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Accounting Conservatism and the Efficiency of Debt Contracts

Authors

  • FRANK GIGLER,

    1. Carlson School of Management, University of Minnesota
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  • CHANDRA KANODIA,

    1. Carlson School of Management, University of Minnesota
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  • HARESH SAPRA,

    1. Graduate School of Business, University of Chicago
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  • RAGHU VENUGOPALAN

    1. University of Illinois at Urbana-Champaign. We thank seminar participants at the University of British Columbia, University of Chicago, University of Houston, University of Illinois at Urbana-Champaign, University of Texas at Austin, University of Texas at Dallas, and Yale University for helpful comments. We are particularly grateful to Rick Antle, Joy Begley, Ron Dye, Brian Mittendorf, Dan Simunic, and an anonymous referee for their insights. Sapra is grateful to the University of Chicago Graduate School of Business for financial support.
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ABSTRACT

In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1997] description of differential verifiability standards. Optimal debt covenants and interest rates on debt are derived from a natural tension between debt holders and equity claimants. We show how optimal covenants vary with the degree of conservatism and derive an efficiency metric that depends on the degree of conservatism. We find that accounting conservatism actually decreases the efficiency of debt contracts, contrary to the suggestions of Watts [2003] and contrary to the hypothesis in numerous empirical studies.

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