Accounting Changes, Asset Substitution, and Debt Contracting

71 Pages Posted: 30 Apr 2019

See all articles by Masako N. Darrough

Masako N. Darrough

Baruch College - CUNY

Mingcherng Deng

City University of New York (CUNY) - Baruch College

Date Written: March 20, 2019

Abstract

This paper examines whether firms benefit, in debt contracting, from committing to incorporate future GAAP changes (referred to as rolling GAAP) or not to incorporate any future changes (referred to as frozen GAAP). We show that informative future accounting changes do not necessarily improve efficiency of debt contracts. We develop a parsimonious model to examine the interplay between a firm's investment decisions made ex ante and the accounting information revealed ex post the rule change. A firm borrows fund and makes investment decisions (project selection and effort choice) before a regulator may change accounting rules, which enable the creditor to observe an accounting signal about the project state. The firm rationally anticipates such a signal and tailors investment decisions accordingly. For example, if the firm knows that a bad project state is likely to be revealed, it will select a more risky technology and exacerbate asset substitution. In such a case, accounting changes might reduce the overall efficiency of debt contracting by distorting the firm's ex ante investment decisions. If asset substitution is sufficiently severe, accounting changes unambiguously reduce the firm's expected payoff and the efficiency of debt contracting, even though they might reduce information asymmetry between the lender and the borrower. Under such a scenario, a firm would prefer not to incorporate future accounting changes.

Keywords: Information Asymmetry, Asset Substitution, Accounting Information Precision, Debt Contracting

JEL Classification: G21, G32, M41, M48

Suggested Citation

Darrough, Masako N. and Deng, Mingcherng, Accounting Changes, Asset Substitution, and Debt Contracting (March 20, 2019). Available at SSRN: https://ssrn.com/abstract=3359922 or http://dx.doi.org/10.2139/ssrn.3359922

Masako N. Darrough

Baruch College - CUNY ( email )

One Bernard Baruch Way
New York, NY 10010
United States
646 312 3183 (Phone)
646 312 3161 (Fax)

Mingcherng Deng (Contact Author)

City University of New York (CUNY) - Baruch College ( email )

One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States

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