The Treatment of Accounting Changes in Covenants and Debt Contracting Efficiency

Abstract

Debt contracts contain accounting-based covenants that could be affected by changes in generally accepted accounting principles (GAAP). There are three types of contractual treatment of GAAP changes: excluding GAAP changes (frozen GAAP); incorporating GAAP changes (floating GAAP); and incorporating changes unless either the borrower or the lenders request a freeze (frozen-on-request GAAP). Motivated by the recent increase and current prevalence of frozen-on-request GAAP, I examine whether this type is more useful in promoting debt contracting efficiency than the other two by collecting a large sample of private debt contracts. I use false positives and false negatives as proxies for debt contracting efficiency and find significantly lower false positives and false negatives under frozen-on-request GAAP than under frozen and floating GAAP after controlling for self-selection bias. The reductions in false positives and false negatives under frozen-on-request GAAP could be attributable to its advantages in incorporating and excluding GAAP changes and in reducing renegotiation costs and facilitating renegotiations. I also find that the reductions become weak during financial crisis and when borrowers and lenders have conflicting preferences towards GAAP changes. My dissertation provides new evidence on the role of accounting standards and GAAP provision designs in improving debt contracting efficiency.