Information, Monitoring, and Manipulation: The Economic Role of Covenant Measurement
41 Pages Posted: 28 Aug 2009
Date Written: August 28, 2009
I document the variation in measurement of financial covenants, focusing on three measurement rules: earnings (EBITDA vs. EBIT), firm value (including or excluding intangible assets) and inclusion of escalator clauses (provisions that increase the threshold of net worth covenants). I find that the selection of earnings and firm value measure is associated with the creditors’ demand for monitoring and that inclusion of escalators is driven by the risk of underinvestment. There is also evidence consistent with borrowers using discretion to lower depreciation and amortization and to inflate goodwill to avoid covenant violation. I draw two conclusions. First, earnings and firm value measurements are designed to aid the creditor in monitoring; however, borrowers use discretion to manipulate the reported figures. Second, escalator clauses encourage capital expenditures, and do so effectively. This evidence collectively supports an economic role for covenant measurement: the choice of measure facilitates efficient monitoring and limits underinvestment.
Keywords: debt contracting, covenants, accounting measurement
JEL Classification: M41, G31
Suggested Citation: Suggested Citation