State Contract Law and the Use of Accounting Information in Debt Contracts Colleen Honigsberg, Sharon P. Katz, Sunay Mutlu, and Gil Sadka
Review of Accounting Studies Vol. 26, 2021, pp. 124-171
Overview This paper examines the relationship between state contract law and the use of accounting information in debt contracts. Contract theory suggests that balance sheet-based covenants resolve debtholder-shareholder conflicts ex ante, while income statement-based covenants trigger the switch of control rights ex post. Lenders find it more difficult to exert their control rights ex post if the contract law is more favorable to debtors, suggesting that balance sheet-based covenants are more efficient in these jurisdictions. We test and find evidence that lenders using pro-debtor law are more likely to rely on balance sheet-based covenants than those using pro-lender law. We measure reliance using both the weight of balance-sheet covenants relative to income-statement covenants and covenant strictness. Our analysis also shows that contracts with performance-pricing grids are less likely to include interest-increasing grids when the law is more favorable to debtors. Results provide initial evidence that contract law is an important determinant in the design of debt contracts.
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