The Importance of Excluding Accounting Changes from the Calculation of Debt Covenant Compliance

Abstract

In this paper we examine the ex-ante importance of accounting changes in debt contracts by examining how the exclusion of the flexibility to make voluntary and mandatory accounting changes from the calculation of covenant compliance affects the interest rate charged on the loan. After controlling for a selectivity correction and other factors known to affect loan spreads, we find that the interest rate charged on a loan is 40 basis points lower when mandatory accounting changes are excluded and is 104 basis points lower when voluntary accounting changes are excluded. Our results support findings in previous studies that accounting changes are important in debt contracts ex-post for borrowers who violate their accounting based covenants.