Does Restricting Managers' Discretion through GAAP Impact the Usefulness of Accounting Information in Debt Contracting?†

Abstract

We examine whether restricting managers' discretion through GAAP impacts the usefulness of accounting information in debt contracting. Our study informs standard setters and regulators regarding the debt contracting implications of limiting managers' discretion via accounting standards. We predict and find that under more restrictive standards, lenders make more non‐GAAP modifications to GAAP‐based performance measures, suggesting that restrictions of managers' discretion reduce the usefulness of accounting information. We perform two additional analyses to enhance identification. First, in line‐item‐level analysis, we document a positive relation between the exclusion of specific nonrecurring items from contractual definitions of earnings and the number of restrictions in the GAAP standards that apply to each specific item each year. Second, using difference‐in‐differences tests around standard changes, we find that the propensity to exclude items varies positively with changes in the restrictiveness of related standards. Moreover, we predict and find that restrictive standards are also positively associated with loan spreads but significantly less so when lenders adjust GAAP numbers in loan contracts. Overall, this study improves our understanding of how attributes of accounting standards impact the usefulness of accounting information.

The predictive ability of tax contingencies for future income tax cash outflows

“…Second, we contribute broadly to research examining the effects of accounting standards on financial statement disclosures by providing new evidence about the effect of limiting managerial discretion (FAF, 2012). Although prior studies suggest more restrictive standards reduce the usefulness of accounting information (Cheng et al, 2022) and make accruals less predictive of future cash flows (Folsom et al, 2017), we find that UTBs accrued under FIN 48 are reliably predictive of future income tax cash outflows despite the financial reporting restrictions that it imposed on managers. Thus, future reforms to constrain managerial discretion could prove fruitful to the extent that bright‐line rules do not induce systematic bias in accounting accruals.…”

“…Regulators and academics frequently debate the costs and benefits of managerial discretion within accounting standards as they relate to financial statement users (Bauguess, 2016; Cheng et al, 2022; Lewis, 2012). This debate is especially salient for contingent liabilities, which represent uncertain claims on firms' future cash flows.…”

Skilled labor and bank loan contracting

“…Third, because of the simultaneous choice of several loan terms in a single contract (e.g., Coyne & Stice (2018), Cheng et al. (2022)), we control for other contracting choices that are available to lenders, including loan maturity (Loan Maturity), the presence of collaterals (Collateral), the number of financial covenants (Num_Fin_Cov), the number of general covenants (Num_Gen_Cov) and the size of loans (Loan Size).…”

“…Second, recent studies demonstrate the importance of examining both pricing and nonpricing terms of loan contracts (e.g., Armstrong et al (2018), Beatty et al (2002), Beatty et al (2019), Bharath et al (2008), Campello & Gao (2017), Cheng et al (2022), Graham et al (2008), Qiu & Shen (2017)). For example, Hsieh et al (2019) and Robin et al (2022) contribute to the literature that examines both pricing and nonpricing terms of loan contracts from the perspectives of management forecasts and board corruption, respectively.…”

“…, Cheng et al (2022),Gigler et al (2009),Graham et al (2008),Ortiz-Molina (2006)), we include a set of control variables that have been found to be related to loan spreads. First, we control for firm size, profitability and operational risks: the natural log of total assets (Firm Size), firm age (Firm Age), market-to-book ratio (MTB), financial leverage (Leverage), tangible assets (Tangibility), profitability (Profitability), cash flow volatility (CF Volatility), current ratio (Current Ratio) and operating loss (Loss).…”