Incremental Usefulness of the Parent-only Balance Sheet to Debt Holders: Evidence from Banks

Abstract

Debt contracts are signed by specific legal entities. However, general-purpose financial statements prepared under U.S. GAAP and Canadian GAAP are for a consolidated reporting entity—a collection of legal entities that include the parent and any subsidiaries it controls. This reporting model results in a loss of crucial information about the individual legal entities within the consolidated reporting entity. Our study uses bank holding companies, which report both consolidated and parent-only financial statements under bank regulations, to examine whether the parent-only balance sheet provides useful information for pricing the parent’s default risk beyond the consolidated balance sheet. We find robust evidence that after controlling for the consolidated leverage ratio, the parent-only leverage ratio is positively associated with the price of protection against the parent’s default risk. The incremental usefulness of parent-only leverage is more pronounced when the parent does not guarantee the subsidiaries’ debt and when the internal capital market within the consolidated reporting entity is weak. Our findings suggest that supplementing consolidated financial statements with parent-only financial statements may better serve debt holders’ information needs.