In this paper we examine whether accounting conservatism facilitates or detracts from the efficiency of debt contracting. We consider both “unconditional” and “conditional” conservatism as discussed in the literature. In both cases, our analysis does not support the positive relationship between accounting conservatism and the efficiency of debt contracting, as suggested by Watts [2003], and as hypothesized in numerous empirical studies. In fact, we find the opposite can be true. Under very plausible conditions, we find that accounting conservatism, that affects the information content of accounting reports, actually decreases the efficiency of debt contracts.
Our notion of efficiency is derived endogenously from the joint optimality of the debt covenant and the corresponding interest rate on debt, but differs from the usual efficiency notion assumed in empirical studies. We also develop and use a statistical characterization of conservatism that is new in the literature but which, we believe, is consistent with the widely accepted definition of accounting conservatism originally proposed by Basu [1997].
The argument in favor of conservatism, as enunciated by Watts [2003] and Ball, Robin, and Sadka [2008] is as follows. Conservative accounting principles anticipate potential decreases in income or assets well before they are realized, but postpone the recognition of income or asset increasing events until they are sufficiently locked in. Thus, conservatism results in timely loss recognition at the expense of timely gain recognition. Given the asymmetric payoff to debt holders, timely loss recognition is of much greater importance to them than timely gain recognition. Timely loss recognition results in earlier violation of debt covenants, allowing debt holders to more quickly exercise their contractual rights and restrict the actions of managers. Hence, accounting conservatism enhances the efficiency of debt contracts.
Though the above argument is intuitively appealing, there are at least three components that have not been fully explored. These components are essential to understanding the relationship between accounting conservatism and the efficiency of debt contracting: First, conservative measurement principles not only increase thefrequency of low accounting reports, but also change the information content of such reports. Second, optimal debt covenants will change with the degree of conservatism in accounting reports. Third, the interest rate on debt is not a measure of efficiency. The appropriate notion of efficiency is determined by the same economic tradeoffs that drive the optimality of the debt covenant. We elaborate on each of these elements below.
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