Debt Covenants, Renegotiation, and Accounting Manipulation

• In Event: Debt contracting and financial reporting

Abstract

This paper shows that granting capital providers greater control over interim liquidation decisions via debt covenants can backfire and reduce both the probability that poor projects are liquidated and the manager's effort incentive. There are three key ingredients that lead to these results: The manager can sometimes misreport the accounting information on which the covenant is based (which reduces but does not eliminate the covenant's ability to protect the lender); the parties can renegotiate the initial contract prior to making the liquidation decision; and a manager who misreported accounting information will not want to take any actions that (indirectly) reveal the accounting fraud. The model generates predictions regarding the determinants of accounting-based covenants, and the effects of covenants on misreporting, managerial effort, the frequency of liquidations, and firm value.

Author

• Volker Laux, University of Texas at Austin