Impact of ASC 606 on the Cost of Debt: Lessons for Principles-Based Accounting Standards

Abstract

This paper examines the consequences of adopting principles-based accounting standards on the cost of debt using a quasi-natural experiment surrounding the adoption of ASC 606. We find that affected firms experience increases in uncertainty regarding future earnings captured by both higher analyst absolute forecast error and analyst forecast dispersion. Consequently, the cost of debt rises for materially affected firms as covenants are used less in debt contracts due to decreased effectiveness of earnings-based covenants. The effect is concentrated in firms with high pre-ASC 606 revenue/operating income volatility and is mitigated by relationship lending. We also show that the increased cost of debt dissipates over time, consistent with learning and adapting to new standards by the debt market. Our analyses imply a costly transition from rules-based to principles-based accounting standards in the short run, but the costs are not long-lasting.