Debt Contract Enforcement and Conservatism: Evidence from a Natural Experiment

• Date: 01 December 2018
• Author: NAN LI,CYRUS AGHAMOLLA
• DOI: http://doi.org/10.1111/1475-679X.12238
• Published date: 01 December 2018

DOI: 10.1111/1475-679X.12238

Journal of Accounting Research

Vol. 56 No. 5 December 2018

Printed in U.S.A.

Debt Contract Enforcement and

Conservatism: Evidence from a

Natural Experiment

CYRUS AGHAMOLLA

∗AND NAN LI

∗

Received 29 July 2015; accepted 11 June 2018

ABSTRACT

This study provides evidence that the use of conservative accounting in debt

contracting depends on the enforceability of the contract. Totest the effect of

debt contract enforcement on borrowers’ timely loss recognition, we exploit

the staggered introduction of enhanced debt contract enforcement in Indian

states as a natural experiment, where the implementation of the enforcement

is exogenous to the accounting choices and borrowing behavior of firms. The

main results show that enhanced enforcement has a significant positive effect

on the timeliness of loss recognition of borrowing firms. We find that the ef-

fect is strongest for firms that increased their overall borrowing and for firms

with high levels of tangible assets, consistent with a collateral-based explana-

tion. This study also provides causal evidence that firms adopt conservative

accounting due to lenders’ demand.

JEL codes: G33; K12; M41

Keywords: debt contracts; enforcement; timely loss recognition; conser-

vatism

∗Carlson School of Management, University of Minnesota.

Accepted by Christian Leuz. We have benefited from valuable comments by two anony-

mous reviewers, Dan Amiram, Fabrizio Ferri, Frank Gigler, Jon Glover, Ilan Guttman, Alon

Kalay, Urooj Khan, Xinlei Li, Tjomme Rusticus, Stephen Ryan, Pervin Shroff, Anup Sri-

vastava, and Ronghuo Zheng. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

1383

CUniversity of Chicago on behalf of the Accounting Research Center,2018

1384 C.AGHAMOLLA AND N.LI

1. Introduction

Debt contracts are among the most important contracts for firms seeking

external finance, and affect a firm’s decisions at many levels, including

project choice, compensation, and financial reporting. The efficacy of debt

contracts, however, crucially depends on their legal enforcement (Djankov

et al. [2008]). Despite the extensive study of debt contracts in accounting

research and the inherent importance of debt contract enforcement, very

little research, to our knowledge, provides causal evidence on the impact of

debt contract enforcement on the accounting choices of firms. In this study,

we seek to bridge this gap by exploiting a natural experiment to investigate

the effect of enhanced enforcement of debt contracts on firms’ financial

reporting decisions, specifically with respect to timely loss recognition. In

particular, we utilize the staggered introduction of debt recovery tribunals

in India, which significantly strengthened the enforcement of debt con-

tracts without being confounded by other economic or legal changes. We

find that enhanced debt contract enforcement has significant, positive ef-

fects on borrowers’ timely loss recognition.

Previous studies have examined the associations between legal institu-

tions and financial reporting in a broad sense, such as with regard to coun-

tries’ legal origin, judicial impartiality, and insider trading laws (e.g., Ball,

Kothari, and Robin [2000], Leuz, Nanda, and Wysocki [2003], Burgstahler,

Hail, and Leuz [2006], Bushman and Piotroski [2006], Jayaraman [2012]).

These cross-country studies generally support the hypothesis that strong in-

vestor protection and judicial enforcement of contracts is associated with

higher earnings quality and more timely loss recognition. While this re-

search is informative of the role of contract enforcement on accounting

choices, the research designs employed in several of these studies rather

assess broad characteristics of the legal system, such as legal origin (e.g.,

common law versus civil law origin) and rule of law indices developed by

Porta et al. [1998], that do not specifically pertain to the enforcement of fi-

nancial contracts. Moreover, these studies do not address a specific judicial

enforcement mechanism through which legal system strength directly af-

fects the accounting choices of firms, leaving us with a limited understand-

ing of the interplay between accounting choices and judicial enforcement.1

In contrast, we consider the effects of one specific change in a particular

country’s legal institution that directly concerns the enforcement of debt

contracts. In doing so, we investigate a specific micro-level mechanism of

legal system strength that generates demand for conservatism.

Timely loss recognition is valuable to lenders since it helps mitigate

agency concerns and limits downside risk (Watts [2003]). Previous studies

1As Bushman and Piotroski [2006] note: “While we attempt to relate these institutional

influences to the contracting, shareholder litigation, regulatory, and tax explanations posited

by Watts [2003], we cannot and do not claim to be directly testing these alternative theories

with our research design” (p. 140).

DEBT CONTRACT ENFORCEMENT AND CONSERVATISM 1385

have found that accounting conservatism is complementary to the design

of debt contracts (Ahmed et al. [2002], Ball and Shivakumar [2005], Ball,

Robin, and Sadka [2008], Beatty, Weber, and Yu [2008], Nikolaev [2010]).

However, accounting information, such as timely loss recognition, is use-

ful for contracting purposes insofar as there is enforcement of the debt

contract.2We argue that the enhanced enforcement of debt contracts indi-

rectly affects timely loss recognition through two channels: debt covenants

and collateral.

Nikolaev [2010] finds that debt covenants are more effective when firms

are timely in their loss recognition. The efficacy of debt covenants, and thus

of conservative reporting, depends on the extent to which the contract can

be enforced by the legal system. Specifically, enhanced enforcement likely

places more emphasis on accounting-based covenants in debt contracts.

This occurs since the reduced legal costs brought by strengthened creditor

rights allow lenders to credibly pursue covenant violations through the

legal system. As a result, this provides the possibility of severe repercussions

(such as immediate repayment) necessary to compel borrowers to engage

in renegotiation following covenant violations (e.g., increased interest rate,

accelerated maturity). The greater reliance on accounting-based covenants

consequently increases lenders’ demand for timely loss recognition, as this

allows lenders to limit their default risk through protective actions from

relatively earlier covenant violations (Watts [2003], Ball and Shivakumar

[2005]).

Likewise, strengthening the rights of creditors to appropriate collateral

in the case of default makes collateral-based lending more appealing, as it

increases the liquidation value of collateral (which allows borrowers to in-

crease their debt capacity; Hart and Moore [1994], Vig [2013]). This leads

to an increased emphasis on collateral in lending agreements following

enhanced enforcement. Conservatism is thus beneficial for lenders as it

helps to assess and monitor the lower bound of the collateral’s value and

ensure that this value is not overstated (Watts [2003]). However, such as-

sessment is less useful under weak enforcement since the net asset value

at default would be less correlated with the value that is ultimately recov-

ered, as mangers have more freedom to dispose of pledged assets be-

fore the lender can seize. Moreover, in an analytical model, G¨

ox and

Wagenhofer [2009] show that conditional conservatism is the optimal ac-

counting policy for firms that must pledge collateral to raise external fi-

nance (when there is sufficient enforcement of the contract).

Our research design allows us to isolate a shock to enforcement with-

out being confounded by other institutional changes, country-level hetero-

geneity, or endogenous policy choices. In 1993, the Government of India

passed a new law to establish special courts devoted solely to debt recovery

2Take financial covenants as a simplified example: if violating a net worth covenant does

not result in a serious de facto legal consequence, then the financial reporting practice that

generates the net worth ratio is irrelevant with respect to the covenant.