DOI: 10.1111/j.1475-679X.2009.00359.xJournal of Accounting Research

Vol. 48 No. 1 March 2010Printed in U.S.A.

Debt Covenants and AccountingConservatism

V A 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 transferof decision-making and control rights from shareholders to bondholders whena company approaches financial distress and thereby limit managers’ abilitiesto 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 lossrecognition should increase with a contract’s reliance on covenants. Consis-tent with this conjecture, I find evidence that reliance on covenants in publicdebt contracts is positively associated with the degree of timely loss recogni-tion. I also find evidence that the presence of prior private debt mitigates thisrelationship.

1. Introduction

I test whether firms that rely on covenants in their public debt contractsrecognize 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 ofmy dissertation committee, S.P. Kothari and Laurence van Lent. I thank Douglas Skinner(the editor) and the anonymous referee for constructive feedback that substantially improvedthe 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 EuropeanAccounting Association meetings, Emory University, MIT, Maastricht University, University ofAntwerp, University of Chicago, University of Manchester, University of Michigan, Universityof North Carolina, and Tilburg University. This study was supported by a grant (R 46-570) fromthe Netherlands Organization for Scientific Research (NWO).

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Copyright C©, University of Chicago on behalf of the Accounting Research Center, 2009

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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 covenantsplay in transferring control over key managerial decisions to bondholderswhenever 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 isrelated to its degree of accounting conservatism. The public debt market of-fers a valuable opportunity to examine this relation. Unlike banks, which areknown as delegated monitors (e.g., Diamond [1984]), public bondholderslack timely inside information, have weaker incentives to monitor manage-rial actions, and exercise less control over these actions. These differencesimply that public bondholders will have a greater demand for timely lossrecognition 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 investmentsin 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 efficiencyof covenants because covenants are more likely to be binding in distressand 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 demandfor 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 fortimely loss recognition to the firm’s management and its auditors. Pub-lic debt contracts often require an auditor to certify compliance withindenture covenants, which potentially exposes the auditor to a greaterlitigation threat. Thus, auditors are likely to be more cautious and ex-ert a higher degree of conservatism in the presence of accounting-basedcovenants.

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,

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are not expected to create the same demand for timely loss recognitionas those in public debt contracts, although little research exists on thistopic. First, private debt covenants require that companies maintain cer-tain financial ratios within a much tighter range as compared to publicdebt. As a result, covenant violations and their subsequent renegotiationsare common (Watts and Zimmerman [1986]; DeAngelo, DeAngelo, andSkinner [1994]; Dichev and Skinner [2002]). The need for renegotiationssubstantially increases private debtholder control over the company andthus reduces scope for managerial opportunism. Second, while public debtcontracts seldom require maintenance of accounting ratios (due to higherrenegotiation costs associated with diffuse ownership), they do employ arange 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. Sincethese actions could be used to expropriate bondholder wealth, covenantslimiting such actions (rather than covenants that require maintenance offinancial ratios) create a demand for timely loss recognition. Third, whileprivate debt usually requires quarterly (or even monthly) compliance withcovenants, public debt contracts normally require only annual compliancecertification (e.g., Kahan and Tuckman [1993], p. 16). Thus, were a firm’sauditor to overlook the recognition of a loss, management could have asubstantially longer period to act opportunistically before the next compli-ance is due in the case of public debt. These three distinctions suggest thatpublic bondholders should be more concerned than private lenders withthe degree of timely recognition of losses.

I use the Mergent Fixed Income Securities Database to retrieve covenantscommonly used in public debt contracts. I construct the index of covenantuse by calculating the total number of covenants present in each contract. Ialso construct an index that proxies for the use of accounting in the covenantsection of the contract. Further, depending on their relation with manage-rial actions, I assign covenants to one of three subgroups: payout-relatedrestrictions, investments-related restrictions, and financing-related restric-tions. Within each of these subgroups, I count the number of covenants tomeasure 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 higherrenegotiation costs make relying on covenants in public debt contractsless attractive than in private credit agreements, accounting informationremains an important component of such contracts (Moody’s [2006]). Isearch 8-K filings on Edgar for public indentures and read their covenantsections. 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. Examplesof such restrictions include those on the issuance of additional debt andequity, payment of dividends, investment, mergers and acquisitions, liens,leases, and asset sales (see appendix A for an example of a typical covenant

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section).1 As a rule, a contract containing such restrictions uses a few ac-counting benchmarks to restrict managerial actions. A common accountingbenchmark cumulates 50% of accounting profits less 100% of all losses overthe contract life. This benchmark can be applied to various covenants; butmost often it is used to determine the threshold restricting payment of div-idends or other spending. Covenants restricting M&A deals or new debtissuance often include thresholds formulated in terms of fixed-charge cov-erage ratio, net worth, and leverage. Asset conveyance restrictions, negativepledge covenants/limitations on liens, as well as limitations on sale-and-leaseback transactions often require a firm to meet a minimum level of nettangible assets or are linked to aggregate indebtedness. While not everycovenant listed above has an accounting link, the more complex an inden-ture’s covenants section, the more likely it is to condition managers’ actionson accounting information.

Following Basu [1997], I measure timely loss recognition as the degree ofrecognition of economic losses over economic gains. My findings show thatfirms whose public debt contracts employ more covenants exhibit timelierrecognition 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 withmore 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 intimely loss recognition after the issue. Finally, a company’s prior private-debtissues and their reliance on financial covenants attenuates the relationshipbetween public debt covenants and timely loss recognition, which suggeststhat alternative monitoring mechanisms can substitute for timely loss recog-nition. The results hold both when I control for firm- and contract-specificcharacteristics and when I measure timely loss recognition in an alternativeway. Overall, my findings suggest that the use of covenants in public debtcontracts is associated with increased demand for timely loss recognition.

Few empirical studies examine a direct link between debt contract designchoices and the properties of accounting information (Sloan [2001]; Guayand 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 moreconservative 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 thatmany covenants limiting managerial actions (e.g., distributions, financing, and mergers andacquisitions) are accounting-based or are associated in an indirect fashion with accountingnumbers (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 ofcovenants.

2 Income escalators are systematic adjustments that exclude a percentage of positive incomewhen the current covenant threshold is determined.

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exclusively study income escalators within a single covenant in private lend-ing agreements. Frankel and Litov [2007] hypothesize that accounting ratioswhose 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 betweencovenants and conservatism must be marginal. One possible explanationfor their findings is their focus on private rather than public debt; as I argueabove, it is easier for private debtholders to directly monitor and controlthe use of their funds, as well as to discipline managers, and so they areless likely to be concerned with reporting timeliness.3 Accordingly, I pro-vide some evidence that the reliance on private debt and the imposition ofextensive 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 andZimmerman [1986]; Ball, Kothari, and Robin [2000]; Watts [2003a, 2003b];Ball and Shivakumar [2005]; Ball, Robin, and Sadka [2008]). These studiesargue 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 andconditional on the presence of debt in a firm’s capital structure, the designof debt contracts has an incremental effect on reporting incentives. Second,my results support complementarity between public debt covenants andtimely loss recognition. If, alternatively, contracts can adjust for the lackof conservatism in accounting by making contractually prespecified adjust-ments in reported numbers (Leftwich [1983]), the need for timely lossrecognition in earnings can be eliminated (e.g., Schipper [2005], Guay andVerrecchia [2006]). Here, covenants would be expected to have zero oreven a negative association with timely loss recognition. My results, how-ever, suggest otherwise and thus should be of interest to standard setters asthe 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 andShivakumar [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, andPattel [1999]), I provide evidence to suggest that the demand for accountinginformation differs in the presence of private debt.

The remainder of my paper is organized as follows: Section II reviewsthe related literature and develops the main hypotheses; section III outlines

3 In line with this argument, Ball and Shivakumar [2005] find that private firms exhibitlower levels of timely loss recognition, while Peek, Cuijpers, and Buijink [2009] indicate lowertimely loss recognition in the presence of relationship-based financing.

