We would like to thank an anonymous referee, Ray Ball, Ryan Ball, Mary Barth, William Beaver, Philip Berger, Robert Bushman, Richard Frankel, Laurence van Lent, Joshua Madsen, Haresh Sapra (the editor), Douglas Skinner, and workshop participants at the University of Chicago, London Business School, Stanford University, Tilburg University, Washington University at St. Louis, and the Fourth Interdisciplinary Accounting Conference in Copenhagen for helpful comments. We also thank Trevor Clark and Peter Notter from Madison Capital Funding for helpful discussion. Financial support from the University of Chicago Booth School of Business is gratefully acknowledged.
Capital Versus Performance Covenants in Debt Contracts
Article first published online: 8 NOV 2011
Copyright ©, University of Chicago on behalf of the Accounting Research Center, 2011
Journal of Accounting Research
Volume 50, Issue 1, pages 75–116, March 2012
How to Cite
CHRISTENSEN, H. B. and NIKOLAEV, V. V. (2012), Capital Versus Performance Covenants in Debt Contracts. Journal of Accounting Research, 50: 75–116. doi: 10.1111/j.1475-679X.2011.00432.x
- Issue published online: 13 JAN 2012
- Article first published online: 8 NOV 2011
- Accepted manuscript online: 7 OCT 2011 03:04AM EST
- Received 4 January 2011; accepted 30 August 2011
Building on contract theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debt holder–shareholder interests. Performance covenants serve as trip wires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on the capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting-based covenants can improve contracting efficiency in two different ways.