Early Warning Signals and Risk-Shifting Incentives

The Accounting Review, Forthcoming

34 Pages Posted: 17 Aug 2019 Last revised: 20 Oct 2022

See all articles by Volker Laux

Volker Laux

University of Texas at Austin - McCombs School of Business

Ronghuo Zheng

The University of Texas at Austin - McCombs School of Business

Date Written: October 11, 2022

Abstract

We study the optimal information system design in a debt contracting setting in which managers can engage in value destroying risk-shifting behavior. The information system issues early-warning signals that allow lenders to take corrective actions such as liquidating unprofitable projects. When managers are empire builders, the optimal system exhibits a conservative bias that leads to excessive early-warning signals and excessive project liquidations relative to first best. In contrast, when managers have a strong preference for a quiet life, the optimal system exhibits a liberal bias that leads to insufficient early-warning signals and excessive project continuations. The broad intuition is that excessive liquidations (continuations) impose costs on managers who have a preference for empire building (a quiet life), and these costs are more severe when managers take excessive risks. The bias in the information system therefore permits managers to commit not to engage in risk shifting and facilitates debt financing.

Keywords: commitment; risk shifting; information system; early warning

JEL Classification: G30; G32; M40; M41

Suggested Citation

Laux, Volker and Zheng, Ronghuo, Early Warning Signals and Risk-Shifting Incentives (October 11, 2022). The Accounting Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3437073 or http://dx.doi.org/10.2139/ssrn.3437073

Volker Laux

University of Texas at Austin - McCombs School of Business ( email )

2317 Speedway
Austin, TX 78712
United States

Ronghuo Zheng (Contact Author)

The University of Texas at Austin - McCombs School of Business ( email )

Austin, TX 78712
United States

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