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The Contracting Benefits of Accounting Conservatism to Lenders and Borrowers

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Journal of Accounting and Economics 45 (2008) 27–54 www.elsevier.com/locate/jae

The contracting benefits of accounting conservatism to lenders and borrowers$
Jieying ZhangÃ
Leventhal School of Accounting, University of Southern California, Los Angeles, CA 90089, USA Received 1 March 2004; received in revised form 17 May 2007; accepted 8 June 2007 Available online 19 July 2007

Abstract This paper examines the ex post and ex ante benefits of accounting conservatism to lenders and borrowers in the debt contracting process. I expect conservatism to benefit lenders ex post through the timely signaling of default risk, as manifested by accelerated covenant violations, and to benefit borrowers ex ante through lower initial interest rates. Consistent with these predictions, I find that more conservative borrowers are more likely to violate debt covenants following a negative price shock, and that lenders offer lower interest rates to more conservative borrowers. r 2007 Elsevier B.V. All rights reserved.
JEL classification: M41; G32 Keywords: Conservatism; Debt contracting; Covenant violation; Spread

1. Introduction While positive accounting theory suggests that accounting conservatism enhances efficiency in the debt contracting process (Watts and Zimmerman, 1986; Watts, 2003a, b), there is little empirical evidence on the debt contracting benefits of conservatism. In this paper, I provide evidence on the ex post and ex ante benefits of conservatism to lenders and borrowers. Specifically, I document that conservatism benefits lenders ex post through the timely signaling of default risk, as manifested by accelerated covenant violations, and benefits borrowers ex ante through lower interest rates.

$ This paper is based on my dissertation at Massachusetts Institute of Technology. I would like to thank the members of my dissertation committee, S.P. Kothari…...

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