Accounting Changes 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 the efficiency in debt contracts. We develop a parsimonious model to examine the interplay between the firm's investment decision made ex ante and the accounting information revealed ex post the rule change. These accounting changes enable the creditor to observe an accounting signal about the project state. Firms rationally anticipate such a signal and tailor investment decisions accordingly. 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.

Keywords: Information Asymmetry, Accounting, Debt Contracting

JEL Classification: G21, G32, M41, M48