Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective

• Published date: 01 May 2016
• Author: VALERI V. NIKOLAEV,HANS B. CHRISTENSEN,REGINA WITTENBERG‐MOERMAN
• DOI: http://doi.org/10.1111/1475-679X.12108
• Date: 01 May 2016

DOI: 10.1111/1475-679X.12108

Journal of Accounting Research

Vol. 54 No. 2 May 2016

Printed in U.S.A.

Accounting Information in Financial

Contracting: The Incomplete

Contract Theory Perspective

HANS B. CHRISTENSEN,

∗VALERI V. NIKOLAEV,

∗

AND REGINA WITTENBERG-MOERMAN

†

ABSTRACT

This paper reviews theoretical and empirical work on financial contracting

that is relevant to accounting researchers. Its primary objective is to discuss

how the use of accounting information in contracts enhances contracting ef-

ficiency and to suggest avenues for future research. We argue that incomplete

contract theory broadens our understanding of both the role accounting in-

formation plays in contracting and the mechanisms through which efficiency

gains are achieved. By discussing its rich theoretical implications, we expect

incomplete contract theory to prove useful in motivating future research and

in offering directions to advance our knowledge of how accounting informa-

tion affects contract efficiency.

JEL codes: G32; G34; M40; M41

Keywords: financial contracting; incomplete contracts; accounting-based

covenants; control allocation; contracting on accounting information

∗Booth School of Business, The University of Chicago; †Marshall School of Business, The

University of Southern California.

Accepted by Douglas Skinner. Weappreciate the helpful comments and suggestions from

Chris Armstrong, Pingyang Gao, Oliver Hart, Laurence van Lent, Christian Leuz, Amir Sufi,

Joseph Weber,and participants at the 50th Annual Jour nal of Accounting ResearchConference.

We gratefully acknowledge the financial support from the University of Chicago Booth School

of Business and the University of Southern California, Marshall School of Business.

397

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

398 H.B.CHRISTENSEN,V.V.NIKOLAEV,AND R.WITTENBERG-MOERMAN

1. Introduction

A central question in the accounting literature is how accounting informa-

tion facilitates transactions between capital providers and firms. Suppose an

entrepreneur (or manager) has access to a profitable investment project

but lacks financing, while an investor has funds but no access to such a

project. How can accounting information enhance the contractual rela-

tionship between these two parties and how does the use of accounting

information affect the choice and design of financial claims? We discuss

answers to these questions by turning attention to the use of accounting

information in debt contracts.

Understanding the role that accounting information plays in con-

tracting is at the heart of the positive accounting theory developed by

Watts [1977], Watts and Zimmerman [1978], Holthausen [1981], Left-

wich [1983], Holthausen and Leftwich [1983], and Watts and Zimmerman

[1986]. Positive accounting theory posits that the use of accounting infor-

mation enhances the efficiency of contracting by minimizing contracting

costs. While the notion of contracting costs is very general (Watts and Zim-

merman [1990]), positive accounting theory emphasizes the agency costs

introduced in Jensen and Meckling’s [1976] seminal work. Jensen and

Meckling [1976] build on agency theory to analyze financial contracting

and explain capital structure choices.

From the viewpoint of Jensen and Meckling’s [1976] theory, the role of

accounting information is to reduce the agency costs associated with out-

side financing, namely, the agency costs of equity and debt. In the context

of debt financing, agency costs arise because firm managers acting on be-

half of shareholders may take inefficient actions that expropriate wealth

from firm creditors. These include increasing the riskiness of the firm (asset

substitution), diluting the value of existing debt claims (claim dilution), or

failing to take advantage of profitable investment opportunities (debt over-

hang). Such behavior reduces contract efficiency and gives the contracting

parties incentives to ex ante limit or provide incentives against opportunis-

tic actions, protecting creditors’ interests. This can be done by including

covenants that restrict certain actions by firm management or ensuring a

sufficient alignment of interests between the firm’s debt holders and share-

holders. Such covenants limit dividend payouts, capital expenditures, asset

sales, or the issuance of additional debt, and are often contingent on ac-

counting information (Smith and Warner [1979]). In sum, the agency per-

spective implies that the contract efficiency role of accounting information

is driven by its ability to limit or provide incentives against opportunistic

behavior by the borrower.

The agency perspective is an important foundation for an extensive lit-

erature in corporate finance and accounting. It has allowed accounting re-

search to make significant progress in understanding the role of accounting

information in contracting. The accounting literature on debt contract-

ing has documented: (1) the widespread use of accounting measures in

ACCOUNTING INFORMATION IN FINANCIAL CONTRACTING 399

formulating contractual provisions (e.g., Leftwich [1983]), (2) the signif-

icant effect of accounting information properties on debt contract de-

sign (e.g., Beatty, Ramesh, and Weber [2002], Ball, Bushman, and Vasvari

[2008], Zhang [2008]), (3) the influence debt contracts have on account-

ing choice (e.g., Skinner [1993], Sweeney [1994], DeFond [1994]), and

(4) associations between accounting-based contract contingencies, such as

covenants and performance pricing provisions, and the cost of debt (e.g.,

Bradley and Roberts [2004], Asquith, Beatty, and Weber [2005]).

Although the literature has made much progress in supporting the no-

tion that accounting improves debt contract efficiency, we have made

less progress understanding the mechanisms through which the efficiency

gains are realized (e.g., Armstrong, Guay, and Weber [2010]). The agency

theory perspective does not directly address several important questions.

What is the role of decision rights in debt contracting? Why do debt con-

tracts feature apparently simple covenant packages and rely on relatively

few accounting ratios? Why do credit agreements require the maintenance

of performance ratios, as opposed to more explicitly addressing the scope

for various opportunistic actions? Why do we have frequent renegotiations

of accounting-based covenants? What is the value of including a covenant

in a debt contract if it is subsequently renegotiated? And, finally, why do

creditors use accounting-based covenants to actively participate in the gov-

ernance of borrowers?

We suggest that the theory of incomplete contracts broadens our per-

spective on the role of accounting information in debt contracting and on

the mechanisms through which the efficiency gains take place. Incomplete

contract theory is rooted in Coase’s [1937] seminal work on the theory

of the firm, but has gained traction more recently, with key contributions

from Klein, Crawford, and Alchian [1978], Grossman and Hart [1986], and

Aghion and Bolton [1992].

The central tenet of this theory is that contracts are inherently incom-

plete because the contracting parties cannot anticipate or explicitly de-

scribe all future states of the world. This leads to postcontractual oppor-

tunism and hold-up problems that adversely affect the incentives of the

contracting parties to enter contracts. Because contracts cannot specify all

future states or actions, there will inevitably be contract renegotiations in

which one of the parties can behave opportunistically. For example, bor-

rowers may sometimes use asset substitution as a threat to extract conces-

sions from creditors. Similarly, creditors can extract rents if the borrower

discovers a new profitable investment project that requires modifications to

the initial contract.

Incomplete contract theory suggests that the mechanism that alleviates

hold-ups is the ex ante allocation of decision power, that is, control rights,

in the contractual relationship. Control rights determine the status quo in

future renegotiations and hence affect the division of the surplus between

contracting parties. This, in turn, has ex ante efficiency implications. One

of the key principles guiding the allocation of decision rights is that control