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the research design; section IV describes the data; section V reports resultson the relation between covenants and timely loss recognition; section VIinvestigates the effect of private debt; and section VII provides a discussionand concludes the study.

2. Related Literature and Hypotheses

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

2.1 ROLE OF DEBT COVENANTS

As a company approaches financial distress, bondholders’ vulnerabilityto wealth expropriation by management and shareholders increases (Bodieand Taggert [1978]; Smith, Smithson, and Wilford [1989]; Nash, Netter, andPoulsen [2003]). Debt overhang (Myers [1977]), asset substitution (Jensenand Meckling [1976]), and claim dilution (Smith and Warner [1979]) arewell-known agency problems that financial difficulty exacerbates. Covenantsrestrict managers’ ability to invest, pay out dividends, and take on additionaldebt and thereby limit actions that potentially hurt bondholders. Covenantsthat limit distributions of dividends to shareholders, for example, can effec-tively force levered firms to reinvest their cash flows, thereby alleviating thedebt overhang problem associated with managers’ unwillingness to under-take positive NPV projects as the ratio of debt to equity grows. Covenants thatrestrict sales of assets or mergers and acquisitions reduce the likelihood ofasset 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 healthycompany, 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]), covenantrestrictions can result in either failure to abandon unproductive assets orinability to investment in good projects. Thus, firms must trade off the costsand 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 intwo ways: (1) by facilitating early transfer of decision rights to bondholdersand (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 constrainton value-expropriating actions when a firm experiences adverse economicconditions. Bondholders are more likely to be able to prevent opportunistic

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managerial actions and to mitigate the agency costs of debt if the accountingincorporates negative economic news in a timely fashion. Covenant thresh-olds, including those used by negative covenants, are commonly based onaccounting information directly linked to reported earnings, book valuesof assets, liabilities, and/or shareholders equity. When a firm approachesdistress, timely loss recognition yields early transfer of control over key firmdecisions to bondholders and thus becomes more important when con-tracts use covenants. Note, however, that covenants need not necessarilyhave strong ties to accounting (although this is an appealing interpreta-tion) because it is often argued that timely loss recognition alleviates agencyproblems in general by, for example, forcing managers to recognize futurelosses 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 ofbondholder value (e.g., unprofitable risky investments).

The empirical literature examines whether conservatism is beneficial fordebt contracting. Accordingly, economies in which public debt is a rela-tively more important source of financing exhibit higher levels of timelyloss recognition (Ball, Kothari, and Robin [2000]; Ball, Robin, and Sadka[2008]). At the firm level, conservatism reduces the cost of debt (Ahmedet 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 covenantsand conservative reporting is an optimal contracting mechanism.4 In theirmodel, a firm seeks debt financing and signs two different contracts, a com-pensation contract with the manager and a debt contract with lenders. Thecompensation contract aims to align managerial incentives. In the absenceof 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 adebt covenant based on earnings with the conservative measurement ofearnings 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 earningsforce 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 unconditionalconservatism. Nevertheless, because their result is effectively due to the downside risk thatbondholders face, conditional conservatism arguably fits the spirit of the model well.

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DeAngelo, DeAngelo, and Skinner [1994] provide evidence that rather thanattempting to portray their firms as less troubled, managers’ accountingchoices 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 thefocus here is on economic losses that are already anticipated (or observed)by the market and thus reflected in share prices, which makes it particularlydifficult for companies’ managers to mask them. Absent accounting-basedcontracts, the market should be largely indifferent to the timely recognitionof economic losses that are already known. In contrast, contracting partiesare not indifferent because the degree of their (future) control directlydepends on the timeliness with which losses are recorded in the financialstatements.

I argue that the demand for timely loss recognition is met due to both themulti-period nature of debt market relationships and auditor pressure forconservative compliance with covenants. The accounting choices includetimely write-downs and impairments of firm’s assets, and/or other accrualsthat recognize adverse economic shocks to future cash flows in the currentperiod. It is here that accounting exhibits the asymmetric treatment of gainsand losses.5 While commitment to such treatment is difficult, the economicincentives at work should discipline the manager and ensure timely lossrecognition.

The first factor that is likely to ensure that companies adhere to conser-vative accounting policies is reputation. The untimely reporting of losses islikely to tarnish a firm’s reputation in the credit market (the manager’s rep-utation will also be affected negatively), which can significantly complicateits future access to public debt markets (Diamond [1991]). Reputation is apowerful tool for improving contracting efficiency in credit markets (Fehr,Brown and Zehnder [2009]), and management has little incentive not tomeet the demand for timely loss recognition, especially when the firm is notclose to violating its covenants.

The second factor promoting timely loss recognition is litigation risk. Au-ditors face considerable litigation risk when default approaches (Kothariet al. [1988]; Lys and Watts [1994]; Watts [2006]) and the failure to discloseall pertinent bad news is known to increase a firm’s legal liability (Skinner[1997]). In addition, the auditor of a borrowing firm is often requiredto provide an annual statement of compliance certifying that no breachof 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 BaldorElectric Company: “So long as not contrary to the then current recommendations of theAmerican Institute of Certified Public Accountants, the year-end financial statements deliveredpursuant to section 4.03 above will be accompanied by a written statement of the Company’s

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failure to recognize adverse economic news increases its litigation risk andalso directly exposes its auditor to such risk. Prior work documents thatclient default and increased litigation risk affect audit plans and increasethe issuance of modified opinions (Pratt and Stice [1994]; Krishnan andKrishnan [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 ofcovenants 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 tosatisfy bondholders’ needs, no association (or even a negative association)between covenants and timely loss recognition is implied. This yields thefollowing hypothesis (stated in the alternative form):

H1: Timely recognition of economic losses increases with the use of debtcovenants in public debt contracts.

The direction of causality between covenants and timely loss recognitionremains an open question: Do conservative firms find it worthwhile to relyon covenants or do firms that introduce covenants alter the degree to whichthey recognize economic losses? Answering this question is difficult becausedoing 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 examinechanges in timely loss recognition following debt issues. The argumentspresented earlier suggest that entering a new debt contract that relies oncovenants should further increase the demand for timely loss recognition.7

Thus, I hypothesize:

H2: Companies that rely on debt covenants more extensively exhibit agreater increase in timely recognition of economic losses followingdebt issue.

3. Research Design

I construct several indices to quantify a public debt contract’s relianceon covenants. The first index, OVRL, is an overall measure of covenant usecalculated by counting the total number of covenants within a public debt

independent public accountants (who will be a firm of established national reputation) thatin making the examination necessary for certification of such financial statements, nothinghas come to their attention that would lead them to believe that the Company has violatedany provisions of Article 4 or Article 5 (‘Covenants’) hereof in so far as it relates to accountingmatters . . .”

7 I am assuming that an incremental effect still exists if a firm has other existing public debtissues that also rely on covenants.

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contract. In addition, I construct narrower covenant indices by assigningcovenants 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 andcovenants that limit a firm’s ability to issue preferred or commonstock.

(4) Accounting-related covenants: covenant benchmarks based on minimumnet worth, coverage of interest, and other earnings, as well as leveragetests and limitations on indebtedness.

(5) Other covenants: covenants that restrict transactions with affiliates,covenants related to changes in control, cross-default covenants, andso on.9

I count covenants within each subgroup: DIV denotes a count of payoutrestrictions, INV denotes a count of covenants limiting investment activitiesand asset dispositions, FIN denotes a count of covenants limiting financingactivities, and ACC is a count of accounting-related covenants or bench-marks. I also perform principal component analysis over the five individualcovenant indices, which clearly identifies one main factor, PRIN . For moredetails 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, allowingthe degree of covenant use to influence the effect of “bad news” on earnings.Specifically, I estimate the following model:

Et/Pt−1 = α0 + α1 D(Rett < 0) + α2Rett + α3 D(Rett < 0)Rett

+ β0Restricts + β1 D(Rett < 0)Restricts + β2Rett Restricts

+ β3 D(Rett < 0)Rett Restricts + εt ,(1)

where Et is year t earnings, P t−1 is the market value of equity in the end ofyear t − 1, Rett is the annual return, and D(.) is an indicator function takingthe value of 1 when its argument is true and 0 otherwise. Restricts denotesone 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 somewhatarbitrary.

