Debt Contracts in the Presence of Performance Manipulation∗

Empirical and survey evidence suggests that firms often manipulate reported numbers to avoid debt covenant violations. The theoretical literature on debt contracting, by and large, has ignored the borrower ability to manipulate financial reports. Building upon a standard debt financing setting with continuation decisions based on reported signals, we study the effect of the borrower’s ability to manipulate his report on the design of debt contracts and the resulting investment continuation and manipulation decisions. The model generates an array of novel empirical predictions regarding the covenant, the interest rate (face value), the efficiency of the continuation/liquidation decisions, and the likelihood of covenant violations. For example, the model predicts that firms with stronger corporate governance may set tighter covenants and, as a result, violate their covenants more often. It also shows that firms with stronger governance may face higher interest rates. We should expect covenants to be more prevalent in environments in which the cost of manipulation is relatively high and the firm’s private information is more precise.