Abstract:

This paper investigates negotiated accounting measurement rules in debt contracts to show how contracting variables are chosen from financial statements to increase contracting efficiency. I predict and document in a large sample of bank loan contracts that debt contracts are not written on comprehensive income, though accumulated other comprehensive income is useful for measuring net assets for debt contracts, and that one principal difference between contractual and GAAP definitions of net income is to exclude transitory components. Cross-sectionally, I find that the likelihood of defining net income differently from the GAAP definition increases with the maturity of the debt and decreases with the contracting usefulness of transitory components. Collectively, the evidence shows that debt contracting parties choose contracting variables from financial statements in a manner consistent with efficient contracting, and that transitory components of earnings are less useful for debt contracting.