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Review of Accounting Studies

Erschienen in:

19.01.2017

The role of audit verification in debt contracting: evidence from covenant violations

verfasst von: Liangliang Jiang, Hui Zhou

Erschienen in: Review of Accounting Studies | Ausgabe 1/2017

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Abstract

We investigate the role of audit verification in the resolution process following debt covenant violations. Using two sets of proxies for demand—audit fees and the independence and diligence of audit committees—we find evidence that covenant violations result in a demand for differentially higher levels of audit verification. Further analyses demonstrate the link between the increased demand for audit verification and the mechanisms designed to control agency costs in debt contracts. We document cross-sectional variations in the observed fee differential with respect to the level of reliance on financial covenants, the type of covenants violated, and waiver decisions. Moreover, we find that the observed audit fee increases are associated with more favorable movements in borrowing costs and the adoption of more conservative investment policies post violation. Our findings suggest that covenant violations increase the demand for audit services to help control contracting costs post violation.

Vorheriger Artikel Voluntary fair value disclosures beyond SFAS 157’s three-level estimates

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For example, the corporate governance role of external auditors is discussed in the United States Securities Exchange Commission’s pronouncement on Audit Committee Disclosure (1999), Corporate Governance Survey of Institutional Investors by PricewaterhouseCoopers of Singapore (1999), and the Asian Corporate Governance Association research report (2000).

As Ball et al. (2012) explain, the choice of the client influences the level of audit services through various dimensions including “the choice of audit firm (e.g., Big Four versus smaller firm), the seniority level of the audit engagement partner, the number of audit personnel on the job and their average hourly rate, the degree of verification of internal control systems and individual transactions required by the client, the frequency of communication with the audit committee, and other variables” (p. 142).

Audit fees reflect the joint outcome of both supply and demand factors. In a working paper, Gao et al. (2015) also document significant increases in audit fees post violation. They characterize the phenomenon as an auditor-driven response in anticipation of increased litigation risk post violation, improved bargaining power in audit fee negotiations, or both. We address these supply-based explanations in Section 5.

We thank an anonymous referee for encouraging us to examine the implications of increased audit verification following covenant violations.

Earlier research on the consequences of debt covenant violations (e.g. Beneish and Press 1993, 1995; DeFond and Jiambalvo 1994; Sweeney 1994) document negative impacts of covenant violations.

Note that fees for due diligence performed by external auditors related to loan initiation are part of non-audit fees and therefore not included in audit fees.

The dataset can be downloaded from http://faculty.chicagobooth.edu/amir.sufi/data.html. Violations are not clustered in any given year. The percentage of firms reporting a covenant violation in our sample for 2000 through 2007 is 14%, 17%, 14%, 11%, 11%, 12%, 11%, and 10%, respectively.

Our sample period starts from year 2000 because audit fee data became available starting year 2000. Nonetheless, we still keep the covenant violations recorded between year 1996 and 1999 to minimize the truncation problem.

The majority of firms in our sample are not rated by S&P and thus do not have credit ratings. To maintain the sample size, we assign SP rating a value of zero for all observations that represent nonrated firms in our regression analyses. We have run the regressions excluding SP rating as an independent variable, and all inferences remain the same.

Filing both the management report on internal controls (required under Section 404(a)) and the auditor attestation of this management report (required under Section 404(b)) went into effect starting fiscal year 2004 for accelerated filers, while non-accelerated filers were never subject to the requirement of Section 404 (b).

A standard DID framework only controls for the simple difference between the treatment and control groups as well as before and after the treatment. Our model provides an extension of this standard DID framework by controlling for more flexible year and firm fixed effects. This method allows for the difference between the treatment and control groups to vary between firms and for the difference before and after the treatment to vary across years.

NYSE and NASDAQ modified their listing requirements in December 1999. The new standards require firms to maintain audit committees composed solely of outside directors. As a result, the majority of firms in our sample (with the sample period of 2000 to 2008) have audit committees composed of 100% outside directors. However, this does not mean that there is no variation in the level of audit committee independence after 2000. In particular, the absolute number of outside directors on the audit committee is also an important determinant of independence. This notion is behind the modified NYSE and NASDAQ listing standards requiring that all firms must maintain audit committees with at least three independent directors.

The SEC filings disclosing a covenant violation typically do not identify the specific loan in technical violation. This complicates the process of linking the violation with the loan records reported by Dealscan (Demiroglu and James 2010).

We formally test the statistical significance of the difference between the two coefficients using an interaction-term approach in a pooled regression. The results confirm that the effects of covenant violations on audit fees are larger for the nonwaiver group than for the waiver group.

To the best of our knowledge, there is no direct empirical evidence indicating an association between debt covenant violations and increased lawsuits against the engaged auditor.

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Titel: The role of audit verification in debt contracting: evidence from covenant violations
verfasst von: Liangliang Jiang
Hui Zhou
Publikationsdatum: 19.01.2017
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 1/2017
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-016-9383-x

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