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In Rememberance: World Trade Center (WTC)

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Accounting Quality and Debt Contracting

by Sreedhar T. Bharath of the University of Michigan,
Jayanthi Sunder of Northwestern University, and
Shyam V. Sunder of Northwestern University

July 2004

Abstract: We study the impact of accounting quality on financial contracting by examining the price and non-price features of loan contracts at the time of loan origination. Borrower accounting quality, measured using standard models of unsigned abnormal accruals, has a significant economic impact on the loan contract terms. Lower accounting quality borrowers face substantially higher loan spreads (17 to 23 percent higher than the average interest cost). Simultaneously, lower accounting quality borrowers also face stricter non-price contract terms for loan maturity (6 percent lower) and collateral (11 percent higher probability). Loan transaction costs are significantly higher for lower accounting quality borrowers with higher upfront fees (16 to 37 percent higher) and higher annual fees (50 percent higher) for the lowest accounting quality borrowers. The results remain robust after controlling for a variety of known proxies for loan default risk and alternative econometric specifications. Additional tests show that loan terms exhibit a "U-shaped" pattern with respect to signed abnormal accruals, with firms having high positive or negative abnormal accruals facing the most stringent loan terms. We hypothesize that poor accounting quality reflects limited information about the borrowers' future operating cash flows. We find that this limited information risk is priced by the bank incremental to other known sources of credit risk. Our study provides unique evidence on how accounting quality influences the design of financial contracts and affects the cost of capital.

JEL Classification: M4, G32.

Keywords: Accounting Quality, Debt Contracts, Loan Spreads, Maturity, Collateral.

Published in: The Accounting Review, Vol. 83, No. 1, (January 2008), pp. 1-28.

Previously titled: Do Sophisticated Investors Understand Accounting Quality? Evidence from Bank Loans

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