Debt contract strictness and auditor specialization

Abstract

The conflicts of interest among managers, shareholders and creditors resulting in agency costs, can be mitigated by restricting managers' adverse behavior, through financial covenants to better align the various stakeholder interests. Thus, debt contract strictness represents an important aspect of agency costs between creditors, shareholders, and management that is not always captured by interest rates. The contract setting provides a unique opportunity to investigate how creditors may rely on auditors to alleviate information uncertainty stemming from reliance on management's financial reporting and thus alleviate the creditor's potential loss of invested capital. After controlling for borrower risks, loan characteristics, and audit factors, we show that auditor industry specialization is significantly associated with a reduction in the strictness of debt contracts, consistent with creditors viewing certain industry expert auditors as effective monitors against financial reporting manipulation aimed at the avoidance of debt covenant triggers that protect creditors against potential loss. Further, we find that the association between loan strictness and auditor specialization is attenuated by stronger corporate governance systems, external monitors, and prior lender relationships. K E Y W O R D Sauditor specialization, corporate governance, loan strictness

What’s My Style? Supply-Side Determinants of Debt Covenant Inclusion

“…We also investigate the covenant effect using covenant strictness. Covenants, in particular restrictive covenants, reflect banks" commitment to monitoring (Rajan and Winton 1995;Garleanu and Zwiebel 2009;Demiroglu and James, 2010;Callahan, Peters, and Zhang, 2019). If covenants are used, as we argue, because banks have a relative advantage in monitoring them, then we would also observe a similar effect using a measure of covenant strictness.…”

How do auditors respond to client firms’ technological peer pressure? Evidence from going‐concern opinions

“…Hence, we control new issuance for capital ( NewFinance ), cash position ( CashReverseRank ) and a combination of total assets and firm age to measure financial constraints ( HPindex ). Following prior studies (e.g., Callaghan et al., 2009; Callahan et al., 2019; DeFond et al., 2002; C. Li, 2009), we also control client importance, audit fees ( LogAuditFee ) and non‐audit fees ( LogNonAuditFee ). Equation (2) also controls year and industry fixed effects.…”

Does product similarity of audit clients influence audit efficiency and pricing decisions?

“…In our estimations, we determine national‐ and city‐level specialists in two ways, following Reichelt and Wang (2010) and Callahan et al. (2020). First, we define a national (city) industry specialist as the auditor with the largest annual market share (in terms of audit fees) in an industry, based on the two‐digit SIC category, as well as whether its annual market share is at least 10 percentage points greater than its closest competitor in that national (city) audit market.…”