Accounting Conservatism and Managerial Information Acquisition

Abstract

Empirical studies find that conservative reporting generally plays a positive role in debt contracting. A key benefit of conservatism is that it results in more frequent early warning signals that allow lenders to intervene and take corrective actions. However, theoretical contributions point out that conservatism also involves costs as it increases the risk of false alarms that lead to excessive lender intervention. We show that managers' incentive and ability to gather information can alleviate the concern for false alarms. The reason is that, following a covenant violation, managers have an incentive to search for additional information, hoping to find evidence that persuades lenders not to intervene and to waive the covenant. The manager's information acquisition reduces the risk that lenders act on false alarms and hence the downside of conservative reporting. Our model also provides a novel explanation for the empirical observation that covenant violations often trigger debt contract renegotiations and covenant waivers.

Keywords: accounting conservatism, debt contracting, early warning, managerial information acquisition