Abstract

We investigate an unexplored channel—loss given default (LGD)—through which accounting information can shape the design of debt contracts. Using a sample of defaulted bonds, we find that borrower accounting information available at contract initiation possesses significant power for predicting realized LGD at the subsequent default date. We then use this model to construct an accounting-based measure of expected LGD at the contracting date for a large sample of bond issuances. We find that this measure is positively associated with issuance date interest spread and covenant use, and document that these relations are not artifacts of an association between LGD and probability of default. We then show that accounting-based expected LGD has a stronger association with issuance date spread when the borrower’s underlying accounting is more conservative and when the accounting-based LGD predictors are more persistent. Our results increase our understanding of both the informational role and contracting role of accounting information.

Introduction

Financial reports are an important source of frm-specifc information available to lenders at the contracting date and thus may afect lenders’ behavior in the design of debt contracts. Whereas prior literature focuses on the usefulness of accounting information for probability of default assessment (e.g., Beaver 1966; Altman 1968; Shumway 2001), this study suggests that accounting information may also shape contracts by facilitating lenders’ assessment of loss given default. Loss given default, defned as the percentage loss that lenders experience from $1 of outstanding principal in a case of default, is a critical component of credit risk and debt contracting theories.1 Despite the theoretical importance of loss given default, there is little empirical evidence regarding how accounting information available to lenders at the contracting date is associated with their expectations about loss given default. This study is the frst to provide evidence that accounting information at the contracting date is a useful predictor of realized loss given default and that lenders behave as if they use accounting information about loss given default to design debt contracts.

Conclusion

A substantial body of research focuses on the informativeness of accounting information with respect to probability of default. However, there is very little research concerning the informativeness of accounting information with respect to loss given default, particularly at the contracting date. There exists some ancillary evidence in extant literature regarding the informativeness of accounting data about loss given default at the time of default. However, given the relatively long time between debt issuance and eventual default, this evidence says little about whether accounting information is useful to lenders in assessing expected loss given default at the contracting date—when lenders need information the most.

This study contributes to the literature along several dimensions. First, using a sample of defaulted bonds, we show that accounting measures available to lenders at the contracting date are informative about future loss given default. To the best of our knowledge, this study is the frst to do so. This fnding complements the literature which shows that accounting measures are informative about probability of default and therefore enhances our understanding of the informational role of accounting. Second, we construct an intuitive measure of accounting-based expected loss given default at the time of bond contract initiation, which could be of use in future research. Third, we show that lenders behave as if their accounting-based expectations about loss given default signifcantly afect price and non-price terms of bond contracts. We provide evidence that the association is stronger when the accounting-based predictors are more persistent, consistent with the intuition that accounting information with higher persistence is more reliable for predicting future outcomes. This fnding contributes to the literature on the role of accounting information in debt contracting by showing a specifc channel through which accounting information may be useful in lending decisions. Finally, our results provide important evidence that establishes a direct link between accounting-based LGD estimation and lenders’ demand for fnancial reporting conservatism.