The Debt-Contracting Value of Accounting Numbers and Financial Covenant Renegotiation

Building on incomplete contract theory, I investigate whether the likelihood of renegotiating financial covenants is affected by the debt-contracting value of borrowers’ accounting numbers. The debt-contracting value captures the inherent ability of accounting numbers to predict credit quality. Using a large sample of private credit agreements, I hypothesize and find that a higher debt-contracting value gives rise to smaller ex post measurement errors in accounting numbers used in covenants, and thus borrowers and lenders are less likely to renegotiate financial covenants. This effect is stronger when the financial covenant intensity is higher. Consistent with the notion that renegotiation improves contracting efficiency by eliminating errors in financial covenants, I show that the distance of the covenant variable to its new contractual threshold better predicts a borrower’s creditworthiness than does the distance to the original threshold absent the renegotiation. This paper was accepted by Shiva Rajgopal, accounting.