9 While these covenants are significantly correlated with indices based on other subgroupsand are a part of the overall covenant index, I do not perform a separate empirical analysis ofthese covenants because of no strong prior about their relation to timely loss recognition.

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primary interest is the coefficient β 3, which is expected to be positive underhypothesis 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 betweencovenants and timely loss recognition thereby can vary in a postissue period.In particular, I estimate the following regression model:

Et/Pt−1 = α0 + α1 D(Rett < 0) + α2Rett + α3 D(Rett < 0)Rett

+ β0Restricts + β1 D(Rett < 0)Restricts + β2Rett Restricts

+ β3 D(Rett < 0)Rett Restricts + γ0After t

+ γ1 D(Rett < 0)Rett Restricts 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 themodel parsimonious, After interacts only with the variable of primary in-terest; however, the results are robust to interacting the After dummy withother regressors.11 Models (1) and (2) are estimated using observationsfrom within a 10-year window, starting five years prior and ending five yearsafter the issue. To rule out mechanical relationships, I exclude the year ofthe issue from analysis.

3.2 CONTROLLING FOR CONFOUNDING EFFECTS

Of concern here is the possibility that the relationship between covenantsand timely loss recognition is affected by factors omitted from the analysis.While isolating agency-related conflicts per se is expected to weaken therelationship under study, it is necessary to control for joint determinantsof 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 covenantswill have an incremental effect on the demand for conditional conservatism. It is reasonableto believe that this impact would be lower if a firm already has in its capital structure publicdebt that relies on covenants. This, however, should bias my estimates toward zero and thuswork against finding my results.

11 One can also interact Aftert with all the variables present in the baseline model. This, how-ever, can over-parameterize the model. Considerations when determining whether to adhereto a more parsimonious specification or augment it include the following. First, while inclusionof the main effects can be desirable, Aiken and West [1991] point out (p. 105) that introducinginto regression unnecessary terms that have no relationship to the criterion in the populationresults in lowering, sometimes appreciably, the efficiency of the estimates. Second, Aiken andWest [1991] recognize (p. 97) that inclusion of the lower level interactions and main effectsshould be guided by theory (for example it would be appropriate to use length×width, ratherthan 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 simplerspecification and recognize the above as a potential caveat. I also check the robustness of theresults with respect to this research design choice and find that the results remain similar whenalternative specifications are used, although the significance levels may decline in some cases.

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approach. In the first stage, by performing an OLS regression of covenantindices on a set of control variables and then saving the residual for use inthe second stage, I orthogonalize the covenant indices with respect to a setof control variables.12 The first stage model is:

Restrictt = α0 + α1log(Assetst−1) + α2Leveraget−1 + α3Leveraget + α4BTMt−1

+ α5ROAt−1 + α6DivYieldt−1 + α7Losst−1 + α8CapIntt−1

+ α9 Z − scoret−1 + α10log(Time) + α11log(CrRating t )

+ α12log(Maturityt ) + α13log(Amountt ) + εt , (3)

where Restrict denotes one of the covenant indices, log(Assets) is a proxy forsize, Leverage is the ratio of long-term debt to assets, Leverage is the changein leverage over the year of debt issue, BTM is the book-to-market ratio, ROAis 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’sbankruptcy score, log(Time) is a logarithmic time trend, CrRating is the quan-tified issue-specific debt rating issued by Moody’s, log(Maturity) is logarithmof the number of years to maturity, and log(Amount) is the logarithm of theprincipal 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/ordegree of conservatism (see Malitz [1986]; Begley [1994]; Nash, Netter, andPoulsen [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. Thisresults 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 issuesused to obtain covenant and issue-specific information. As discussed earlier,covenants are assigned to subgroups, and their counts within each subgroupare used to measure their degree of use. If covenant information is notavailable, I exclude the issue from the analysis. Appendix B provides moredetails about the individual covenants.

Balance sheet and income statement data are taken from Compustat, andmonthly 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 thecovenant 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 regressionswill 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 theearnings at each tail of the population distribution. Earnings, Et , are mea-sured as income before extraordinary items (Compustat item data18), andPt−1 is the end-of-prior-year price (data199) times the number of shares out-standing (data25). Returns, Rett , are compounded over the fiscal year usingmonthly data. Fiscal-year returns are used to mitigate the concerns raised inDietrich, Muller, and Riedl [2007] (see Ryan [2006] for a discussion). Referto appendix C or tables’ headers for definitions of control variables used inequation (3).

Approximately 205,000 debt issues (by 10,900 companies) exist on theFISD database for the period 1980–2006. The majority of these issues are bynonindustrial companies (e.g., banks, financial institutions, insurance com-panies, and so on). Restricting the sample to issues by industrial companiesyields 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, Iretain only one issue per firm per year. This yields the final sample of 5,420firm-year observations by 2,466 companies (for the period 1980–2006).13 Asdiscussed 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 applythe Basu [1997] methodology. This procedure results in 32,716 firm-yearobservations. 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 particulartest in each table.

4.1 DESCRIPTIVE STATISTICS

Table 1 displays the descriptive statistics for covenant indices. Panel Adisplays the frequencies with which different types of covenants are encoun-tered in public credit agreements. The number of covenants per contractranges from 0 to 23. The distribution is somewhat positively skewed, and anumber 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 restrictionson managerial actions. A range of covenant frequencies is well representedin 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. PanelC shows that all covenant indices exhibit high positive correlations amongthemselves; all correlations are statistically significant.

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

150 V. V. NIKOLAEV

T A B L E 1Description of Covenant Indices

Panel A: Frequency of Covenant OccurrenceCount of Covenants OVRL DIV INV FIN ACC Other

0 36 3,270 370 1,546 3,214 1,0731 199 367 42 2,134 257 1,6182 243 1,683 2,568 875 1,814 8603 636 100 265 574 100 8184 714 2,066 206 30 7565 664 75 70 3 2906 666 33 14 2 57 218 1 18 1279 84

10 13711 23012 33113 34014 36515 25916–23 171

Panel B: Summary StatisticsStatistic OVRL DIV INV FIN ACC

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

Panel C: Correlation Statistics

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

Panel A reports the frequency distribution of covenants present in public debt contracts, based on theirtype. OVRL is the overall count of covenant restrictions included in a contract, DIV is a count of payoutrestrictions, 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 covenantindices. Data is taken from the Mergent Fixed Income Securities Database. To give all firm-year observationsequal weight, I retain only one debt issue per year. The sample includes industrial debt issues for the period1980–2006.

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 α3 has a positive andstatistically 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

T A B L E 2Asymmetric 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:

Et /Pt−1 = α0 + α1 D(Rett < 0) + α2Rett + α3 D(Rett < 0)Rett + β0Restricts

+ β1 D(Rett < 0)Restricts + β2Rett Restricts + β3 D(Rett < 0)Rett Restricts + εt ,

where Et 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), Rett is the returnfrom CRSP compounded over the 12 months starting at the beginning of the fiscal year, D(.) is indicatorfunction, and Restricts is a covenant restrictiveness index given by the count of covenants of the particulartype included in a debt contract. Types of covenant indices are specified in the first row of the table andare defined as follows: OVRL is the overall count of covenant restrictions a contract includes, PRIN is thefirst 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 acount of covenants that limit financing activities, and ACC is a count of accounting-based covenants. Debtissues are taken from the Mergent Fixed Income Securities Database. Analysis includes firm-years withina 10-year window starting five years prior to and ending five years after debt issuance (I exclude the yearof the issue from analysis). To give all firm-year observations equal weight, I retain only one issue perfirm per year. The sample includes industrial debt issues for the period 1980–2006 and amounts to 5,420debt issues and 32,716 firm-years with nonmissing Compustat data. The standard errors are clusteredby firm; t-statistics are in parentheses. To mitigate the influence of outliers, 1% of scaled Compustatdata 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 magnitudeof β 3 is 0.015, which suggests that adding 10 covenants (i.e., close to twostandard deviations) to a contract yields an economically important 0.15(or 56% of α3) increase in timely loss recognition. The results based on thesecond 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 ) hasthe strongest effect on timely loss recognition (followed by restrictions on ad-ditional financing, FIN ). The use of a dividend restriction is associated witha 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 thatwhen such conflicts are present, companies respond with more conserva-tive accounting treatment. Finally, timely loss recognition increases in theaccounting-related covenant index (ACC); the coefficient exhibits a highlevel of statistical significance. Overall, the evidence supports hypothesis H1across different types of covenants.

