Conditional conservatism and trade credit during the global financial crisis

https://doi.org/10.1016/j.jaccpubpol.2020.106728Get rights and content

Highlights

  • Conditional conservatism was positively associated with trade credit both before and after the crisis, indicating suppliers’ preference for conservative customers.

  • The conservatism-trade credit association declined following the onset of the crisis, indicating suppliers’ increased tolerance to less conservative customers.

  • The declined association during the crisis can be explained by suppliers’ information advantage, intermediate goods characteristics, relative bargaining power, and financial situation of customers and suppliers.

  • These findings illustrate suppliers’ multifaceted demand for conservatism.

Abstract

We investigate conditional conservatism and firms’ access to trade credit during the 2007–2008 global financial crisis. Previous studies argue that suppliers prefer conservative customers because of information asymmetry in production networks; we extend this line of research by focusing on trade credit during the 2007–2008 global financial crisis, a period that was characterized by a credit supply shock. We first document a positive association between conditional conservatism and firms’ access to trade credit both before and after the onset of the crisis, which indicates suppliers’ demand for conditional conservatism. Meanwhile, the association between conditional conservatism and trade credit experienced a significant decline following the onset of the crisis, and this only held when suppliers and customers had frequent transactions or were in close proximity, when transacted goods were standardized rather than differentiated, when customers were financially constrained and had high bargaining power, and when suppliers had sufficient liquidity. It implies that, when information asymmetry along the supply chain was low and customers had strong bargaining power, liquid suppliers increased their tolerance to less conservative customers, and they were even willing to grant trade credit to the less conservative customers that were financially constrained. Overall, this study adds to previous literature by demonstrating suppliers’ multifaceted demand for conditional conservatism.

Introduction

Conditional conservatism is an important attribute of financial reporting, and it represents a timelier recognition of economic losses than of economic gains (Basu, 1997, Watts, 2003a, Watts, 2003b).1 Previous studies show that conditional conservatism reduces information asymmetry and facilitates efficient debt contracting (e.g., Ahmed et al., 2002, Zhang, 2008, Tan, 2013, Aier et al., 2014, Haw et al., 2014, García Lara et al., 2016, Gong and Luo, 2018). One stream of literature extends the contracting role of conditional conservatism to the supplier-customer relationship (e.g., Hui et al., 2012), and studies find that suppliers prefer customers that report conservatively.2 Following this line of research, we explore suppliers’ demand for conditional conservatism by examining the association between conditional conservatism and firms’ access to trade credit before and after the onset of the 2007–2008 global financial crisis. We are particularly interested in how the conservatism-trade credit association was affected by the credit supply shock during the financial crisis.

Suppliers’ demand for conditional conservatism is complicated and not well explored in the literature. On the one hand, significant information asymmetry exists between suppliers and customers (Coase, 1937, Williamson, 1979, Allee and Yohn, 2009, Costello, 2013, Radhakrishnan et al., 2014, Hope et al., 2017, Files and Gurun, 2018), and suppliers rely on conservative financial reporting to evaluate customers’ capabilities to fulfill trading obligations and implicit claims (Hui et al., 2012). On the other hand, suppliers can acquire information through business transactions (Smith, 1987, Biais and Gollier, 1997, Petersen and Rajan, 1997, Ng et al., 1999, Burkart and Ellingsen, 2004, Aktas et al., 2012, Chen et al., 2017), and the literature on information complementarities along the supply chain is also in line with this argument (e.g., Dass et al., 2014, Guan et al., 2015, Luo and Nagarajan, 2015, Cen et al., 2017, Gong and Luo, 2018); thus, this would reduce suppliers’ reliance on conditional conservatism. However, given that business transactions only reflect parts of corporate operations, suppliers might lack a broad view on customers. It is unclear whether suppliers’ information acquisition along the supply chain would enable them to rely less on conditional conservatism.

We examine suppliers’ demand for conditional conservatism through the lens of trade credit. Trade credit occurs when customers purchase intermediate inputs from suppliers on open account, and it is an important financing source for customers (Rajan and Zingales, 1995, Fisman and Love, 2003, Klapper et al., 2012). Information asymmetry and lack of trust are great concerns when suppliers provide trade credit to customers (Mian and Smith, 1992, Ng et al., 1999, Costello, 2013, García Teruel et al., 2014). We believe that suppliers’ demand for conditional conservatism would ultimately reflect on trade credit. Since conditional conservatism comes with timely downside information, by providing trade credit to conservative customers, it would be easier for suppliers to avoid counterparty credit risk. Furthermore, trade credit strengthens the connection between trade partners (Kiyotaki and Moore, 1997, Jacobson and von Schedvin, 2015); thus, providing trade credit to conservative customers also reduces suppliers’ exposure to risk contagion along the supply chain. However, considering suppliers’ advantage in acquiring information through business transactions, it is unclear to what extent suppliers consider conditional conservatism when granting trade credit.

