Contracting on GAAP Changes: Large Sample Evidence

• Date: 01 December 2017
• DOI: http://doi.org/10.1111/1475-679X.12175
• Author: VALERI V. NIKOLAEV,HANS B. CHRISTENSEN
• Published date: 01 December 2017

DOI: 10.1111/1475-679X.12175

Journal of Accounting Research

Vol. 55 No. 5 December 2017

Printed in U.S.A.

Contracting on GAAP Changes:

Large Sample Evidence

HANS B. CHRISTENSEN

∗AND VALERI V. NIKOLAEV

∗

Received 31 July 2013; accepted 18 April 2017

ABSTRACT

We explore revealed preferences for the contractual treatment of changes to

GAAP in a large sample of private credit agreements issued by publicly held

U.S. firms. We document a significant time-trend toward excluding GAAP

changes from the determination of covenant compliance over the period

from 1994 to 2012. This trend is positively associated with proxies for stan-

dard setters’ shift in focus toward relevance and international accounting har-

monization. At the firm level, borrowers facing higher uncertainty are more

likely to write contracts that include GAAP changes, but these firms also show

a more pronounced time-trend toward excluding GAAP changes. While this

evidence is broadly consistent with an efficiency role for GAAP changes in

debt contracting, it is also consistent with a shift in standard setters’ focus of-

fering a partial explanation of why fewer contracts rely on GAAP changes in

2012 than in 1994.

JEL codes: M4; G32

Keywords: standard setting; GAAP changes; debt contracting; incomplete

contracts theory

∗The University of Chicago, Booth School of Business

Accepted by Douglas J. Skinner. We thank two anonymous referees, Ray Ball, and

Christian Leuz for helpful comments. A previous version of this paper benefitted from

workshops at the University of Amsterdam, Baruch College, the University of Chicago,

the Hong Kong University of Science and Technology, MIT, Northwestern University,

the University of Pennsylvania, Tilburg University, Rice University, and the University of

Rochester. We thank Amir Sufi for making debt contracts available. Financial support

from the University of Chicago Booth School of Business is gratefully acknowledged.

An online appendix to this paper can be downloaded at http://research.chicagobooth.

edu/arc/journal-of-accounting-research/online-supplements.

1021

Copyright C, University of Chicago on behalf of the Accounting Research Center,2017

1022 H.B.CHRISTENSEN AND V.V.NIKOLAEV

1. Introduction

Do changes in Generally Accepted Accounting Principles (GAAP) improve

contract efficiency? This question is of broad interest in the accounting lit-

erature. One influential view maintains that private contracts can include

a comprehensive set of adjustments to GAAP to directly meet the needs of

the contracting parties. Under this perspective, changes to GAAP play no

role in debt contracting because the initial contract can adjust the existing

GAAP to achieve optimal accounting measurement. But this raises the ques-

tion of why contracts often incorporate GAAP changes into the determina-

tion of covenant compliance. To shed more light on this issue, we study

the preferences revealed by debt contracts for the use of floating vs. fixed

GAAP definitions in a novel and comprehensive sample of debt contracts.

The use of floating GAAP incorporates changes as they occur, whereas the

use of fixed GAAP excludes future changes (Mohrman [1996]). By docu-

menting revealed preferences for floating vs. fixed GAAP definitions, our

objective is to better understand whether GAAP changes play a contracting

role and how this role has evolved over time.

To construct a comprehensive set of contracting practices with respect

to GAAP changes, we begin by manually classifying contracts into fixed vs.

floating GAAP categories based on a subsample of the credit agreements

collected by Nini, Smith, and Sufi [2009]. Based on this manual classifica-

tion, we construct an automated search procedure that identifies and classi-

fies GAAP definitions for a much larger sample. In constructing the sample,

we aim at approximating the population of credit agreements issued over

the 1994–2012 period, provided that they are disclosed in companies’ fil-

ings available on the Web site of the Securities and Exchange Commission

(SEC) and explicitly mention the terms “GAAP” and “financial covenants.”

This procedure generates a sample of 16,655 credit agreements issued by

publicly listed U.S. firms for which we observe the contractual treatment of

GAAP changes. We use this sample to document and explore the revealed

preferences of the contracting parties with respect to GAAP changes.

The mission of the Financial Accounting Standards Board (FASB) is to

“keep standards current to reflect changes in methods of doing business

and changes in the economic environment” and to “consider promptly

any significant areas of deficiency in financial reporting that might be im-

proved through the standard setting process” (Reither [1997], p. 91; see

also FASB [2007]). These objectives imply that GAAP changes can play an

important contracting role by improving GAAP’s ability to portray changes

to the borrower’s economics. To the extent that standard setters react to in-

formation about the substance of economic transactions arriving after con-

tracts are in place when they develop new accounting rules, contracts writ-

ten on accounting information can benefit from including GAAP changes

in the determination of covenant compliance. For example, the informa-

tion arriving after contract initiation may be related to new types of eco-

nomic transactions or new models and methods of doing business that were