Accounting Conservatism and Performance Covenants: A Signaling Approach

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