use contracting theory and explain why firms ( i.e board of directors acting on shareholders' behalf) would prefer to allow a managers set of accounting policies ( e.g, GAAP) from which to choose, rate than to completely prescribed accounting policy choice so that managers have no flexibility to choose accounting policies. Use contracting theory to explain why managers may also prefer to have a choice of accounting policies.

2. Why do debt contracts typically impose covenants based on accounting information, such as working capital, interest coverage, and the debt-equity ratio? Are debt covenants completely credible as a way to give lenders trust that managers will not take opportunistic actions that reduce their security? Explain.