The magnitudes of estimated β 3 coefficients based on the individualcovenant indices are higher than that of the OVRL covenant index. Thisimplies that the presence of multiple covenants lowers the marginal effectof an additional covenant on timely loss recognition. Further, it is interestingto note that the three covenant indices measuring restrictions on managerialactions have equally strong association with timely loss recognition as com-pared to the accounting-based covenant index. This suggests that it is notnecessarily the use of accounting per se, but rather its combination with therestrictions on managerial actions potentially leading to bondholder wealthexpropriation that affect the demand for timely loss recognition.

To shed some light on the direction of causality in the association betweencovenants and timely loss recognition, I allow for changes in the degree oftimely loss recognition conditional on a contract’s use of covenants followinga debt issue. Under H2, firms that use covenants more (less) extensivelyshould 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 todebt issuance, while the coefficient γ 1 measures the incremental associationbetween covenants and timely loss recognition in the period following theissue. 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 useof covenants and the degree of timely loss recognition strengthens after theissue. The estimate of γ 1, in the case of the OVRL covenant index, equals0.009 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 betweencovenants and timely loss recognition in the years after the issue is twice thatin the years before the issue. The PRIN measure also exhibits a stronger as-sociation with timely loss recognition after the issue. The results based onpayout (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 othervariables are included in regression at the same time, the estimates of β 3 and γ 1 (i.e., theiranalogs 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 thesemeasures.

DEBT COVENANTS AND ACCOUNTING CONSERVATISM 153

T A B L E 3Asymmetric 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:

Et /Pt−1 = α0 + α1 D(Rett < 0) + α2Rett + α3 D(Rett < 0)Rett + β0Restricts + β1 D(Rett < 0)Restricts

+ β2Rett Restricts + β3 D(Rett < 0)Rett Restricts + γ0After t + γ1 D(Rett < 0)Rett After t Restricts + εt ,

where Aftert is an indicator variable that takes the value of one in years after a company issues debt and zerootherwise, Et 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), Rett is the returnfrom CRSP compounded over the 12 months starting at the beginning of the fiscal year, D(.) is indicatorfunction, and Restricts is a covenant restrictiveness index given by a count of covenants of the particulartype included in a debt contract. Types of covenant indices are specified in the first row of the table andare defined as follows: OVRL is the overall count of covenant restrictions included in a contract, PRIN isthe 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 countof covenants limiting financing activities, and ACC is a count of accounting-based covenants. Debt issuesare taken from the Mergent Fixed Income Securities Database. Analysis includes firm-years within a 10-yearwindow starting five years prior to and ending five years after debt issuance (I exclude the year of the issuefrom 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 and32,716 firm-years with nonmissing Compustat data. The standard errors are clustered by firm; t-statistics arein 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 insection 3.2) and re-examine H1 and H2. To preserve table space, I combinecovenants that limit key managerial decisions into one index, KDEC , and useit in subsequent analysis.15 Specifically, KDEC = DIV + INV + FIN . Table 4

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

154 V. V. NIKOLAEV

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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%. Overthe year of debt issuance, leverage increases by 5.6% of total assets.

Table 5 displays the estimates from the first-stage regression, given byequation (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 viewthat covenants are used to respond to elevated agency problems, their usedeclines with firm size and increases with book-to-market and leverage. Onthe other hand, consistent with the view that covenants impose costs on acompany, they are used less frequently by firms that pay dividends.

Table 6 presents the second stage results based on orthogonalizedcovenant indices. Estimates in the first four columns test H1 and are basedon model (1). The slope coefficient on the variable of interest (β 3) equals0.014 (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 coefficientβ 3 is also positive and statistically significant when constraints on manage-rial actions, KDEC , and ACC proxy for reliance on covenants. The fourremaining 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 proxiesfor 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 and3. The association between covenants and timely loss recognition predictedunder H1 and H2 still exists when controlling for common firm-specific andcontract-specific characteristics.

5.3 ROBUSTNESS CHECKS

I perform several robustness checks. First, I demonstrate that my resultsare robust to alternative model specifications, and then I investigate sampleselection bias.

5.3.1. Alternative Model Specifications. First, instead of performing the two-stage analysis described in the previous subsection, I control for commondeterminants of conditional conservatism in a one-stage regression. Specif-ically, I augment equations (1) and (2) by adding Size, BTM , and Leveragealong 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]; LaFondand 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 introducinginto the model up to 60 correlated regressors.

DEBT COVENANTS AND ACCOUNTING CONSERVATISM 157

T A B L E 5Determinants of Covenant Use (First Stage)

Variable OVRL PRIN DIV INV FIN ACCIntercept −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 anindenture agreement. The types of covenant indices are specified in the first row and are as follows: OVRLis the overall count of covenant restrictions included in a contract, PRIN is the first principal componentbased on the main groups of covenant restrictions, DIV is a count of payout restrictions, INV is a countof covenants limiting M&A and investment activities and asset dispositions, FIN is a count of covenantslimiting financing activities, and ACC is a count of accounting-based covenants. The explanatory variablesare measured at the end of the fiscal year prior to debt issuance using Compustat data. Log(Assets) isthe 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 bytotal assets, Loss is a dummy variable for negative net income, CapInt is capital intensity measured as a ratioof property, plant, and equipment (data8) to total assets, DivYield is dividend yield measured as commondividends (data21) divided by market value of equity, Z-score is Altman’s Bankruptcy score, log(Trend) is thelogarithm 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 ratingstaken from FISD. Moody’s rating is measured by assigning the value of 1 to the highest credit rating, thevalue of 2 to the second best credit rating, and so on. Debt issues are taken from the Mergent Fixed IncomeSecurities Database. The sample consists of 4,020 debt issues with nonmissing firm characteristics over theperiod 1980–2006, which includes only issues by industrial firms. Only covenants that occur in more than1% of debt issues in the population are used. To give all firm-year observations equal weight, I retain onedebt issue per firm per year. The standard errors are clustered by firm; t-statistics are in parentheses. Tomitigate the influence of outliers, 1% of scaled Compustat data is dropped at each tail. ∗, ∗∗, ∗∗∗ indicatestatistical significance at less than 10%, 5%, and 1%, respectively.

158 V. V. NIKOLAEV

TA

BL

E6

Cov

enan

tsan

dT

imel

yL

oss

Rec

ogni

tion

Con

trol

ling

for

Oth

erFa

ctor

s(S

econ

dSt

age)

Vari

able

OVR

LPR

INK

DEC

AC

CO

VRL

PRIN

KD

ECA

CC

Inte

rcep

t0.

0529

∗∗∗

0.05

29∗∗

∗0.

0531

∗∗∗

0.05

28∗∗

∗0.

0616

∗∗∗

0.06

16∗∗

∗0.

0617

∗∗∗

0.06

15∗∗

∗(2

3.6)

(23.

43)

(23.

85)

(23.

47)

(25.

86)

(25.

74)

(26.

06)

(25.

82)

D(R

et<

0)0.

016∗

∗∗0.

0162

∗∗∗

0.01

58∗∗

∗0.

0164

∗∗∗

0.01

51∗∗

∗0.

0153

∗∗∗

0.01

51∗∗

∗0.

