Ebook Debt Covenants and Accounting Conservatism: Complements or Substitutes?
I examine whether firms with more covenants in their public debt contracts recognize economic losses in earnings in a more timely fashion. Covenants are designed to limit a manager’s ability to take actions leading to bondholder wealth expropriation when a firm approaches financial distress. In particular, covenants are designed to protect bondholders from management opportunistically making unwarranted distributions to shareholders or non-optimal investments (Jensen and Meckling, 1976, Myers, 1977, Smith and Warner, 1979).
However, because covenants typically become binding when accounting performance deteriorates below a pre-specified threshold, they protect bondholders only to the extent that a manager’s discretion to postpone the recognition of economic losses in earnings is limited.
The literature recognizes that accounting information is useful in contracting and that the demands of contracting parties shape its properties (Watts and Zimmerman, 1986). Specifically, debt contracting creates demand for timely loss recognition, an important property of accounting information also referred to as conditional conservatism (Watts, 2003a, Holthausen and Watts, 2001, Ball, Robin, and Sadka, 2005). It is more difficult for outsiders to monitor and control a manager’s actions in firms that rely on public rather than private debt. As a result, the conflicts of interest between bondholders and management are more severe for public firms. To mitigate the presence of such conflicts, that is, to limit managerial ability to expropriate bondholder wealth, policies adopted by the accounting system recognize economic losses in earnings more promptly (Ball, Kothari, and Robin, 2000, Ball and Shivakumar, 2005).
While the general mechanism through which debt contracting affects accounting information is well understood, relatively little research exists on how the microeconomic foundations of debt contracting influence the properties of accounting information (e.g., Sloan, 2001, Guay and Verrecchia, 2006). In this paper I focus on the role of timely loss recognition in debt contracts, and more specifically on the direct link between debt covenants and the degree of conditional conservatism in annual reports (Guay and Verrecchia, 2006). Following Basu (1997), I measure timely loss recognition via a piecewise linear regression of earnings on positivereturns (as a proxy for good news) and negative returns (as a proxy for bad news).
Two opposing views on how the demand for timely loss recognition is resolved in practice exist in the literature. The first view maintains that the timely recognition of losses facilitates the early transfer of decision rights from shareholders to bondholders as a firm approaches financial difficulties and thus reduces the likelihood of bondholder wealth expropriation (Watts, 2003a, Ball and Shivakumar, 2005, Ball, Robin, and Sadka, 2005). This view is also consistent with Levine and Hughes (2005), who argue that covenants are more valuable when losses are recognized in a timely manner because this allows for more effective bonding against ex post sub-optimal actions.
Conservative recognition of news induces early truth-telling about future cash flows and allows a company with lower default risk to signal its type. Without timely accounting signals about a firm’s economic health, the efficiency of protective covenants in curbing the agency costs of debt is lower, i.e., timely loss recognition complements and reinforces the effectiveness of covenants. As a result, debtholders wishing to reduce the potential for losses include covenants in contracts and insist on more conservative recognition of economic losses in debtor’s accounts. This implies that covenants and accounting conservatism should be positively associated.
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