The Role of Accounting Conservatism in Capital Structure Adjustments

Abstract

This study examines the relation between accounting conservatism and firms’ capital structure adjustments. We find that firms with more conservative financial reporting adjust their capital structure toward the target more quickly, especially within firms that rely more on external financing for adjustments. Further, we find that the positive effect of conservatism on adjustment speeds is concentrated in under-levered firms and this effect occurs through conservatism facilitating debt issuance. Additionally, we show that higher conservatism is associated with higher future profitability for under-levered firms. Taken together, our findings suggest that accounting conservatism plays an important role in facilitating under-levered firms’ adjustment of capital structure toward the target.

Keywords: conservatism, capital structure, adjustment speed, under-levered firms, over-levered firms

JEL Classification: G20, M41, M43