Debt Contracts and the Need for Mandatory Accounting Changes ...

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and, in fact, GAAP changes may exacerbate post contractual opportunism (e.g., Watts and Zimmerman 1978, Weber, Beatty and Ramesh, 2002). In such case, the contracting parties will find it efficient to exclude any subsequent GAAP changes. The choice to include GAAP changes when writing a contract will thus depend on whether the benefits of including GAAP changes outweigh the costs. As these costs and benefits vary cross-sectionally with different types of frictions, our data offers an opportunity to understand the tradeoffs faced by contracting parties when deciding on the contractual treatment of GAAP changes. We posit that the choice to include GAAP changes depends on the effectiveness of accounting standard setters in alleviating the frictions that contracting parties are subject to. We begin our analysis by examining whether the contractual treatment of GAAP changes responds to two broadly defined types of inefficiencies. First, we examine opportunism on the side of the borrower that leads to agency costs of debt (Jensen and Meckling 1976). Second, we examine the opportunism on the side of lenders leading to “hold up” problems (Rajan 1992). Next, we discuss the two inefficiencies in more details. Opportunism by borrowers. In states of the world where borrowers’ incentives to expropriate debt-holder value (via, e.g., asset substitution) intensify, incomplete contracts cannot prevent the borrowers from exploiting grey areas in GAAP and inventing new ways to remove debt from the balance sheet or to overstate performance (in order to loosen accounting-based covenants). Empirically, such behavior is likely to increase with leverage. While levered firms can to some extent contract around the agency problems at the time of the contract initiation, their incentives to behave opportunistically ex post, in unanticipated states of the world, are still likely to be stronger. We find that levered firms tend to exclude GAAP changes. 4 As the 4 Note that leverage is an imperfect proxy for borrower’s opportunism due to its endogenous nature. For example, high leverage firms are also less risky and lower growth firms. Nevertheless, as leverage goes up, the incentives to 3
preceding arguments suggest, this result is inconsistent with the efficiency enhancing role of GAAP changes. Instead, such evidence is expected when GAAP changes enable borrowers to use discretion in implementing GAAP changes to expropriate debtholder value (Watts and Zimmerman 1978, Amir and Ziv 1997, Beatty et al. 2002). This result is also consistent with creditors charging a risk premium when borrowers insist on including future GAAP changes (Beatty et al. 2002). Opportunism by lenders. Hold-up problems arise when borrowers develop innovative products or services for which GAAP has not been established and, as a result, the borrower must share the value of innovations with lenders. Specifically, in the absence of a GAAP treatment, accountants and auditors are likely to follow a conservative treatment with respect to new products or services. 5 As a result, the innovations are likely to result in lower earnings thus reallocating the bargaining power and potentially control to lenders. In turn, lenders can extract rents from the borrower by, e.g., threatening a liquidation (Sharpe 1990, Rajan 1992). Furthermore, the initial R&D investment usually becomes a sunk cost, which places the borrower in an inferior bargaining position and only exacerbates the hold-up problem. As a result, the incompleteness of GAAP with respect to previously unknown products and services can reduce borrowers’ incentives to innovate. To the extent accounting standard setters complete GAAP in response to unanticipated developments in an efficient manner, contracts are expected to include GAAP changes. We proxy for potential hold-up problems in two ways. We use R&D and capital expenditures to expropriate are likely to become stronger. For example, a GAAP change could result in a significant wealth transfer (e.g., to the extent it significantly relaxes covenants). We believe that such incentives will be important in determining the contractual treatment of GAAP changes. We also considered other proxies for agency problems. In particular, we measured the extent of contractual restrictiveness via accounting-based covenants to proxy for incentives for opportunistic behavior. The results are consistent with those based on leverage. 5 Accounting conservatism can reduce opportunistic behavior by the borrower by transferring control to lenders (e.g., Ball and Shivakumar 2005). However, conservatism is less likely to limit lenders’ opportunism. 4
Page 1 and 2: Debt Contracts and the Need for Man
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Page 7 and 8: explanation is that the approach to
Page 9 and 10: 2. Conceptual Underpinnings and Hyp
Page 11 and 12: acting in their own interest, can e
Page 13 and 14: standard setters may also interfere
Page 15 and 16: the distribution of contracts by ye
Page 17 and 18: Table 3 presents the means conditio
Page 19 and 20: consolidation requirements. Curbing
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Page 23 and 24: whereas the trend toward excluding
Page 25 and 26: etween contracting practices and bo
Page 27 and 28: to indicate whether the loan is des
Page 29 and 30: References Aghion, P. and P. Bolton
Page 31 and 32: Appendix A: Examples of Contracting
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Page 35 and 36: Figure 3. Contracting Practices wit
Page 37 and 38: Table 1. Sample Selection and Contr
Page 39 and 40: Table 3. Means Classified by the In
Page 41 and 42: Table 5. Contracting Practices and
Page 43: Table 7. The Sequential Choice of C

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