The Asymmetric Accounting in the Creditor's Decision: An Aggregation Perspective

• In Event: Financial Accounting and Reporting

Abstract

This study examines the implications of unit-level accounting asymmetry for contracting decisions, which are based on the firm-level aggregate accounting report. More asymmetry under aggressive accounting increases the likelihood of low reports at unit levels and decreases the likelihood of high reports such that the aggregate accounting report at the firm level is coarsened (more volatile). Conversely, more asymmetry under conservative accounting makes the aggregate accounting report refined (less volatile). Because the interim liquidation value is commonly low, a false alarm is a major concern in a debt contract. The more coarsened aggregate report exacerbates the false alarm problem. Anticipating such an effect, ex-ante debt covenants for the interim options will be further loosened. In contrast, the more refined aggregate report mitigates and even offsets the false alarm problem. Hence, the ex-ante covenant will be eventually tightened. Overall, we find that the optimal covenant is non-monotonic to the degree of accounting asymmetry both theoretically and empirically. Consequently, we find that asymmetric accounting is optimal for the firm value.

Author

• Lanyi Zhang, University of Houston-Downtown