No full-text available
To read the full-text of this research,
you can request a copy directly from the authors.
Private Debt and Timely Loss Recognition
Abstract
In this study, we investigate whether private debt contracting provides incentives for borrowers to recognize economic losses earlier in accounting earnings. Focusing on the window around firms' issuances of private loans, we document that timely loss recognition significantly increases following an issuance. This effect is significantly stronger for debt contracts that include performance covenants acting as trip-wires when firm performance deteriorates. We also find that timely loss recognition is particularly used when writing debt contracts is hampered by uncertainty about a firm's future development. These findings are consistent with timely loss recognition being used to increase contract efficiency by facilitating state-contingent control allocation based on a borrower's performance over the loan term.
... Watts (2003) documents that under a contracting perspective, conservatism is useful to mitigate moral hazard. Franke and Müller (2018) find that conditional conservatism is used to alleviate moral hazard matters in debt contracts. Debt contracting is considered the most important cause for conditional conservatism (e.g., Watts, 2003;Penalva & Wagenhofer, 2019), and it improves contracting efficiency (Ball & Shivakumar, 2005). ...
... This indicates that the lower level of conservatism in high-tech firms is more pronounced in firms with low leverage. This finding provides support for the importance of the extent to which debt contracting may explain the demand for conditional conservatism ( & Wagenhofer, 2009;Nikolaev, 2010;Watts, 2003;Zhang, 2008;Franke & Müller, 2018). Table 4 presents our main evidence for H1 using the classification of Francis and Schipper for high-tech firms. ...
We examine whether U.S. high-tech firms are more or less conditionally conservative compared to low-tech firms. We anticipate high-tech firms to display lower conditional conservatism because they are more financially constrained and feature lower level of asset tangibility. In line with our predictions, we show that high-tech companies are less conditionally conservative relative to low-tech companies. We also show that this negative relationship between conditional conservatism and tech-sector membership is attributable to low leverage and high R&D expenditures since SFAS No. 2 allows U.S. companies to expense R&D costs.
... This effect might be stronger among firms that heavily rely on bank loans. German firms use loans as the most essential external financing source (e.g., Franke and Müller 2019). Although the traditional bank loan has lost importance in Germany over the last 10 years, the German financial market is still regarded as bank-based (Schmidt and Zwick 2018). ...
... In addition, the efficiency of debt contract clauses is increased through timely loss recognition when accounting numbers are used in debt contracts (Franke and Müller 2019). Moreover, Göx and Wagenhofer (2009) demonstrate that conservative accounting maximizes the ex-ante probability of obtaining financing. ...
This study investigates whether the deterioration of banks’ financial health affects borrowers’ earnings quality. To examine this issue, we consider the European sovereign debt crisis a shock to the health of certain European banks; these banks were affected and tightened their lending conditions relatively more than nonexposed banks during the crisis. This setting represents an exogenous shock to German nonfinancial firms that were not directly affected by the crisis. We use a difference-in-differences research design, and German firms with lending relationships with nonexposed banks are used as controls. Using various discretionary accrual measures and a timely loss recognition concept to evaluate earnings quality, we find interesting evidence. Our investigation of discretionary accruals reveals that during the European sovereign debt crisis, exposed banks’ borrowers do not engage in less earnings management than other borrowers. However, we observe that exposed banks’ borrowers are more likely to report losses in a timely manner. Overall, our results provide new insight into the indirect consequences of the sovereign debt crisis on firms’ earnings quality.
We study the influence of bank competition on U.S. public borrowers’ accounting conservatism by exploiting the staggered adoption of the Riegle-Neal Interstate Banking and Branching Efficiency Act (IBBEA) of 1994, which increased the threats of new bank entrants and actual bank entry. We find that borrowers’ conditional conservatism fell after IBBEA. Conservatism fell more for firms located in states with weak incumbent banks and states with more out-of-state entrants, especially entrants with better monitoring technologies. The decrease in conservatism partially stems from borrowers’ increased investment and risk-taking incentives. Conservatism fell more for firms relying more on bank loans, especially those that borrowed loans for the first time after IBBEA and for firms having lower dedicated institutional ownership and board independence. We also find that loans included fewer covenants and that bank loan borrowers became less likely to choose Big N auditors and industry specialist auditors after IBBEA.
Data Availability: Data are available from the public sources cited in the text.
JEL Classifications: G21; G28; K23; M41.
We investigate the private debt contracting implications of when the lender and borrower share the same audit firm. Specifically, we posit that when the lender and borrower share the same audit firm, this shared auditor relationship provides lenders with privileged access to a trustworthy third party that can be used to verify information about borrowers’ financial information and leads to gains in contracting efficiency to the benefit of both the lender and borrower. Our findings indicate that the shared auditor relationship is associated with a decrease in the cost of debt and the likelihood of future default. Our findings highlight the role played by external auditors in facilitating lenders’ screening and monitoring efforts in private debt contracts for public firms.
