Bank loan covenants, accrual quality and firms’ information environment

We examine whether initiations of bank loans with financial covenants motivate banks to monitor borrowers’ accounting practice and result in a higher quality of reported accruals and a better information environment for firms. We document that, relative to loans without financial covenants, loans with financial covenants lead to an improvement in accrual quality measured by the extent to which accruals can be mapped into cash flows. The effect of loan covenants on accrual quality is stronger when external monitoring by non-bank stakeholders (i.e., institutional investors and financial analysts) is weaker. Furthermore, initiations of bank loans with financial covenants are related to subsequent improvements in analysts’ information environment. The evidence supports the view that bank monitoring improves accounting quality.