Accounting Conservatism and Performance Covenants: A Signaling Approach

49 Pages Posted: 8 Jul 2015 Last revised: 6 Feb 2018

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: July 6, 2015

Abstract

This study examines the relation between performance covenants in private debt contracting and conservative accounting under adverse selection. We find that under severe adverse selection (i.e., high information asymmetry), accounting conservatism and performance covenants act as complements to signal that the borrower is unlikely to appropriate wealth from the lender. No such relation obtains in a 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 than borrowers with low levels of conservatism and loose performance covenants. Consistent with our signaling theory, in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants are less likely to make abnormal payouts to shareholders. Our empirical results are robust to alternative measures of conservatism and covenant restrictiveness.

Keywords: Accounting Conservatism, Performance Covenants, Signaling, Wealth Appropriation

JEL Classification: M41, D82

Suggested Citation

Callen, Jeffrey L. and Chen, Feng and Dou, Yiwei and Xin, Baohua, Accounting Conservatism and Performance Covenants: A Signaling Approach (July 6, 2015). Contemporary Accounting Research (2016) 33 (3): 961-988; Rotman School of Management Working Paper No. 1538660. Available at SSRN: https://ssrn.com/abstract=1538660

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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