Debt Contract Enforcement and Conservatism: Evidence from a Natural Experiment

Abstract

This study provides evidence that the usefulness of conservative accounting in debt contracting depends on the enforceability of the contract. To test the effect of debt contract enforcement on the use of timely loss recognition by borrowers, we use 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 across different states. The main results reveal that enhanced enforcement has a significant positive effect on the timeliness of loss recognition of borrowing firms. We predict that enhanced enforcement affects the financial reporting choices of borrowers indirectly through changes in the design of debt contracts, primarily through the increased emphasis on covenants and collateral. We find that the effect is strongest for firms who increased their overall borrowing, asset tangibility, and secured debt, consistent with our hypothesized channels. This study also provides causal evidence that firms adopt conservative accounting due to lenders' demand.