Accounting conservatism and debt contract efficiency with soft information.

Abstract

This paper shows how accounting conservatism affects the efficiency of debt contracting when the optimal debt contract allows parties to renegotiate. In my model allowing for renegotiation is optimal because both borrowers and lenders have access to non-contractible “soft information”, in addition to the more objective accounting information. I show that conservative accounting can increase the efficiency of debt contracting when the other soft information is also sufficiently conservative (to be defined in the paper). However, when the soft information is aggressive, conservative accounting is detrimental to the efficiency of debt contracting. Thus, whether more conservative financial reporting is good for debt contracting depends on the interaction between the informational characteristics of the accounting system and other available information. Interestingly, the result that the informational characteristics of the accounting system should be the same as those of the soft information stands in contrast to the conjecture proposed by many studies -- that accounting needs to be conservative because other information, such as that offered by management, is opportunistically aggressive.