Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective

Abstract

This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency. JEL codes: G32; G34; M40; M41

Dynamic threshold values in earnings-based covenants

“…First, we expand the literature on the critical role of covenants in debt contracting (e.g., Christensen et al, 2015). Prior work examines mainly the determinants of specific covenants and the number of covenants in loan contracts (e.g., Bradley and Roberts, 2004;Demerjian, 2011;Christensen and Nikolaev, 2012) or explores the factors that explain the financial covenants' tightness at loan issuance (e.g., Dichev and Skinner, 2002;Chava and Roberts, 2008;Drucker and Puri, 2009;Demiroglu and James, 2010;Murfin, 2012).…”

Uncertainty and Compensation Design in Strategic Interfirm Contracts

“…Literature in accounting examines interfirm contracting using the lens of agency theory (Jensen and Meckling 1976) as well as TCE (Williamson 1979). The Appendix compares these two theories in the context of two common interfirm contracting situations: debt contracting and strategic outsourcing (see Christensen et al 2016 andWilliamson 1988 for reviews).…”

“…Further, unlike traditional outsourcing contracts, where vendors leverage scale economies to provide 2. Christensen et al (2016) in their review article triangulate agency theory and incomplete contracting theory related to the use of accounting information in debt contracts. Debt contracts differ from strategic outsourcing contracts in terms of scope and contracting hazards.…”

Stock‐bond return co‐movement and accounting information

“…The finance literature emphasizes the role of different contracting mechanisms through which the incentives of creditors and shareholders can be aligned (Bodie & Taggart 1978;Myers, 1997;Nash, Netter, & Paulsen, 2003;Smith, Smithson, & Wilford, 1991). Firms typically mitigate shareholder-bondholder conflicts by using restrictive covenants in their debt contracts (Billett, King, & Mauer, 2007;Chava & Roberts, 2008;Christensen, Nikolaev, & Wittenberg-Moerman, 2016;Lehn & Paulsen, 1991;Nikolaev, 2010;Nini, Smith, & Sufi, 2009;Smith & Warner, 1979;Wittenberg-Moerman, 2008) or by keeping the maturity of their debt short (Ozkan, 2000). Covenants that constrain the borrowing firm's production and investment policies (including mergers and acquisition restrictions), as well as those that limit financing activities (issuance of new debt or equity instruments) or payout policy, mitigate the asset substitution and claim dilution problems.…”