Debt Structure and Conditional Conservatism

Abstract

We investigate whether characteristics of firms’ debt structure, beyond leverage, are associated with predictable variation in conditional conservatism. The contracting theory of conservatism holds that conditional conservatism is an efficient mechanism employed by an organization to address agency conflict arising from contracts with various parties. For firms with contracts that are associated with more agency conflict (asymmetric information, asymmetric payoffs and differing control rights) the potential benefit of a conservative reporting strategy should increase. We examine the following debt characteristics: (1) maturity, (2) convertibility, (3) securitization, (4) seniority, and (5) placement. We find that debt characteristics thought to be associated with an upwards shift in the demand for conservative reporting, based on the contracting theory framework, are associated with more asymmetric timely loss recognition. Thus, our evidence supports the assertion that the contracting theory links debt structure and conservatism. Also, our evidence suggests that the effect of debt on conservatism can be under or over-stated when firms, or sub-samples of firms, have heterogeneous debt characteristics.

Keywords: Conditional conservatism, features of debt, agency costs

JEL Classification: M41, D21, D82, G14