Valeri V. Nikolaev

Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism

A substantial literature investigates conditional conservatism, defined as asymmetric accounting recognition of economic shocks (�news�), and how it depends on various market, political, and institutional variables. Studies typically assume the Basu [1997] asymmetric timeliness coefficient (the incremental slope on negative returns in a piecewise-linear regression of accounting income on stock returns) is a valid conditional conservatism measure. We analyze the measures validity, in the context of a model with accounting income incorporating different types of information with different lags, and with noise. We demonstrate that the asymmetric timeliness coefficient varies with firm characteristics affecting their information environments, such as the length of the firms operating and investment cycles, and its degree of diversification. We particularly examine one characteristic, the extent to which �unbooked� information (such as revised expectations about rents and growth options) is independent of other information, and discuss the conditions under which a proxy for this characteristic is the market-to-book ratio. We also conclude that much criticism of the Basu regression misconstrues researchers� objectives.

The endogeneity bias in the relation between cost-of-debt capital and corporate disclosure policy

Abstract The purpose of this paper is twofold. First, we provide a discussion of the problems associated with endogeneity in empirical accounting research. We emphasize problems arising when endogeneity is caused by (1) unobservable firm-specific factors and (2) omitted variables, and discuss the merits and drawbacks of using panel data techniques to address these causes. Second, we investigate the magnitude of endogeneity bias in Ordinary Least Squares (OLS) regressions of cost-of-debt capital on firm disclosure policy. We document how including a set of variables which theory suggests to be related with both cost-of-debt capital and disclosure and using fixed effects estimation in a panel data-set reduces the endogeneity bias and produces consistent results. This analysis reveals that the effect of disclosure policy on cost-of-debt capital is 200% higher than what is found in OLS estimation. Finally, we provide direct evidence that disclosure is impacted by unobservable firm-specific factors that are also correlated with cost of capital.

On Estimating Conditional Conservatism

The concept of conditional conservatism has provided new insight into financial reporting and has stimulated considerable research since Basu (1997) developed it. While the concept encapsulated in the adage “anticipate no profits but anticipate all losses” is reasonably clear, estimating it is the subject of some discussion, notably by Dietrich et al. (2007), Givoly et al. (2007), and Ball, Kothari and Nikolaev (2011). Recently, Patatoukas and Thomas (2011) report important evidence of possible bias in firm-level cross-sectional estimates of conditional conservatism (asymmetric earnings timeliness) which they attribute to scale effects. They advise researchers to avoid using conditional conservatism estimates or making inferences from prior research using them, a view we regard as excessively alarmist. Our theoretical and empirical analyses suggest the explanation is a correlated omitted variables problem that can be addressed in a straightforward fashion, for example by fixed-effects regression. We show that crosssectional correlation between the expected components of earnings and returns confounds the relation between the news components, and biases estimates of how earnings incorporates the news in returns (e.g., timeliness). We also show that the correlation between the expected components of earnings and returns depends on the sign of returns, biasing estimates of asymmetric timeliness. When firm-specific effects in earnings are taken into account, estimates of asymmetric timeliness do not exhibit the bias, are statistically and economically significant (though smaller in magnitude and perhaps more consistent with priors), and behave as a predictable function of market-to-book, size and leverage. It would be surprising if this was not the case. Conditional conservatism accords with the long-standing accounting principle of anticipating losses but not gains, with specific asymmetric accounting rules such as the lower-ofcost-or-market method for inventories and the rules for impairment of long term assets, and with loss recognition practices that occurred prior to the promulgation of formal rules.

Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective

This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency.

Scope for renegotiation in private debt contracts

I study whether the demand for monitoring explains the scope for renegotiation in private debt contracts. Theory suggests that renegotiation trades off the benefits of enhanced monitoring with the costs of creditor intervention. Consistent with this tradeoff, I show that monitoring demand proxies bear a positive association with renegotiation intensity. In contrast, the costs of creditor intervention are associated with less frequent renegotiations. I also find that contractual monitoring mechanisms, such as covenants and concentrated syndicate structures, are positively related to renegotiation intensity. Furthermore, renegotiations transmit new information to the market, in line with private creditors discovering information during renegotiations.

Identifying Accounting Quality

I develop a new approach to understanding accounting accruals. Unlike prior studies, I explicitly address the economic role of accruals in performance measurement. I characterize accounting quality in terms of a new construct, namely, the degree to which accruals facilitate performance measurement. Further, I develop a flexible strategy for identifying accounting quality. The core identifying assumptions derive from institutional properties of both earnings and cash flows: that both are noisy measures of the same economic performance and they converge as the time horizon extends. These assumptions characterize moments of earnings, cash flows, and accruals solved to recover the variance of performance and accounting error in accruals. I implement several model specifications and consider a number of generalizations. My analysis suggests that the variance of the performance component exceeds accounting error and explains a high fraction of accruals’ variance. I conclude that accruals meet their objective.

