Accounting Conservatism and Debt Contract Efficiency with Soft Information

Abstract

This paper shows how accounting conservatism affects the efficiency of debt contracting in the presence of other non-accounting information. I show that conservative accounting will increase the efficiency of debt contracting when the other information is incrementally conservative to accounting information (the notion of incremental conservatism will be defined in the paper). However, when the non-accounting information is incrementally aggressive, conservative accounting is detrimental to the efficiency of debt contracting. Thus, whether more conservative financial reporting is good for debt contracting depends on the interaction between the informational characteristics of the accounting information and other non-accounting information. Interestingly, the result that the informational characteristics of the accounting system should be the same as those of the other information provides theoretical support for the conjecture proposed in prior studies (e.g., LaFond and Watts (2008)) -- that conservative accounting serves as a benchmark for other information sources that provide more informative information about gains. Although originated in the debt contracting framework, the conclusion that complementary information systems improves the efficiency of decision making is more general and can be adapted to any decision-making setting with correlated information sources.