Accounting Rules for Debt Covenants

This paper examines the properties of accounting rules designed to maximize the efficiency of accounting-based debt covenants in a setting with incomplete contracts and asset substitution. Accounting takes the role of a state-contingent decision facilitator by inducing covenant violations, and hence a transfer of decision rights from the borrowing firm to the lender, whenever the lender has less detrimental decision incentives than the firm. This representation of accounting is distinctive in two respects. First, accounting does not have to enlarge the contracting parties' information sets but is nonetheless valuable because it provides verifiable information and hence improves contract efficiency. Second, accounting is an endogenously chosen information aggregation rule rather than an information signal with exogenous properties. The optimal accounting rule in this setting is a function of cash flows and fair value estimates and implements a debt contract with a unique optimal tradeoff between decision rights and interest rates. The optimal degree of conservatism of this accounting rule, measured as the tendency to yield low accounting measures and hence more frequent covenant violations, is higher for firms with high leverage, low profitability, and high liquidation values.