Review of Accounting Studies

, Volume 1, Issue 3, pp 225–258 | Cite as

Financial contracts, opportunism, and disclosure management

  • Sri S. Sridhar
  • Robert P. Magee
Article

Abstract

This article shows that if all variables that determine a firm's future cash flows are not contractible, it can be ex ante optimal to design a financial contract that admits debtholders waiving debt covenants on a discretionary basis and firms investing opportunistically subsequent to contracting. Further, as the contractible variable becomes less informative, the contract attaches greater significance to it. Finally, uncertainty in the magnitude of reporting latitude induces aggressive reporting by the firm to avoid violating the covenant or to enhance the chances of a waiver. The debtholders respond by sometimes not allowing the firm to implement mutually beneficial projects.

Keywords

Cash Flow Future Cash Flow Debt Covenant Financial Contract Discretionary Basis 

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Copyright information

© Kluwer Academic Publishers 1997

Authors and Affiliations

  • Sri S. Sridhar
    • 1
  • Robert P. Magee
    • 2
  1. 1.Kellogg Graduate School of ManagementNorthwestern UniversityEvanstonUSA
  2. 2.Kellogg Graduate School of ManagementNorthwestern UniversityEvanstonUSA

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