Leverage Influence on Accounting Policy Choices and Reporting Behavior

Abstract

This research investigates the underexplored nexus between corporate financial leverage
and the strategic selection of accounting policies, positing that leverage acts not merely as
a financial metric but as a primary institutional force shaping reporting behavior. Moving
beyond traditional agency and contracting cost frameworks, we introduce a novel ’LeverageInduced Reporting Pressure’ (LIRP) model that conceptualizes debt covenants and creditor
scrutiny as creating a distinct reporting environment characterized by asymmetric information pressures and outcome-dependent validation. The study employs a mixed-methodology
approach, combining a longitudinal analysis of accounting policy changes in highly leveraged firms from 1995 to 2004 with a series of experimental simulations involving financial
executives. Our findings reveal a non-linear relationship between leverage levels and accounting conservatism, with a critical threshold beyond which firms exhibit a pronounced shift
towards income-increasing and asset-valuing policies, contrary to the conservative bias predicted by debt covenant hypotheses. We identify a unique ’reporting elasticity’ phenomenon,
where the sensitivity of accounting choices to earnings targets intensifies disproportionately
with leverage. Furthermore, the research documents the emergence of ’covenant-proximate
reporting’, a strategic clustering of aggressive accounting estimates in periods immediately
preceding debt covenant tests. These results contribute a new theoretical lens for understanding financial reporting, suggesting that high leverage environments foster a calculative
culture where accounting policy becomes a direct tool for managing creditor perceptions and
covenant compliance, with significant implications for standard setters, auditors, and credit
analysts concerned with the quality and sustainability of reported earnings in debt-heavy
capital structures.