Accounting Bias and Debt Contracting

Tong Lu, Ziyun Yang and Lanyi Yan Zhang

European Accounting Review, 2025, vol. 34, issue 1, 367-395

Abstract: This study investigates the effects of accounting bias on the efficiency of a debt-financed investment, which is subject to an interim liquidation/continuation decision based on the accounting report. We decompose the overall effect of accounting bias into a mean effect and a variance effect and transform binary state and report spaces into continuous ones. We derive two main results. (1) The highest investment efficiency is induced by a downward bias for gloomy investment prospects and an upward bias for rosy investment prospects. (2) The optimal covenant tightness is U-shaped and the optimal interest rate is hump-shaped in the degree of bias. In particular, neutral (unbiased) accounting neither minimizes the variance of the report nor maximizes investment efficiency.

Date: 2025
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DOI: 10.1080/09638180.2023.2248620

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