Creditor Rights, Implicit Covenants, and the Quality of Accounting Information

Abstract

We study a 2013 court decision that enhanced creditor control rights in Israeli firms by allowing them to force companies into bankruptcy. We find that the market expected the court ruling to benefit creditors: bond (equity) prices of companies affected by the new rule responded positively (negatively). We attribute this to the ability of creditors to initiate bankruptcy procedures earlier than in the period before the court ruling. We also observe a pronounced increase in the reported net worth of the firms affected by the new rule. We find evidence suggesting that some firms affected by the new rule increased their net worth by raising more equity. We also find, however, that firms changed their accounting practices, as reflected by an increase in long-term discretionary accruals and a decrease in accounting conservatism. As a result of these accounting changes, we document a decline in the informativeness of the treated firms' financial reports. We conclude that the benefits from creditor control rights may be mitigated by unintended consequences in the form of increased incentives for firms to adopt aggressive accounting practices and, as a result, a reduction in the informativeness of firms' financial reporting.

Keywords: Accounting conservatism, Accruals, bankruptcy, Covenants, Creditor rights, financial distress, Informativeness

JEL Classification: G30, G33, K22, M41