Optimal Precision of Accounting Information in Debt Financing

Abstract

This paper studies qualitative characteristics of accounting systems that are used in debt financing. We consider a financially constrained firm that provides to lenders information on the value of assets that serve as collateral in a financing contract for a risky investment project. We find that the investor prefers an accounting system that provides biased signals about the value of assets. This bias adjusts the information content of the signals to maximize the probability of undertaking the project. Under fair value accounting, low book values are more precise measures of actual value than high book values, which is consistent with conditional conservatism. Next, we study accounting risk to study the effect of institutions that govern the financial reporting policy based on the optimal precision. We find that fair value measurement introduces greater accounting risk and is preferred by financially constrained firms to measurement at historical cost.

Acknowledgements

Helpful comments by John Christensen, Christian Hofmann, Dirk Simons, an anonymous referee, participants at the EAR Research Conference in Segovia and at a workshop at the University of Mannheim are gratefully acknowledged.

Notes

See, for example, the survey in Watts (2003).

See again Watts (2003).

Of course, this argument ignores contracting costs.

Bachar et al. (1997) consider a similar adverse selection issue.

Otherwise the analysis would be similar for the net of investment cost and cash and cash equivalents available.

A contract with d _F  = 0 is always preferable to a contract with d _F  < 0 because such a contract would require a higher d _S in order to satisfy the lender's participation constraint, which makes it more difficult to satisfy the incentive compatibility constraint that requires d _S  − d _F be less than a threshold.

That is, if the existing projects decrease in value over the period, the loss is exactly balanced by a reinvestment of the cash they earn over the same period.

This solution assumes that the firm's expected profit (4) is positive; otherwise the firm will not undertake the project.

Since this assumption is based on an endogenous variable, we assume the somewhat stricter condition, NPV − φ·A ₂ > 0 that is based on primitives of the model.

Assuming a strict preference will generate a trade-off between expected return and lending volume. Given the lending volume (I) is fixed, the conclusions are the same.

It would also obtain from reporting deprival value if the current replacement cost is higher than the value in use.

See, for example, Smith (2007) and Gigler et al. (2009).

This definition of accounting conservatism is consistent with that used in Gigler and Hemmer (2001).

For example, Ball et al. (2000) study conservatism across countries but focus mainly on common vs. code law countries. However, the financial structure of firms is endogenous.

This observation is similar to the results in Smith (2007).

The information risk may even provide an incentive to implement an informative accounting system if the firm had sufficient assets available for pledging.

However, it should be noted that there is no costless information system that avoids all accounting risk because from (16) and (17) there is an expected amount of overstatement of A(y ₁) − A ₁ for f ₁ = 1, and as long as the information system is imperfect, that is f ₂ < 1, this difference is strictly positive.