The economics of risk shifting (or asset substitution) has long been established in the finance literature. With limited liability, equityholders of a levered firm have incentives to increase the firmss risk once the debt is in place. Debtholders use covenants as the governance mechanism to protect their investments from various types of shareholder(debtholder agency conflicts.
For example, Smith & Warner (1979) discuss covenants as addressing four categories of conflicts dividend payment, claim dilution, asset substitution and underinvestment. This study investigates the impact of debt governance on the firmss risk taking behavior. We ask three questions: What is the relationship between debt governance and the firmss risk shifting behavior? What is the role of debt governance in mitigating the impact of managerial risk(taking incentives on the firm risk? What implication does our study have for the design of corporate governance?
The recent reform of America’s bankruptcy law favored the interests of creditors. In the two years since the reform, obtaining consumer bankruptcy relief has become more expensive, time consuming, and difficult. These legal changes were motivated by a perceived need to reduce the incentives and ability of consumer debtors to “overborrow” and then seek relief from the bankruptcy system. The credit industry aggressively promoted this “strategic behavior” model of bankruptcy, which focuses on consumers’ personal responsibility for financial outcomes. In the credit industry’s view, many bankruptcy debtors were prodigal spenders who accumulated debts through irresponsible financial activity. The credit industry assailed bankrupt families for lacking the moral conviction to repay their debts. Bankruptcy was proffered as an easy way out that attracted consumers who were intent on gaming the credit system. The credit industry convinced Congress that curtailing bankruptcy relief was sound social policy; such reforms were needed to dampen prodigality and encourage consumers to make prudent financial decisions.
The competing model of causation focused on the role of adverse financial events such as job loss, illness, or divorce in causing financial distress and bankruptcy filings. The adverse events model posits that most families fail to pay their debts because of an external financial shock not because they lack moral fiber or borrowed with no intention of repaying. This view focuses on macroeconomic and social trends, rather than individual consumers’ decisions, to understand the rise in bankruptcy filings. Advocates of the adverse events model note that America offers families a relatively weak, and declining, social safety net to help them cope with adverse financial events.The expansion of consumer credit in recent decades has left families more highly leveraged and less able to weather financial shocks. If the adverse-events model is correct, creditors’ lending practices and the scope of social programs are necessary loci for reforms aimed at reducing the incidence of bankruptcy.
In this paper I examine the relationship between systematic risk and accounting conservatism. Conservatism is the asymmetrical verification requirements for the recognition of economic losses and gains (Basu, 1997; Watts, 2003a). While prior literature has suggested various factors that create demand for and explain the cross-sectional differences in accounting conservatism, the effect of systematic risk on conservatism has not been studied. Systematic risk, the non-diversifiable risk that is attributable to market factors, is one of the fundamental concepts in asset pricing. The risk disclosure literature in accounting has related accounting numbers to systematic risk (Ryan, 1997), which assumes the role of accounting as providing information for risk assessment. Few papers have examined whether systematic risk affects managers’ financial reporting incentives and consequently, earnings properties such as timeliness or conservatism. This paper may help fill this gap, providing an examination of the effect of systematic risk on accounting conservatism.
