Accounting Conservatism and Debt Contracts: Efficient Liquidation and Covenant Renegotiation

his paper develops a theoretical model to understand the contractual role of accounting conservatism in debt contracts. The optimal debt contract includes an accounting based covenant that gives the creditor the right to liquidate when accounting information reveals unfavorable news about the firm. I find that the demand for accounting conservatism depends on whether renegotiation occurs and if so, at what cost. When the covenant is not renegotiable or when renegotiation cost is sufficiently high, more conservative accounting actually reduces the efficiency of debt contracts. When renegotiation cost is small or moderate, on the other hand, more conservative accounting may increase the entrepreneur's welfare under certain circumstances, especially for firms with fewer positive NPV projects and higher liquidation values. When renegotiation is costless, accounting information becomes irrelevant. These results call for more cross-sectional examinations on the role of accounting conservatism in debt contracts in empirical studies.