Abstract Many accounting research studies address the importance of financial statement numbers in debt contracts. Because corporate lending contracts often contain covenants that use numbers from the borrowers' financial statements, researchers concluded that voluntary and mandatory accounting method changes have economic consequences for borrowing firms and lenders. This article describes the risks involved for both lenders and borrowers when they negotiate lending contracts containing covenants based on financial statement numbers. Lending contracts that specify accounting methods (fixed GAAP contracts) can minimize such risk. A sample ot 228 lending agreements contained 174 covenants using financial statement numbers. Contrary to results presented in prior studies, 90 of the 174 sample contracts containing financial statement covenants specify accounting methods. Only 84 of the contracts contain accounting-based covenants for which the accounting methods are not specified. Further, contracts with more financial statement covenants are more likely to contain provisions specifying accounting methods, and that the use of such provisions is increasing over time.
Mary Beth Mohrman (Sun,) studied this question.