This study examines whether and how firms adjust their accounting conservatism in response to government support through industrial policies, which reduce firms’ dependence on external financing from the capital market. Based on China’s unique economic programme called ‘Five-Year Plan’ from 1991 to 2015, we observe a decline in accounting conservatism among firms covered by government industrial policies. The decline is more pronounced in covered firms, which face higher ex-ante financial constraints, and in the subsample of firms which receive higher government support. These findings are robust to alternative specifications of accounting conservatism and policy timing. Our evidence implies that government industrial policies can have unintended consequences for corporate financial reporting.
Purpose – The purpose of this paper is to investigate the relationship between restrictive covenants and
accounting conservatism. More specially, the authors try to explain how the use of restrictive covenants of
public debt may affect accounting conservatism.
Design/methodology/approach – The sample is composed of non-financial firms and for each firm one
debt contract is considered. The authors have used the Ball and Shivakumar (2005) models to test the relationships.
All variables were retrieved from Mergent Fixed Investment Securities and COMPUSTAT Databases.
Findings – The findings of this study show that the more the firm relies on bond covenants, the higher is
the degree of conservatism. The authors found also that these firms also exhibited a widely significantly
increased level of conservatism in the years following the issuance of debt.
Research limitations/implications – The results should be interpreted with caution because the use of
covenants does not take into consideration the tightness of their inclusion in the public debt contract.
Originality/value – This paper makes a timely contribution to the debate of timely loss recognition by
confirming the complementarity between the inclusion of restrictive covenants in the debt agreement and the
accounting conservatism before and after the emission of public debt.
Keywords Accounting conservatism, Restrictive covenants, Public debt contracts,
Managerial opportunism, Wealth expropriation, Corporate governance, Accounting,
Financial reporting
This study examines the effect of banking competition on borrowing firms’ conditional accounting conservatism (i.e., asymmetric timely loss recognition). The context of the study is the staggered passage of the Interstate Banking and Branching Efficiency Act (IBBEA), the deregulation that permits banks to establish branches across state lines and increases bank competition. I find that firms report less conservatively after the passage of the IBBEA in their headquarter states. The effect on conditional conservatism is stronger for firms in states with a greater increase in competition among banks, firms that are more likely to borrow from in-state banks, firms with greater financial constraint, and firms subject to less external monitoring. Additional tests confirm that the decline in conditional conservatism is observed only after the adoption of IBBEA and lasts for two years. The findings indicate that banks tend to “lowball” borrowers when competition arises by relaxing their demand for conservative reporting. Overall, this study highlights the unintended impacts of banking competition on borrowing firms’ financial reporting.
We predict that accounting conservatism influences insiders' opportunities to speculate on good and bad news, and thus, insider trading profitability. We find that greater conditional (unconditional) conservatism is associated with lower (higher) insiders' profitability from sales. We find limited evidence that conservatism influences profitability from purchases. These findings are consistent with our hypotheses on the different informational roles of conditional and unconditional conservatism, and on the asymmetric influence of conservatism over the opportunities to speculate on good versus bad news. Our research design takes into consideration the endogenous nature of insiders' trading and conservatism. The results are robust to different measures of conservatism and a number of additional analyses.
This article is protected by copyright. All rights reserved
This study examines how conditional accounting conservatism varies after debt contracts are executed (ex-post conditional conservatism) depending on the closeness to violations of debt covenants, the costs of covenant violations, and bank monitoring. I hypothesise that borrowers with lower debt-covenant slack have an incentive to avoid covenant violations and will have lower ex-post conditional conservatism levels than those with higher slack. I find that borrowers with both lower and higher slack increase their ex-post conditional conservatism, but that the magnitude of this increase in conservatism is positively associated with the level of covenant slack. Further, this positive relationship between the ex-post change in conditional conservatism and the debt-covenant slack is more pronounced when the costs of the debt-covenant breach are greater, and is less pronounced when lenders have stronger incentives to monitor borrowers. This study provides evidence that the ex-post change in conditional conservatism is affected by the costs of a covenant breach and bank monitoring.
The effect of voluntary disclosure on the choice of debt source: A study of French listed firms
This paper examines the effect of voluntary disclosure on the choice of debt source. Theory suggests that banks play an important role in monitoring managerial behavior given that lending activities allow them an easy access to private information. We hypothesize that a greater reliance on bank debt substitutes for voluntary disclosure in its monitoring role, leading to higher bank debt in low-disclosure firms. Using a sample of 1,560 observations of French listed firms over the period 2007-2013, results show a negative relationship between voluntary disclosure and bank debt financing, suggesting that less transparent firms rely more heavily on bank debt as a way to mitigate information asymmetry. This research provides evidence that bank debt plays an effective disciplinary role and that, overall, the quality of corporate information environment matters in the choice of debt source.
This paper surveys both the theoretical and the empirical archival literature on conservatism when accounting information is used for debt contracting. The theoretical literature shows mixed results whether conservative accounting is desirable, which depends on the underlying agency problem, the information available, and the contracting space. The empirical literature takes a more holistic view in measuring the degree of conservatism. It studies a broad array of possible effects of conservatism in debt financing, but also beyond. The results overwhelmingly support the view that conservatism plays a useful role in debt contracting, although there are also some mixed results. We describe key results and empirical designs, and we provide suggestions for future research.
