Financial Reporting Quality and the Choice of Monitoring Mechanisms in Debt Contracts: Evidence from Borrowing Base RestrictionsWorking Paper (2016)
Borrowing base restrictions are common debt contractual features which limit the amount available to the borrower based on its working capital assets. The lender determines the availability of credit to the borrower based on the success of borrowing base assets. Identifying the unique setting of borrowing base restrictions, I examine whether financial reporting quality affects the choice of monitoring mechanisms that lenders use in debt contracts. I find that borrowers with low quality financial statements are more likely to access borrowing base lines of credit, as they face high adverse selection costs in non-borrowing base lines of credit. Accordingly, I show that the effect of financial reporting quality on the cost of debt is diminished in borrowing base lines of credit as compared to non-borrowing base lines of credit. These results are robust to several financial reporting quality measures such as accrual model based proxies, internal control weakness disclosures and big auditors. Moreover, based on the narrative length of borrowing base restrictions specifically written on eligible accounts receivables in loan contracts, I construct a borrowing base restrictiveness measure and find that the effect of financial reporting quality on the cost of debt is decreasing with the restrictiveness, supporting the substitution effect between contractual monitoring mechanisms and borrower’s financial reporting quality.
- Debt Contracts,
- Accounting Quality
Publication DateJanuary 5, 2016
Citation InformationSunay Mutlu. "Financial Reporting Quality and the Choice of Monitoring Mechanisms in Debt Contracts: Evidence from Borrowing Base Restrictions" Working Paper (2016)
Available at: http://works.bepress.com/sunay-mutlu/4/