Debt Covenants And Accounting Conservatism

Accounting conservatism, a basic rule for accounting information, requires enterprises to be cautious for uncertain economic businesses. It is necessary to recognize expected losses and expenses promptly; however, uncertain revenue should not be recognized unless its probability is more than 95 percentages. This asymmetric asymmetry accounting treatment is useful for creditor to keep abreast of the financial situation of enterprises operate; help solve creditors and shareholders, the problem of asymmetric information between managers. But at the same time, accounting conservatism has distributable profits for companies, adversely affecting free cash flow, results of operations. There is a tradeoff choice for the level of accounting conservatisms.Particular covenants can be classified into four main kinds:Option covenants, investment covenants, conditions, financial covenants, covenants to restrict asset-transformation. Covenants are the essential tool for bond holders to protect their legal rights. Since bond holders couldn’t get management information’s directly, they depend on accounting conservatism to improve their unfavorable plights. Therefore the more covenants contained in debt contracts, the more bond holders depend on accounting conservatism. This demand of bond holders is a main factor that enables enterprises to improve their accounting conservatism.Conservatism is beneficial for companies. Firstly, the combination of accounting conservatism and covenants of bond contracts, is the market identification of excellence, which would contribute to reduce debt financing cost.Secondly, debt financing is one kind of long term financing, and it is also the most useful financing outside tool for companies. Therefore, the enterprise with a strong desire to reduce their cost of bond financing and credit risk, would like improve accounting conservatism to gain the contracting benefits. For the above reasons, I argue that timely recognition of economic losses increases with the use of debt covenants in public debt contracts.And companies that rely on debt covenants more extensively exhibit a greater increase in timely recognition of economic losses following debt issue.These two questions were answered through six parts. Firstly I describe the background and significance of this study. Secondly followed by domestic and foreign relevant research literature review I propose two hypothesis in this paper by theoretical analysis; Finally, I use the corporation bonds issued between 2007 and 2013 as samples to whether my hypothesis.Through in-depth research, we draw the following three conclusions:1、In order to reduce financing costs and meet the require of bond holders, companies will improve accounting conservatism.2、Timely recognition of economic losses increases with the use of debt covenants in public debt contracts.3、Companies that rely on debt covenants more extensively exhibit a greater increase in timely recognition of economic losses following debt issue.Based on the above findings, we propose corresponding suggestions:First, when selecting investment targets, investors should not only focus on the general terms of the bond contracts, adequate attention should also be paid to special covenants of bond contracts; Second, bond covenants’ design plays an important role in solving agency problems. A perfect covenants’ design will improve corporate accounting conservatism, creditors should pay more attention to those covenants. Thirdly, effective covenants’ design and accounting conservatism, through the signal effect, would reduce the cost of bond financing.