Abstract
We study the dual role of borrowers’ balance sheet conservatism (i.e., conservatism in asset values) in debt contract design. Conservative asset values reduce lenders’ uncertainty regarding asset valuation and mitigate debtholder-shareholder conflicts. However, as asset valuation approaches its lower-bound estimates, it constrains the borrowers’ future ability to take write-downs in response to bad news. Consistent with these two effects, we find that high balance sheet conservatism is associated with lower interest and less restrictive covenants for bank loans. Further, lenders appear to recognize that future conservatism is constrained when balance sheet conservatism is high. Our results highlight the importance of considering time-series dependencies of accounting policies in contract design.
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