The Impact of Financial Covenants on the Use of Accounting Conservatism in Debt Contracting: International Evidence

Abstract

This paper examines the impact of financial covenants on the use of accounting conservatism in debt contracting. Using a relatively new database on global loan contracts, we find that the association between conservatism and debtholder-stockholder conflicts increases with the intensity of financial covenants and that this association is significant only in countries with a relatively high intensity of financial covenants. In addition, we show that the effect of financial covenants is not sensitive to controlling for other institutional factors (such as legal origin, importance of the debt markets, or ownership concentration) that are used in prior studies to proxy for the contracting demand of accounting. Our additional analysis also finds that the cost of debt is negatively associated with the debt contracting component of conservatism worldwide. Overall, these results are consistent with the use of financial covenants being an important mechanism for conservatism to mitigate debtholder-stockholder conflicts. Our study contributes to the literature by being the first to measure the use of financial covenants worldwide and directly document its impact on the contracting demand of accounting.