Accounting Quality, Debt Covenants Design, and the Cost of Debt

We examine whether the presence of alternative debt covenant designs (threshold tightness, covenants frequency and covenant interdependence) reduces the adverse effect of poor accounting quality on debt cost in the private lending market. Our results indicate that when lenders face borrowing firms characterized by low accounting quality (hereafter, low quality borrowers), the lender tends to increase debt contract restrictiveness through debt covenant design (e.g., increasing the number of covenants, decreasing covenant interdependence or introducing covenants with more threshold tightness). We also find that debt cost for low quality borrowers is significantly influenced by the debt covenant restrictiveness. Controlling for endogeneity, we find that although debt covenants design mitigates adverse information risk, financial reporting quality is more important than strict debt covenants in lowering the cost of debt, a matter of concern for firm managers and lenders.