Debt Contract Enforcement and Conservatism: Evidence from a Natural Experiment
Posted: 23 May 2019
Date Written: December 1, 2018
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 show that enhanced enforcement has a significant positive effect on the timeliness of loss recognition of borrowing firms. We find that the effect is strongest for firms that increased their overall borrowing and for firms with high levels of tangible assets, consistent with a collateral‐based explanation. This study also provides causal evidence that firms adopt conservative accounting due to lenders' demand.
Keywords: debt contracts; enforcement; timely loss recognition; conservatism
JEL Classification: G33; K12; M41
Suggested Citation: Suggested Citation