The Debt-Contracting Value of Accounting Numbers and Financial Covenant Renegotiation
Forthcoming in Management Science
48 Pages Posted: 30 Sep 2012 Last revised: 12 Dec 2018
Date Written: December 11, 2018
Building on incomplete contract theory, I investigate whether the likelihood of renegotiating financial covenants is affected by the debt-contracting value of borrowers’ accounting numbers (DCV). DCV captures the inherent ability of accounting numbers to predict credit quality. Using a large sample of private credit agreements, I hypothesize and find that a higher DCV gives rise to smaller ex-post measurement errors in accounting numbers used in covenants, and thus borrowers and lenders are less likely to renegotiate financial covenants. This effect is stronger when the financial covenant intensity is higher. Consistent with the notion that renegotiation improves contracting efficiency by eliminating errors in financial covenants, I show that the distance of the covenant variable to its new contractual threshold better predicts a borrower’s creditworthiness than does the distance to the original threshold absent the renegotiation.
Keywords: debt-contracting value of accounting numbers; renegotiation; financial covenants; incomplete contract theory
JEL Classification: M40, G30
Suggested Citation: Suggested Citation