Accounting Conservatism and the Efficiency of Debt Contracts

In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1997] descriptio...

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Bibliographic Details
Published in:Journal of accounting research 2009-06, Vol.47 (3), p.767-797
Main Authors: GIGLER, FRANK, KANODIA, CHANDRA, SAPRA, HARESH, VENUGOPALAN, RAGHU
Format: Article
Language:English
Subjects:
Accounting
Accounting reports
Accounting research
Cash flow
Conservatism
Corporate debt
Corporate finance
Debt
Debt contracts
Debt management
Efficiency
Efficiency metrics
False alarms
Financial accounting
Hypotheses
Information content
Interest rates
Residual claimant theory of wages
Studies
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Summary:In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1997] description of differential verifiability standards. Optimal debt covenants and interest rates on debt are derived from a natural tension between debt holders and equity claimants. We show how optimal covenants vary with the degree of conservatism and derive an efficiency metric that depends on the degree of conservatism. We find that accounting conservatism actually decreases the efficiency of debt contracts, contrary to the suggestions of Watts [2003] and contrary to the hypothesis in numerous empirical studies.
ISSN:0021-8456
1475-679X
DOI:10.1111/j.1475-679X.2009.00336.x