Creditor control rights, 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 becomes more conservative immediately after covenant violations and this effect persists for at least eight quarters. 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. My findings identify a specific channel through which debt financing shapes corporate financial reporting and provide direct evidence supporting the debt contracting explanation for conservatism posited in Watts (2003).

► This paper provides direct evidence supporting the debt contracting explanation for conservatism posited in Watts (2003). ► I examine the impact of state-contingent allocation of creditor control rights on financial reporting conservatism. ► The discontinuity analysis isolates the control rights channel through which debt financing shapes financial reporting. ► Firms' financial reporting becomes more conservative immediately after covenant violations. ► Such effect persists in the long run and varies cross-sectionally according to financial contracting theory.