Treatment of Accounting Changes and Covenant Violation Errors

Abstract

ABSTRACTGAAP provisions in loan contracts specify how to address the effect of accounting changes on financial covenants. I document a pronounced upward trend in and the dominance of frozen‐on‐request (FOR) GAAP provisions, which incorporate accounting changes unless either the borrower or the lender requests a freeze. FOR GAAP streamlines the process of incorporating accounting changes into covenant calculations by obviating the need for renegotiations and prevents opportunistic GAAP freezes by requiring good faith renegotiations. Therefore, FOR GAAP is more likely to incorporate accounting changes beneficial to covenant informativeness, leading to lower false positives (i.e., Type I errors of financial covenant violations) and false negatives (i.e., Type II errors of financial covenant violations). Based on a large sample of loan contracts, I find that FOR GAAP decreases false positives and false negatives after controlling for self‐selection bias and that the decrease is more pronounced when accounting changes relevant to financial covenants are more significant. My study provides new evidence of the role accounting standards and GAAP provisions play in debt contracting efficiency.