Conditional Conservatism, Agency Costs, and the Contractual Features of Debt

In this paper, I examine the effects of debt structure on conservatism. The analysis is conducted in two steps. First, I examine the direction of causality between capital structure and conditional conservatism by using a unique sample of zero leverage firms that transition to non-zero leverage. Also I investigate whether off-balance-sheet leverage incrementally explains conditional conservatism. Second, I study whether the various characteristics of debt also affect conditional conservatism. Specifically, the characteristics I investigate include: (1) whether the debt is public or private, (2) maturity, (3) convertibility, (4) seniority, and (5) securitization. Since these different characteristics of debt affect agency costs to varying degrees, I predict that differences in the type of debt will lead to cross-sectional differences in conditional conservatism. I find that entering the debt market is an important factor driving demand for conditional conservatism, and that off-balance-sheet leverage incrementally increases conditional conservatism relative to on-balance-sheet leverage. Consistent with my predictions, I find that firms with greater levels of public debt, short-term debt, subordinate debt, and unsecured debt provide more timely loss recognition. After controlling for the likelihood of conversion, I also find firms with a greater level of convertible debt provide less timely loss recognition. Overall my results indicate that accounting conservatism not only varies with the presence of debt, but also with the contractual features of debt