We investigate the relation between conditional conservatism and firms’ access to trade credit based on the 2007–2008 global financial crisis. The global financial crisis was characterized by a credit supply shock (Campello et al., 2010, Duchin et al., 2010, Iyer et al., 2013), and it provides an interesting setting to examine our research question. Previous studies find that banks strongly relied on conservative financial reporting to monitor borrowers, and less conservative firms experienced more difficulties to obtain bank loans during the crisis (Balakrishnan et al., 2016). As important liquidity providers during the crisis, suppliers also suffered from reduced bank loans and liquidity constraints (Garcia-Appendini and Montoriol-Garriga, 2013, Carbó Valverde et al., 2016). By investigating the association between conservatism and trade credit around the crisis, our results would shed light on suppliers’ relative reliance on conservatism compared to banks.3 Furthermore, trade credit extensions essentially are activities on the product market, while the financial crisis resulted in a shock to the capital market. If suppliers’ trade credit extensions were affected by the financial crisis, it would indicate a spillover effect from a shock on the capital market to the trade credit decisions on the product market.

Our sample consists of quarterly observations of U.S. incorporated non-financial public firms in Compustat with fiscal quarters ending between July 2006 and June 2008, following Duchin et al., 2010, Garcia-Appendini and Montoriol-Garriga, 2013, and Balakrishnan et al. (2016). Our sample period includes both a pre-crisis period and a crisis period. The U.S. subprime mortgage market began to collapse in July 2007, and we set it as the start of the global financial crisis. One year following the onset of the crisis (i.e., July 2007–June 2008) was characterized by a credit supply shock, and we define it as the crisis period. One year before the onset of the crisis (i.e., July 2006–June 2007) is defined as the pre-crisis period.

We first examine the association between conditional conservatism and firms’ access to trade credit in the pre-crisis and crisis periods separately. The ex-ante conditional conservatism prior to the crisis was positively associated with firms’ access to trade credit in both the pre-crisis period and the crisis period, indicating that conservative firms were more likely to receive trade credit from suppliers both before and after the crisis. This is consistent with Hui et al.’s (2012) arguments on the contracting role of conditional conservatism in the supplier-customer relationship, and it is also in line with the role of conditional conservatism in mitigating information asymmetry between firm insiders and outsiders as suggested by previous literature (e.g., Watts, 2003a, LaFond and Watts, 2008, Aier et al., 2014, Smith, 2014, Cheng et al., 2015).

We then explore how the association between conditional conservatism and firms’ access to trade credit changed with the global financial crisis. The association between conservatism and trade credit decreased by 46.42% after the onset of the financial crisis, which is economically significant. This finding indicates that suppliers showed certain tolerance to less conservative customers under the credit supply shock. To compare the relative reliance of suppliers and debt holders on conditional conservatism, we further examine the association between conditional conservatism and firms’ access to bank loans around the crisis, following Balakrishnan et al. (2016). We find that conservative firms were more likely to obtain the access to bank loans both before and after the crisis. However, in contrast to the reduced association for trade credit, the association between conservatism and bank loans increased after the onset of the crisis. This is consistent with Balakrishnan et al. (2016) and indicates debt holders’ increased demand for borrowers’ conservatism, which is also in line with the prudent lending behavior of banks during the crisis (Iyer et al., 2013). Collectively, these results suggest that suppliers increased their tolerance to less conservative customers under the credit supply shock, and they seemed to demonstrate less demand for conditional conservatism during the crisis.

We also conduct a battery of robustness tests. First, we repeat our analysis for a placebo (i.e., non-existent) crisis starting in July 2006 and for the negative market demand shock caused by the 9/11 terrorism attack, and we do not find a similar phenomenon, which implies that suppliers’ reduced demand for conditional conservatism was stimulated by the credit supply shock. Second, we adopt a propensity score matching approach to address the possible model misspecification. The average treatment effects based on the propensity score matched sample are consistent with our regression results. Finally, we further control for suppliers’ exposure to the liquidity shock during the crisis, and the results are qualitatively similar.

