Accounting Changes, Asset Substitution, and Debt Contracting

Abstract

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.