Accounting Conservatism and the Efficiency of Debt Contracts

54 Pages Posted: 17 Jul 2008 Last revised: 10 Feb 2009

Frank Gigler

University of Minnesota - Carlson School of Management

Chandra Kanodia

University of Minnesota - Carlson School of Management

Haresh Sapra

University of Chicago - Booth School of Business

Raghu Venugopalan

University of Illinois at Urbana-Champaign

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Abstract

In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1987] description of differential verifiability standards. Optimal debt covenants and interest rates on debt are derived from a natural tension between debt holders and equity claimants. We show how optimal covenants vary with the degree of conservatism and we derive an efficiency metric that depends on the degree of conservatism. We find that accounting conservatism actually decreases the efficiency of debt contracts, contrary to the suggestions of Watts [2003] and contrary to the hypothesis in numerous empirical studies.

JEL Classification: G32, D82, M41, M44

Suggested Citation

Gigler, Frank and Kanodia, Chandra and Sapra, Haresh and Venugopalan, Raghu, Accounting Conservatism and the Efficiency of Debt Contracts. Journal of Accounting Research, Forthcoming; Chicago GSB Research Paper No. 08-02. Available at SSRN: https://ssrn.com/abstract=1161267 or http://dx.doi.org/10.2139/ssrn.1161267

Frank Gigler

University of Minnesota - Carlson School of Management ( email )

321 19th Avenue South
Minneapolis, MN 55455
United States
612-624-7641 (Phone)

Chandra Kanodia

University of Minnesota - Carlson School of Management ( email )

321 19th Avenue South
674 Management and Economics
Minneapolis, MN 55455
United States
612-624-6880 (Phone)
612-626-7795 (Fax)

Haresh Sapra (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Raghu Venugopalan

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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