I examine the use of financial covenants when contracting for debt under uncertainty. Uncertainty, in the context of this study, is a lack of information about future economic events and their consequences for the borrower’s creditworthiness. I examine the implications of ex ante uncertainty that is resolved by information received following loan initiation but prior to maturity. I argue that financial covenants, by transferring control rights ex post, provide a trigger for creditor-initiated renegotiation when the borrower is revealed to be of low credit quality. Using a large sample of private loans, I predict and find that financial covenant intensity is associated with greater uncertainty. I also revisit the agency-based explanation for covenant use and find that this uncertainty explanation is robust to various controls for agency conflicts.
Conservatism, through the timelier recognition of losses in the income statement, is expected to increase firm investment efficiency through three main channels: (1) by decreasing the adverse effect of information asymmetries between outside equity holders and managers, facilitating the monitoring of managerial investment decisions; (2) by increasing managerial incentives to abandon poorly performing projects earlier and to undertake fewer negative net present-value investments; and (3) by facilitating the access to external financing at lower cost. Using a large US sample for the period 1990-2007 we find a negative association between conservatism and measures of over- and under- investment, and a positive association between conservatism and future profitability. This is consistent with firms reporting more conservative numbers investing more efficiently and in more profitable projects. Our results add to a growing stream of literature suggesting that eliminating conservatism from accounting regulatory frameworks may lead to undesirable economic consequences.
Using a large sample of private credit agreements between U.S. publicly traded firms and financial institutions, we show that over 90% of long-term debt contracts are renegotiated prior to their stated maturity. Renegotiations result in large changes to the amount, maturity, and pricing of the contract, occur relatively early in the life of the contract, and are rarely a consequence of distress or default. The accrual of new information concerning the credit quality, investment opportunities, and collateral of the borrower, as well as macroeconomic fluctuations in credit and equity market conditions, are the primary determinants of renegotiation and its outcomes. The terms of the initial contract (e.g., contingencies) also play an important role in renegotiations; by altering the structure of the contract in a state contingent manner, renegotiation is partially controlled by the contractual assignment of bargaining power.
We hypothesize debt markets—not equity markets—are the primary influence on “association” metrics studied since Ball and Brown
(1968 J Account Res 6:159–178). Debt markets demand high scores on timeliness, conservatism and Lev’s (1989 J Account Res 27(supplement):153–192) R
2, because debt covenants utilize reported numbers. Equity markets do not rate financial reporting consistently with these
metrics, because (among other things) they control for the total information incorporated in prices. Single-country studies
shed little light on debt versus equity influences, in part because within-country firms operate under a homogeneous reporting
regime. International data are consistent with our hypothesis. This is a fundamental issue in accounting.
This paper determines when a debt contract will be monitored by lenders. This is the choice between borrowing directly (issuing a bond, without monitoring) and borrowing through a bank that monitors to alleviate moral hazard. This provides a theory of bank loan demand and of the role of monitoring in circumstances in which reputation effects are important. A key result is that borrowers with credit ratings toward the middle of the spectrum rely on bank loans, and in periods of high interest rates or low future profitability, higher-rated borrowers choose to borrow from banks. Copyright 1991 by University of Chicago Press.
The report argues that aid volatility is an important source of volatility for the poorest countries. Following a method already applied by the Agence Française de Développement, the report argues that loans to LICs should incorporate a floating grace period, which the country could draw upon when hit by a shock. The definition of a shock should include aid uncertainty, along with others such as commodity shocks and natural disasters. The idea is calibrated to a key IMF policy instrument towards Low-Income Countries, the Poverty-Reducing and Growth Facility (PRGF).
Le rapport montre que l’aide aux pays pauvres contribue à accroître la volatilité de ces pays. Suivant une méthode déjà élaborée par l’Agence Française de Développement, l’article propose d’accorder des crédits aux pays pauvres, qui incorporent un droit de grâce flexible, utilisable par le pays, lorsqu’il est confronté à un choc négatif, quelle qu’en soit la cause : choc d’aide, de prix des matières premières ou catastrophe naturelle. Il montre comment l’instrument utilisé par le FMI à destination des pays pauvres, le PRGF, pourrait être modifié pour ce faire.
Using a sample of firms that disclose the realizations of earnings used for determining covenant compliance in loan contracts, we provide direct evidence on the informational properties of earnings used in the performance covenants included in debt contracts. We find that the earnings measure used in performance covenants does not exhibit asymmetric loss timeliness and has significantly greater cash flow predictive ability than GAAP measures of earnings. We suggest that these results reflect the idea that contracting parties design accounting rules for performance covenants to enhance their efficacy as “tripwires”. This article is protected by copyright. All rights reserved
Despite the importance of banks’ role as delegated monitors, little is known about how non-price terms of loan contracts are structured to optimize information production in a lending relationship. Using a large sample of corporate loans, this paper examines the effect of relationship lending on covenant choice. Consistent with information asymmetry theories, covenant tightness is relaxed over the duration of a relationship, especially for opaque borrowers. In contrast, the effect of lending relationship intensity on the number of covenants included in a loan follows an inverted U shape. I discuss potential explanations for this finding.
