Dynamic Relationship Between Voluntary Disclosure and Conservatism Kyoungwon Mo, Korea Advanced Institute of Science and Technology (KAIST), South Korea

The Journal of Applied Business Research – July/August 2015 Volume 31, Number 4 Dynamic Relationship Between Voluntary Disclosure And Conservatism Kyoungwon Mo, Korea Advanced Institute of Science and Technology (KAIST), South Korea ABSTRACT Despite the several studies on the relationship between voluntary disclosure and conservatism, empirical findings are not conclusive. In this paper, I argue that the relation is not static but dynamic. I investigate the dynamic relation between voluntary disclosures and conservatism by examining their relation around debt financing. Debt financing can be a good natural experimental setting to examine the relation between voluntary disclosures and conservatism because both of them play an important role in reducing information asymmetry during debt financing. Particularly, I hypothesize that less conservative firms are more likely to increase voluntary disclosures around debt financing than at other times. Consistent with my hypothesis, empirical results show that less conservative firms are more likely to increase voluntary disclosures around debt financing than at other times. Overall, these results support the dynamic relationship between voluntary disclosures and conservatism. Keywords: Conservatism; Voluntary Disclosure; Debt Financing 1. INTRODUCTION he voluntary disclosure of earnings forecasts gives the benefit of lowering the effective interest rate of debt by reducing information asymmetry between firms and creditors. Since creditors could be T concerned that companies withhold information that could increase the default risk of the loan, or that the companies are not trustworthy in the disclosures that they made, creditors depend on public information to monitor a firm’s default risk without biased information from borrowers (Mazumdat and Sengupta, 2005). Therefore, firms in anticipation of debt financing can have incentives to increase their disclosures to satisfy the creditors’ needs. Sengupta (1998) suggests that firms with high disclosure quality can enjoy a lower effective interest cost of public debt. Similarly, Mazumdat and Sengupta (2005) argue that firms try to reduce information asymmetry by increasing their disclosures even before private debt financing. Accounting conservatism is another method that firms have to reduce information asymmetry. Prior literature finds that conservatism substantial influences on a firm’s cost of debt by reducing information asymmetry between firms and creditors. Positive Accounting theory explains that creditors need a mechanism for mitigating the downside risk to maximize the probability of steady repayment and accounting conservatism is eligible to serve as this ‘mechanism’ (Watts and Zimmerman, 1986) Empirical evidence generally supports the theoretical expectation. Watts and Zimmerman (1986) argue that conservatism improves the efficiency of debt contracting activities, and it gives a benefit of lowering the interest rate to the firms. Ahmed et al. (2002) argue that conservatism gives borrowers benefit of better debt ratings, which imply a lower interest rate. Moerman (2006) finds that more conservative firms enjoy a lower bid-ask spread in the secondary market. This lower bid-ask spread imply that conservatism offers more information to the lenders, so it gives discount on the corresponding portion of the cost of debt by relaxing the information asymmetry between the lenders and borrowers. Recently, Zhang (2008) suggests that conservatism benefits both lenders and borrowers: ex post benefits to lenders through timely signaling of default risk, and ex ante benefits to borrowers through lower initial interest rates. Despite the common role in reducing information asymmetry, the relationship between conservatism and voluntary disclosure is still debatable. LaFond and Watts (2008) suggest that conservatism reduces the extent of information asymmetry by increasing the speed with which negative information is revealed in the earnings Copyright by author(s); CC-BY 1377 The Clute Institute The Journal of Applied Business Research – July/August 2015 Volume 31, Number 4 numbers, and thus conservatism can be a substitute for disclosures. Hui et al. (2009) provide empirical evidences on the substitution relationship between conservatism and management earnings forecast. On the other hand, Li and Zining (2008) argues that the impact of conservatism on voluntary disclosures is complementary since conservatism increases the probability that reported earnings will be unexpectedly low, analysts do not properly adjust for conservatism in their forecasts of future earnings and firms need to issue more forecasts to correct analysts’ forecasts. In this paper, I argue that