Accounting Conservatism and the Efficiency of Debt Contracts: A Note

Abstract

Using the debt contracting framework in Gigler et al. [2009], this paper examines the efficiency implication of accounting conservatism in the sense of timelier loss recognition. I characterize conservatism as timelier recognition of economic losses than gains for one component of the accounting signal, assuming the debt covenant is written on the whole signal reported. I show two main results. First, although information contents of accounting regimes with different timeliness in gains and losses recognition are not comparable in the Blackwell sense under my characterization of accounting regimes, the contracting efficiency always increases with timeliness in gain and loss recognition. Second, although it is true that bad news is more useful than good news for debt contracting, it is not sufficient to justify that economic losses are more useful than gains on one component of the accounting signal. My findings imply that conservatism increases the efficiency of debt contracts when the timeliness in gains recognition is fixed, which is inconsistent with the conclusions in Gigler et al. [2009].

Keywords: conservatism, debt contract

JEL Classification: M41, M44, G32