0157

∗∗∗

(3.7

4)(3

.78)

(3.7

1)(3

.81)

(3.4

9)(3

.55)

(3.5

)(3

.65)

Ret

−0.0

151∗

∗∗−0

.014

9∗∗∗

−0.0

155∗

∗∗−0

.014

7∗∗∗

−0.0

161∗

∗∗−0

.015

9∗∗∗

−0.0

165∗

∗∗−0

.015

8∗∗∗

(−3.

5)(−

3.46

)(−

3.55

)(−

3.46

)(−

3.72

)(−

3.69

)(−

3.77

)(−

3.7)

D(R

et<

0)∗R

et0.

3784

∗∗∗

0.37

88∗∗

∗0.

3791

∗∗∗

0.37

94∗∗

∗0.

3736

∗∗∗

0.37

44∗∗

∗0.

3751

∗∗∗

0.37

61∗∗

∗(2

2.21

)(2

2.09

)(2

2.24

)(2

2.16

)(2

1.74

)(2

1.77

)(2

1.76

)(2

1.99

)R

estr

ict

−0.0

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(−0.

41)

(−0.

23)

(−0.

72)

(−0.

53)

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41)

(−0.

24)

(−0.

74)

(−0.

58)

D(R

et<

0)∗R

estr

ict

0.00

28∗∗

0.00

7∗∗∗

0.00

49∗∗

∗0.

0124

∗∗0.

0025

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0063

∗∗0.

0045

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0114

∗∗(2

.49)

(2.6

5)(2

.82)

(2.4

1)(2

.24)

(2.4

)(2

.54)

(2.2

2)R

et∗R

estr

ict

0.00

090.

0028

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007∗

0.00

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003

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∗(0

.92)

(1.2

6)(0

.39)

(1.6

9)(1

)(1

.35)

(0.4

9)(1

.76)

D(R

et<

0)∗R

et∗

0.01

35∗∗

∗0.

0308

∗∗∗

0.02

34∗∗

∗0.

0568

∗∗∗

0.00

74∗∗

0.01

68∗∗

0.01

43∗∗

0.03

16∗

Res

tric

t(3

.89)

(3.7

9)(4

)(3

.23)

(2.0

6)(2

)(2

.19)

(1.7

1)

(Con

tinue

d)

DEBT COVENANTS AND ACCOUNTING CONSERVATISM 159

TA

BL

E6

—C

ontin

ued

Vari

able

OVR

LPR

INK

DEC

AC

CO

VRL

PRIN

KD

ECA

CC

Afte

r−0

.019

2∗∗∗

−0.0

194∗

∗∗−0

.019

2∗∗∗

−0.0

195∗

∗∗(−

8.79

)(−

8.84

)(−

8.77

)(−

8.85

)D

(Ret

<0)

∗Ret

∗0.

0107

∗∗0.

025∗

∗0.

0146

∗∗0.

0462

∗∗R

estr

ict∗

Afte

r(2

.44)

(2.3

9)(1

.99)

(2.3

3)

Adj

.R-s

quar

e0.

137

0.13

70.

138

0.13

714

.20.

142

0.14

20.

141

Th

eta

ble

disp

lays

esti

mat

esfr

omth

efo

llow

ing

regr

essi

on:

Et/

P t−1

=α

0+

α1D

(Ret

t<

0)+

α2R

ett+

α3D

(Ret

t<

0)R

ett+

β0R

estr

ict s

+β

1D

(Ret

t<

0)R

estr

ict s

+β

2R

ettR

estr

ict s

+β

3D

(Ret

t<

0)R

ettR

estr

ict s

+γ

0A

fter t

+γ

1D

(Ret

t<

0)R

ettR

estr

ict s

Afte

r t+

εt,

wh

ere

Et

isye

art

earn

ings

,mea

sure

dby

inco

me

befo

reex

trao

rdin

ary

item

s(C

ompu

stat

item

data

18),

Pt−

1is

the

mar

ket

valu

eof

equi

tyat

year

t−

1(C

ompu

stat

item

sda

ta19

9∗

data

25),

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tis

the

retu

rnfr

omC

RSP

com

poun

ded

over

the

12m

onth

sst

arti

ng

atth

ebe

gin

nin

gof

the

fisc

alye

ar,D

(.)

isin

dica

tor

fun

ctio

n,A

fter t

isan

indi

cato

rva

riab

leta

kin

gth

eva

lue

ofon

ein

year

saf

ter

aco

mpa

ny

issu

esde

bt.R

estr

ict s

labe

lsth

eor

thog

onal

ized

cove

nan

tin

dex

from

the

firs

tst

age:

Ico

nst

ruct

the

cove

nan

tin

dice

sby

coun

tin

gco

ven

ants

ofth

epa

rtic

ular

type

;su

bseq

uen

tly,

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thog

onal

ize

thes

ein

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sby

regr

essi

ng

each

ofth

emon

the

firm

char

acte

rist

ics

and

savi

ng

the

resi

dual

(see

tabl

e5)

.Ty

pes

ofco

ven

ant

indi

ces

are

spec

ified

inth

efi

rst

row

ofth

eta

ble

and

are

defi

ned

asfo

llow

s:O

VRL

isth

eov

eral

lco

unt

ofco

ven

ant

rest

rict

ion

sin

clud

edin

aco

ntr

act,

PRIN

isth

efi

rst

prin

cipa

lco

mpo

nen

tba

sed

ondi

ffer

ent

type

sof

cove

nan

ts,K

DEC

isth

esu

mof

DIV

,FIN

,an

dIN

V,w

her

eD

IVis

aco

unt

ofpa

yout

rest

rict

ion

s,IN

Vis

aco

unt

ofco

ven

ants

limit

ing

M&

Aan

din

vest

men

tac

tivi

ties

and

asse

tdi

spos

itio

ns,

and

FIN

isa

coun

tof

cove

nan

tslim

itin

gfi

nan

cin

gac

tivi

ties

;AC

Cis

aco

unt

ofac

coun

tin

g-ba

sed

cove

nan

ts.D

ebt

issu

esar

eta

ken

from

the

Mer

gen

tFi

xed

Inco

me

Secu

riti

esD

atab

ase.

An

alys

isin

clud

esfi

rm-y

ears

wit

hin

a10

-yea

rw

indo

wst

arti

ng

five

year

spr

ior

toan

den

din

gfi

veye

ars

afte

rde

btis

suan

ce(I

excl

ude

the

year

ofth

eis

sue

from

the

anal

ysis

).To

give

allfi

rm-y

ear

obse

rvat

ion

seq

ualw

eigh

t,I

reta

inon

lyon

eis

sue

per

firm

per

year

.Th

esa

mpl

ein

clud

esin

dust

rial

debt

issu

esfo

rth

epe

riod

1980

–200

6an

dam

oun

tsto

4,02

0de

btis

sues

and

29,1

85fi

rm-y

ears

wit

hn

onm

issi

ng

Com

pust

atda

ta.

Th

est

anda

rder

rors

are

clus

tere

dby

firm

;t-s

tati

stic

sar

ein

pare

nth

eses

.To

mit

igat

eth

ein

flue

nce

ofou

tlie

rs,1

%of

scal

edC

ompu

stat

data

isdr

oppe

dat

each

tail.

∗ ,∗∗

,∗∗∗ i

ndi

cate

stat

isti

cals

ign

ifica

nce

atle

ssth

an10

%,5

%,a

nd

1%,r

espe

ctiv

ely.

160 V. V. NIKOLAEVT

AB

LE

7A

sym

met

ric

Tim

elin

ess

ofEa

rnin

gsan

dth

eU

seof

Cov

enan

ts:A

nA

ltern

ativ

eSp

ecifi

catio

n

Vari

able

OVR

LPR

INK

DEC

AC

CO

VRL

PRIN

KD

ECA

CC

Inte

rcep

t0.

0571

∗∗∗

0.05

25∗∗

∗0.

0551

∗∗∗

0.05

24∗∗

∗0.

