21 Financial: Executive compensation/Debt contract/Ownership structure

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Bank Loan Covenants and Accrual Quality

( 2018-08-29) Chen, Chao-Jung ; He, Wen ; Lu, Chien-Ju

We examine whether financial covenants in loan contracts motivate banks to monitor borrowers’ financial reporting practices and result in a higher quality of reported accruals. We document that, relative to loans without financial covenants, loans with financial covenants lead to a significant improvement in accrual quality measured by the extent to which accruals can be mapped into cash flows. The effect of loan covenants on accrual quality is stronger when external monitoring by non-bank stakeholders (i.e., institutional investors and financial analysts) is weaker. Furthermore, initiations of bank loans with financial covenants are related to subsequent improvements in analysts’ information environment. The evidence supports the view that bank monitoring improves accounting quality.