Creditor Control Rights and Financial Reporting Conservatism

Abstract

Covenant violations transfer control rights from shareholders/managers to creditors and provide a clear mechanism through which creditors can impose their preference on corporate financial reporting policies. Consistent with creditors using their control rights to demand more conservative financial reporting, we find significant evidence that firms exhibit a higher level of accounting conservatism after covenant violations. Results from quasi-discontinuity regressions show that the effect of covenant violations on accounting conservatism is beyond that of deteriorating firm performance that triggers covenant violations. In addition, the post-violation increase in accounting conservatism is more pronounced in firms with higher expected agency costs of debt and firms experiencing more severe violations, and is more evident in the years immediately following covenant violations. Our findings provide direct support for debtholder demand for accounting conservatism (Watts (2003)) and highlight the importance of creditor control rights and shareholder-debtholder conflicts in shaping corporate financial reporting policies.