The role of financial reporting in debt contracting and in stewardship

Abstract

In this paper, I review the role that financial accounting plays in contracts aimed at mitigating agency problems between shareholders and managers and between shareholders and debtholders. The paper discusses the reasons why and how financial accounting numbers are used in debt and stewardship contracting. It further considers the effects of conservatism and fair-value accounting on the relevance of financial reports for contracting. The paper provides some key takeaways from academic literature for accounting practice and regulation.

Keywords:

• financial reporting
• contracting
• stewardship
• debt covenants
• fair-value accounting
• conservatism

Acknowledgement

I am grateful for comments from Ray Ball, Jayaraman Sudarshan, an anonymous reviewer and Pauline Weetman (editor).

Notes

An alternative way to view this incentive is to realise that equity represents a call option on the firm's assets, and because option value increases with the volatility of the underlying asset, equity holders have an incentive to shift the firm's investments into high-risk projects, to the detriment of debtholders.

Since, as observed by Coase (1937), corporations can be viewed as a nexus of contracts designed to minimise contracting costs, almost all activities in a firm can be brought under the framework of contracting. For instance, the role of financial reporting for valuation can be seen as aiding an implicit contract between managers and investors to provide timely information for accurate valuation of the firm. Such a wide characterisation of contracting would essentially bring the entire academic literature in financial accounting under its purview. So to keep the task at hand to more manageable levels, I have relied on a narrower focus of contracting, namely that aimed at mitigating agency issues within a firm.

Even in discussions of agency problems between shareholders and debtholders, I focus only on studies that are based on the assumption that managers act in shareholders' interests.

Moir and Sudarsanam (2007) provide one explanation for this greater availability of data for US firms by pointing out that in the UK public debt information often does not include financial covenants, while private debt details are regarded by UK companies as extremely sensitive and so are kept confidential. In contrast, in the USA, many private debt contracts are required to be publicly filed.

Although Ball et al. (2012a) focus their arguments and analysis primarily on voluntary disclosures made to outside investors and capital market participants, their arguments apply equally to voluntary disclosures made to outside directors.

Compensating based on share prices runs the risks that managers may not be interested in actually delivering performance, because share prices reflect the effects of managerial plans on an anticipated basis, rather than reflecting the value created upon implementation of the manager's plans. This concern could be addressed by boards simply imposing vesting restrictions on share awards.

Shivakumar (2000) documents that, in a world with managerial discretion over accounting numbers, managers overstate earnings before announcing an equity offering, and subsequently, on the announcement of the equity offering, investors reverse the stock price effects of the earlier earnings management.

Examining a large sample of private loan agreements, Dichev and Skinner (2002) find that covenant violations are not only common, occurring in approximately 30% of loans, but also occur when borrowers are not in serious financial difficulty. Roberts and Sufi (2009b) record that almost 90% of the long-term private debt contracts they study are renegotiated prior to their maturity date. These renegotiations are often voluntary and are driven by accrual of new information concerning a borrower's credit quality and by greater availability of financing options for the borrower.

Consistent with lenders' expectations that managers will use accounting flexibility opportunistically, Beatty and Weber (2003) find that firms are more likely to make income-increasing changes when such changes affect contract calculations.

Roberts and Sufi (2009c) find that covenant violations lead to an increase in interest rates and a decrease in the availability of credit financing to a firm.

Ahmed et al. (2002) also report lower debt costs for more conservative borrowers. However, their measures of conservatism do not distinguish between unconditional conservatism and conditional conservatism, making it difficult to draw clear inferences on the benefits of conditional conservatism in debt contracting.

An example of such a contractual adjustment is income escalators, which systematically exclude a percentage of positive net income from net worth covenant calculations.

The alternative solution of discounting future anticipated gains and losses before recognising them in the income statement also suffers from reliability issues, as the relevant discount rates for such computations are highly subjective and would allow managers substantial discretion to manipulate the recognised gains and losses.

The self-selection bias arises when the unique characteristics of firms voluntarily adopting IFRS cause these firms to have lower interest rates, fewer restrictive covenants, etc., but these results are incorrectly attributed to IFRS adoption itself.

Like IFRS, the US GAAP is also oriented towards fair-value accounting.

This reversal argument assumes that firms are able and willing to hold the relevant assets until the reversals materialise.

The recent regulations loosening the fair-value standards in the absence of orderly markets address the concerns associated with liquidity effects.

IFRS 9 allows firms to designate a financial liability to be measured at fair value either if such designation significantly lowers accounting mismatch that might otherwise arise from recognising gains and losses on an asset and a liability differently, or if the liability is managed on a fair-value basis.

The solution to this problem is not for regulators to simply disallow fair-valuing of liabilities, as fair-valuing of assets alone could lead to significant accounting mismatch (both in the income statement and in the balance sheet) when an asset and liability are economically related, but do not satisfy the stringent rules needed for these items to be accounted as a hedge. Another alternative solution would be for debt covenants to explicitly require the use of face values for liabilities in computation of net worth and accounting ratios. However, this disallows borrowers from matching fair values of assets with those of hedged liabilities, but which do not qualify for hedge accounting.

Level 3 fair-value accounting refers to fair values that are those that are not directly linked to market or traded prices and require substantial judgement in the selection and application of valuation techniques and relevant inputs.