Accruals, financial distress, and debt covenants

This paper documents that accruals provide information that is useful for predicting financial distress and examines the use of this information by commercial lenders in setting debt covenants. Results show that firms with extreme accruals are more likely to experience financial distress than firms with moderate accruals. These results hold when controlling for the level of earnings. Tests of the relation between accruals and debt covenant tightness show that the debt covenants of borrowing firms with extreme low accruals are set tightly; however, the debt covenants of borrowing firms with extreme high accruals are set relatively loosely. While this result indicates that lenders do not use the information in accruals in setting debt covenants, further tests show that lenders extract compensation for the added risk of lending to firms with extreme accruals by charging higher interest rates.