A Theory of Covenant Accounting Adjustment

TL;DR

This paper presents a model of covenant accounting adjustments, analyzing how errors are corrected and their effects on control rights and effort, with implications for policy and empirical testing.

Contribution

It introduces a novel incomplete-contracting model for covenant adjustments, highlighting error correction properties and managerial effort implications.

Findings

Adjustments always correct false-alarm errors.

Undue-optimism errors are corrected only when small.

Managers may exert wasteful effort to identify errors.

Abstract

We develop an incomplete-contracting model with accounting-based covenants to study how covenant accounting adjustments are made and what properties they exhibit. Standard accounting rules (e.g., GAAP) can generate false-alarm errors or undue-optimism errors. The manager can exert costly effort to privately identify these errors and propose adjustments. If errors are not corrected, control rights may be inefficiently allocated, leading to costly renegotiation. We show that (1) adjustments always correct false-alarm errors, but correct undue-optimism errors only when their magnitude is small; and (2) the manager may expend socially wasteful effort to identify these errors. The model yields testable empirical predictions and policy implications.