ACCTG 502 | Session 7 | Capital Versus Performance Covenants in Debt Contracts

ACCTG 502 | Session 7 | Capital Versus Performance Covenants in Debt Contracts - 2012 HANS B. CHRISTENSEN AND VALERI V. NIKOLAEV Introduction: The article contends that financial covenants in debt contracts help reduce conflicts of interest between lenders and borrowers through two separate mechanisms: capital covenants, which align debt holder–shareholder interests before the fact, and performance covenants, which serve as trigger points that shift control back to lenders after the fact when their claims' value is at risk. The authors demonstrate that firms balance these mechanisms depending on their financial constraints and the ease of accounting information contractibility. Their findings indicate that covenants enhance contracting efficiency in various ways, highlighting the important role of accounting in debt governance.