Debt Contract Enforcement and Conservatism: Evidence from a Natural Experiment
56 Pages Posted: 16 Sep 2015 Last revised: 29 Sep 2017
Date Written: September 28, 2017
This study provides evidence that the use of conservative accounting in debt contracting depends on the enforceability of the contract. To test the effect of debt contract enforcement on borrowers' timely loss recognition, we exploit the staggered introduction of enhanced debt contract enforcement in Indian states as a natural experiment, where the implementation of the enforcement is exogenous to the accounting choices and borrowing behavior of firms. The main results reveal that enhanced enforcement has a significant positive effect on the timeliness of loss recognition of borrowing firms. We predict that the enhanced enforcement affects the financial reporting choices of borrowers through the increased emphasis on covenants and collateral. We find that the effect is strongest for firms who increased their overall borrowing and for firms with high levels of tangible assets, consistent with our hypothesized channels. This study also provides causal evidence that firms adopt conservative accounting due to lenders' demand.
Keywords: conservatism, debt contracts, enforcement
JEL Classification: M41
Suggested Citation: Suggested Citation