In this paper we examine how the exclusion of voluntary and mandatory accounting changes from the calculation of covenant compliance affects the interest rate charged on the loan. After controlling for self-selection bias and other factors known to affect loan spreads, we find that the rate charged is 84 basis points lower when voluntary accounting changes are excluded and 71 basis points lower when mandatory accounting changes are excluded. Our results suggest that borrowers are willing to pay substantially higher interest rates to retain accounting flexibility that may help them avoid covenant violations and to avoid duplicate record keeping costs.
In this paper we examine the ex-ante importance of accounting changes in debt contracts by examining how the exclusion of the flexibility to make voluntary and mandatory accounting changes from the calculation of covenant compliance affects the interest rate charged on the loan. After controlling for a selectivity correction and other factors known to affect loan spreads, we find that the interest rate charged on a loan is 40 basis points lower when mandatory accounting changes are excluded and is 104 basis points lower when voluntary accounting changes are excluded. Our results support findings in previous studies that accounting changes are important in debt contracts ex-post for borrowers who violate their accounting based covenants.
This paper examines whether firms benefit, in debt contracting, from committing to incorporate future GAAP changes (referred to as rolling GAAP) or not to incorporate any future changes (referred to as frozen GAAP). We show that informative future accounting changes do not necessarily improve the efficiency in debt contracts. We develop a parsimonious model to examine the interplay between the firm's investment decision made ex ante and the accounting information revealed ex post the rule change. These accounting changes enable the creditor to observe an accounting signal about the project state. Firms rationally anticipate such a signal and tailor investment decisions accordingly. If asset substitution is sufficiently severe, accounting changes unambiguously reduce the firm's expected payoff and the efficiency of debt contracting, even though they might reduce information asymmetry between the lender and the borrower. Under such a scenario, a firm would prefer not to incorporate future accounting changes.
This paper examines whether firms benefit, in debt contracting, from committing to incorporate future GAAP changes (referred to as rolling GAAP) or not to incorporate any future changes (referred to as frozen GAAP). We show that informative future accounting changes do not necessarily improve efficiency of debt contracts. We develop a parsimonious model to examine the interplay between a firm's investment decisions made ex ante and the accounting information revealed ex post the rule change. A firm borrows fund and makes investment decisions (project selection and effort choice) before a regulator may change accounting rules, which enable the creditor to observe an accounting signal about the project state. The firm rationally anticipates such a signal and tailors investment decisions accordingly. For example, if the firm knows that a bad project state is likely to be revealed, it will select a more risky technology and exacerbate asset substitution. In such a case, accounting changes might reduce the overall efficiency of debt contracting by distorting the firm's ex ante investment decisions. If asset substitution is sufficiently severe, accounting changes unambiguously reduce the firm's expected payoff and the efficiency of debt contracting, even though they might reduce information asymmetry between the lender and the borrower. Under such a scenario, a firm would prefer not to incorporate future accounting changes.
One of the major uses of accounting information is in mitigating the conflict of interest problems which arise because of the different incentives of debt-holders and equity-holders. These incentive problems frequently lead to the inclusion of contractual debt covenants within lending agreements. The optimal use and form of such covenants is therefore of interest to both academics and practitioners. This dissertation expands on existing theory by considering two important aspects of debt covenants which have often been ignored. The first chapter of the dissertation considers the role played by the use of multiple covenants within the same debt contract. I develop a model that highlights the tradeoffs and interdependencies among different covenants in a multi-dimensional contract, and the effect of specific covenants on controlling over and under-investment problems caused by the different incentives faced by lenders and shareholders. A second chapter of the dissertation recognizes that debt covenants are written using numbers produced by the firm's accounting system, and develops a theory of how expected future accounting changes may affect the optimal debt contract in the presence of renegotiation. In particular the dissertation establishes how the effect of changes in accounting rules can play a role in determining when renegotiation occurs.
Using a hand-collected sample of private debt contracts between U.S. publicly traded firms and financial institutions, I examine the role of accounting in the renegotiation of debt contracts following a positive shock to the borrower's credit quality. I find that, following a positive shock to their credit quality, firms with more timely reporting of good news are more likely to renegotiate their loan contracts and they do so sooner than firms with less timely good news reporting. Further, these effects are more pronounced for firms whose positive shocks can be more credibly communicated through financial reporting. My paper contributes to the literature on the role of accounting information in debt contract renegotiations.
