Discussion of “Accounting standards and debt covenants: Has the “Balance Sheet Approach” led to a decline in the use of balance sheet covenants?”

Abstract

Demerjian (this issue) argues that a shift by U.S. standard setters towards the balance sheet approach reduces the usefulness of balance sheet numbers for contracting. Consistent with this argument, he provides evidence of a decline in the use of balance sheet-based covenants in debt contracts, a useful finding. Nevertheless, I argue that the evolution of standard-setting is more complex than this argument implies, and evaluate the economic basis of Demerjian's arguments for how debt contracts respond to changes in accounting rules. One conclusion that emerges is that there are still some important open issues regarding the economic determinants of debt contracts.