Auditor Quality and Debt Covenant Violations

• In Event: Valuation and Measurement

Abstract

This paper examines the impact of auditor quality on debt covenant violations. Using a large sample of covenant violations, we find an overall negative relation between auditor quality and the probability of covenant violations. Because covenant violations are associated with significant economic costs, their avoidance has economic value; the negative relation between auditor quality and covenant violations suggests that high-quality auditors enable this value addition. In interpreting our results, we conjecture that high-quality auditors may play important roles both in providing assurance to lenders at contract inception (encouraging fewer and less restrictive covenants, and, consequently, ensuring a lower probability of eventual covenant violations) and in ensuring the integrity of accounting numbers around technical defaults (enforcing higher-quality reporting and, consequently, ensuring a higher probability of covenant violations). Given this, our overall finding of a negative relation between auditor quality and covenant violations implies the relative importance of the former. We verify this implication by showing that auditor quality is negatively associated with the intensity and tightness of covenants when debt contracts are initiated.

Authors

• Qiang Wu, Rensselaer Polytechnic Institute

• Hao Zhang, Rochester Institute of Technology

• Ashok Robin, Rochester Institute of Technology