Financial Accounting Characteristics and Debt Covenants

We examine the relation between financial accounting characteristics and accountingbased debt covenants. We hypothesize that use of accounting-based covenants is more likely when asymmetric timeliness is higher and accounting discretion is reduced, because the covenants can more efficiently reduce agency costs in these circumstances. Overall, we find little association between the use of accounting-based debt covenants and three financial reporting characteristics (1) the magnitude of past discretionary accruals, (2) Basu’s (1997) asymmetric timeliness measure, or (3) Ball and Shivakumar’s (2006) asymmetric timeliness measure. We also are unable to find a consistently significant relation between these accounting characteristics and initial-covenant slack. Our results suggest that the relation between the effectiveness of accounting-based and these characteristics is marginal. * We gratefully acknowledge financial support from the Center for Research in Economics and Strategy (CRES) at Washington University in Saint Louis. We thank Kose John, Joshua Ronen, and the participants of the finance brown bag seminar at the Washington University in St. Louis for useful discussions. We further thank Stacie Driebusch and Michelle Wang for research assistance. All remaining errors of course are our own. 1