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Negotiated Measurement Rules in Debt Contracts

Authors


  • This paper is based on my dissertation at University of Chicago. I am grateful to my committee members, Ray Ball (chair), Christian Leuz, Haresh Sapra, and Douglas Skinner, for their encouragement and guidance. I thank the editor, an anonymous referee, Joy Begley, Philip Berger, Feng Gao, Pingyang Gao, Yu Gao, Cristi Gleason (the discussant), Andrei Kovrijnykh, Pepa Kraft, Lakshmanan Shivakumar, Leonard Soffer, Amir Sufi, Irem Tuna, Zheng Wang, Regina Wittenberg-Moerman, Jerold Zimmerman, and participants of the 2010 FARS meeting and the accounting workshops at CEIBS, Chicago, CMU, Emory, Georgetown, Houston, LBS, NYU, Purdue, Rochester, SMU, Toronto, and UBC for helpful suggestions and comments. I am thankful to Greg Nini, David Smith, and Amir Sufi for providing the contract data. I acknowledge able research assistance by Xin Li. I thank the University of Chicago Booth School of Business and the London Business School RAMD Fund for financial support. All errors are my own.

ABSTRACT

This paper investigates contractual definitions of net income and net worth and the cross-sectional variation in definitions of net income in a large sample of private debt contracts to shed light on the debt contracting demand for accounting numbers. The descriptive evidence indicates that removing transitory earnings is one principal concern in the measurement of earnings but not in the measurement of net worth. In the extreme, contracts are never written on comprehensive income as an earnings concept, whereas accumulated other comprehensive income is included in net worth in most contracts. In contrast, conservative adjustment, in the sense of including certain types of negative earnings but not the corresponding positive earnings, does not seem to be a primary consideration in measuring net income and net worth. Cross-sectionally, I find that net income is more likely to be defined differently from the GAAP when net income plays a more important role in a contract, when the loan maturity is longer, and when transitory earnings are less useful for debt contracting. Collectively, the evidence shows that debt contracting parties choose contracting variables in a manner consistent with efficient contracting, and that transitory earnings are relatively less useful in measuring firm performance for debt contracting.

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