Renegotiation and the Properties of Accounting Information: Evidence from a Bankruptcy Reform

Abstract

I examine whether a bankruptcy reform that increases the ability to renegotiate debt contracts when a firm is in distress affects firms’ timely loss recognition. The legal changes that are embedded in the reform are expected to decrease renegotiation costs and the risk of coordination failure in the cases of the disclosure of bad news or covenant violations, providing firms with incentives to increase timely loss recognition. For identification, I exploit the introduction of a recent bankruptcy law in Italy that substantially facilitated the renegotiation of outstanding debt and court congestion as a source of cross-sectional variation in the enforcement of debt contracts. I address endogeneity concerns by relying on discontinuous changes in court congestion among similar contiguous municipalities located across judicial district borders. I find that after the introduction of the law, firms in more efficient courts experience a greater increase in timely loss recognition than firms in less efficient courts. Cross-sectional analyses suggest that the effect is greater for firms that are more likely to address contracting costs through accounting-based covenants, and with higher benefits of increasing the number of lending relationships. In addition, I find that the change in timely loss recognition is accompanied by an increase in arm’s length contracting. Taken together, I provide evidence on a specific institutional mechanism through which the legal institutions that govern debt renegotiation affect the properties of accounting information.