Evidence on the role of accounting conservatism in debt contracting

I examine how accounting conservatism relates to the design of private debt contracts with consideration of managerial risk preferences embedded in compensation contracts. Theoretical explanations for conservatism relate to the design of financial covenants or valuation of pledged assets in efficiently resolving asset substitution and incentive conflicts, respectively. I also consider conservatism in earnings in conjunction with other devices in signaling credit risk. I find evidence that accounting conservatism, the presence of financial covenants, and collateral are positively associated with the choice of long-term debt; with short-term debt constituting an alternative form of creditor protection. More notably, I find evidence of a predicted positive association between the use of collateral and conservatism. I fail to find a predicted positive association, however, between the presence of financial covenants and conservatism when managerial incentives indicate greater risk of asset substitution. Finally, I find no evidence of an association between conservatism in conjunction with earnings-based covenants and yield spreads as a measure of signaling content.