The Role of Financial Reporting in Debt Contracting and in Stewardship

In this review, I discuss how accounting numbers are used in contracts aimed at mitigating agency problems between shareholders and managers and between shareholders and debtholders. I highlight the reasons why accounting numbers are widely employed in these contracts, even though share prices provide more timely information on firm performance. Audited financial reports are shown to be important for effective board monitoring, as they enable senior executives to convey information to non-executive directors in a timely, but credible, manner. Debt contracts rely on accounting numbers to mitigate asymmetric information problems at inception of contracts as well as for subsequent monitoring. I then discuss the role of accounting conservatism and fair-value accounting in contracting and conclude that the current shift in standard-setters' emphasis from financial reports providing verifiable backward-looking data to providing more valuation-relevant fair-value estimates is likely to lower the explicit use of accounting numbers in contracting