0542

∗∗∗

0.04

84∗∗

∗0.

0525

∗∗∗

0.04

86∗∗

∗(3

.45)

(3.2

8)(3

.46)

(3.1

9)(3

.26)

(3.0

1)(3

.28)

(2.9

5)Si

ze0.

0037

∗∗0.

0039

∗∗0.

004∗

∗∗0.

004∗

∗0.

0045

∗∗∗

0.00

5∗∗∗

0.00

47∗∗

∗0.

0049

∗∗∗

(2.5

1)(2

.55)

(2.6

7)(2

.56)

(2.9

4)(3

.18)

(3.1

1)(3

.1)

Size

∗Ret

0.00

270.

003

0.00

260.

0031

0.00

260.

0028

0.00

250.

003

(1.3

6)(1

.48)

(1.2

9)(1

.55)

(1.3

1)(1

.41)

(1.2

4)(1

.48)

Size

∗D(R

et<

0)−0

.003

5−0

.002

8−0

.004

6−0

.002

5−0

.003

3−0

.003

1−0

.004

2−0

.002

6(−

1.17

)(−

0.94

)(−

1.53

)(−

0.82

)(−

1.12

)(−

1.02

)(−

1.42

)(−

0.85

)Si

ze∗D

(Ret

<0)

∗−0

.065

3∗∗∗

−0.0

642∗

∗∗−0

.067

2∗∗∗

−0.0

632∗

∗∗−0

.064

5∗∗∗

−0.0

634∗

∗∗−0

.066

∗∗∗

−0.0

62∗∗

∗R

et(−

6.46

)(−

6.3)

(−6.

63)

(−6.

22)

(−6.

45)

(−6.

27)

(−6.

6)(−

6.16

)B

TM

−0.0

152

−0.0

153

−0.0

152

−0.0

154

−0.0

146

−0.0

145

−0.0

146

−0.0

147

(−1.

35)

(−1.

36)

(−1.

34)

(−1.

36)

(−1.

3)(−

1.29

)(−

1.3)

(−1.

3)B

TM

∗Ret

0.00

610.

0061

0.00

610.

0061

0.00

610.

006

0.00

60.

0061

(1.1

1)(1

.11)

(1.1

)(1

.12)

(1.1

1)(1

.1)

(1.0

9)(1

.11)

BT

M∗D

(Ret

<0)

0.03

260.

0326

0.03

240.

0323

0.03

370.

0335

0.03

340.

0331

(1.5

3)(1

.52)

(1.5

1)(1

.51)

(1.5

8)(1

.57)

(1.5

7)(1

.55)

BT

M∗D

(Ret

<0)

∗0.

1518

∗∗∗

0.15

23∗∗

∗0.

1515

∗∗∗

0.15

17∗∗

∗0.

1516

∗∗∗

0.15

35∗∗

∗0.

1514

∗∗∗

0.15

21∗∗

∗R

et(3

.18)

(3.1

8)(3

.17)

(3.1

7)(3

.2)

(3.2

2)(3

.19)

(3.2

)L

ev−0

.069

7∗∗∗

−0.0

709∗

∗∗−0

.070

9∗∗∗

−0.0

713∗

∗∗−0

.062

5∗∗∗

−0.0

613∗

∗∗−0

.063

6∗∗∗

−0.0

629∗

∗∗(−

4.51

)(−

4.58

)(−

4.56

)(−

4.64

)(−

4.02

)(−

3.95

)(−

4.06

)(−

4.08

)L

ev∗R

et−0

.023

4−0

.027

1∗−0

.022

9−0

.028

5∗−0

.023

7−0

.027

5∗−0

.023

3−0

.028

7∗(−

1.49

)(−

1.74

)(−

1.47

)(−

1.85

)(−

1.51

)(−

1.77

)(−

1.49

)(−

1.87

)L

ev∗D

(Ret

<0)

0.01

760.

0167

0.02

190.

0146

0.01

610.

0154

0.02

080.

0129

(0.6

)(0

.56)

(0.7

4)(0

.5)

(0.5

5)(0

.52)

(0.7

1)(0

.44)

Lev

∗D(R

et<

0)∗

0.16

26∗∗

0.17

24∗∗

0.17

1∗∗

0.16

71∗∗

0.12

460.

1604

∗∗0.

1394

∗0.

141∗

Ret

(2.1

5)(2

.24)

(2.2

7)(2

.21)

(1.6

3)(2

.1)

(1.8

4)(1

.85)

D(R

et<

0)0.

0107

0.02

64∗∗

∗0.

0136

0.01

8∗0.

0126

0.02

69∗∗

∗0.

0152

0.01

9∗∗

(0.9

9)(2

.96)

(1.3

3)(1

.92)

(1.1

8)(3

.02)

(1.4

9)(2

.04)

(Con

tinue

d)

DEBT COVENANTS AND ACCOUNTING CONSERVATISM 161

TA

BL

E7

—C

ontin

ued

Vari

able

OVR

LPR

INK

DEC

AC

CO

VRL

PRIN

KD

ECA

CC

Ret

−0.0

148∗

∗−0

.010

4∗∗

−0.0

145∗

∗−0

.013

8∗∗∗

−0.0

152∗

∗−0

.010

6∗∗

−0.0

149∗

∗−0

.014

∗∗∗

(−2.

2)(−

2.42

)(−

2.21

)(−

2.83

)(−

2.25

)(−

2.46

)(−

2.26

)(−

2.87

)D

(Ret

<0)

∗Ret

0.48

61∗∗

∗0.

5199

∗∗∗

0.49

09∗∗

∗0.

5029

∗∗∗

0.49

05∗∗

∗0.

5167

∗∗∗

0.49

7∗∗∗

0.50

18∗∗

∗(1

3.12

)(1

6.63

)(1

3.59

)(1

5.34

)(1

3.44

)(1

6.57

)(1

3.98

)(1

5.39

)R

estr

ict

−0.0

006

−0.0

007

−0.0

007

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firs

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tabl

ean

dar

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over

all

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tre

stri

ctio

ns

incl

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ina

con

trac

t,PR

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base

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pes

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ants

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the

sum

ofD

IV,F

IN,a

nd

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,wh

ere

DIV

isa

coun

tof

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utre

stri

ctio

ns,

INV

isa

coun

tof

cove

nan

tslim

itin

gM

&A

and

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stm

ent

acti

viti

esan

das

set

disp

osit

ion

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Nis

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ofco

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ants

limit

ing

fin

anci

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ants

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clud

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atio

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ain

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est

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rors

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stic

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nth

eses

.To

mit

igat

eth

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flue

nce

ofou

tlie

rs,1

%of

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ompu

stat

data

isdr

oppe

dat

each

tail.

∗ ,∗∗

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ndi

cate

stat

isti

cals

ign

ifica

nce

atle

ssth

an10

%,5

%,a

nd

1%,r

espe

ctiv

ely.

162 V. V. NIKOLAEV

levels of statistical significance weaken (which is expected given substan-tially larger number of parameters and mechanical correlations among thevariables), the estimated coefficients β 3 in model (1) and γ 1 in model (2)remain statistically and economically significant, which confirms my priorresults.

Second, to investigate the robustness of estimated coefficients on highorder 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 itsmedian, and 0 otherwise, and I re-estimate models (1) and (2). Such analysisinforms on whether the empirical results are driven by relatively few obser-vations in the tails. While limiting the variation in the independent variableis unlikely to add power to the specification, the results remain very similarto those reported in the paper.

