Christensen, Nikolaev & Wittenberg-Moerman
Title
Accounting Information in Financial Contracting: The Incomplete Contract Theory
Perspective.
Focus areas
How the two theories are combined: the frst part of the article.
Purpose
Discuss how the use of accounting information in contracts enhances contracting
efciency.
Theory
Positive accounting theory / agency perspective (Watts, 1977; Watts &
Zimmerman, 1978/1981; Holtausen, 1981) = the use of accounting information enhances
the efciency of contracting by minimining contracting costs. Contracting costs can be
interpreted as the agency costs associated with outside fnancing (either equity or debt).
In the context of debt fnancing, agency costs arise because frm managers that act on
behalf of shareholders take inefcient actions that expropriate wealth from frm creditors.
This includes:
- Asset substitution = increasing the riskiness of the frm.
- Claim dilution = diluting the value of existing debt claims.
- Debt overhang = failing to take advantage of proftable investment
opportunities.
Such behavior reduces contract efciency and gives the contracting parties incentives to
ex ante limit or provide incentives against opportunistic actions. This can be done by
including covenants that restrict certain actions by frm management or ensuring
sufcient alignment of interests between the frmss debt holders and shareholders. Such
covenants limit dividend payouts, capital expenditures, asset sales or the issuance of
additional debt. They are often contingent on accounting information. From the agency
perspective, the contract efciency role of accounting information is its ability to limit or
disincentivine opportunistic behavior.
Incomplete contract theory (Coase, 1937) = contracts are inherently incomplete
because the contracting parties cannot anticipate or explicitly describe all future states of
the world. This leads to post contractual opportunism and hold-up problems that
adversely affect the incentives of the contracting parties to enter contracts. There will
inevitably be contract renegotiations in which one of the parties can behave
opportunistically. For example, borrowers may use asset substitution as a threat. The
mechanism that alleviates hold-ups is the ex ante allocation of decision power or
control rights. Control rights determine the status quo in future renegotiations and
hence affect the division of the surplus between contracting parties. Control should be
given to the party whose decisions will contribute more to the joint surplus (the value
created by entering the contract), the contract party that has incentives to make value-
maximining decisions. The optimal allocation of control rights is contingent on a
contractible signal that refects the underlying economics of the borrower. The accounting
system produces summary measures of frm performance, thus accounting signals
become primary candidates for governing the state-contingent allocation of control
rights. From the incomplete contracting perspective, the contract efciency role of
accounting information is enhancing the state-contingent allocation of control rights.
Research method
The authors draw on existing theory and empirical work to advance their understanding
of the efciency role of accounting information in debt contracting. The paper is thus a
review. It argues that literature has made much progress in supporting the notion that
accounting improves debt contract efciency. However, less progress is made in
understanding the mechanisms through which the efciency gains are realined. The
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Title
Accounting Information in Financial Contracting: The Incomplete Contract Theory
Perspective.
Focus areas
How the two theories are combined: the frst part of the article.
Purpose
Discuss how the use of accounting information in contracts enhances contracting
efciency.
Theory
Positive accounting theory / agency perspective (Watts, 1977; Watts &
Zimmerman, 1978/1981; Holtausen, 1981) = the use of accounting information enhances
the efciency of contracting by minimining contracting costs. Contracting costs can be
interpreted as the agency costs associated with outside fnancing (either equity or debt).
In the context of debt fnancing, agency costs arise because frm managers that act on
behalf of shareholders take inefcient actions that expropriate wealth from frm creditors.
This includes:
- Asset substitution = increasing the riskiness of the frm.
- Claim dilution = diluting the value of existing debt claims.
- Debt overhang = failing to take advantage of proftable investment
opportunities.
Such behavior reduces contract efciency and gives the contracting parties incentives to
ex ante limit or provide incentives against opportunistic actions. This can be done by
including covenants that restrict certain actions by frm management or ensuring
sufcient alignment of interests between the frmss debt holders and shareholders. Such
covenants limit dividend payouts, capital expenditures, asset sales or the issuance of
additional debt. They are often contingent on accounting information. From the agency
perspective, the contract efciency role of accounting information is its ability to limit or
disincentivine opportunistic behavior.
Incomplete contract theory (Coase, 1937) = contracts are inherently incomplete
because the contracting parties cannot anticipate or explicitly describe all future states of
the world. This leads to post contractual opportunism and hold-up problems that
adversely affect the incentives of the contracting parties to enter contracts. There will
inevitably be contract renegotiations in which one of the parties can behave
opportunistically. For example, borrowers may use asset substitution as a threat. The
mechanism that alleviates hold-ups is the ex ante allocation of decision power or
control rights. Control rights determine the status quo in future renegotiations and
hence affect the division of the surplus between contracting parties. Control should be
given to the party whose decisions will contribute more to the joint surplus (the value
created by entering the contract), the contract party that has incentives to make value-
maximining decisions. The optimal allocation of control rights is contingent on a
contractible signal that refects the underlying economics of the borrower. The accounting
system produces summary measures of frm performance, thus accounting signals
become primary candidates for governing the state-contingent allocation of control
rights. From the incomplete contracting perspective, the contract efciency role of
accounting information is enhancing the state-contingent allocation of control rights.
Research method
The authors draw on existing theory and empirical work to advance their understanding
of the efciency role of accounting information in debt contracting. The paper is thus a
review. It argues that literature has made much progress in supporting the notion that
accounting improves debt contract efciency. However, less progress is made in
understanding the mechanisms through which the efciency gains are realined. The
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