State Contract Law and the Use of Accounting Information in Debt Contracts

Review of Accounting Studies, Volume 26, pp. 124-171, 2021

Posted: 10 Sep 2015 Last revised: 20 Jun 2021

See all articles by Colleen Honigsberg

Colleen Honigsberg

Stanford Law School

Sharon P. Katz

INSEAD

Sunay Mutlu

Kennesaw State University - Michael J. Coles College of Business

Gil Sadka

University of Texas at Dallas

Date Written: July 1, 2020

Abstract

This paper examines the relation between state contract law and the use of accounting information in debt contracts. Contract theory suggests that balance sheet-based covenants resolve debtholder-shareholder conflicts ex ante, whereas income statement-based covenants serve as trip-wires that trigger the switch of control rights ex post. It is more difficult for lenders to exert their control rights ex post if the contract law is more favorable to debtors (i.e., the law is pro-debtor), suggesting that balance sheet-based covenants are more efficient in these jurisdictions. We therefore test and find evidence that lenders using pro-debtor (pro-lender) law are more (less) likely to rely on balance sheet-based covenants. We measure reliance using both the weight of balance sheet covenants, relative to income statement covenants and the covenant strictness. Our analysis further shows that contracts with performance-pricing grids are less likely to include interest increasing grids when the law is more favorable to debtors. The results provide initial evidence that contract law is an important determinant for the design of debt contracts.

Keywords: debt contracts, debt covenants, state contract law

JEL Classification: G21, K12, M41

Suggested Citation

Honigsberg, Colleen and Katz, Sharon P. and Mutlu, Sunay and Sadka, Gil, State Contract Law and the Use of Accounting Information in Debt Contracts (July 1, 2020). Review of Accounting Studies, Volume 26, pp. 124-171, 2021, Available at SSRN: https://ssrn.com/abstract=2658420 or http://dx.doi.org/10.2139/ssrn.2658420

Colleen Honigsberg

Stanford Law School ( email )

559 Nathan Abbott Way
Stanford, CA 94305
United States

Sharon P. Katz (Contact Author)

INSEAD ( email )

Boulevard de Constance
CEDEP No. 11
F-7705 Fontainebleau Cedex, 77305
France

Sunay Mutlu

Kennesaw State University - Michael J. Coles College of Business ( email )

1000 Chastain Road
Kennesaw, GA 30144
United States

Gil Sadka

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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