State Contract Law and the Use of Accounting Information in Debt Contracts

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 ex ante resolve debtholder-shareholder conflicts, whereas income statement based covenants serve as trip wires that trigger the switch of control rights ex post. Importantly, 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. The authors therefore test and find evidence that lenders using pro-debtor (pro-lender) law are more (less) likely to rely on balance sheet based covenants. They measure reliance using both the weight of balance sheet covenants relative to income statement covenants and the covenant strictness. Their analysis also 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.