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While prior research has examined the effects of violating debt covenants from managers’ and investors’ perspectives, there is a paucity of research on how auditors view debt covenant violations. We examine the relation between debt covenant violations and viable auditor responses. Incremental to client attributes and audit risk variables identified in prior research, we document a positive association between debt covenant violation and several auditor actions, including increased audit fees, going concern opinions, and auditor resignations. We find that audit fees for firms with at least one debt covenant violations are 15.3 percent higher than for firms without violations. Further, we find that the increase in fees persists for at least 10 years following the initial debt covenant violation. Interestingly, contrary to our expectations, we find that client financial distress does not enhance the relationships between debt covenant violations and auditor actions (e.g., following debt covenant violations, auditors are not more likely to issue going concern opinions to firms who are financially distressed as compared to those who are financially non-distressed). Overall, the findings contribute to our understanding of the indirect, yet significant financial consequences of debt covenant violations to firms.
Gopal V. Krishnan, American University
Lori B Shefchik, Georgia Institute of Technology
Wei Yu, The University of Tennessee–Knoxville