Non-Recurring Items in Debt Contracts

We study the determinants of whether the definition of EBITA used to calculate covenant compliance excludes or includes the effects of non-recurring items, using a large sample of debt contracts that include Debt-to-EBITDA covenants. We find that special items are more likely to be excluded when borrowers have recorded negative special items in the period prior to contract initiation. Special items tend to be excluded when future goodwill impairments are more likely to occur, especially after the adoption of SFAS 142. Since goodwill impairments represent unverifiable estimates of future values these impairments do not necessarily reflect conservative accounting. Also, we find contracts tend to exclude special items in firms that are less conservative and in firms that are more financially constrained. Finally, controlling for endogeneity, we find that the interest rates in loans in which special items are excluded are, on average, lower.