#07-07
Financial Accounting Characteristics and Debt Covenants
Richard Frankel and Lubomir Litov, March 2007
Abstract: We examine the relation between financial accounting characteristics and accountingbased
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 covenants in lending
agreements 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.
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