Conservatism Flow and the Pricing of Credit Risk

Abstract

I study the relation between the pricing of credit default swaps (CDSs) and three recently proposed firm-year measures of conditional conservatism or conservatism flow: asymmetric timeliness of earnings, asymmetric behavior of accruals, and conservatism ratio. Using CDS pricing data from Fitch, I show that there is a negative association between CDS price with maturities from one to ten years, and the first two metrics of conservatism flow. I also document that the strength of the association decreases as maturity increases. My results are consistent with the hypothesis that managers practicing timely accounting recognition of economic losses tend to avoid ex ante negative NPV projects and more quickly abandon projects that turn out to be negative NPV ex post. These, in turn, lead to an association with CDS price, via a reduction of information asymmetry between firm insiders and outsiders, the provision of a reliable estimate of future firm wealth, and a reduction in probability of bankruptcy. I also show that the effect of asymmetric timeliness is incremental to the book-to-tax ratio, which is thought to be a measure of conservatism by the literature on taxation.