A Theory of Covenant Accounting Adjustment

2026-04-16

AI Summary

This study addresses how standard accounting rules, such as GAAP, can induce misreporting or excessive optimism in debt contracts, leading to inefficient control allocations and costly renegotiations. The authors develop a model integrating incomplete contracting theory and game theory to examine how managers endogenously identify and propose corrections to accounting errors to enhance contractual efficiency. The analysis reveals that contract adjustments always correct misreporting errors but only rectify excessive optimism when the bias is sufficiently small. Moreover, managers may exert socially inefficient effort in this process. The model elucidates the interaction between accounting information and contract design, generating testable empirical predictions and policy implications.

Technology Category

• Game Theory and Economic Paradigms: Imperfect Information
• Multiagent Systems: Mechanism Design
• Cognitive Modeling & Cognitive Systems: Social Cognition And Interaction

Application Category

• Economics, Online Markets and Human Computation: Incentives in network design for Web infrastructures and ecosystems
• User Modeling, Personalization and Recommendation: Accountability, Transparency, and Ethics for personalization
• Security and Privacy: Tracking, profiling, and countermeasures against them

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.

Problem

• covenant accounting adjustment
• incomplete contracting
• accounting errors
• control rights allocation
• GAAP

Innovation

• incomplete contracting
• accounting-based covenants
• covenant adjustments
• false-alarm errors
• undue-optimism errors