Accounting quality and the choice of borrowing base restrictions in debt contracts

Abstract

This paper examines the effect of accounting quality on the inclusion of a specific debt contract feature, the borrowing base restriction, which limits the borrower’s access to the credit line by the amount of its working capital assets. The quality of the working capital, in turn, becomes relevant to the choice of borrowing base restrictions. I argue that private monitoring of working capital decreases the effect of publicly available accounting information in debt contracts. I find that borrowers with low accounting quality, measured as low accrual quality, are more likely to access borrowing base lines of credit, as they face high adverse selection costs in non-borrowing base lines of credit. Accordingly, I show that the effect of accounting quality on the cost of debt is diminished in borrowing base lines of credit as compared to non-borrowing base lines of credit. Further results show that the diminishing effect of accounting quality in borrowing base lines is mainly due to the discretionary portion of accrual quality, rather than the innate portion. Moreover, based on the narrative length of borrowing base restrictions specifically written on eligible accounts receivables in loan contracts, I construct a borrowing base restrictiveness measure and find that the effect of accounting quality on the cost of debt is decreasing with the restrictiveness, supporting the substitution effect between contractual monitoring mechanisms and borrower accounting quality.