Creditor Control, State of Nature Verification, and Financial Reporting Conservatism

I examine the impact of state-contingent allocation of creditor control rights on financial reporting. Using a discontinuity analysis, I find that firms' financial reporting appears more conservative immediately after covenant violations and this effect persists for at least eight quarters. Investigation of specific transactions (write-downs, goodwill impairment, restructuring and discontinued operations) corroborates the findings from a statistical conservatism model. The conservatism effect is more pronounced when creditors possess greater bargaining power, when firms' operations are more volatile, and when creditors put Chief Restructuring Officers in place. Moreover, firms with more conservative reporting after violations have a larger decline in subsequent capital expenditure, acquisition, and financing activities, but a greater improvement in operating performance. These results are consistent with implications of financial contracting theory that creditors acquire more information to verify the state of nature after covenant violations, and an improved information environment helps creditors exercise their control rights and promote efficient corporate governance.