A common approach to evaluating robustness to omitted variable bias is to observe coefficient movements after inclusion of controls. This is informative only if selection on observables is informative about selection on unobservables. Although this link is known in theory (i.e. Altonji, Elder and Taber (2005 —, —, and —, “Selection on Observed and Unobserved Variables: Assessing the Effectiveness of Catholic Schools,” Journal of Political Economy, 2005, 113 (1), 151–184.)), very few empirical papers approach this formally. I develop an extension of the theory which connects bias explicitly to coefficient stability. I show that it is necessary to take into account coefficient and R-squared movements. I develop a formal bounding argument. I show two validation exercises and discuss application to the economics literature.
This paper examines how performance measures are defined in major earnings-based financial covenants in loan contracts to shed light on the economic rationales underlying the contractual use of performance measures. I find an earnings-based covenant is typically based on a performance measure close to earnings before interest, tax, amortization, and depreciation expenses (EBITDA). However, my empirical analyses show that EBITDA is less useful in explaining credit risk than earnings before interest and tax expenses (EBIT) and even the bottom-line net income. Thus, measuring credit risk cannot fully explain the choice of accounting performance measures in earnings-based covenants. I conjecture that contracting parties choose an EBITDA-related measure, instead of a measure calculated after depreciation and amortization expenses (e.g., EBIT), to make the performance measure less sensitive to investment activities, which can be controlled through other contractual terms, such as a restriction on capital expenditure, and provide empirical evidence consistent with this conjecture. © 2016 University of Chicago on behalf of the Accounting Research Center
In this paper we critically evaluate the standard-setting inferences that can be drawn from value relevance research studies that are motivated by standard setting. Our evaluation concentrates on the theories of accounting, standard setting and valuation that underlie those inferences. Unless those underlying theories are descriptive of accounting, standard setting and valuation, the value-relevance literature's reported associations between accounting numbers and common equity valuations have limited implications or inferences for standard setting, they are mere associations. We argue that the underlying theories are not descriptive and hence drawing standard-setting inferences is difficult.
This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating more research and in offering directions to advance our knowledge of how accounting information affects contract efficiency. This article is protected by copyright. All rights reserved
This study examines the relation between performance covenants in private debt contracting and conservative accounting under adverse selection. We find that under severe adverse selection (i.e., high information asymmetry), accounting conservatism and performance covenants act as complements to signal that the borrower is unlikely to appropriate wealth from the lender. No such relation obtains in a low information asymmetry regime. We further show that in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants generally enjoy lower interest rate spreads than borrowers with low levels of conservatism and loose performance covenants. Consistent with our signaling theory, in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants are less likely to make abnormal payouts to shareholders. Our empirical results are robust to alternative measures of conservatism and covenant restrictiveness.This article is protected by copyright. All rights reserved.
This paper is the first in a two-part series on conservatism in accounting. Part I examines alternative explanations for conservatism in accounting and their implications for accounting regulators. Part II summarizes the empirical evidence on conservatism, its consistency with alternative explanations, and opportunities for future research. The evidence is consistent with conservatism's existence and, in varying degrees, the various explanations. Conservatism is defined as the differential verifiability required for recognition of profits versus losses. Its extreme form is the traditional conservatism adage: "anticipate no profit, but anticipate all losses." Despite criticism, conservatism has survived in accounting for many centuries and appears to have increased in the last 30 years. The alternative explanations for conservatism are contracting, shareholder litigation, taxation, and accounting regulation. The evidence in Part II suggests the contracting and shareholder litigation explanations are most important. Evidence on the effects of taxation and regulation is weaker, but consistent with those explanations playing a role. Earnings management could produce some of the evidence on conservatism, but cannot be the prime explanation. The explanations and evidence have important implications for accounting regulators. FASB attempts to ban conservatism in order to achieve "neutrality of information" without understanding the reasons conservatism existed and prospered for so long are likely to fail and produce unintended consequences. Successful elimination of conservatism will change managerial behavior and impose significant costs on investors and the economy in general. Similarly, researchers and regulators who propose the inclusion of capitalized unverifiable future cash flows in financial reports should consider the costs generated by their proposal's effect on managerial behavior.
Using data from Securities and Exchange Commission filings, I show that the typical bank loan is renegotiated five times, or every nine months. The pricing, maturity, amount, and covenants are all significantly modified during each renegotiation, whose timing is governed by the financial health of the contracting parties and uncertainty regarding the borrowers' credit quality. The relative importance of these factors depends on the duration of the lending relationship. I interpret these results in light of financial contracting theories and emphasize that renegotiation is an important mechanism for dynamically completing contracts and for allocating control rights ex post.
