Debt Covenants and Accounting Manipulation

56 Pages Posted: 11 Feb 2017 Last revised: 11 Jan 2020

See all articles by Volker Laux

Volker Laux

University of Texas at Austin - McCombs School of Business

Date Written: January 9, 2020

Abstract

This paper studies the effects of allocating control rights to lenders via debt covenants when managers can sometimes misreport the accounting information on which the covenants are based. When contract renegotiation is exogenously prohibited, including a covenant in the contract is ex ante optimal for the manager because it increases both the probability that poor projects are liquidated and the manager's effort incentive, relative to a contract with no covenant. This is the case although the covenant induces the manager to misreport accounting information to retain control ex post. When the parties can renegotiate the contract, however, the results can flip: Granting the lender more control can then lead to less frequent liquidations of low-quality projects and lower managerial effort incentives and, hence, reduce the manager's ex ante payoff. The key behind these results is not the manager's incentive to misreport per se but her desire to take subsequent actions that conceal the misreporting. The model generates predictions regarding the determinants of accounting-based covenants, and the effects of covenants on misreporting, managerial effort, the frequency of liquidations, and firm value.

Keywords: control right allocation, debt contracting, debt covenants, renegotiation, accounting manipulation

Suggested Citation

Laux, Volker, Debt Covenants and Accounting Manipulation (January 9, 2020). Available at SSRN: https://ssrn.com/abstract=2915311 or http://dx.doi.org/10.2139/ssrn.2915311

Volker Laux (Contact Author)

University of Texas at Austin - McCombs School of Business ( email )

2317 Speedway
Austin, TX Texas 78712
United States

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
642
Abstract Views
2,949
Rank
76,103
PlumX Metrics