Direct Evidence on the Informational Properties of Earnings in Loan Contracts

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 the performance covenants included in debt contracts. We find that the earnings measure used in performance covenants does not exhibit asymmetric loss timeliness and has significantly greater cash flow predictive ability than GAAP measures of earnings. We suggest that these results reflect the idea that contracting parties design accounting rules for performance covenants to enhance their efficacy as “tripwires”.