We use Dealscan, a database of private corporate lending agreements, to provide large-sample tests of the debt covenant hypothesis. Dealscan offers several advantages over the data available in previous studies, principally larger and more representative samples and the m,,availability of extensive actual covenant detail. These advantages allow us to construct powerful tests in which we find clear support for the debt covenant hypothesis. We also use these data to provide broad evidence on the economic role of debt covenants. We find that private lenders set debt covenants tightly and use them as "trip wires" for borrowers, that technical violations occur relatively often, and that violations are not necessarily associated with financial distress. Finally, since we measure covenant slack directly, we report evidence that the extensively-used leverage variable is a relatively noisy proxy for closeness to covenants.
We study optimal disclosure via two competing communication channels: hard information whose value has been verified, and soft disclosures such as forecasts, unaudited statements, and press releases. We show that certain soft disclosures may contain as much information as hard disclosures, and we establish that: (1) exclusive reliance on soft disclosures tends to convey bad news, (2) credibility is greater when unfavorable information is reported, and (3) misreporting is more likely when soft information is issued jointly with hard information. We also show that a soft report that is seemingly unbiased in expectation need not indicate truthful reporting. We demonstrate that mandatory disclosure of hard information reduces the transmission of soft information, and that the aggregation of hard with soft information will turn all information soft.
JEL Classifications: D72; D82; D83; G20.
This study investigates the role of public debt financing in shaping accounting conservatism in privately held companies. We focus on the change in conservatism of private firms following initial issuance of public debt and examine the effects of agency conflicts between bondholders and shareholders on the change in conservatism. Regression analyses on a large sample of public bond issues by Korean private firms reveal the following: First, private firms with public debt exhibit a higher degree of conservatism than those with exclusively private debt. The incremental effect of public debt on the level of conservatism is virtually equivalent in magnitude to that of public equity. Second, and more importantly, private firms that issue public debt for the first time show a significant increase in conservatism, whereas corresponding public firms do not. Third, private firms with high agency costs of public debt (characterized by high information asymmetry and high credit risk) undergo a greater increase in conservatism following their initial bond issues than those with low agency costs. Further analysis shows that private firms sustain increased levels of conservatism even beyond the time period of average maturity of initial bonds and that bond investors reward this long-term commitment to conservative accounting by gradually reducing interest rates for seasoned bond issuers. The findings of this study shed light on how information demand arising from public debt issuance, especially by private firms with high ex ante agency costs, engenders conservative financial reporting in emerging markets.
This paper uses survival analysis to investigate the timing of a firm’s decision to issue for the first time in the public bond market. We find that firms that are more creditworthy and have higher demand for external funds issue their first public bond earlier. We also find that issuing private bonds or taking out syndicated loans is associated with a faster entry to the public bond market. According to our results, the relationships that firms develop with investment banks in connection with their private bond issues and syndicated loans further speed up their entry to the public bond market. Finally, we find that a firm’s reputation has a “U-shaped” effect on the timing of a firm’s bond IPO. Consistent with Diamond’s reputational theory, firms that establish a track record of high creditworthiness as well as those that establish a track record of low creditworthiness enter the public bond market earlier than firms with intermediate reputation.
The savings/investment process in capitalist economies is organized around bank-like financial intermediaries (“banks≓), making them a central institution of economic growth. These intermediaries borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why are banks so pervasive? What are their roles? Are banks inherently unstable? Must the government regulate them? In this chapter we survey the last 15 years' of theoretical and empirical research on these issuesWe begin with theories and evidence on the uniqueness of banks. Key issues include monitoring or evaluating borrowers, providing liquidity, combining lending and liquidity provision as a commitment mechanism, and the coexistence of banks and markets. We then examine interaction between banks and borrowers in more detail, focusing on the pros and cons of dynamic bank—borrower relationships, the relationship between loan structure and monitoring, and between banking sector structure and monitoring, “credit cycles≓ and capital constraints, and the role of “non-traditional≓ bank activities such as equity investment.We then turn to research on banking panics and the stability of the banking system, focusing on the incidence of banking panics internationally and historically, the causes of panics, the role of bank coalitions in forestalling panics, and whether banks are inherently flawed. This leads to questions concerning government regulation of banks. Here, we focus on possible moral hazard problems emanating from deposit insurance and on the roles of bank corporate governance and capital requirements. We conclude with a summary of our current understanding and directions for future research.
Using both a market-based and an accrual-based measure of conservatism, we find that firms facing more severe conflicts over dividend policy tend to use more conservative accounting. Furthermore, we document that accounting conservatism is associated with a lower cost of debt after controlling for other determinants of firms' debt costs. Our collective evidence is consistent with the notion that accounting conservatism plays an important role in mitigating bondholder-shareholder conflicts over dividend policy, and in reducing firms' debt costs.
We study the impact of reputational incentives in markets characterised by moral hazard problems. Social preferences have been shown to enhance contract enforcement in these markets, while at the same time generating considerable wage and price rigidity. Reputation powerfully amplifies the positive effects of social preferences on contract enforcement by increasing contract efficiency substantially. This effect is, however, associated with a considerable bilateralisation of market interactions, suggesting that it may aggravate price rigidities. Surprisingly, reputation in fact weakens the wage and price rigidities arising from social preferences. Thus, in markets characterised by moral hazard, reputational incentives unambiguously increase mutually beneficial exchanges, reduce rents, and render markets more responsive to supply and demand shocks.
