The Contracting Benefits of Accounting Conservatism to Lenders and Borrowers

Abstract

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.

Keywords: Conservatism, Debt contracting, Covenant violation, Spread

JEL Classification: M41, G32