Audit Quality and Loan Contract Strictness

• In Event: Breakfast and Research Forum
  In Roundtable Session: Table 10: Financial Markets and Audit Quality

Abstract

We examine the effects of audit quality metrics and corporate governance mechanisms on the strictness of the borrowing firms’ debt contract over the time-period of 2000 to 2010. We identify a specific (debt-covenant) channel and monitoring mechanism through which external auditor’s expertise may impacts loan contracting. We utilize a modified debt contract strictness metric, first developed by Murfin (2012) that captures the ex-ante probability of a forced renegotiation between the lender and borrower. First we find that debt contract strictness is negatively correlated with borrowing firms’ audit fees incurred, debt rating, profitability and firm size, while positively correlated with the probability of the auditor’s issuance of a going-concern report, debt maturity, financial leverage and the occurrence of financial restatement. Secondly, after controlling for borrower risks, debt and audit characteristics, we demonstrate that the use of an industry specialist auditor is significantly associated with a reduction in the strictness of the borrowing firms’ debt contract. We find that on average, the use of an industry specialist auditor is associated with a reduction of 85to 90 basis points in loan strictness for our firms, depending on the industry specialist classification used. Further, we find that this effect is driven by firms that have relatively weak corporate governance mechanisms in terms of (board size / independence, institutional ownership, and the number of analysts following). This suggests that audit quality driven by industry specialists may act as a strong substitute for weak monitoring mechanisms in debt contracting. In short, our results are consistent with the notion that there is more demand for higher quality audits when the agency cost of debt is relatively more severe.

Authors

• Carolyn M Callahan, The University of Memphis

• Joseph H. Zhang, The University of Memphis