The Quality of Accruals: Lender Side Evaluation of Borrowers, Covenant Analysis, and Current Evaluation Trends.

Abstract

Debt Covenant Hypothesis states that managers of borrowing firms may act in an opportunistic manner to avoid a potential breach of loan covenants set by lenders. Following evidence of earnings manipulation from prior research, this research analyses whether lenders can evaluate the exposure to risk and managerial opportunism, processing available information related to the borrowers. Earnings can be decomposed into cash flows and accrual components; where cash flows relate to the movement of tangible liquid assets and are less prone to manipulation, discretion can be exercised by firm management over the treatment of accruals. This research tests the accrual component of earnings for consistency and quality. If lenders are sophisticated users of financial information and take all the information in a borrower’s earnings into account, a negative (positive) relationship is expected between the quality of accruals of the borrower, and tightness of minima (maxima) based financial covenant thresholds and slack.