Debt Covenants and Accounting Conservatism

Adamu Pantamee Abdurrahman,Ooi Chee Keong,Syed Ehsanullah,Shafi Mohamad

doi:10.5430/ijfr.v11n4p537

Adamu Pantamee Abdurrahman, Ooi Chee Keong + Show 2 more

Open Access

https://doi.org/10.5430/ijfr.v11n4p537

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Abstract

The purpose of this study is to examine the association between debt covenants and accounting conservatism. The study uses the data of 180 non-financial listed companies on the Malaysian Stock Exchange during the period of 2008 to 2018. Our findings suggest that the increasing use of debt covenants automatically gears up the firm to focus on the timely recognition of loss in order to satisfy the debt market. Further, we also examine whether there is a relationship between those firms’ that are more dependent on debt covenants and timely recognition of losses. This study finds that as the firm depends more on covenants their emphasis on the timely recognition of economic loss increases to avoid potential debt market issues. We also discuss the transfer of controls and power to the bondholders in a situation of financial distress and the auditor’s responsibility to monitor the limitations of accounting conservatism.

Highlights

The imposition of accounting conservatism following the introduction of debt covenants is frequently touched upon in the accounting literature
Since debt covenants are based on accounting numbers, the introduction of accounting conservatism helps to mitigate the conflict between bondholders and shareholders (Christensen et al, 2016)
The results above explain how debt covenant plays a role in satisfying the requirements of accounting conservatism (Balsam et al, 2018)

Summary

Introduction

The imposition of accounting conservatism following the introduction of debt covenants is frequently touched upon in the accounting literature. Prior studies report that accounting conservatism is one of the mechanisms to remove potential conflicts between bondholders and shareholders and has contributed to development of the debt market (Zhong & Li 2017). Since debt covenants are based on accounting numbers, the introduction of accounting conservatism helps to mitigate the conflict between bondholders and shareholders (Christensen et al, 2016). The importance of conservatism when developing debt covenants. Previous studies found a lot of evidence showing that accounting conservatism permits the acceptance of debt covenant in order to protect bondholders’ wealth. The background to this study is based on an earlier study by Nikolaev(2010) and the sample data is collected from the annual reports of Malaysian listed companies

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