The Ex-Ante Monitoring Role of Accounting Covenants in Public Debt

Journal of Business Finance & Accounting, Forthcoming

Posted: 4 Aug 2016

See all articles by Zahn Bozanic

Zahn Bozanic

Ohio State University (OSU) - Fisher College of Business

Date Written: May 12, 2016

Abstract

In contrast to what is known about accounting covenants in private debt, little empirical evidence on the role of accounting covenants in public debt exists. Diffuse ownership, arm’s length monitoring, and collective action problems are unique to the public debt setting and raise the question of whether these covenants serve their intended role. As such, this study investigates whether including covenants reliant upon accounting inputs influences borrowers’ actions to prevent adverse credit events. Accounting covenants in the public debt setting provide firms with a disciplining mechanism to renegotiate ahead of costly technical default — a stark contrast to the ex-post renegotiation “trip wire” role covenants play in private debt. In particular, the results show that including accounting covenants in public debt is associated with an increased probability of ex-ante renegotiation, that is, negotiation through consent solicitations ahead of covenant violation. This ex-ante renegotiation, in turn, is associated with decreased adverse credit events. Cross-sectional results support these findings as the ex-ante renegotiation role of accounting covenants varies with bondholders’ and trustees’ monitoring ability.

Keywords: Public debt, bonds, covenants, consent solicitations, monitoring, renegotiation, information environment quality, financial reporting quality

JEL Classification: G32, L14, M41

Suggested Citation

Bozanic, Zahn, The Ex-Ante Monitoring Role of Accounting Covenants in Public Debt (May 12, 2016). Journal of Business Finance & Accounting, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2817554

Zahn Bozanic (Contact Author)

Ohio State University (OSU) - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

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