Despite the documented phenomenon, the underlying rationale is not fully answered; thus, we perform a series of subsample analyses to explore the cross-sectional variations, which would help uncover the potential mechanisms. First, we find that the association between conservatism and trade credit significantly decreased only when suppliers and customers had frequent business transactions or were in close proximity. It indicates that, when information asymmetry along the supply chain was high, the crisis did not significantly affect suppliers’ demand for conditional conservatism. Only when suppliers had a superior information advantage through business transactions, they were willing to grant trade credit even to less conservative firms during the crisis. Second, the association between conservatism and trade credit significantly decreased only when the transacted goods were standardized rather than differentiated, when customers were financially constrained and had high bargaining power, and when suppliers had sufficient liquidity. This result suggests that suppliers’ trade credit extensions were also influenced by the intermediate inputs characteristics, bargaining power, and liquidity constraints of suppliers and customers.

This study contributes to the literature in several ways. First, it advances our understanding on suppliers’ demand for conditional conservatism through the lens of trade credit. On the one hand, we find that conservative firms were more likely to receive trade credit from suppliers, which indicates suppliers’ demand for conditional conservatism, and it is also in line with the role of conditional conservatism in facilitating supplier-customer contracting as suggested by Hui et al. (2012). On the other hand, we show that the association between conditional conservatism and trade credit declined following the onset of the global financial crisis, which contrasts with the increased association between conditional conservatism and bank credit as documented by Balakrishnan et al. (2016). This suggests that, unlike debt holders, suppliers show tolerance to less conservative customers under certain circumstances. This result is also aligned with Gong and Luo (2018), who find that, when a bank has private information on a borrower’s major customers, the bank shows less demand for the borrower’s conditional conservatism.

Second, this study broadly contributes to a growing stream of literature on accounting choices in supplier-customer relationships. Various accounting choices are examined in previous studies, such as income smoothing (Dou et al., 2013, García Teruel et al., 2014), accruals quality (Raman and Shahrur, 2008, Radhakrishnan et al., 2014, Chen et al., 2017, Hope et al., 2017), earning announcements (Pandit et al., 2011, Files and Gurun, 2018), tax avoidance (Cen et al., 2017), auditing (Allee and Yohn, 2009, Johnstone et al., 2014), and analyst forecasting (Guan et al., 2015, Luo and Nagarajan, 2015). We contribute to these studies by demonstrating suppliers’ multifaceted demand for conditional conservatism, which highlights the role of timely downside information in supplier-customer relationships.

Third, our study adds to the literature on the global financial crisis. Previous accounting-related literature on the global financial crisis mainly focuses on the accounting choices of financial institutions (e.g., Huizinga and Laeven, 2012, Bowen and Khan, 2014, Lim et al., 2014), whereas financial reporting in non-financial firms is not well explored. Balakrishnan et al. (2016) investigate how conditional conservatism affected non-financial firms’ access to bank loans and investment activities during the global financial crisis. Our study complements Balakrishnan et al. (2016) by showing the influence of conditional conservatism on non-financial firms’ access to trade credit, which is an important financing source during the crisis (Garcia-Appendini and Montoriol-Garriga, 2013, Carbó Valverde et al., 2016). Given that trade credit extensions occur on the product market, our study essentially documents a spillover effect from the capital market to the product market, and it was driven by the interaction of multiple stakeholders’ demand for conservatism. Therefore, our study provides insights on the role of financial reporting in the product market during the financial crisis.

The remainder of this paper proceeds as follows. Section 2 develops the hypotheses. Section 3 describes the sample and research design. Section 4 shows the main results. Section 5 reports the robustness tests. Section 6 presents subsample analyses, and we conclude in Section 7.

