Creditors’ bankruptcy rights and accounting conservatism: Evidence from a quasi-natural experiment

Abstract

Extant research has demonstrated that creditors prefer for borrowers to follow conservative accounting practices to safeguard their interests as lenders. We extend this literature by examining whether the strength of creditors' rights moderates their demand for accounting conservatism. To do so, we take advantage of India's recent implementation of the Insolvency and Bankruptcy Code (“IBC”), which significantly improved the efficiency of bankruptcy proceedings, thereby strengthening creditors' rights. We divide our sample into control (zero net debt firms) and treatment groups (“debt firms”) and then compare the difference between the change in the conservatism of each group from the pre-to post-IBC periods. Results reveal that firms with meaningful debt exposure decreased their accounting conservatism pre-to post-IBC, relative to the zero net debt (control) firms. This finding holds when (i) utilizing propensity score matched samples; (ii) using alternative methods to define zero net debt (control) firms; (iii) employing alternative measures of conservatism; or (iv) controlling for corporate governance characteristics. We also find that certain credit-related characteristics (e.g., a firm's proportions of secured debt, bank debt, and tangible assets) moderate the observed post-IBC decrease in conservatism among debt firms. Our final analysis reveals that the decrease in conservatism post-IBC is stronger among debt firms with greater default risk (those with lower Altman Z-scores). Overall, results are consistent with our prediction that stronger creditor rights diminish the importance of accounting conservatism in safeguarding the interests of creditors.