the relation between voluntary disclosures and conservatism is not static but dynamic. To verify it, I investigate the dynamic relation between voluntary disclosures and accounting conservatism by examining their relation around debt financing. Particularly, I hypothesize that less conservative firms are more likely to increase voluntary disclosures around debt financing than at other times. In addition, I also examine the nature of the disclosures around debt financing. Since accounting conservatism is defined as a mechanism which forces a firm to recognize bad news quickly and good news slowly, a firm with high conservatism level would not need to release more bad news before debt financing to satisfy creditors’ needs for it. To test my hypotheses, I test all sample firms reporting at least one management earnings forecasts from 1996 to 2010. I identify a firm’s level of conservatism with a firm-year conservatism measure of Khan and Watts (2009). Consistent with my hypothesis, the results show that less conservative firms are more likely to increase management earnings forecasts around debt financing than at other times. Second, more conservative firms are less likely to increase good news before debt financing than at other times. This result implies that the substitute relation between voluntary disclosures and conservatism is pronounced around debt offerings. This study contributes to the literature in several ways. First, this paper adds empirical evidence on the strategic use of either voluntary disclosures or conservatism around debt financing. Second, more importantly, this paper finds that firms strategically change the level of their voluntary disclosures according to their conservatism lever before debt financing, which means dynamic substitute relation between voluntary disclosures and conservatism. The reminder of this study is organized as follows. In sections 2, I review prior literature and develop my hypotheses. Section 3 describes sample and research methodology. Section 4 presents the empirical results and Section 5 summarizes and concludes this paper. 2. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT 2.1 Voluntary Disclosures and Debt Financing Prior literature suggests that firms have incentives to increase voluntary disclosures before debt financing. Sengupta (1998) expects that since potential public debt holders do not have right to access borrowing firms’ information, which is essential to evaluate the firm’s default risk, firms with higher disclosure level would enjoy the lower cost of public debt. Consistent with her expectation, she finds that firms with high disclosure quality are more likely to have the lower yield-to-maturity and spread. Similarly, Mazumdat and Sengupta (2005) argue that firms financing through private debt can also enjoy the lower cost of the debt by increasing their disclosure level. They explain that although private lenders have direct access to inside information at their demand, private lenders are still attracted to voluntary disclosures because they help for private lenders to reduce information search cost. Moreover, in the case of asymmetric information, lenders would be concerned that companies withhold information that could increase the default risk of the loan or that the companies were not trustworthy in the disclosures that they made. Therefore, firms can use voluntary disclosures to alleviate these creditors’ concerns over withholding information and in turn, to obtain lower cost of private debt. Their empirical results show that firms with high disclosure level are more likely to have lower cost of private debt. The literature also shows that firms strategically increase their disclosures around debt offerings. Healy at al. (1999a) find that firms with increased analyst ratings of disclosures have an abnormally high frequency of subsequent public debt offers. Frankel et al. (2005) similarly find that firms are more likely to release disclosures before debt offerings. Copyright by author(s); CC-BY 1378 The Clute Institute The Journal of Applied Business Research – July/August 2015 Volume 31, Number 4 2.2 Conservatism and Debt Financing Conservatism also has substantial influence on a firm’s cost of debt financing. Conservatism improves the efficiency of debt contracting activities (Watts and Zimmerman, 1986) and gives borrowers the benefit of lowering the interest rate (Ahmed et al., 2002; Moerman, 2006; Zhang, 2008). In particular, Ahmed et al. (2002) provide empirical evidence that conservatism gives borrowers the benefit of better debt ratings, and in turn, firms with better debt ratings enjoy a lower interest rate. Moerman (2006) finds that more conservative firms enjoy a lower bid-ask spread in the secondary market. This lower bid-ask spread implies that conservatism offers more information to the lender, so it

Load more