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Faculty & Research


Do Debt Covenants Constrain Leverage Prior to Violation? Evidence from SFAS 160

Journal Article
Prior evidence shows a reduction in leverage after covenant violations, but one does not know whether covenants affect leverage before they are violated. In this study, the authors use an exogenous accounting-based shock to debt covenants that relaxed covenant tightness (SFAS 160) and examine whether covenants constrain leverage for borrowers that are close to violation, even when the borrower is financially healthy. The authors find that SFAS 160 increased debt levels in firms that were close to violation. This increase in debt was driven by financially healthy firms, suggesting the likelihood of future covenant violations could impede borrowing by firms. The authors also find an increase in investment sensitivity to Q after SFAS 160 in firms close to violation, suggesting the additional debt was used to make legitimate investments. Because SFAS 160 was passed in the midst of the financial crisis, it is difficult to generalize their findings to more normal financial periods.

Professor of Accounting and Control