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Accounting Bias and Debt Contracting

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  • Tong Lu
  • Ziyun Yang
  • Lanyi Yan Zhang

Abstract

This study investigates the effects of accounting bias on the efficiency of a debt-financed investment, which is subject to an interim liquidation/continuation decision based on the accounting report. We decompose the overall effect of accounting bias into a mean effect and a variance effect and transform binary state and report spaces into continuous ones. We derive two main results. (1) The highest investment efficiency is induced by a downward bias for gloomy investment prospects and an upward bias for rosy investment prospects. (2) The optimal covenant tightness is U-shaped and the optimal interest rate is hump-shaped in the degree of bias. In particular, neutral (unbiased) accounting neither minimizes the variance of the report nor maximizes investment efficiency.

Suggested Citation

  • Tong Lu & Ziyun Yang & Lanyi Yan Zhang, 2025. "Accounting Bias and Debt Contracting," European Accounting Review, Taylor & Francis Journals, vol. 34(1), pages 367-395, January.
    • Handle: RePEc:taf:euract:v:34:y:2025:i:1:p:367-395
    DOI: 10.1080/09638180.2023.2248620
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