Accounting Standards and Debt Covenants: Has the ‘Balance Sheet Approach’ Led to a Decline in the Use of Balance Sheet Covenants?

Abstract

Recent years have seen a sharp decline in the use of balance sheet-based covenants in private debt contracts. I hypothesize that changes in accounting standards can explain part of this decline. Standard setting has shifted towards a “balance sheet approach”, which I predict has made the balance sheet less useful for contracting. I measure the effect of the balance sheet approach on specific borrowers using a volatility ratio. I find that borrowers with greater volatility ratios are less likely to have balance sheet-based covenants. This evidence is consistent with reductions in the contracting usefulness of the balance sheet being associated with reductions in balance sheet covenants.

Keywords: Debt Contracting, Covenants, Balance Sheet, Accounting Standards, Fair Value

JEL Classification: M41