Section snippets

Suppliers’ demand for conditional conservatism

Previous studies examine conditional conservatism from the perspective of debt holders, and they find that debt holders strongly rely on conditional conservatism to monitor borrowers. Information asymmetry between debt holders and borrowers results in adverse selection and moral hazard problems, which obstruct efficient debt contracting (LaFond and Watts, 2008, Armstrong et al., 2010, Smith, 2014). Because conservative financial reporting improves the disclosure of downside information, it

Data

Our sample consists of firm-quarter observations of U.S. incorporated public firms in Compustat with fiscal quarters ending between July 2006 and June 2008. Following Balakrishnan et al. (2016), our sample period includes a pre-crisis period, July 2006–June 2007, and a crisis period, July 2007–June 2008. The start of the global financial crisis is set as July 2007, which was the month when the U.S. subprime mortgage market began to collapse. Because we focus on the period in which the credit

Main results

To examine the association between conditional conservatism and firms’ access to trade credit, we first estimate Eq. (1) based on the pre-crisis period and the crisis period separately. The results are reported in columns 1 and 2 of Table 2. In the pre-crisis period (column 1), the coefficient estimate of Conservatism is 0.795, and it is statistically significant at the 1% level. One standard deviation increase in Conservatism raises Trade Credit by 11% (=0.795 × 0.082/0.590), and on annual

Placebo tests

To verify our regression specification, we repeat the analysis for a placebo (i.e., non-existent) crisis starting in July 2006 and for the market demand shock caused by the 9/11 terrorism attack. We suspect that suppliers’ reduced reliance on conservatism was triggered by the credit supply shock. Given that no credit supply shock existed around the placebo crisis or the 9/11 event, the association between conservatism and trade credit is not expected to demonstrate significant changes before

Subsample analyses

In this section, we conduct subsample analyses to explore the scenarios in which the association between conservatism and trade credit more likely decreased during the crisis. These analyses would shed light on the rationale for why some suppliers reduced their reliance on conservatism under the credit supply shock.

Conclusion

Previous literature documents that conditional conservatism is valued by debt holders and that it is used to facilitate efficient debt contracting. However, it is unclear to what extent suppliers, as an important non-financial stakeholder, rely on conditional conservatism to monitor customers. We investigate suppliers’ demand for conditional conservatism by examining the association between conditional conservatism and firms’ access to trade credit before and after the onset of the global

References (81)

  • E. Garcia-Appendini et al.

    Firms as liquidity providers: evidence from the 2007–2008 financial crisis

    J. Financ. Econ.

    (2013)
  • J.M. García Lara et al.

    Conditional conservatism and firm investment efficiency

    J. Account. Econ.

    (2016)
  • M.G. Hertzel et al.

    Inter-firm linkages and the wealth effects of financial distress along the supply chain

    J. Financ. Econ.

    (2008)
  • O. Hope et al.

    Stakeholder demand for accounting quality and economic usefulness of accounting in US private firms

    J. Account. Publ. Policy

    (2017)
  • K.W. Hui et al.

    Corporate suppliers and customers and accounting conservatism

    J. Account. Econ.

    (2012)
  • H. Huizinga et al.

    Bank valuation and accounting discretion during a financial crisis

    J. Financ. Econ.

    (2012)
  • V. Ivashina et al.

    Bank lending during the financial crisis of 2008

    J. Financ. Econ.

    (2010)
  • M. Khan et al.

    Estimation and empirical properties of a firm-year measure of accounting conservatism

    J. Account. Econ.

    (2009)
  • C.Y. Lim et al.

    Bank accounting conservatism and bank loan pricing

    J. Account. Publ. Pol.

    (2014)
  • I. Love et al.

    Trade credit and bank credit: Evidence from recent financial crises

    J. Financ. Econ.

    (2007)
  • J.E. Rauch

    Networks versus markets in international trade

    J. Int. Econ.

    (1999)
  • L. Tan

    Creditor control rights, state of nature verification, and financial reporting conservatism

    J. Account. Econ.

    (2013)
  • J. Zhang

    The contracting benefits of accounting conservatism to lenders and borrowers

    J. Account. Econ.

    (2008)
  • A.S. Ahmed et al.

    The role of accounting conservatism in mitigating bondholder-shareholder conflicts over dividend policy and in reducing debt costs

    Account. Rev.

    (2002)
  • J.K. Aier et al.

    Debtholders’ demand for conservatism: evidence from changes in directors’ fiduciary duties

    J. Account. Res.

    (2014)
  • A. Ali et al.

    The limitations of industry concentration measures constructed with Compustat data: implications for finance research

    Rev Financ. Stud.

    (2009)
  • K.D. Allee et al.

    The demand for financial statements in an unregulated environment: an examination of the production and use of financial statements by privately held small businesses

    Account. Rev.

    (2009)
  • K. Balakrishnan et al.

