The Signaling Role of Accounting Conservatism in Debt Contracting

Abstract

TThere has been debate over the economic consequences of accounting conservatism in debt contracting. We contribute to this debate by arguing that the prospect of signaling project return may give rise to the demand for conservative accounting, even though it may not improve contracting efficiency ex post. The empirical evidence of the negative correlation between interest rates and conservative accounting may be explained by the heterogeneity among firms, such as riskiness, leverage and the strength of balance sheet. While debt covenants may also serve as a signaling device, they lead to a lower Type-I error, but a higher Type-II error, than signaling via accounting conservatism. Our results further indicate that conditional conservatism may either alleviate or amplify the distortion required for the signaling purpose.

Keywords: accounting conservatism, debt covenants, signaling

JEL Classification: M41, M44, G21, G32