Accounting and Debt Markets

Four Pieces on the Role of Accounting Information in Debt Markets

Mark Clatworthy, Juan Manuel García Lara, Edward Lee, Mark Clatworthy, Juan Manuel García Lara, Edward Lee

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000344660
• Edition: 1
• Topic: Business
• Subtopic: Accounting
• Index: Business

Accounting and Debt Markets: Four Pieces on the Role of Accounting Information in Debt Markets provides novel and up-to-date evidence on the role of accounting information in debt markets

Companies and organisations worldwide rely heavily on debt markets for short, medium and long-term financing, and debt markets and financial intermediaries have significant effects on the real economy. Accounting information has various functions in debt markets, including inter alia, informing pricing decisions and credit ratings, determining the allocation of creditor control rights and establishing bank capital adequacy requirements. The chapters in this book provide illustrative discussion, analysis and evidence on the importance of accounting information in credit markets. The first of the four pieces reflects on how a conservative financial reporting system helps firms obtain debt funds and with better conditions, and why this is the case. The second examines the effects of accounting disclosure on credit ratings of private companies and shows that accounting information is useful for credit rating agencies. The two final pieces reflect on how banks should account for credit losses, and on how regulators are tackling this issue.

The chapters in this book were originally published as a special issue of Accounting and Business Research.

Conservatism in debt contracting: theory and empirical evidence†

†This paper is based on our contributions to the 'Accounting and Business Research Special Issue Symposium: The Role of Accounting Information in Debt Markets' at the Annual Congress 2017 of the European Accounting Association.

FERNANDO PENALVA • and ALFRED WAGENHOFER •

This paper surveys both the theoretical and the empirical archival literature on conservatism when accounting information is used for debt contracting. The theoretical literature shows mixed results whether conservative accounting is desirable, which depends on the underlying agency problem, the information available, and the contracting space. The empirical literature takes a more holistic view in measuring the degree of conservatism. It studies a broad array of possible effects of conservatism in debt financing, but also beyond. The results overwhelmingly support the view that conservatism plays a useful role in debt contracting, although there are also some mixed results. We describe key results and empirical designs, and we provide suggestions for future research.

1. Introduction

Conservatism is one of the most important features of accounting. It has been present well before the advent of legal innovations such as limited liability of equity, widespread litigation, standard setting and regulation, auditing, stock exchanges, public debt and fractional ownership of equity, which are the bases for the other explanations of conservatism: contacting, litigation, taxation and regulation (Watts and Zimmerman, 1986; Basu, 1997; Ball, 2001; Watts 2003a). Among these many explanations for the existence of conservatism, its usefulness in debt contracting is one of the oldest and probably the strongest (Ball, Robin, and Sadka, 2008).¹

This paper surveys both the theoretical and the empirical archival literature on conservatism when accounting information is used for debt financing. The theoretical literature shows mixed results on whether conservative accounting is desirable, depending on the underlying agency problem, the information available, and the contracting space. The empirical literature overwhelmingly supports the view that conservatism plays a useful role in debt contracting, although there are some mixed results. Theory and empirical results are not always in line because of different research approaches: theory usually singles out a specific economic setting to derive benefits and costs of conservatism, whereas empirical research has to deal with the wide set of possible different effects embedded in the data. Theory work can benefit from the rich settings studied by empirical research and the insights in economically significant effects; and empirical work can benefit from theory in developing more specific predictions, which allows for better empirical research designs.

Prior survey papers on conservative accounting include, among others, Watts (2003a, 2003b), Beatty, Weber, and Yu (2008), Armstrong, Guay, and Weber (2010), Ewert and Wagenhofer (2011), Mora and Walker (2015), Rucli and Taylor (2015), Shivakumar (2013), and Zhong and Li (2017). Some of them discuss potential benefits of conservatism generally, whereas this paper focuses on how conservatism facilitates debt contracting. Most surveys provide little coverage of the analytical literature, but are geared towards reporting results of empirical research. This paper combines these two streams of research because we believe both provide fundamental insights from different angles and can benefit from each other.

