GAAP goodwill and debt contracting efficiency: evidence from net-worth covenants

Richard Frankel, Chandra Seethamraju, Tzachi Zach

Review of Accounting Studies · 2008 · Volume 13 · Issue 1

Abstract

We study the role of goodwill in promoting contracting efficiency and the effect of SFAS 141 and 142 on this role. We provide three main results. First, when a lending agreement contains some type of minimum net-worth covenant, the probability of a tangible net-worth covenant is decreasing in the borrower’s goodwill. Second, the use of tangible net-worth covenants has increased since the promulgation of SFAS 141 and 142. Finally, covenant slack is not significantly related to the use of tangible net-worth covenants relative to net-worth covenants. These results suggest that contracting parties realize efficiency gains by permitting borrowers’ actions to be restricted by the value of GAAP goodwill. However, recent changes in GAAP have reduced the contracting usefulness of goodwill.

Keywords

Contracting efficiency, Goodwill, Debt covenants

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