Lenders are concerned about narrowing down their risk and maximizing the probability that principal and interest will be paid. Debt contracts between debtors and creditors can help accomplish this.
Many of these contracts enforce constraints on the behavior of borrowers. For instance, some contracts limit the total sum of debt a borrower can incur. In such cases, measurement of the borrower’s debt is based on the liabilities reported in the balance sheet. As another instance, some debt contracts limit the cash dividends a borrower can distribute. This restriction is defined in terms of retained earnings, an element of owners’ equity that appears on the balance sheet.
Various penalties are in existence for violating debt contracts. These include
1. Increase in the rate of interest
2. An increase in collateral
3. A single time renegotiation fee, and
4. Quickening in the maturity date.
As these debt contracts are defined in terms of financial statement numbers, the use of accounting principles that increase reported net income can lessen the chances of contract violation. Accordingly, the possibility of violating debt contracts is another influence on managers’ accounting policy selections.