Financial reporting, debt contracting and valuation

An important insight from the current literature is that the quality of accounting information is determined by economic incentives provided to managers and not by accounting standards per se. In four related essays, I examine topics revolving around this idea. The first essay draws on the theoretical argument that the economic incentives of managers are such that when a firm approaches financial difficulties, bondholders need to be protected against wealth expropriation. One mechanism available to protect bondholders is to restrict management’s actions via a set of accounting-based covenants included in a debt contract. I demonstrate that these covenants are effective when a firm’s accounting practices recognize economic losses as accounting earnings in a timely fashion. From this, I conclude that debt covenants and timely loss recognition are complements rather than substitutes. In the next essay, I exploit the agency theory of overvalued equity to understand why some managers fail to recognize economic losses in financial statements. I use the insights from this theory to explain the “accrual anomaly”, i.e., the well-known empirical result that abnormal returns can be earned by trading based on the magnitude of accruals. I also show that “functional fixation” of investors, a competing hypothesis, is not consistent with the data. In the third essay, I investigate the role of transparency of financial reporting in reducing the cost of debt capital. Whereas extant work in the area has established the existence of an association between these two variables, I focus on establishing a causal link by exploiting both cross-sectional and time series variation in the transparency proxy. The final essay addresses a methodological issue. I argue that traditional cost of equity capital measures are subject to potentially severe measurement problems, which arise due to uncertainty about future expected returns.