Lending
Agreements.” The Accounting Review 58 (1983): 23–42.
LEVINE, C., AND J. HUGHES. “Management Compensation and Earnings-Based Covenants as
Signaling Devices in Credit Markets.” Journal of Corporate Finance 11 (2005): 832–50.
LYS, T., AND R. WATTS. “Lawsuits against Auditors.” Journal of Accounting Research 32 (1994):
65–93.
MALITZ, I. “On Financial Contracting: The Determinants of Bond Covenants.” Financial Man-
agement 15 (1986): 18–25.
MOODY’s. Moody’s Indenture Covenant Research and Assessment Framework, Special Com-
ment. 2006.
MYERS, S. “Determinants of Corporate Borrowing.” Journal of Financial Economics 5 (1977):
147–75.
NASH, R.; J. NETTER; AND A. POULSEN. “Determinants of Contractual Relations between Share-
holders and Bondholders; Investments Opportunities and Restrictive Covenants.” Journal of
Corporate Finance 9 (2003): 201–32.
PEEK, E.; R. CUIJPERS; AND W. BUIJINK. “Creditors’ and Shareholders’ Reporting Demands in
Public versus Private Firms: Evidence from Europe.” Working paper, University of Maastricht,
2009.
PRATT, J., AND J. STICE. “The Effects of Client Characteristics on Auditor Litigation Risk Judg-
ments, Required Audit Evidence, and Recommended Audit Fees.” The Accounting Review 69
(1994): 639–56.
QIANG, X. “The Effects of Contracting, Litigation, Regulation, and Tax Costs on Conditional
and Unconditional Conservatism: Cross-Sectional Evidence at the Firm Level.” The Accounting
Review 82(2007): 759–96.
RAJAN, R., AND A. WINTON. “Covenants and Collateral as Incentives to Monitor.” The Journal of
Finance 4 (1995): 1113–46.
RYAN, S. “Identifying Conditional Conservatism.” European Accounting Review 15 (2006): 511–25.
SCHIPPER, K. “Fair Values in Financial Reporting,” http://fars.org/2005AAAFairValueK Schip-
per.pdf. 2005.
DEBT COVENANTS AND ACCOUNTING CONSERVATISM 175

SKINNER, D. “Earnings Disclosures and Stockholder Lawsuits.” Journal of Accounting and Eco-
nomics 23 (1997): 249–82.
SLOAN, R. “Financial Accounting and Corporate Governance: A Discussion.” Journal of Account-
ing & Economics 32 (2001): 335–47.
SMITH, C.; C. SMITHSON; AND D. WILFORD. “Managing Financial Risk.” Journal of Applied Corporate
Finance 2 (1989): 27–48.
SMITH, C., AND J. WARNER. “On Financial Contracting: An Analysis of Bond Covenants.” Journal
of Financial Economics 7 (1979): 117–61.
WATTS, R. “Conservatism in Accounting Part I: Explanations and Implications.” Accounting
Horizons 17 (2003a): 207–21.
WATTS, R. “Conservatism in Accounting Part II: Evidence and Research Opportunities.” Ac-
counting Horizons 17 (2003b): 287–301.
WATTS, R. What Has the Invisible Hand Achieved, Information for Better Capital Markets
Conference, London, Institute of Chartered Accountants in England and Wales, 2006.
WATTS, R., AND J. ZIMMERMAN. Positive Accounting Theory. Englewood Cliffs, NJ: Prentice-Hall,
1986.
WITTENBERG-MOERMAN, R. “The Role of Information Asymmetry and Financial Reporting Qual-
ity in Debt Contracting: Evidence from the Secondary Loan Market.” Journal of Accounting
& Economics 46 (2008): 240–60.
ZHANG, J. “The Contracting Benefits of Accounting Conservatism to Lenders and Borrowers.”
Journal of Accounting and Economics 45 (2008): 27–54.
176

Das könnte Ihnen auch gefallen