Adjustment for Non-Cash Items in Earnings-Based Covenants

Abstract

This paper examines how non-cash items are adjusted for in the measurement of earnings-based covenants in loan contracts. I first provide descriptive evidence on the forms and frequencies of these adjustments: 15% of covenants subtract “non-cash income,” 36% adds back “other non-cash expenses” (“non-cash expenses” other than depreciation and amortization expenses), and 89% adds back depreciation and amortization expenses. Next, I show evidence that the cross-sectional variations of these adjustments are consistent with concerns about the reliability of these items being a reason for their exclusion: Firms with higher agency costs of debt and lower reputational capital are more likely to exclude these items. Finally, I show that working capital accruals increase the usefulness of earnings in measuring credit risk and that operating cash flows are significantly less associated with credit risk than net income. This finding suggests that the usual inclusion of working capital accruals in the covenant measurement is consistent with contracting parties choosing a performance measure that is more useful in measuring credit risk.