Debt Financing and Accounting Conservatism in Private Firms

• Published in: Contemporary accounting research 2014-12, Vol.31 (4), p.1220-1259
• Main Authors: Haw, In-Mu, Lee, Jay Junghun, Lee, Woo-Jong
• Format: Article
• Language: English
• Subjects: Accounting; Conservatism; Debt; Debt financing; Deficit financing; Financial reporting; Loss recognition; Private enterprise; Stockholders
• ISSN: 0823-9150; 1911-3846
• DOI: 10.1111/1911-3846.12064

Conservative accounting is thought to improve contracting efficiency in debt markets by mitigating conflicting interests between lenders and borrowers (Holthausen and Watts 2001; Watts 2003). Specifically, timely loss recognition induced by conservative accounting provides an early signal on declines in debt value and facilitates timely transfer of control rights from shareholders to debtholders (Ball and Shivakumar 2006; Nikolaev 2010). Consistent with this view, prior accounting studies document a significant association between accounting conservatism and level of debt (Ball and Shivakumar 2005; Khan and Watts 2009), issuance of new debt (Nikolaev 2010; Basu et al. 2011), cost of debt (Ahmed et al. 2002; Zhang 2008), and nonpricing terms of debt contracts (Ball et al. 2008a; Nikolaev 2010; Li 2010). However, these studies treat all debt as uniform or focus on conservative accounting in publicly held companies; they pay little attention to the impact of public debt financing on the conservative accounting of privately held companies, which predominate in all economies.1 To fill this void, this study examines the hitherto unexplored questions of (1) how accounting conservatism in private firms is associated with their issuance of public debt and (2) how agency conflicts between bondholders and shareholders affect the relation between public debt financing and conservative accounting in private firms. We consider private firms with high information asymmetry and high credit risk to have more severe agency problems with bondholders.