Covenant-lite Deals and Financial Reporting Quality

Abstract

We examine how covlite deals, which are debt contracts that lack systematic covenant compliance requirements, affect financial reporting quality. Examining publicly traded U.S. issuers, we show that firms significantly reduce conservative financial reporting but increase the quality of voluntary non-GAAP earnings information in the post-issue-period. Moreover, covlite issuers tend to reduce accruals-based management incentives, are less likely to receive SEC’s key issue comment letters and are no more likely to have internal control weakness flagged by their auditors in the post-issue-period. We argue that covenant/monitoring quality erosion, often associated with covlite deal structures, does not necessarily result in subordinate financial reporting quality. Instead, we conjecture that firms alter their reporting incentives due to major shifts in their debt market investor profile from traditional banking institutions towards non-bank institutional investors with different financial reporting needs. Our results are robust to alternative data construct and modelling settings that address variable omission and self-selection problems.