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

63 Pages Posted: 4 Aug 2011 Last revised: 29 Nov 2011

Date Written: July 21, 2011

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

Suggested Citation

Demerjian, Peter R., Accounting Standards and Debt Covenants: Has the ‘Balance Sheet Approach’ Led to a Decline in the Use of Balance Sheet Covenants? (July 21, 2011). Journal of Accounting & Economics (JAE), Vol. 52, Nos. 2-3, pp. 178-202, 2011. Available at SSRN: https://ssrn.com/abstract=1892236

Peter R. Demerjian (Contact Author)

University of Illinois at Chicago ( email )

601 South Morgan Street
University Hall, Room 2303
Chicago, IL 60607
United States

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