Financial Reporting Quality and Corporate Bond Markets

Recent research proposes that financial reporting is actually shaped by debt markets instead of by equity markets. As noted by Baker, Greenwood and Wurgler (2003), “Relative to the literature on equity financing patterns, and relative to the actual importance of debt finance in the U.S. economy, the literature on debt financing patterns is surprisingly underdeveloped”. Hence, the interface between financial reporting and debt financing has recently emerged as a fruitful idea for research. In fact, because of their asymmetric payoff function and fixed claims on corporate assets, creditors have stronger incentives than equity investors to demand high quality financial reporting. In this dissertation, I build up alternative arguments for conservatism that can be applied to the public bond market and cannot be generalized to the private debt market or the equity market. For instance, Merton’s (1974) theoretical bond pricing model indicates that equity holders and bondholders value a firm’s operating volatility in different ways. Thus, bond and equity investors could have different expectations and needs regarding what they consider to be useful financial reporting. In that regard, recent evidence on the interface between financial reporting quality and debt markets largely focuses on private bank loan contracting. However, in terms of providing capital to corporations, public debt markets are as large as private debt markets, with substantial differences in terms of monitoring efficiency, private information availability, seniority in liquidation, and re-contracting flexibility. Hence, public bondholders can value financial reporting quality in a way that differs from private debt holders’ perspective. Using accounting conservatism and internal control effectiveness as proxies for financial reporting quality, I investigate two sets of research questions that relate to the effects of financial reporting quality on corporate bond financing. I consider both conditional and unconditional conservatism. Conditional conservatism depends upon future economic circumstances and reflects the writing down of book values under sufficiently adverse circumstances while not allowing their writing up under favorable circumstances (e.g., lower of cost or market for inventories). Unconditional conservatism reflects the consistent application of Generally Accepted Accounting Principles (GAAP) that reduces earnings independent of future economic events, resulting in the book value of net assets being understated due to predetermined aspects of the accounting process (e.g., immediate expensing of R&D expenditures according to U.S. GAAP). First, I investigate the main effect of accounting conservatism and the moderating effect of internal control effectiveness on the yield spread of new corporate bond issues. Second, I assess the main effect of accounting conservatism and internal control effectiveness on the underpricing of newly issued corporate bonds. Both yield spreads and underpricing reflect different market realities. While the yield spread of new corporate bond issues is determined through negotiations among bond issuers, investment bankers and large institutional investors the underpricing of newly issued corporate bonds reflects the responses of all bond investors based on their assessment of the available information. My main empirical findings are: (1) conditional conservative reporting relates to higher yield spreads in new corporate bond issues; (2) unconditional conservative reporting relates to lower yield spreads in new corporate bond issues; (3) ineffective internal controls enhance the effect of conditional conservative reporting to raise the yield spread; (4) both conditional and unconditional conservative reporting relate to the underpricing of newly issued corporate bonds. However, internal control effectiveness does not seem to matter in the underpricing. This dissertation mainly contributes to the existing literature in two ways. First, this study extends the conservatism literature by linking conservative reporting to corporate bond financing patterns. With theoretical arguments and empirical evidence that are inconsistent with the debt contracting efficiency view of conservatism, my study casts some doubt as to how generalizable is the traditional debt contracting efficiency argument regarding the interface between conservatism and the cost of debt. Second, research on Sarbanes-Oxley Act’s internal control provisions needs to go beyond the equity holders’ and private debt holders’ perspectives, and consider other financial stakeholders who contract on the basis of financial statements. This dissertation fills the void in the internal control literature by providing initial empirical evidence as to how internal control effectiveness affects corporate bond financing.