We examine how alternative accounting measures of fair value impact the ability of debt covenants to mitigate inefficient investment decisions. In our setting, shareholders make a non-contractible project choice after signing a debt contract. At a later date, the project can be abandoned and new information determines whether shareholders or creditors make that decision. The value of debt covenants depends on their ability to deter costly asset substitution while also mitigating inefficient continuation decisions. A covenant based on a conservative fair value measure tends to perform best in this respect. Departing from purely fair value-based covenants, an even more conservative covenant based on fair values and historical cost outperforms those based solely on fair values. Notably, the “highest and best use” measure advocated by the FASB performs poorly in deterring the choice of inferior projects. Our results provide a setting in which the contracting efficiencies associated with different accounting measures cannot be replicated across measures by altering covenant “triggers”.
Building on contract theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debt holder–shareholder interests. Performance covenants serve as trip wires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on the capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting-based covenants can improve contracting efficiency in two different ways.
This paper investigates contractual definitions of net income and net worth and the cross-sectional variation in definitions of net income in a large sample of private debt contracts to shed light on the debt contracting demand for accounting numbers. The descriptive evidence indicates that removing transitory earnings is one principal concern in the measurement of earnings but not in the measurement of net worth. In the extreme, contracts are never written on comprehensive income as an earnings concept, whereas accumulated other comprehensive income is included in net worth in most contracts. In contrast, conservative adjustment, in the sense of including certain types of negative earnings but not the corresponding positive earnings, does not seem to be a primary consideration in measuring net income and net worth. Cross-sectionally, I find that net income is more likely to be defined differently from the GAAP when net income plays a more important role in a contract, when the loan maturity is longer, and when transitory earnings are less useful for debt contracting. Collectively, the evidence shows that debt contracting parties choose contracting variables in a manner consistent with efficient contracting, and that transitory earnings are relatively less useful in measuring firm performance for debt contracting.
We study the economic determinants of conditional conservatism. Consistent with prior literature, we find that contracting induces only conditional conservatism and litigation induces both conditional and unconditional conservatism. We extend prior evidence by Qiang (2007) by showing that taxation and regulation induce not only unconditional conservatism, but conditional conservatism as well. We show that in certain scenarios taxation and regulation create incentives to shift income from periods with high taxation pressure and high public scrutiny to periods with lower taxation pressure and lower public scrutiny. These income shifting strategies are implemented by recognising current economic losses that, given managerial incentives to report aggressively, would not have been recognized otherwise, or by delaying the recognition of current economic gains that would have been recognized had circumstances been different.
This paper explores direct relations between corporate investment behavior and the timeliness of accounting recognition of economic losses (TLR) reflected in a country's accounting regime. We explicitly investigate the extent to which TLR influences investment decisions of firm managers. Given the asymmetric emphasis on negative outcomes inherent in TLR, we hypothesize that TLR will most strongly influence investment behavior when managers face deteriorating investment environments. We conjecture that TLR will have an asymmetric impact on investment behavior whereby TLR impacts firms’ investment decisions in the face of declining investment opportunities, but not in the face of increasing in investment opportunities. Using firm-level investment decisions spanning twenty five countries, we find that investment responses to declining opportunities increases with TLR, while we find no evidence that TLR influences the sensitivity of investment to increasing investment opportunities. Our results are robust to alternative estimates of TLR, alternative estimates of investment responses to changing investment opportunities, and to controls for important country-level, industry-level, and firm-level variables that may impact firms’ investment decisions.
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.
This paper examines the secondary market for loan sales and, in particular, loan contract design as a mechanism to resolve
informational issues in loan sales and associated costs and benefits. Using loan-level data, we find that sold loans contain
additional covenants and more restrictive net worth covenants, particularly when agency and informational problems are more
severe. Why do borrowers agree to incur the additional costs associated with loan sales? Our evidence suggests that these
borrowers benefit through increased private debt availability. Further, loan sales go hand in hand with more durable lending
relationships, suggesting that risk management aids continued relationship lending.
We predict that firms with stronger corporate governance will exhibit a higher degree of accounting conservatism. Governance
level is assessed using a composite measure that incorporates several internal and external characteristics. Consistent with
our prediction, strong governance firms show significantly higher levels of conditional accounting conservatism. Our tests
take into account the endogenous nature of corporate governance, and the results are robust to the use of several measures
of conservatism (market-based and nonmarket-based). Our evidence is consistent with the direction of causality flowing from
governance to conservatism, and not vice versa, indicating that governance and conservatism are not substitutes. Finally,
we study the impact of earnings discretion on the sensitivity of earnings to bad news across governance structures. We find
that, on average, strong-governance firms appear to use discretionary accruals to inform investors about bad news in a timelier
manner.
