Download this Paper Open PDF in Browser

Debt Contract Enforcement and Conservatism: Evidence from a Natural Experiment

67 Pages Posted: 16 Sep 2015 Last revised: 15 Sep 2016

Cyrus Aghamolla

University of Minnesota - Twin Cities

Nan Li

Columbia University - Columbia Business School

Date Written: September 10, 2016

Abstract

This study provides evidence that the usefulness of conservative accounting in debt contracting depends on the enforceability of the contract. To test the effect of debt contract enforcement on the use of timely loss recognition by borrowers, we use 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 across different states. The main results reveal that enhanced enforcement has a significant positive effect on the timeliness of loss recognition of borrowing firms. We predict that enhanced enforcement affects the financial reporting choices of borrowers indirectly through changes in the design of debt contracts, primarily through the increased emphasis on covenants and collateral. We find that the effect is strongest for firms who increased their overall borrowing, asset tangibility, and secured debt, 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

Aghamolla, Cyrus and Li, Nan, Debt Contract Enforcement and Conservatism: Evidence from a Natural Experiment (September 10, 2016). Columbia Business School Research Paper No. 15-84. Available at SSRN: https://ssrn.com/abstract=2661033 or http://dx.doi.org/10.2139/ssrn.2661033

Cyrus Aghamolla

University of Minnesota - Twin Cities ( email )

420 Delaware St. SE
Minneapolis, MN 55455
United States

Nan Li (Contact Author)

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Paper statistics

Downloads
263
Rank
97,135
Abstract Views
1,520