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Accounting conservatism, debt contracts and financial institutions

Jing Li, 2009
Faculty Advisor: Tim Baldenius
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This thesis studies the role of accounting conservatism in debt contracting and in financial institutions. In the first setting, I find that the demand for accounting conservatism in debt contracts depends on whether the debt covenant can be renegotiated and the cost of renegotiation. When the covenant is not renegotiable or when renegotiation cost is sufficiently high, more conservative accounting reduces the efficiency of debt contracts. When renegotiation cost is moderate, more conservative accounting may increase the entrepreneur's welfare under certain conditions, especially for firms with less promising investment opportunities and for firms with higher liquidation values. When renegotiation is costless, the degree of accounting conservatism becomes irrelevant and the first best liquidation is always achieved. In the second part, I examine the effectiveness of capital regulation in controlling excessive risk-taking by banks under three different accounting regimes: historical cost accounting, lower-of-cost-or-market accounting and fair value accounting. Given some minimum capital requirement, the bank is more likely to issue equity capital in excess of the minimum required level and implement less risky investment policy under either lower-of-cost-or-market accounting or fair value accounting than under historical cost accounting. But fair value accounting induces more risk-taking compared to lower-of-cost-or-market accounting because of the short term interest of the bank manager. From the regulator's perspective, if the social cost associated with capital regulation is high, lower-of-cost-or-market accounting is the optimal regime; however, if the ex-ante effort by the bank to discover the risky investment is important, the regulator may find it optimal to choose either historical cost accounting or fair value accounting, when the bank manager is very short term oriented.

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