Contracting on GAAP Changes: Large Sample Evidence

Abstract

We explore revealed preferences for the contractual treatment of changes to GAAP in a large sample of private credit agreements issued by publicly held U.S. firms. We document a significant time-trend towards excluding GAAP changes from the determination of covenant compliance over the period from 1994 to 2012. This trend is positively associated with proxies for standard setters’ shift in focus towards relevance and international accounting harmonization. At the firm level, borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but these firms also show a more pronounced time-trend towards excluding GAAP changes. While this evidence is broadly consistent with an efficiency role for GAAP changes in debt contracting, it is also consistent with a shift in standard setters’ focus offering a partial explanation of why fewer contracts rely on GAAP changes in 2012 than in 1994.

Keywords: Standard setting, GAAP changes, debt contracting, incomplete contract theory

JEL Classification: M4, G32