Prospective Wealth Transfer and the Signaling Role of Accounting Conservatism in Debt Contracts

This October paper by Jeffrey L. Callen, Feng Chen, Yiwei Dou, and Baohua Xin shows analytically and empirically that the relation between conservatism and covenants is conditioned on the extent of information asymmetry between borrowers and lenders.

In particular, when the degree of information asymmetry is high, conservatism and covenants complement each other to signal potential wealth transfers from debt holders to equity holders. No such a relation obtains when the degree of information asymmetry is low.

The authors further show that under a high information asymmetry regime, borrowers with a high level of conservatism and tight covenants generally enjoy lower interest rates than borrowers with a low level of conservatism and loose covenants.

Consistent with their signaling theory, they also document that borrowers with a high level of conservatism and tight covenants in the high information asymmetry regime are less likely to make future wealth transfers from creditors to equity holders.

Their empirical results are fairly robust to alternative measures of conservatism and covenant

Meet Baohua Xin 11/7/2012 from 10:00AM – 11:30AM at the University of California, Davis.

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