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

5.3.3. Sample Selection Bias. Because covenant information is unavailablefor a number of debt issues in the database (possibly owing to the absenceof a covenants section in the given contract), a selection issue may arise. Iaddress this issue using the approach in Heckman [1979]. First, I model theprobability of covenant information being available. I then control for theinverse of Mill’s ratio in equation (3).18 To ensure that equation (3) is wellidentified, I use additional instruments in the first-stage regression.19 I usevariables potentially correlated with the inclusion of covenants: Convertibleindicates the presence of a conversion option; Putable indicates the presenceof a put option; Redeemable indicates the presence of a call option; andAssetBacked indicates that certain assets back the issue. The coefficient onthe inverse of Mill’s ratio is negative and statistically significant. Finally, I re-estimate equations (1) and (2) using a selection-corrected set of covenantindices (based on the residuals from equation (3)) and determine that myfindings 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 betweencovenants and timely loss recognition. I posit that the demand for timelyloss recognition varies with the presence of private versus public debt ow-ing to the different mechanisms that resolve debt-related agency problemsin these forms of debt. Unlike public bondholders, who rely mainly onfinancial 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 muchtighter financial covenants serving as tip-wires (Berlin and Mester [1992];Rajan and Winton [1995]). In practice, this results in frequent transfers ofcontrol followed by one-sided renegotiations in which private debtholdersselectively relax covenants in exchange for some additional consideration(Dichev and Skinner [2002]; Garleanu and Zwiebel [2009]). I expect thatthe likelihood of public bondholder wealth being expropriated decreaseswith the degree of monitoring by private lenders. The amount of privatelender monitoring is likely to be proportional to the amount lent. There-fore, I expect that the demand for timely loss recognition decreases withthe extent a company relies on private debt. This gives rise to the followinghypothesis:

H3: The relationship between covenants in public debt contracts andtimely 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 inprivate lending agreements. I expect that the amount of control and mon-itoring that private debtholders exercise over a company is proportionalto the number of financial covenants these bondholders impose. The abil-ity to monitor and discipline the management is likely to be higher in thepresence of tight financial covenants, which in turn should decrease publicbondholders’ demand for timely loss recognition. Hence I hypothesize:

H4: The relationship between covenants in public debt contracts andtimely recognition of economic losses weakens as the number offinancial covenants present in coexisting private credit agreementsincreases.

Using Dealscan data, I take the most recent private debt issues issued withinthe three years prior to each public debt issue in my sample (I also use afive-year window as a sensitivity check).20 If no issues are found within thisperiod, the monitoring effect of private debt is assumed to be zero. SinceDealscan 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-matchedby company name.

164 V. V. NIKOLAEV

measure private debt variables, the sample of public debt is further restrictedto the period after 1996.

To test hypotheses H3 and H4, I estimate the model,

Et/Pt−1 = α0 + α1 D(Rett < 0) + α2Rett + α3Rett D(Rett < 0)

+ β0Restricts + β1 D(Rett < 0)Restricts + β2Rett Restricts

+ β3 D(Rett < 0)Rett Restricts + γ0DealAmtt− + δ0FinCovent−+ γ1 D(Rett < 0)Rett Restricts DealAmtt−+ δ1 D(Rett < 0)Rett Restricts FinCovent− + εt , (4)

where DealAmtt− proxies for reliance on prior private debt, and FinCovenis the number of financial covenants present in the prior private creditagreement. As argued above, both of these characteristics are associated withthe higher degree of bank monitoring. To keep the model parsimonious(as discussed earlier), I interact only DealAmt and FinCoven with the mainvariable of interest; my findings, however, are not sensitive to this researchdesign choice.

Table 8 presents the results. Of interest here are the coefficients γ1 andδ1. In line with hypotheses H3 and H4, both coefficients are negative andstatistically significant across all four specifications. This finding suggeststhat (irrespective of how we measure the reliance on public debt covenants)the association between public debt covenants and timely loss recognitionis attenuated by the extent to which companies rely on private debt orits covenants. Overall, the evidence is consistent with private debt marketsexhibiting a lower demand for timely loss recognition than public debtmarkets. Also, the results suggest that alternative monitoring mechanismsalter public bondholder demand for timeliness of financial reporting.

7. Discussion and Concluding Remarks

I test whether covenants that protect bondholders in public debt contractsare associated with the timely recognition of economic losses in accountingearnings. Covenants transfer decision power from shareholders to bond-holders when a company moves toward distress, limiting a manager’s abilityto expropriate bondholder wealth. Covenants are expected to be more ef-fective in preventing agency costs of debt when a firm’s accounting systemgenerates timely signals of the firm’s economic health. Therefore, the useof covenants creates a demand for timely loss recognition.

My analysis demonstrates that the more a company relies on protectivecovenants in its public indentures, the greater its degree of timely loss recog-nition. I also find that firms whose debt contracts use covenants extensivelyexhibit a significant increase in timely loss recognition in the years afterthe debt issues. This suggests that a reliance on covenants promotes timelyloss recognition. Further, the relationship between covenants and timelyloss recognition weakens in the presence of private debt, as is consistentwith the lower demand for reporting timeliness in this market. The results

DEBT COVENANTS AND ACCOUNTING CONSERVATISM 165

T A B L E 8Private 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:

Et /Pt−1 = α0 + α1 D(Rett < 0) + α2Rett + α3 D(Rett < 0)Rett + β0Restricts

+ β1 D(Rett < 0)Restricts + β2Rett Restricts + β3 D(Rett < 0)Rett Restricts + γ0DealAmtt−1

+ δ0FinCovent−1 + γ1 D(Rett < 0)Rett Restricts DealAmtt−1

+ δ1 D(Rett < 0)Rett Restricts FinCovent−1 + εt ,

where Et 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), Rett is the return fromCRSP compounded over the 12 months starting at the beginning of the fiscal year, D(.) is indicator function,and Restricts is a covenant restrictiveness index given by a count of covenants of the particular type includedin a debt contract. Types of covenant indices are specified in the first row of the table and are defined asfollows: OVRL is the overall count of covenants included in a contract, PRIN is the first principal componentbased on differnt types of covenants, KDEC is the sum of DIV , FIN , and INV , where DIV is a count of payoutrestrictions, INV is a count of covenants limiting M&A and investment activities and asset dispositions, andFIN 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 covenantsin a prior debt issue (if no prior issue is found, these variables are set to zero). Public debt issues are takenfrom the Mergent Fixed Income Securities Database; private debt comes from Dealscan. I merge Dealscanwith FISD by taking the most recent debt issue within the three years prior to a public debt issue. Analysisincludes firm-years within a 10-year window starting five years prior to and ending five years after public debtissuance (I exclude the year of the issue from the analysis). To give all firm-year observations equal weight, Iretain only one issue per firm per year. The sample includes industrial debt issues for the period 1990–2006and amounts to 18,764 firm-years with nonmissing Compustat data. The standard errors are clustered byfirm; t-statistics are in parentheses. To mitigate the influence of outliers 1% of scaled Compustat data isdropped 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 ofcovenants. The results are also robust to two alternative measures of earn-ings timeliness as well as to controlling for firm-specific and issue-specificcharacteristics. 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 satisfythe 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 anyattendant adjustments to accounting information—does not substitute fortimely loss recognition. Rather, including covenants creates a demand fortimely 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 informationused in such adjustments is nevertheless backed out from GAAP numbersthat 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 indemand.

Two main caveats are in order. First, judging whether the link betweencovenants and accounting information is sufficiently strong to explain therelation I document is difficult, and one should bear in mind an alterna-tive interpretation. Because the benefits of timely loss recognition are notlimited to cases of distress (Watts [2003a]), timely loss recognition anddebt covenants both represent mechanisms used to reduce a firm’s un-derlying agency problems, and hence they may simply complement eachother. Timely loss recognition is known to alleviate, for example, a firmmanagement’s orientation toward the short-, rather than the long-, term aswell as to prevent management from pursuing negative NPV investments(Ball and Shivakumar [2005]). Were bondholders to exhibit a preferencefor using both instruments simultaneously, a positive relationship betweencovenants and timely loss recognition could obtain. Second, I only mea-sure the number of covenants contained in a given debt contract. Owing todata limitations, I cannot measure the tightness with which these covenantsare imposed. Therefore, the extent to which covenant use correlates withcovenant tightness can make the results more, or less, attributable to theinclusion of covenants per se.

