Research on the information role of accounting conservatism in the debt market

Accounting conservatism is an important convention in corporate financial report. In this paper, we used the signal game approach to discuss the information role of accounting conservatism in the debt market with asymmetric information. In the signal game, accounting conservatism serves as a signal by which the inside equity holders of firms can convey their private information about the risk to the outside lenders, prior to signing the debt contract. There is only a dominant separating equilibrium conservatism-signaling for this signal game model. The separating equilibrium is that the low risk firms choose a high level of conservatism and the high risk firms choose a low level of conservatism. The separating equilibrium demonstrates that accounting conservatism, acting as a signaling device, can reduce the information asymmetry between the inside equity holders of firms and the outside lenders in the debt market.