Direct Evidence on the Informational Properties of Earnings in Loan Contracts

• In Event: Accounting and Debt Contract

Abstract

Using a sample of firms that disclose the realizations of earnings used for determining covenant compliance in loan contracts, we provide the first direct evidence on the informational properties of earnings used in debt contracts. We find that the informational properties of contractual earnings differ markedly across difference types of covenants. The earnings underlying performance covenants, instead of being conservative, exhibit timely gain recognition and have significantly greater cash flow predictive ability than FASB GAAP earnings. In contrast, earnings for capital covenants have similar levels of conservatism and cash flow predictive ability as FASB GAAP earnings. We suggest that these results reflect the fundamentally different purposes of performance and capital covenants and banks take into account these differences when designing the contractual accounting rules.

Authors

• Rahul Vashishtha, Duke University

• Scott D Dyreng, Duke University

• Joseph Weber, Massachusetts Institute of Technology