Do Financial Market Developments Influence Accounting Practices? Credit Default Swaps and Borrowers’ Reporting Conservatism

Abstract

This paper investigates whether the initiation of trading in credit default swaps (CDSs) on a borrowing firm’s outstanding debt is associated with a decline in that firm’s reporting conservatism. CDS investments can modify lenders’ payoffs on their loan portfolios by providing insurance on negative credit outcomes. The onset of CDS trading reduces lenders’ incentives to continuously monitor borrowers and also their demand that borrowers report conservatively. Additionally, borrowers expect CDS-insured lenders to be more intransigent in renegotiations triggered by defaults and covenant violations. Since conservatism can trigger earlier covenant violations, borrowers have heightened incentives to report less conservatively in the post-CDS period. Using a differences-in-differences research design, we observe a decline in borrowing firms’ reporting conservatism after CDS trade initiation. This effect is more pronounced when reputation costs lenders face from reducing monitoring are lower, when debt contracts outstanding at the time of CDS trade initiation have more financial covenants, and when lenders who monitor borrowers more regularly in the pre-CDS period enter into CDS contracts to hedge their credit exposures.

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

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