We review recent literature on the role of financial reporting transparency in reducing governance-related agency conflicts among managers, directors, and shareholders, as well as in reducing agency conflicts between shareholders and creditors, and offer researchers some suggested avenues for future research. Key themes include the endogenous nature of debt contracts and governance mechanisms with respect to information asymmetry between contracting parties, the heterogeneous nature of the informational demands of contracting parties, and the heterogeneous nature of the resulting governance and debt contracts. We also emphasize the role of a commitment to financial reporting transparency in facilitating informal multiperiod contracts among managers, directors, shareholders, and creditors.
Using a sample of 1,560 new debt financings, we examine the choice among bank debt, non-bank private debt, and public debt. The primary determinant of the debt source is the credit quality of the issuer. Firms with the highest credit quality borrow from public sources, firms with medium credit quality borrow from banks, and firms with the lowest credit quality borrow from non-bank private lenders. Non-bank private debt thus plays a unique role in accommodating the financing needs of firms with low credit quality. In addition, the choice of debt source is (weakly) influenced by managerial discretion.
The East Asian countries Hong Kong, Malaysia, Singapore and Thailand provide rare insight into the interaction between accounting standards and the incentives of managers and auditors. Their standards derive from common law sources (UK, US, and IAS) that are widely viewed as higher quality than code law standards. However, their preparers’ incentives imply low quality. We show their financial reporting quality is not higher than under code law, with quality operationalized as timely recognition of economic income (particularly losses). It is misleading to classify countries by standards, ignoring incentives, as is common in international accounting texts, transparency indexes, and IAS advocacy.
This paper examines the ex post and ex ante benefits of accounting conservatism to lenders and borrowers in the debt contracting process. I expect conservatism to benefit lenders ex post through the timely signaling of default risk, as manifested by accelerated covenant violations, and to benefit borrowers ex ante through lower initial interest rates. Consistent with these predictions, I find that more conservative borrowers are more likely to violate debt covenants following a negative price shock, and that lenders offer lower interest rates to more conservative borrowers.
Despite the unquestionable influence of conservatism, disagreement remains about what economic demands lead to financial reporting conservatism. Research examining lenders’ demands for reporting conservatism has been questioned for ignoring conservative contract modifications. We document that these modifications exist but are not ubiquitous. We find contract modifications are more likely when agency costs are higher and litigation, tax and equity demands for conservatism are lower. However, we find a positive association between unexplained reporting conservatism and contract modifications, suggesting contractual modifications alone do not fulfill lenders’ demands for conservatism.
This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears these costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem.The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.Adam Smith, The Wealth of Nations, 1776, Cannan Edition(Modern Library, New York, 1937) p. 700.
Many corporate assets, particularly growth opportunities, can be viewed as call options. The value of such ‘real options’ depends on discretionary future investment by the firm. Issuing risky debt reduces the present market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy. The paper predicts that corporate borrowing is inversely related to the proportion of market value accounted for by real options. It also rationalizes other aspects of corporate borrowing behavior, for example the practice of matching maturities of assets and debt liabilities.
Theories based on incomplete contracting suggest that small organizations have a comparative advantage in activities that make extensive use of “soft” information. We provide evidence consistent with small banks being better able to collect and act on soft information than large banks. In particular, large banks are less willing to lend to informationally “difficult” credits, such as firms with no financial records. Moreover, after controlling for the endogeneity of bank-firm matching, we find that large banks lend at a greater distance, interact more impersonally with their borrowers, have shorter and less exclusive relationships, and do not alleviate credit constraints as effectively.
This paper examines accounting changes, costs of default, and accounting-based covenants violated by 130 firms reporting violations in annual reports. I find that managers of firms approaching default respond with income-increasing accounting changes and that the default costs imposed by lenders and the accounting flexibility available to managers are important determinants of managers' accounting responses. I also document that private lending agreements are the first violated, that net worth and working capital restrictions are the most frequently violated restrictions, and that in 52 percent of the cases lenders require concessions from borrowers to resolve default.
I explore which firm and loan characteristics decrease or exacerbate information asymmetry in the trading of private debt. I find that loans of public firms, loans with an available credit rating, loans of profit firms and loans syndicated by more reputable arrangers are traded at lower bid–ask spreads, while revolvers, distressed loans and loans issued by institutional investors are associated with higher information costs. I also find that timely loss recognition reduces the bid–ask spread. This finding suggests that conservative reporting decreases information asymmetry regarding a borrower and increases the efficiency of the secondary trading of debt securities.
Negotiable certificates of deposit (CD's) trade in the capital market in competition with other securities like commercial paper and bankers' acceptances. If CD's must pay lenders competitive monetary interest, the reserve tax on CD's is borne by bank borrowers. Viability of the tax means there must be something special about bank loans that makes some borrowers willing to pay higher interest rates than those on other securities of equivalent risk. Moreover, there must be something special about banks that prevents other intermediaries from competing to assure that it never pays to finance loans with CD's.
ABSTRACT Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision-making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers' abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if the accounting system recognizes economic losses in earnings in a timely fashion. Thus, the demand for timely loss recognition should increase with a contract's reliance on covenants. Consistent with this conjecture, I find evidence that reliance on covenants in public debt contracts is positively associated with the degree of timely loss recognition. I also find evidence that the presence of prior private debt mitigates this relationship. Copyright (c), University of Chicago on behalf of the Accounting Research Center, 2009.
