Effects of corporate financial distress on peer firms: do intra-industry non-distressed firms become more conditionally conservative?

Abstract

We study whether public announcements (through delisting warnings) of financial distress of some firms in an industry affect the conditional accounting conservatism of intra-industry non-distressed firms. We hypothesize that the lenders of non-distressed firms perceive higher riskiness and demand for stricter debt covenants and more efficient monitoring of debt contracts when some firms show signals of financial distress in that industry. Intra-industry non-distressed firms increase their levels of conditional conservatism to meet the lenders’ demands for stricter monitoring of debt contracts and to reduce debt costs. Using the delisting warning data from the Chinese stock exchanges, we find that financial distress announcements lead to increases in conditional conservatism of non-distressed firms in that industry. We provide new evidence for the spillover effects of financial distress within an industry and the usefulness of conditional conservatism in debt contracts.