Accounting Conservatism and Debt Contract Renegotiation

• In Event: Financial Accounting and Reporting 6

Abstract

We examine the effect of borrowing firms’ accounting conservatism on debt contract renegotiations outside of default. We find that financial covenants in the debt contract are more likely to be renegotiated when borrowers’ accounting is more conservative. Financial covenants are also renegotiated sooner for more conservative borrowers than less conservative ones. Furthermore, the negative association between conservatism and ex ante cost of debt documented in prior literature is driven by the implication of conservatism on future renegotiation. Additional analyses confirm that the impact of conservatism on renegotiations occurs in the absence of any covenant violation and is not driven by other earnings attributes. Our study demonstrates the role of conservatism in the renegotiation process and expands the debt contracting explanation for conservatism (Watts, 2003) to a broader set of states, including those that are outside of default and financial distress.

Authors

• Yuan Ji, George Washington University

• Liang Tan, The George Washington University