Despite the limitations, the documented association between covenantsand timely loss recognition should be of interest to both theorists and em-pirical researchers who study the interactions between conservatism andoptimal contract design, as well as to standard setters, because it suggeststhat contracts cannot fully satisfy the demand for conservatism via a set ofconservative adjustments to general purpose financial statements based onGAAP.

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, 20076.875% 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 Subsidiariesthat are not Subsidiary Guarantors to issue any shares ofPreferred 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 theSubsidiary Guarantors may issue shares of Disqualified Stock (includingAcquired Disqualified Stock) if the Fixed Charge Coverage Ratio for theCompany’s most recently ended four full fiscal quarters for which earn-ings have been publicly disclosed immediately preceding the date on whichsuch additional Indebtedness is incurred or such Disqualified Stock is issuedwould have been at least 2.0–1 , determined on a pro forma basis (includinga 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 timeoutstanding not to exceed an amount equal to the greater of(i) $3.6 billion and (ii) 38.0% of Consolidated Net TangibleAssets of the Company determined as of the date of the incur-rence of such Indebtedness after giving pro forma effect to suchincurrence and the application of the proceeds therefrom;

(ix) the incurrence by the Company or any Restricted Subsidiaryof Indebtedness or the issuance by any Restricted Subsidiaryof Preferred Stock in an aggregate principal amount (or ac-creted value or liquidation preference, as applicable) at anytime outstanding and incurred or issued in reliance on thisclause (ix) not to exceed the greater of (i) $200.0 million and(ii) 2.0% of Consolidated Net Tangible Assets of the Companyat 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 withan aggregate liquidation preference not exceeding the amountof Indebtedness of the Company held by such Finance Sub-sidiary; provided that the Fixed Charge Coverage Ratio for theCompany’s most recently ended four full fiscal quarters forwhich earnings have been publicly disclosed immediately pre-ceding the date on which such Preferred Stock is issued wouldhave 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 ofsuch 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 anyEquity Interests . . .

(iii) make any principal payment on, or purchase, redeem, defeaseor 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 otheractions 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 RestrictedPayment . . .

(b) the Company would, at the time of such Restricted Payment and af-ter giving pro forma effect thereto as if such Restricted Payment hadbeen made at the beginning of the most recently ended four fullfiscal quarters for which earnings have been publicly disclosed im-mediately preceding the date of such Restricted Payment, have beenpermitted to incur at least $1.00 of additional Indebtedness pursuantto the Fixed Charge Coverage Ratio test set forth in section 4.06(a);and

(c) such Restricted Payment, together with the aggregate of all otherRestricted Payments made by the Company and its Restricted Sub-sidiaries . . . and 50% of any Restricted Payments permitted by section4.07(b)(vii) is less than or equal to the sum, without duplication, of:

(i) 50% of the Consolidated Net Income of the Company for theperiod (taken as one accounting period) beginning on July 1,2006 to the end of the Company’s most recently ended fiscalquarter for which earnings have been publicly disclosed at thetime of such Restricted Payment (or, if such Consolidated NetIncome 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 theretoas if such Restricted Payment had been made at the beginningof the most recently ended four-full-fiscal-quarter periodfor which earnings have been publicly disclosed immedi-ately preceding the date of such Restricted Payment, theCompany’sConsolidatedLeverageRatiowouldhavebeenlessthan 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 enterinto or make any contract, agreement, understanding, loan, advanceor 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 thatthe Company or any Restricted Subsidiary may enter into a Sale and Lease-back Transaction if: (a) the Company or such Restricted Subsidiary, as thecase may be, could have (i) incurred Indebtedness in an amount equalto the Attributable Debt relating to such Sale and Leaseback Transactionpursuant to section 4.06 (whether or not such covenant has ceased to beotherwise in effect pursuant to section 4.18) (in which case it shall bedeemed to have been incurred thereunder) and (ii) incurred a Lien tosecure such Indebtedness pursuant to section 4.11 without securing theNotes; and (b) the gross cash proceeds of such Sale and Leaseback Transac-tion are at least equal to the fair market value (as conclusively determinedby the Board of Directors) of the property that is the subject of such Saleand 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 ornot the Company is the surviving corporation), or sell, assign, transfer,conveyor otherwise dispose of all or substantially all its assets in one ormore related transactions, to another corporation, Person or entityunless:

170 V. V. NIKOLAEV

(A) the Company or the entity or person formed by or survivingany 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 havea Consolidated Net Worth immediately after the transactionequal 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 Companywith or into a Person that has no outstanding Indebtedness,either (I) at the time of such transaction and after giving proforma effect thereto as if such transaction had occurred at thebeginning of the applicable four-quarter period, the Companyor the entity or Person formed by or surviving any such consoli-dation or merger (if other than the Company), or to which suchsale, assignment, transfer, lease, conveyance or other dispositionshall have been made, will be permitted to incur at least$1.00 ofadditional Indebtedness pursuant to the Fixed ChargeCoverage Ratio test set forth in section 4.06(a) or (II) the FixedCharge Coverage Ratio at the time of such transaction andafter giving pro forma effect thereto as if such transaction hadoccurred at the beginning of the applicable four-quarter periodwill be equal to or greater than it was immediately before suchtransaction;

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 someother ratio (dividends related payments).

2. Restrictions on an issuer’s freedom to make payments (other thandividend-related payments) to shareholders and others (restrictedpayments).

3. Restrictions on a subsidiary’s payment of dividends to a certain per-centage of net income or some other ratio (su dividends relatedpayments).

Investment-related covenant restrictions (INV )

1. Restrictions on consolidations or mergers between an issuer and otherentities (consolidation merger).

2. Restrictions on an issuer’s investment policy in an effort to preventrisky investments (investments).

3. Restrictions on subsidiaries’ investments (su investmentsunrestricted subs).

DEBT COVENANTS AND ACCOUNTING CONSERVATISM 171

4. Restrictions on the ability of an issuer to sell assets or restrictions onthe 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’sassets to reduce debt (su sale xfer assets unrestricted).

6. Restrictions on the type or amount of property used in a sale leasebacktransaction and on the use of proceeds from a sale (sales leaseback).

7. Restrictions on subsidiaries from selling leaseback assets that providesecurity for the debtholder (su sales leaseback).

Financing-related covenant restrictions (FIN )

1. Restrictions on the amount of senior debt an issuer may issue in thefuture (senior debt issuance).

2. Restrictions on the issuance of junior or subordinated debt(subordinated debt issuance).

3. Restrictions on subsidiaries issuing additional funded debt (sufunded debt).

4. Restrictions on issuing additional common stock (stockissuance issuer).

5. Restrictions from transferring, selling, or disposing of the issuer’sown common stock or the common stock of a subsidiary (stocktransfer 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 (supreferred stock issuance).

8. Restrictions on issuing secured debt unless the new issue secures thecurrent 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 bondprovisions 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 aratio of earnings available for fixed charges, of at least a minimumspecified level (fixed charge coverage).

Other Covenants (OTHR)

1. A bondholder protective covenant that activates an event of defaultin their issue if a default event has occurred under any other debt ofthe company (cross default).

2. A bondholder protective covenant that allows the holder to acceleratetheir debt if any other debt of the organization has been accelerateddue 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 (changecontrol put provisions).

4. A covenant whereby a decline in the credit rating of the issuer(or issue) triggers a bondholder put provision (rating declinetrigger put).

5. Restrictions on an issuer’s business dealings with its subsidiaries(transaction affiliates).

6. Restrictions on a subsidiary issuing guarantees for the payment ofinterest and/or principal of certain debt obligations (su subsidiaryguarantee).

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). Controlvariables based on Compustat are winsorized at the 1st and 99th percentilesto 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 assignedby Moody’s. Rating is constructed by assigning the value of 1 to “Aaa” rateddebt, value of 2 to “Aa” rated debt, and so on, with the lowest value attachedto nonrated debt.

log(Maturity) = the natural logarithm of years to maturity;log(Amount) = the natural logarithm of the principal amount.

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