Poor accounting quality likely to mean worse lending terms

Companies are well advised to beef up accounting practices before they seek to raise new capital, says a professor at the Ross School of Business.

A new study by Sreedhar Bharath shows that firms with poorer accounting quality are more likely to choose private lenders (bank loans) than public lenders (bonds) because the impact of accounting quality on interest rates in the public market is 2.5 times greater than in the private market.

Poorer accounting-quality borrowers not only face significantly higher interest costs but lower maturities and a greater likelihood of posting collateral when they obtain bank loans, Bharath says. The effects of poor accounting quality also show up in bonds in the form of higher interest rates.

"Accounting quality has a significant impact on the choice of bank loans versus bonds," says Bharath, assistant professor of finance at the Ross School. "It also affects debt-contract design in systematically different ways. The quality of accounting information affects lenders' estimates of future cash flows from which debt repayments will be serviced."

Bharath and colleagues Jayanthi Sunder and Shyam Sunder of Northwestern University analyzed data on a sample of 12,676 bank loans obtained by 3,261 firms and 3,681 bonds issued by 709 firms from 1988-2003. To gauge accounting quality, they used a measurement tool that detects unexpected deviations between the cash flows and earnings of a firm, which would make it harder for lenders to estimate future operating cash flows.

According to the study, institutional differences between private and public lenders play an important role in determining how accounting quality is incorporated into debt contracts.

Banks have greater access to firm information and better ability to monitor the borrower; more flexibility in resetting the price and non-price terms over the course of the loan through covenants and pricing performance provisions; and lower costs associated with renegotiating the loan contract at a later date. Thus, banks can customize and fine-tune the risk-return relationship with the borrower by setting terms not only for the interest cost but also the maturity term and collateral required in the contract. This explains why all terms of the bank loan contract respond to differences in accounting quality.

Bondholders, on the other hand, are relatively unsophisticated compared to banks and lack the monitoring capabilities and flexibility to renegotiate borrowing terms once those are set. As a result, all the risk arising from poor accounting quality is reflected in the price terms of bond contracts, which explains why the initial price impact of accounting quality is higher for bonds compared to bank loans.

Borrowers with poorer accounting quality are more likely to choose private debt, in part, because the superior information gathering and processing abilities of banking institutions serve to reduce the adverse selection costs, the researchers say. Poorer-quality borrowers with high-growth opportunities appear more likely to seek public debt on the margin, because growth firms with higher anticipated future financing needs attempt to avoid the information-monopoly rent extraction by banks.

The study also reveals significant differences across the two markets in the contract terms set by lenders in response to variations in borrowers' accounting quality. Borrowers with higher accounting quality enjoy significantly lower interest spreads in the case of both bank loans and bonds. Those with poorer accounting quality find just the opposite—more stringent spreads in both markets, with the effect being significantly greater in bonds.

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