Accounting Policy Changes and Debt Contracts

Abstract

Prior research provides evidence that firms make accounting choices to avoid violation of debt covenant provisions and the resulting costs of technical default. We extend this research by asking why some firms refrain from making accounting policy changes when faced with costs of technical default. We considered two possible explanations. First, we hypothesise that these defaulting firms may lack the flexibility to make accounting changes. Second, we hypothesise that these defaulting firms may lack incentive to change accounting methods. Results confirm prior research and indicate that defaulting firms make more accounting changes than non‐defaulting firms. The decision by defaulting firms to change or not change accounting methods during the three years ending in the year of a technical default of debt covenants can be explained in part by the ability of the firm and by the incentives of the firm to make a change.