    The effect of accounting conservatism on corporate investment during the global financial crisis

    J. Bus. Finance Account.

    (2016)
  • J. Barrot et al.

    Input specificity and the propagation of idiosyncratic shocks in production networks

    Q. J. Econ.

    (2016)
  • W.H. Beaver et al.

    Conditional and unconditional conservatism: concepts and modeling

    Rev. Acc. Stud.

    (2005)
  • B. Biais et al.

    Trade credit and credit rationing

    Rev. Financ. Stud.

    (1997)
  • M. Burkart et al.

    In-kind finance: a theory of trade credit

    Am. Econ. Rev.

    (2004)
  • S. Carbó Valverde et al.

    Trade credit, the financial crisis, and SME access to finance

    J. Money Credit Bank.

    (2016)
  • D. Chen et al.

    Accounting quality and trade credit

    Account. Horizons

    (2017)
  • C.S. Cheng et al.

    Hedge fund intervention and accounting conservatism

    Contemp. Account. Res.

    (2015)
  • R.H. Coase

    The nature of the firm

    Economica

    (1937)
  • V. Cuñat

    Trade credit: suppliers as debt collectors and insurance providers

    Rev. Financ. Stud.

    (2007)
  • N. Dass et al.

    Trade credit, relationship-specific investment, and product market power

    Rev. Finance

    (2015)
  • N. Dass et al.

    Board expertise: do directors from related industries help bridge the information gap?

    Rev. Financ. Stud.

    (2014)
  • Y. Dou et al.

    Relationship-specificity, contract enforceability, and income smoothing

    Account. Rev.

    (2013)
  • Cited by (13)

    • The Journal of Accounting and Public Policy at 40: A bibliometric analysis

      2023, Journal of Accounting and Public Policy
      Citation Excerpt :

      The pink nodes denote this cluster in Figs. 3–7. Articles with the highest PageRank are Cheng et al. (2020), Zhang (2020), and De Vito and Gómez (2020). Cheng et al. (2020) investigate the relationship between the opacity of operating cash flow (OCF) and stock price crash risk.

    • Stakeholder orientation and trade credit: Evidence from a natural experiment

      2023, International Review of Economics and Finance
    • Firm-level trade credit responses to COVID-19-induced monetary and fiscal policies: International evidence

      2022, Research in International Business and Finance
      Citation Excerpt :

      We also find the mean of SIZE is 9.17, and LEV, 26.8 %. This figure is very close to that of Zhang (2020). We find the mean for the ROA is 0.03 %, and for CASH 14.6 %, which is close to that in Li et al. (2020).

    • Unpacking the black box of trade credit to socially responsible customers

      2020, Journal of Banking and Finance
      Citation Excerpt :

      Second, our finding that socially responsible customers acted as liquidity providers during the crisis provides new insights into the literature on trade credit. Previous literature on trade credit focuses on suppliers’ liquidity provision to customers (e.g., Klapper et al., 2012; Restrepo et al., 2019), especially during the financial crisis (Garcia-Appendini and Montoriol-Garriga, 2013; Costello, 2020; Zhang, 2020). In contrast, our study demonstrates the backward liquidity provision from financially sound customers to liquidity-constrained suppliers during the crisis.

    View all citing articles on Scopus

    I thank Marco Trombetta (the editor) and two anonymous reviewers for their constructive comments. I am grateful to Juan M. García Lara and Josep A. Tribó for their patient guidance, and I also appreciate the comments from Zhangfan Cao, Chris Chapman, Hyungjin Cho, Mark Clatworthy, Hang Dong, Anastasios Elemes, Daniel Ferreira, Andrei Filip, Miguel García Cestona, Beatriz García Osma, Encarna Guillamon Saorin, Bing Guo, Kevin Jackson, Thomas Jeanjean, Yun Lou, Juan Pedro Sánchez-Ballesta, Shuo Wang, Zhifang Zhang, as well as from the participants of the 2016 BAFA Conference, 2016 Madrid Accounting Research Symposium, 2016 EAA Talent Workshop, 2017 EAA Annual Congress, and the seminars at Copenhagen Business School, ESSEC, Harbin Institute of Technology, NEOMA, Stockholm School of Economics, Universidad Carlos III de Madrid, and University Paris Dauphine. The financial support from Copenhagen Business School and Spanish Ministry of Economy and Competitiveness [ECO2012-36559] is acknowledged. The usual disclaimers apply.

    View full text