Conservatism and Debt

Abstract

Despite the unquestionable influence of conservatism, disagreement remains about what economic demands lead to financial reporting conservatism. Research examining lenders' demands for reporting conservatism has been questioned for ignoring conservative contract modifications. We document that these modifications exist but are not ubiquitous, and consider the relative efficiency of contract adjustments versus contracting over GAAP. We find contract modifications are more likely when agency costs are higher and litigation, tax and equity demands for conservatism are lower. However, we find a positive association between unexplained reporting conservatism and contract modifications, suggesting contractual modifications alone cannot fulfill lenders' demands for conservatism.

Keywords: Conservatism, Covenants, Debt Contracting

JEL Classification: G21, G30, G34, G39, M41, M44, M49