We investigate if timely loss recognition is associated with acquisition-investment decisions. Using a Basu (1997) piece-wise linear regression model, we find that firms with more timely incorporation of economic losses into earnings make more profitable acquisitions, measured by the bidder's announcement returns and by changes in post-acquisition operating performance. These firms are also less likely to make post-acquisition divestitures (consistent with better ex ante investment decisions), but act more quickly to divest. We also find that the positive association between timely loss recognition and acquisition profitability is more pronounced for firms with higher ex ante agency costs.
This paper explores the determinants of corporate failure and the pricing of financially distressed stocks using US data over the period 1963 to 2003. Firms with higher leverage, lower profitability, lower market capitalization, lower past stock returns, more volatile past stock returns, lower cash holdings, higher market-book ratios, and lower prices per share are more likely to file for bankruptcy, be delisted, or receive a D rating. When predicting failure at longer horizons, the most persistent firm characteristics, market capitalization, the market-book ratio, and equity volatility become relatively more significant. Our model captures much of the time variation in the aggregate failure rate. Since 1981, financially distressed stocks have delivered anomalously low returns. They have lower returns but much higher standard deviations, market betas, and loadings on value and small-cap risk factors than stocks with a low risk of failure. These patterns hold in all size quintiles but are particularly strong in smaller stocks. They are inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.
We analyze incomplete long-term financial contracts between an entrepreneur with no initial wealth and a wealthy investor.
Both agents have potentially conflicting objectives since the entrepreneur cares about both pecuniary and non-pecuniary returns
from the project while the investor is only concerned about monetary returns. We address the questions of (i) whether and
how the initial contract can be structured in such a way as to bring about a perfect coincidence of objectives between both
agents (ii) when the initial contract cannot achieve this coincidence of objectives how should control rights be allocated
to achieve efficiency? One of the main results of our analysis concerns the optimality properties of the (contingent) control
allocation induced by standard debt financing.
ABSTRACT We investigate how both the ownership structure and explicit contractual structure of syndicated loan deals are shaped by the debt-contracting value (DCV) of borrowers' accounting information. DCV captures the inherent ability of firms' accounting numbers to capture credit quality deterioration in a timely fashion. We hypothesize and document that when a borrower's accounting information possesses higher DCV, information asymmetry between the lead arranger and other syndicate participants is lower, allowing lead arrangers to hold a smaller proportion of new loan deals. Further, we document that the influence of DCV on the proportion of the loan retained is conditional on the lead arranger's reputation, the existence of a credit rating, and the lead arranger's previous relationships with the same borrower. Finally, we find that when loans include performance pricing provisions, the likelihood that the single performance measure used is an accounting ratio, rather than a credit rating, is increasing in DCV. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2008.
This paper asks how well different organizational structures perform in terms of generating information about investment projects and allocating capital to these projects. A decentralized approach-with small, single-manager firms-is most likely to be attractive when information about projects is "soft" and cannot be credibly transmitted. In contrast, large hierarchies perform better when information can be costlessly "hardened" and passed along inside the firm. The model can be used to think about the consequences of consolidation in the banking industry, particularly the documented tendency for mergers to lead to declines in small-business lending. Copyright The American Finance Association 2002.
Recent studies argue that the spread-adjusted Taylor rule (STR), which includes a response to the credit spread, replicates monetary policy in the United State. We show (1) STR is a theoretically optimal monetary policy under heterogeneous loan interest rate contracts in both discretionay and commitment monetary policies, (2) however, the optimal response to the credit spread is ambiguous given the financial market structure in theoretically derived STR, and (3) there, a commitment policy is effective in narrowing the credit spread when the central bank hits the zero lower bound constraint of the policy rate.
Conservatism is interpreted to mean that accountants more frequently report current "bad news" about future cash flows in contemporaneous earnings than current "good news." Thus, earnings reported under GAAP should be more timely in reporting "bad news" about future cash flows than "good news." This paper, using the firm's stock return as a measure of news, shows that the contemporaneous association between earnings and negative returns is two to five times as large as the contemporaneous association between earnings and positive returns. It is also shown that the greater timeliness of earnings relative to cash flow measures is largely due to a greater sensitivity to concurrent negative returns. This result is consistent with accountants recording accruals conservatively. Another implication of conservatism is that negative earnings surprises are likely to be less persistent than positive earnings surprises, because earnings reports more bad news concurrently than good news, with the latter being spread over several periods. This is shown to be true empirically. It is predicted and found that earnings response coefficients are higher for positive earnings changes than for negative earnings changes, which is consistent with the market correcting for the difference in persistence in conservatively determined earnings. It is also found that the sensitivity of earnings to negative returns has more than quadrupled since 1980, while the sensitivity of earnings to negative returns has declined by two-thirds, suggesting that earnings measurement has become more conservative. Increases in accounting conservatism are found to be correlated with increases in auditor liability, but no causal inferences are drawn.