Accounting Conservatism in Debt Contracting Process

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Summary of Zhang’s Article

The article in question explores the effects of accounting conservatism on the debt contracting process. It is stressed that conservatism is associated with certain benefits to lenders, which makes this approach seem less attractive for borrowers. Hence, the focus on fair value is quite common. The author states that the role of conservatism has been well-researched, but the field lacks empirical evidence of its impact on both lenders and borrowers. This study addresses the mentioned gap. The researcher comes up with the following hypothesis:

Hypothesis 1a: The more conservative borrowers tend to violate debt covenants more often as compared to the less conservative borrowers.
Hypothesis 1b: The more conservative borrowers tend to violate debt covenants sooner as compared to the less conservative borrowers.
Hypothesis 2: More conservative borrowers tend to have lower interest rates.

The author evaluates accounting conservatism with the help of several measures. These aspects include earnings’ sensitivity to negative changes as compared to sensitivity to positive changes, nonoperating accruals, and the explanatory power of positive and negative changes, earnings’ skewness. These measures are also used to check the hypothesis developed.

To check the three hypotheses mentioned above, the author uses a sample of 327 companies that experienced one or more adverse negative price shock between 1999 and 2000. The eligible companies’ debt contracting documentation was available. The companies had to be characterized by a certain degree of conservatism. The major contributions of the research, as stated by the author, include the provision of empirical data concerning the benefits of debt contracts to both lenders and borrowers. Furthermore, the article can be helpful for standard establishers who try to choose between the fair value approach and conservatism.

It is found that the more conservative borrowers tend to violate debt contracts when some adverse price shocks occur. At the same time, conservative borrowers have lower interest rates. These findings are regarded as evidence of the benefits of accounting conservatism for both borrowers and lenders. It is emphasized that the majority of works on the matter focus on the benefits of accounting conservatism for lenders. However, this research also unveils some positive outcomes for borrowers. In simple terms, conservatism is beneficial as lenders manage to mitigate their downside risks while borrowers get lower interest rates. Conservatism is also seen as a factor contributing to the efficiency of the debt contracting process.

The researcher mentions certain limitations to the study in question. The major limitation is associated with the sample size. It is noted that due to the limited number of companies participating in the research, the findings can hardly be generalized. Besides, bank loans became the focus of the paper while private placements and public debt were not analyzed. Therefore, there are chances that the outcomes can be somewhat different.

At that, the author stresses that the findings are still relevant as bank loans can be regarded as an appropriate illustration of the benefits of conservatism. Finally, the researcher mentions some areas for further consideration. For instance, it is beneficial to focus on the role of conservatism in the development of accounting policies. Future research can address the limitations mentioned above.

Summary of Nikolaev’s Article

The article under analysis dwells upon the relevance of accounting conservatism to debt covenants development. The major focus is on the timely recognition of losses and their correlation with the use of covenants. The author states that covenants are aimed at minimizing the opportunism of managers and mitigating the risks of bondholders. However, even debt contracts do not ensure that this major goal will be met as loss recognition can still be untimely.

The major finding reported is that the use of covenants in the process of public debt contracts development positively correlates with timely recognition of losses. The researcher emphasizes that public debt contracts are associated with limited demand for timely recognition of economic losses.

At the same time, the author notes that managers still tend to report losses promptly due to several reasons. These factors include the need to maintain the company’s reputation and litigation risks. The author hypothesizes that timely loss recognition grows if debt covenants are used in the process of public debt contract development. The second hypothesis is as follows: firms relying on the extensive use of covenants tend to focus on timely loss recognition after the debt issue.

The third hypothesis is as follows: if a firm relies on private debt, the association between timely recognition of losses and the use of covenants in public debt contracts decreases. Finally, the researcher hypothesizes that the association between timely recognition of losses and covenants used in public debt contracts becomes more apparent if the number of covenants in private credit contracts is significant. The sample size is significant as the author analyzes 5,420 company-year observations during the period between 1980 and 2006. The corresponding accounting documents from 2,466 firms were analyzed.

The major findings of this study are consistent with the existing research but add valuable insights into the matter. For instance, the author reports that companies using covenants extensively in public debt contracts tend to exhibit high timely loss recognition. Moreover, the growth of timely loss recognition often takes place a year after some debt issues. The author concludes that the use of covenants in public debt contracts promotes timely recognition of losses. At that, the occurrence of private date negatively affects timely loss recognition. The researcher stresses that the use of covenants in public debt contracts cannot be regarded as a replacement for timely recognition of losses.

The researcher identifies two major limitations to the present study. First, there are chances that timely loss recognition and the use of covenants in public debt contracts are complementary to each other. It is also vital to remember numerous factors affecting the development of companies and managerial decisions. Second, it is noted that the tightness of covenants is difficult to estimate due to limited resources although this factor can play an important role in the process of contract development and managerial opportunism.

Nevertheless, the implications of the study in question are apparent. Standard setters can benefit from the research as they will understand that covenants do not ensure timely loss recognition. On the contrary, the use of covenants is associated with a strong demand for timely loss recognition. Finally, it is essential to remember that public debt contracts are often associated with timely recognition of losses especially if some debt issues persist while the existence of some private debt issues tends to hurt timely loss recognition.

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Accounting Conservatism in Debt Contracting Process

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