Creditor Rights and Accounting Quality: Evidence from a Natural Experiment

I investigate whether increases in creditor rights affect borrowers’ accounting quality. I hypothesize that creditors monitor borrowers’ financial statements to a greater extent when they have stronger enforcement rights, which induces increases in borrowers’ accounting quality. Exploiting a landmark reform that increased secured creditor enforcement rights, I find that borrowers with high levels of secured debt (i.e., treated borrowers) increased accounting quality following passage of the reform. The accounting quality improvements are driven by a tightening of working capital. These improvements subsequently lower the cost of debt for borrowers. The effect of creditor rights on borrowers’ accounting quality is stronger when borrowers risk missing loan payments and when creditors have greater negotiating power. My results are consistent with 1) lenders increasing their reliance on financial statements under an arm’s length contracting regime and 2) accounting information serving as an instrument in enforcing debt contracts.