Professional Documents
Culture Documents
x
Journal of Accounting Research
Vol. 48 No. 1 March 2010
Printed in U.S.A.
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
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
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.
2.2 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).
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.
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
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
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
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.
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
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.
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.
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)
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.
TABLE 4
Descriptive Statistics
Panel A: Summary Statistics
V. V. NIKOLAEV
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.
16 Consistent with prior literature, Size is defined as the logarithm of market capitalization
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
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
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
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.
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,
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.
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
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
APPENDIX C
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