Measurement Error when Estimating Covenant Violations

59 Pages Posted: 18 Nov 2021

See all articles by Scott Dyreng

Scott Dyreng

Duke University - Accounting

Elia Ferracuti

Duke University - Fuqua School of Business

Robert Hills

Pennsylvania State University

Matthew Kubic

University of Texas at Austin

Date Written: September 27, 2021

Abstract

Prior research often estimates covenant slack and violations using financial data from Compustat and covenant thresholds from Dealscan, which may induce measurement error since covenants are commonly based on non-GAAP numbers and Dealscan often fails to capture threshold changes associated with contractual amendments. Using a hand-collected sample of actual covenant thresholds and realizations from SEC filings, we find that estimated covenant slack measures grossly overstate the frequency of covenant violations. Although Type I errors (overestimation) are common, Type II errors (underestimation) are rare, suggesting the measurement error is not random. We show Type I errors are responsible for previous findings that suggest lenders fail to “enforce” approximately 90% of covenant violations (Bird et al. 2020). We identify differences between true covenant realizations and estimated realizations from Compustat data as the primary source of measurement error and propose measurement adjustments to reduce measurement error when estimating covenant slack.

Keywords: Debt covenants, Covenant Slack, Covenant Violation

JEL Classification: G30, M40, M41

Suggested Citation

Dyreng, Scott and Ferracuti, Elia and Hills, Robert and Kubic, Matthew, Measurement Error when Estimating Covenant Violations (September 27, 2021). Available at SSRN: https://ssrn.com/abstract=3931427 or http://dx.doi.org/10.2139/ssrn.3931427

Scott Dyreng (Contact Author)

Duke University - Accounting ( email )

Box 90120, Fuqua School of Business
Durham, NC 27708-0120
United States

Elia Ferracuti

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-1974 (Phone)

Robert Hills

Pennsylvania State University ( email )

University Park, PA 16802-3306
United States

HOME PAGE: http://https://directory.smeal.psu.edu/rwh5494

Matthew Kubic

University of Texas at Austin ( email )

2317 Speedway
Austin, TX 78712
United States

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