The Incidence of Accounting-based Covenants in UK Public Debt Contracts: An Empirical Analysis

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Abstract
Accounting-based covenants are of particular interest to accounting researchers in view of their potential to influence management's accounting policy choices and their attitudes to new accounting standards. This exploratory paper provides evidence on the incidence of accounting-based covenants in 108 UK public debt contracts for the period 1987-1990. Thirty percent of the agreements contain such covenants, the majority of which are affirmative gearing covenants. Focusing on the institutional differences between the UK and the US, the paper examines relationships between the presence of accounting-based covenants and (a) characteristics of the issuing firm, and (b) other control mechanisms included in the debt agreement. UK firms raising public debt are of good credit quality and UK insolvency procedures afford unambiguous protection to secured creditors. As a result, accounting-based covenants are associated with long-term unsecured debt and with firms having high values for assets-in-place but, in contrast with US findings, are unrelated to gearing. Convertibility appears to reduce the need for accounting-based covenants, especially when the debt is also subordinated. The relationship between accounting- based covenants and security depends on the nature of the security (fixed or floating). Longer term non-convertible debt agreements are, therefore, particularly likely to contain covenants that could influence management's accounting behaviour. This paper provides a starting point for further research into these issues.