Do Financial Market Developments Influence Accounting Practices? Credit Default Swaps and Borrowers’ Asymmetric Loss Recognition Timeliness

Abstract

Lenders can transfer credit risk by purchasing credit default swaps (CDS), but holding swaps can diminish their incentives to monitor borrowers. Contracting theory predicts that lenders demand conservatism, in particular asymmetric timeliness of loss recognition, to effectively monitor borrowers. We hypothesize that the onset of CDS trading reduces lenders’ demand for conservatism from borrowing firms. In empirical analyses, we find that the onset of CDS trading is associated with a reduction in borrowing firms’ asymmetric loss recognition timeliness. This reduction is more pronounced when lenders have stronger monitoring incentives prior to the onset of CDS trading. Further, the decline in conservatism with CDS trading initiation is less pronounced during the recent economic crisis, when counter-party risk in CDS contracts increased sharply.

Keywords: credit default swaps, timely loss recognition, conservatism, economic crisis, financial market developments, lender monitoring

JEL Classification: G1, G2, G21, G30, M40, M41, M44