Accounting Conservatism and Performance Covenants: A Signaling Approach

54 Pages Posted: 29 Aug 2009 Last revised: 9 Aug 2014

See all articles by Jeffrey L. Callen

Jeffrey L. Callen

University of Toronto - Rotman School of Management

Feng Chen

University of Toronto - Rotman School of Management

Yiwei Dou

New York University (NYU) - Department of Accounting

Baohua Xin

University of Toronto - Rotman School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: June 26, 2014

Abstract

This study examines the private debt contracting relation between performance covenants and conservative accounting under asymmetric information. Asymmetric information is characterized by borrowers’ proclivity to appropriate wealth from lenders to themselves. We find that accounting conservatism and performance covenants act as complements to signal borrowers’ commitment not to appropriate wealth from lenders in the high information asymmetry regime. No such relation obtains in the low information asymmetry regime. We further show that in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants generally enjoy lower interest rate spreads in comparison to borrowers with low levels of conservatism and loose performance covenants. Consistent with our signaling theory, we document that borrowers with high levels of conservatism and tight performance covenants in the high information asymmetry regime are less likely to appropriate wealth from lenders to themselves. Our empirical results are robust to alternative measures of conservatism and covenant restrictiveness.

Keywords: Information asymmetry; accounting conservatism; performance covenants; signaling; wealth appropriation

JEL Classification: M41, G32, G35

Suggested Citation

Callen, Jeffrey L. and Chen, Feng and Dou, Yiwei and Xin, Baohua, Accounting Conservatism and Performance Covenants: A Signaling Approach (June 26, 2014). AAA 2010 Financial Accounting and Reporting Section (FARS) Paper. Available at SSRN: https://ssrn.com/abstract=1463573 or http://dx.doi.org/10.2139/ssrn.1463573

Jeffrey L. Callen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-946-5641 (Phone)
416-971-3048 (Fax)

Feng Chen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Yiwei Dou

New York University (NYU) - Department of Accounting ( email )

40 West 4th Street
Suite 10-180
New York, NY 10012
United States

Baohua Xin

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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