Conditional conservatism and trade credit during the global financial crisis☆
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
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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.