In this study, I examine whether the use of conservative accounting reporting mitigates the adverse consequences of covenant violations, such as restrictions on borrowing firms’ financing and investing activities. I also examine the implications of accounting conservatism, which can trigger quicker covenant violations (Zhang, 2008) and allow transfer of decision rights to lenders, for violating firms’ operating performance in the post-violation period. Accounting information has been extensively used in debt contracts (Leftwich, 1983; Dichev and Skinner, 2002) and the characteristics of accounting information have important implications for debt contracting. Particularly, Watts (2003a, b) argues that one of the accounting characteristics, conservatism, can enhance contracting efficiency because reporting conservatism can ensure lenders the minimum level of asset values at liquidations and thereby reduces lenders’ downside risk.
Consistent with Watts’ assertion, recent literature documents that conservatism is associated with a lower cost of debt (Ahmed et al., 2002; Zhang, 2008). However, the role of accounting conservatism in debt contracting is still being debated. The main divergence of opinion lies in deciding whether accounting conservatism, triggering quicker covenant violations, causes borrowers to abandon positive net present value projects (Gigler et al, 2009), or causes transfer of decision rights to lenders, leading to better monitoring of borrowers’ operating decision. My study attempts to offer some insight into this contentious issue by providing evidence on whether accounting conservatism mitigates or exacerbates the adverse effects of covenant violations. Specifically, I examine whether the use of conservative accounting policies by borrowing firms is associated with smaller reductions in investing and financing activities and consequently better operating performance in the post-violation period.
Following Basu (1997), I define conservatism as the practice of imposing a higher degree of verification requirement for recognizing good news in earnings as compared to bad news. Thereby, this form of conservatism, referred to as conditional conservatism (Beaver and Ryan, 2005), is likely to trigger rapid covenant violations (Zhang, 2008). The other form of conservatism, namely, unconditional conservatism, can also trigger quick covenant violations because assets are reported at lower than expected values, irrespective of the type of news. However, lenders can probably anticipate and incorporate this bias in their debt covenants, and I expect unconditional conservatism not to affect the probability and the speed of covenant violations. In this paper, I examine the implications of conditional conservatism for the consequences of covenant violations and in the rest of this paper I refer to “conditional conservatism” as “conservatism” or “accounting conservatism”.
Chava and Roberts (2008) and Roberts and Sufi (2009) argue and find that covenant violations exacerbate the conflict of interest between lenders and borrowers, leading to restrictions in firms’ financing and investing activities. In this paper, I argue that the adverse effects of covenant violations are mitigated if the violating firm uses conservative accounting policies. This occurs because accounting conservatism reduces information asymmetry between lenders and borrowers. For example, asset impairments provide information to the lenders about the borrowing firms’ expectations of future cash flows. In addition, timely recognition of losses, leading to quicker violations of covenants, also enables lenders to make an early assessment of the borrowing firms’ current and potential future losses. This allows lenders to better monitor the violating firms’ operating performance at an early stage through regular assessments as well as intervention in financial and investment decisions.
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Accounting Conservatism and the Consequences of Covenant Violations