Disproportional Control Rights and the Governance Role of Debt

We examine the governance role of debt in the context of U.S.-based dual class ownership structures. We hypothesize that the use of debt alleviates the conflict between shareholder classes by balancing the power of controlling insiders. We document that dual class firms have higher leverage and a greater propensity to issue private debt; they also more frequently use cash sweeps and performance-based covenants. Dual class firms with greater agency conflicts and a greater need to access the capital market appear to rely more extensively on debt. These findings are consistent with controlling insiders bonding against the agency costs associated with dual class ownership. The governance role of debt is further corroborated by the valuation effect of debt for dual class companies. Private debt issuances trigger greater positive market reactions to the inferior dual class stock in relation to both the superior dual class stock and a matched sample of single class firms. Further, leverage attenuates the previou...

Contracting on GAAP Changes: Large Sample Evidence

We use incomplete contracts theory to explain the inclusion or exclusion of changes to GAAP based on which debt covenants are written. We posit that GAAP is often incomplete with respect to unanticipated future developments (innovations), which can lead to post contractual opportunism and thus destroy ex ante incentives. We argue that the choice to include GAAP changes depends on the effectiveness of accounting standard setters to act as an arbiter who ‘completes’ GAAP ex post. Our evidence indicates that the accounting standard setters achieve mixed success. The GAAP changes we study appear to address inefficiencies associated with opportunism by lenders but not by borrowers. Further, we find that the frequency of credit agreements that rely on standard setters to complete GAAP has decreased by more than fifty percent from 1996 to 2005. This trend is at least partly explained by the actions of standard setters and is consistent with reduced regulatory responsiveness to contracting needs.We explore revealed preferences for the contractual treatment of changes to GAAP in a large sample of private credit agreements issued by publicly held U.S. firms. We document a significant time‐trend toward excluding GAAP changes from the determination of covenant compliance over the period from 1994 to 2012. This trend is positively associated with proxies for standard setters’ shift in focus toward relevance and international accounting harmonization. At the firm level, borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but these firms also show a more pronounced time‐trend toward excluding GAAP changes. While this evidence is broadly consistent with an efficiency role for GAAP changes in debt contracting, it is also consistent with a shift in standard setters’ focus offering a partial explanation of why fewer contracts rely on GAAP changes in 2012 than in 1994.

Outside Blockholders' Monitoring of Management and Debt Financing: An Alternative Perspective

Liao (2015) argues that the monitoring by large outside shareholders (blockholders) exacerbates the conflict between debt and equity and in turn affects the choice and structure of debt financing. The study contends that private debt is more immune to the increase in debt-equity conflict. Consistent with this argument, companies with outside blockholders are inclined to issue private debt over public debt. Further, private debt exhibits less price protection but relies on more protective covenants than does public debt. The findings are interesting and intuitive. I evaluate the economic arguments in the paper and discuss some of the challenges that the study faces. My conclusion is that the interpretation of the results is more complex than the one the study presents. I offer a broader framework that can be used to shed light on why the governance structure combines equity blockholders and private debt issuance. I also discuss several questions to be addressed by future research.

Financial Sector Shocks and Corporate Investment Activity: The Role of Financial Covenants

We examine whether shocks to credit institutions affect the choice among accountingbased covenants in private debt contracts and whether this effect represents a channel through which shocks to lenders affect corporate investment. We exploit plausibly exogenous variation in the payment defaults experienced by lenders outside the borrower’s region and industry. We find that financial institutions respond to payment default shocks by shifting the composition of financial covenants towards performance-based covenants (away from capital-based covenants) in newly signed credit agreements. In turn, the increased reliance on performance covenants constrains borrowers’ future investments, particularly among relationship-based borrowers. We also find that lender-specific shocks after a contract is in place affect investments, and that this effect varies depending on the composition of the covenants in place. Overall, our results are consistent with financial covenants being a channel through which idiosyncratic shocks to lenders propagate to the real sector.We show that financial shocks to lenders affect the composition of covenants in new debt contracts in a way that cannot be explained by borrower fundamentals. Using two distinct measures of lender-specific shocks—defaults in a lender’s corporate loan portfolio that occur outside the borrower’s region and industry, and non-corporate loan delinquencies—we show that lenders respond to financial shocks by increasing the use and strictness of performance-based and negative covenants, while reducing the use of capital covenants. We investigate two possible channels for these effects, specifically, the capital channel (lenders are concerned about capital depletion) and the learning channel (defaults carry information about lenders’ screening ability), and find evidence in support of both. Our results indicate that lenders’ preferences influence the use of accounting information in debt contracts.