We explore revealed preferences for the contractual treatment of changes to GAAP in a large sample of private credit agreements issued by publicly held U.S. firms. We document a significant time-trend toward excluding GAAP changes from the determination of covenant compliance over the period from 1994 to 2012. This trend is positively associated with proxies for standard setters' shift in focus toward relevance and international accounting harmonization. At the firm level, borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but these firms also show a more pronounced time-trend toward excluding GAAP changes. While this evidence is broadly consistent with an efficiency role for GAAP changes in debt contracting, it is also consistent with a shift in standard setters' focus offering a partial explanation of why fewer contracts rely on GAAP changes in 2012 than in 1994.
The effect of a change in accounting standards on reporting firms' economic behavior is often a concern raised by those opposing the accounting change. Some view these changes in behavior as an inevitable consequence of a rule change. Others are not persuaded by these arguments. Although the empirical evidence of changes in economic behavior is not extensive it is consistent with accounting changes resulting in firms changing both operating and financing decisions. The evidence of which economic incentives give rise to these changes is more limited. Changes in economic behavior appear to consistently be related to the regulatory use of accounting numbers. In addition some evidence related to incentives created by management compensation and by market discipline has been found. Evidence of the importance of debt covenants in inducing accounting changes is less convincing given limited examination of actual debt contracts and the use of poor proxies of covenant slack. The existing research does very little to tell us whether any changes in behavior are for the better or for the worse.
Performance pricing is a recent contractual innovation, which ties interest rates to a pre-specified grid of some measure of credit risk. We investigate performance pricing because it is becoming a common feature in bank debt, and essentially represents a rare example of market pricing directly tied to accounting-based measures of performance. Our major findings can be summarized as follows. First, we argue that performance pricing emerged as a response to increasing competitive pressures in the market for corporate financing. It reduces transaction and agency costs, and allows for more efficient contracts, furthering the competitive appeal of bank debt. Second, accounting-based performance pricing provisions are detailed, sophisticated, and expansive. The typical pricing grid accommodates ranges of credit risk and interest rate changes, which seem large compared to the economics of private lending. Third, there is a strong pattern of complementarity between same-variable performance pricing and covenant provisions. Probing further, we find that the typical contract sets the initial pricing at the high-cost end of the performance grid, with a same-variable covenant set tightly beyond the top of the grid. Thus, performance pricing and covenants form a well-defined contractual package, where performance pricing provisions are typically designed to handle credit improvements, while credit deteriorations are handled with covenant provisions.
This dissertation is comprised of three essays relating to accounting regulation and debt contracting. The first essay is designed to draw inferences about lenders' demand for lease accounting rules in light of proposed lease accounting standard changes. I study changes in lease-related debt covenants surrounding the adoption of Statement of Financial Accounting Standards 13: Accounting for Leases in 1976. I find that lenders are significantly less likely to inhibit leasing activity via lease restrictions after SFAS 13 adoption and that lenders are significantly more likely to modify debt covenants to capitalize operating leases across time in the post-SFAS 13-adoption period. The findings suggest that lenders adapt debt covenant definitions to changes in accounting standards. Further, the findings indicate that lenders adapt debt covenant definitions to changes in borrowers' financial reporting incentives. The second essay investigates whether lenders capitalize operating leases uniformly when defining debt covenants. I argue that bankruptcy treatment of leases affects lenders' incentives to incorporate operating leases into debt covenants leading to differential treatment of operating leases as opposed to a "one-size-fits-all" contracting treatment of operating leases. Using a hand-collected sample of lending agreements from firms that use operating leases extensively, I find a positive association between the probability of lenders capitalizing operating leases into debt covenants and the duration of borrowers' lease contracts. The results indicate that lenders discriminate among operating leases when designing debt covenants and suggest that operating leases vary in their effect on credit risk. The third essay examines the relation between contract-specified accounting standards and private lender country of domicile. Prior studies provide evidence suggesting that equity investors' information gathering and processing costs are related to differences in reported accounting standards. While lenders have access to private information about prospective borrowers, I document that US lenders are more likely to contract on US accounting standards that match their home country. These findings generalize to Canadian, UK, and IFRS-country lenders and suggest that lenders exhibit a preference for home-country GAAP. In additional tests, I examine whether the degree of difference between borrower- and lender-country accounting standards affects the likelihood that a debt contract from a US lender specifies US GAAP and whether contracting on similar GAAP affects other loan terms. I find no significant effect on the probability of contracting on US GAAP when accounting differences are larger. Similarly, I find no significant evidence that lenders modify loan spread, maturity, and financial covenant use for loans from US lenders that specify US accounting standards.
