Financial Reporting Quality and Corporate Bond Issue

Abstract:     
Building upon recent research suggesting that debt markets rather than equity markets shape financial reporting, this study examines the relationship between financial reporting quality, as proxied by accounting conservatism and SOX internal control disclosures, and the cost of corporate bond issues. Consistent with our expectations, empirical evidence suggests that bond market participants demand higher risk premiums for new corporate bond issues if issuers report a higher degree of conditional conservatism. At the same time, these same participants positively value issuers’ unconditional conservatism reporting through risk premiums. These findings are inconsistent with the debt contracting efficiency argument for conservatism. In addition, we document that, pursuant to the auditors’ report under SOX Section 404 indicating that issuers’ internal control are effective, bond issuers enjoy lower risk premiums than the issuers who have ineffective internal control. This study extends the conservatism literature by providing arguments and empirical evidence that is inconsistent with the traditional debt contracting efficiency view of conservatism. Furthermore, by investigating the impact of effective internal control disclosure on new corporate bond issues, this study fills a void in the SOX internal control literature, which focuses mainly on equity and private loan markets. This study has two practical implications: First, the finding that conditional conservative reporting increases the cost of new corporate bond issues supports fair value accounting argument. Second, policymakers may use our finding that internal control disclosure decreases the cost of new corporate bond issues when defending the effect of SOX internal control provisions to lower the cost of capital.

Number of Pages in PDF File: 44

Keywords: Accounting Conservatism, Internal Control, Information Asymmetry, New Corporate Bond Issue

JEL Classification: M41

working papers series