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State contract law and the use of accounting information in debt contracts

Colleen Honigsberg (), Sharon P. Katz, Sunay Mutlu and Gil Sadka
Additional contact information
Colleen Honigsberg: Stanford Law School
Sharon P. Katz: INSEAD
Sunay Mutlu: Kennesaw State University
Gil Sadka: University of Texas at Dallas

Review of Accounting Studies, 2021, vol. 26, issue 1, No 5, 124-171

Abstract: Abstract This paper examines the relation 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, whereas income statement based covenants serve as trip- wires that trigger the switch of control rights ex post. It is more difficult for lenders to exert their control rights ex post if the contract law is more favorable to debtors (i.e., the law is pro-debtor), suggesting that balance sheet based covenants are more efficient in these jurisdictions. We therefore test and find evidence that lenders using pro-debtor (pro-lender) law are more (less) likely to rely on balance sheet based covenants. We measure reliance using both the weight of balance sheet covenants relative to income statement covenants and the covenant strictness. Our analysis further shows that contracts with performance pricing grids are less likely to include interest increasing grids when the law is more favorable to debtors. The results provide initial evidence that contract law is an important determinant for the design of debt contracts.

Keywords: Contract law; Debt contracts; Income statement based covenants; Balance sheet based covenants; Pricing grids (search for similar items in EconPapers)
JEL-codes: G21 G30 K12 M41 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1007/s11142-020-09559-4

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