Mandatory Accounting Changes and Debt Contracting

• In Event: Changes in Accounting Standards

Abstract

This paper examines whether or not firms benefit from committing to incorporate future accounting changes (such as IFRS adoption) in debt contracting. We find that future regulatory changes do not necessarily improve efficiency in debt contracts, even though they are expected to reduce information asymmetry between the borrower and the creditor. We develop a parsimonious model to examine the interplay between the accounting information revealed ex post and the firm investment decision ex ante. In our model, a firm makes investment decisions (project selection and effort decision) before a regulator makes any change accounting rules ex post. Such regulatory actions allow a creditor to observe a noisy accounting signal of the project state, thereby alleviating information asymmetry. However, firms rationally anticipate such accounting signals and make investment decisions accordingly. For example, if a firm knows the project state is bad and such state is likely to be revealed via an accounting system, it would take a more risky project technology and exacerbate asset substitution. We demonstrate that because of the structure of debt contracting, regulatory changes might reduce the overall efficiency of debt contracting by distorting the firm's ex ante investment decisions. If asset substitution is sufficiently severe, then regulatory actions unambiguously reduce the firm's expected payoff and the efficiency of debt contracting, even though they improve the quality of accounting information per se. Under such a scenario, a firm would prefer frozen to rolling GAAP.

Authors

• Masako Darrough, CUNY-Baruch College

• Ming Cherng Deng, CUNY-Baruch College