Do Financial Market Developments Influence Accounting Practices? Credit Default Swaps and Borrowers' Reporting Conservatism

This paper investigates whether the initiation of trading in credit default swaps (CDSs) on a borrowing firm's outstanding debt is associated with a decline in that firm's reporting conservatism. Contracting theory predicts that lenders' asymmetric payoffs generate a demand for conservatism, in particular the asymmetric timeliness of loss recognition. CDS investments can modify lenders' payoffs on their loan portfolios by providing insurance on negative credit outcomes. We examine the possibility that the onset of CDS trading reduces lenders' demand for conservatism from borrowing firms. Empirical results obtained using a differences-indifferences research design show a reduction in borrowing firms' reporting conservatism after CDS trade initiation. Furthermore, the decline in conservatism after CDS trade initiation is more pronounced in instances when reputation costs lenders face from reducing monitoring of financial statements are likely to be lower, when debt contracts outstanding at the time of CDS trade initiation have more financial covenants, and when lenders are more likely to have entered into CDS contracts on underlying borrowers.