Debt Contracts and the Need for Mandatory Accounting Changes

Abstract

We use incomplete contracts theory to explain the inclusion or exclusion of changes to GAAP based on which debt covenants are written. We posit that GAAP is often incomplete with respect to unanticipated future developments (innovations), which can lead to post contractual opportunism and thus destroy ex ante incentives. We argue that the choice to include GAAP changes depends on the effectiveness of accounting standard setters to act as an arbiter who 'completes' GAAP ex post. Our evidence indicates that the accounting standard setters achieve mixed success. The GAAP changes we study appear to address inefficiencies associated with opportunism by lenders but not by borrowers. Further, we find that the frequency of credit agreements that rely on standard setters to complete GAAP has decreased by more than fifty percent from 1996 to 2005. This trend is at least partly explained by the actions of standard setters and is consistent with reduced regulatory responsiveness to contracting needs.