Debt Contracts in the Presence of Performance Manipulation

39 Pages Posted: 24 Jan 2017 Last revised: 18 Oct 2018

See all articles by Ilan Guttman

Ilan Guttman

Leonard N. Stern School of Business, New York University; New York University - Stern Scholl of business

Ivan Marinovic

Graduate School of Business, Stanford University

Date Written: May 12, 2018

Abstract

Empirical evidence suggests that firms often manipulate reported numbers to avoid debt covenant violations. We study how a firm’s ability to manipulate reports affects the terms of its debt contracts and the resulting investment and manipulation decisions that the firm implements. Our model generates novel empirical predictions regarding the use and the level of debt covenant, the interest rate, the efficiency of investment decisions, and the likelihood of covenant violations. For example, the model predicts that the optimal debt contract for firms with relatively strong (weak) corporate governance (i.e., cost of manipulation) induces overinvestment (underinvestment). Moreover, for firms with strong (weak) corporate governance, an increase in corporate governance quality leads to tighter (looser) covenant, more (less) frequent covenant violations and lower (higher) interest rate. Our model highlights that the interest rate, which is a common proxy for the cost of debt, neither accounts for the distortion of investment efficiency nor the expected manipulation costs arising under debt financing. We propose a measure of cost of debt capital that accounts for these effects.

Keywords: Asymmetric Information, Debt Contracts, Earnings Management

JEL Classification: D81; D82

Suggested Citation

Guttman, Ilan and Marinovic, Ivan, Debt Contracts in the Presence of Performance Manipulation (May 12, 2018). Review of Accounting Studies, Vol. 23, No. 3, 2018. Available at SSRN: https://ssrn.com/abstract=2902942 or http://dx.doi.org/10.2139/ssrn.2902942

Ilan Guttman

Leonard N. Stern School of Business, New York University ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

New York University - Stern Scholl of business ( email )

No Address Available

Ivan Marinovic (Contact Author)

Graduate School of Business, Stanford University ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

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