Accounting quality, debt covenant design, and the cost of debt

Charlene P. Spiceland (), Leo L. Yang () and Joseph H. Zhang ()
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Charlene P. Spiceland: The University of Memphis
Leo L. Yang: University of Miami
Joseph H. Zhang: The University of Memphis

Review of Quantitative Finance and Accounting, 2016, vol. 47, issue 4, No 15, 1302 pages

Abstract: Abstract We examine whether debt covenant design (threshold tightness, covenants frequency, covenant interdependence, and overall covenant strictness) reduces the adverse effect of poor accounting quality on the cost of debt in the private lending market. We predict and find that when borrowing firms exhibit low accounting quality, lenders tend to increase debt contract strictness through debt covenant design (e.g., increasing the number of covenants, decreasing covenant interdependence or including covenants with greater threshold tightness). Moreover, our results indicate that the cost of debt for borrowers with low accounting quality is significantly influenced by the covenant strictness. Further evidence shows that, although debt covenant designs help mitigate adverse information risk, financial reporting quality is more important than strict debt covenants in lowering the cost of debt, a matter of concern for firm managers and lenders.

Keywords: Accounting quality; Debt covenants; Covenant strictness; Cost of debt (search for similar items in EconPapers)
JEL-codes: G12 M41 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (10)

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DOI: 10.1007/s11156-015-0538-9

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