The contracting benefits of accounting conservatism to lenders and borrowers

Abstract

In this paper, I examine the ex post and ex ante benefits of conservatism to lenders and borrowers in the debt contracting process. First, I argue that conservatism benefits lenders ex post through a timely signal of default risk in the form of accelerated covenant violations by more conservative borrowers. I present evidence that the likelihood of a covenant violation following a negative shock increases in borrower conservatism. Second, I argue that conservatism benefits borrowers ex ante through lower initial interest rates. I provide both insample and out-of-sample evidence that lenders offer lower interest rates to more conservative borrowers. The result is robust to controlling for a series of other earnings attributes. AcknowledgementI am deeply indebted to S.P. Kothari, chair of my thesis committee, for his guidance, advice, and encouragement. S.P. is the best mentor one can ever hope for, and his influence goes far beyond research. He spent his valuable time reading and revising numerous drafts of this paper. I attribute my achievements so far mostly to him.I am grateful to Joseph Weber, member of my thesis committee, for supervising me closely and responsibly. Joe played a critical role in the idea formation process and in the idea implementation. He is good at dealing with both the big question and the nitty-gritty detail of each empirical step. I have had the pleasure to work under his supervision and also to work with him on other projects.I am thankful to Peter Wysocki, member of my thesis committee, for teaching me how to think broadly. Every comment from Peter is insightful. He taught me how to think beyond the physical paper so as not to confine myself to a small niche. Peter communicates his points in such a concise yet clear way, and his comments and suggestions improved this paper greatly. I wish I could articulate as well as he does.I also want to thank other faculty members, Jennifer Altamuro, Richard Frankel, Peter Joos, George Plesko, and Sugata Roychowdhury, for helpful comments and inspiring discussions.My two years in the Ph.D. program at Kellogg provided me with solid training in economics and econometrics. I was lucky that I was first exposed to accounting research in the seminars taught by Ronald Dye, Robert Magee, Sri Sridharan, and Beverly Walther.I receive a lot of valuable comments from the workshop participants at Boston University, Georgetown University, Southern Methodist University, University of British Columbia, University of Minnesota, University of Pennsylvania, and University of Southern California. I am grateful that the professors at these universities thought enough of me to give me the opportunity to interview to be a potential colleague. M]Iy fellow students are an important part of the whole process of getting a Ph.D. We share the joy and the pain. We also share the limited office space that makes us close to each other. I want to thank Gloria (Xiaohui) Liu and Daniel Cohen, who graduated from Northwestern last year; they were there with me in the first t...

The role of information and financial reporting in corporate governance and debt contracting

“…Both papers suggest the extent of debt in the firm's capital structure drives decisions to report conservatively. Zhang (2008) finds that firms that report conservatively are more likely to violate covenants after experiencing negative news.…”

“…Ahmed et al measure conservatism using adjusted measures of bookto-market and accruals and find that firms that report more conservatively have better credit ratings. As Zhang (2008) discusses, this paper is an important first step in the evolution of the research on the relationship between attributes of the accounting system and the cost of debt. She also discusses its limitations, such as the potential endogeneity between other firm characteristics, the cost of debt, and the extent to which firms provide higher quality financial reports.…”

“…Establishing which of these factors increases the importance of accounting information will help us better understand why accounting information is important in the debt markets. Zhang (2008) investigates the relationship between the extent to which firms report conservatively and the interest rate spread charged on the loan and finds that firms that report more conservatively are able to negotiate lower interest rates. Beatty, Ramesh, and Weber (2002) examine the relationship between interest rates and firms' flexibility to make accounting changes and finds that firms that are afforded the flexibility to make accounting changes are charged a premium in their cost of debt.…”

Implications for GAAP from an analysis of positive research in accounting

“…It is precisely under these circumstances that debt holders wish to be informed about bad news as early as possible so that they can determine whether to restrict shareholders' opportunistic risk-taking through greater oversight and debt covenants. This is the role of conditional conservatism, which provides debt holders with the ability to intervene in circumstances when firm value would otherwise be reduced (see Watts, 2003a;Zhang, 2008).…”

IFRS – 10 years later

“…An extensive and long-standing literature holds that this asymmetry in accounting is due in large part to the use of financial statement information in debt contracting, and also to its use in firms contracting with managers. The literature includes Leftwich (1983), Watts and Zimmerman (1986), Ball et al (2000a), , Holthausen and Watts (2001), Ahmed et al (2002), Watts (2003a,b), Shivakumar (2005, 2006), Beatty et al (2008), Wittenberg-Moerman (2008), Zhang (2008), and Aier et al (2014).…”