The aim of this paper is not to give a comprehensive survey of the large literature related to conservatism in debt contracting, but to focus on what we, in our opinion, view as important findings.

2. Defining accounting conservatism

Conservatism (or prudence) is a key characteristic of accounting systems, going back for centuries. Sterling (1967, p. 110) claims that conservatism is 'the most ancient and probably the most pervasive principle of accounting valuation.' Maltby (2000) traces prudence in accounting back to one of the bourgeois virtues in the Middle Ages. Conservatism reflects the accountants' rule of 'anticipate no profits but anticipate all losses' (Bliss, 1924).

The previous framework of the IASC defined prudence in a similar way: 'Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated' (IASC, 1989, para. 37). In an overhaul of their frameworks, the IASB and the FASB decided to eliminate prudence from the qualitative characteristics (IASB, 2010; FASB, 2010). The rationale is that a conservative bias prevents accounting numbers from being neutral and, thus, representationally faithful. Recently, the IASB Conceptual Framework reintroduced prudence in a specific form: 'Prudence is the exercise of caution when making judgements under conditions of uncertainty' (IASB 2018, para. 2.16) and explains that prudence does not imply a need for asymmetry towards downward biased equity, arguing that 'such asymmetry is not a qualitative characteristic of useful financial information' (IASB 2018, para. 2.17). The FASB did not follow that. Nevertheless, current IFRS and US GAAP - as well as the accounting standards of most countries - include conservative asymmetric requirements and there is no sign that they will be abandoned in the near future. Barker (2015) lists the main instances of conservatism in the IFRSs.²

Accounting research distinguishes two forms of conservatism: conditional and unconditional conservatism (Beaver and Ryan, 2005; Ball and Shivakumar, 2005), Conditional conservatism involves the timelier recognition in earnings of unrealised losses than of unrealised gains. Recognition is conditional on the receipt of news and the timeliness of recognition is conditional on the content of the news received. When news is sufficiently bad, conditional conservatism requires timely incorporation of this information in earnings, whereas the information in good news is not incorporated in earnings until it is realised. Alternatively, bad news is recorded even if it is still uncertain, whereas recognition of good news requires a higher degree of verification. Examples of conditional conservatism are goodwill impairment, long-lived assets impairment, measurement of inventory at the lower of cost or market, and recognition of provisions for expected losses but no recognition of expected gains. In other words, under conditionally conservative reporting, contemporaneous earnings incorporate in a timelier manner bad news information about firm value than good news information. Basu (1997) was the first to formalise this construct even though he did not refer to it as conditional conservatism.

Unconditional conservatism involves the predetermined understatement of assets and overstatement of liabilities regardless of the actual value of those assets and liabilities. Examples of unconditional conservatism are the immediate expensing of research and development expenditures, the non-recognition of internally generated intangibles and internally originated goodwill, accelerated depreciation independent of the loss in capacity, and LIFO inventory valuation. This form of conservatism is news-independent and introduces a downward bias of net assets of an unknown amount in the reported accounting numbers. Consequently, it suppresses information about the value of assets or liabilities that arises over time (Ball and Shivakumar, 2005).

Accounting research generally views conditional conservatism as useful and unconditional conservatism as undesirable. The reason is that conditional conservatism provides some new information in a timelier manner, whereas unconditional conservatism is uninformative. It should be noted, though, that conditional conservatism also suppresses information because it asymmetrically conveys only bad, but not good news.³ Going a step further, full disclosure of news of any kind would seem to be even more desirable (Guay and Verrecchia, 2006). This argument underlies the use of fair value measurement in financial accounting, particularly for financial instruments. However, concerns about misaligned management incentives and other undesirable economic consequences of fair value measurement are considered important enough so as to suppress the recognition of uncertain favourable news.

