The Usefulness of GAAP Earnings in Financial Covenants

ABSTRACT Earnings-based debt covenants in Japan typically reference GAAP earnings, particularly “ordinary income,” an earnings measure unique to Japan defined as earnings before taxes and special items. We posit that ordinary income serves as an effective summary indicator of firms’ operating and financing performance and that its use in debt covenants helps lenders reduce their contracting costs. Consistent with this prediction, we find that the use of ordinary income in earnings-based loan covenant is negatively associated with the number of covenant types, suggesting that it reduces the need for additional covenants. Interestingly, we also find that EBITDA is more useful than other earnings measures, including ordinary income, in explaining credit risk and predicting future cash flows. Overall, our evidence suggests that ordinary income is employed primarily to economize on contracting costs, rather than to serve as an information signal. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G21; G32; M41.