This is not to claim that unconditional conservatism is strictly non-useful. For example, it can effectively restrict distribution of dividends, facilitate the design of debt contracts or can be used as a commitment device to less disclosure of information if more transparency can trigger unfavourable economic outcomes. However, evidence suggests that unconditional conservatism is unlikely to play a significant role in debt contracting. For example, Ball, Robin, and Sadka (2008) find that neither balance-sheet-based nor income-statement-based measures of unconditional conservatism are related to the importance of debt markets and Sunder, Sunder, and Zhang (2018) find that unconditional conservatism does not improve contracting efficiency. To understand this, consider the case of depreciation. Accelerated depreciation is considered a form of unconditional conservatism, including its extreme form when internally developed assets, such as research and development or advertising, are not capitalised. Lev and Sougiannis (1996) show that capitalised and subsequently amortised research and development is value relevant and associated with current and future stock returns. Sunder et al. (2018) construct measures of unconditional conservatism that take into account research and development and advertising following Penman and Zhang (2002). They find that none of these measures is associated with reduced borrowing costs (spreads), unlike measures of conditional conservatism.⁴ This does not imply that firms' use of accelerated depreciation is uninformative or that changes in depreciation rates do not convey information about the use of assets or future capital expenditures. Yet the lack of timeliness of accounting information due to this form of conservatism appears to attenuate its usefulness in efficient debt contracting. That is a possible reason that accounting research to date has been unable to identify a useful role of depreciation (unconditional conservatism) in debt contracting.

Unconditional and conditional conservatism are not independent of each other. Unconditional conservatism can preempt conditional conservatism: assets unconditionally written down (e.g. expensed research and development) cannot be further written down conditional on unfavourable news, so the firm will appear to be less conditionally conservative. This interdependence causes a negative association between conditional conservatism and unconditional conservatism, even though these two types of conservatism are conceptually distinct. Acknowledging this effect is important for empirical studies across jurisdictions that require more or less unconditional conservatism.

While accounting standards include requirements for conservative accounting, management has room for discretion as to what extent it can report more or less conservatively. While conditional conservatism requires judgment, e.g. regarding the existence of a trigger for impairment, unconditional conservatism can require judgment as well, e.g. when accounting standards contain criteria for recognition or full expensing of development costs.

In this paper, we focus on conditional conservatism because it is the type of conservatism with more contracting value (Watts and Zimmerman, 1986; Basu, 1997; Ball, 2001; Watts, 2003a; Ball and Shivakumar, 2005; Ball, Robin, and Sadka, 2008; Sunder, Sunder, and Zhang, 2018, among many others) and, consequently, it has received most attention in the literature. Following the empirical literature, we use the terms conditional conservatism, conservatism, timeliness of loss recognition, asymmetric timely loss recognition, and financial reporting conservatism interchangeably, unless otherwise indicated.

3. Role of conservative accounting in debt contracts

Conservatism is considered an efficient contracting mechanism, particularly in debt settings (Watts and Zimmerman, 1986; Watts, 2003a; Kothari, Ramanna, and Skinner, 2010). The typical argument is that lenders demand timely information about the performance of borrowers. This information must be observable and contractible to the parties. Therefore, lenders are not interested in difficult-to-verify information about future cash inflows; they prefer expected future gains not to be included in reported earnings and asset values until they are realised. In contrast, they prefer earnings and asset values that incorporate difficult-to-verify expected losses because negative information can act as a timely trigger to increase monitoring and even to take control of the borrowing firm in the most serious cases.

The intuition for this asymmetric preference for timely recognition of losses, but not gains, is that lenders have an asymmetric return function: at maturity of the loan, if a borrower's net assets are worth more than the value of the loan, the lender receives just the principal and the interest but nothing more, regardless of how high the ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Contents
• Citation Information
• Notes on Contributors
• Introduction
• 1 Conservatism in debt contracting: theory and empirical evidence
• 2 The impact of filing micro-entity accounts and the disclosure of reporting accountants on credit scores: an exploratory study
• 3 Reflections on the development of the FASB's and IASB's expected-loss methods of accounting for credit losses
• 4 Bank loan loss accounting and its contracting effects: the new expected loss models
• Index