The Governance Role of Private Debt and the Monitoring Role of External Auditors: Evidence from Covenant Violations

31 Pages Posted: 26 Dec 2011

See all articles by Liangliang Jiang

Liangliang Jiang

Hong Kong Polytechnic University

Hui Zhou

University of Melbourne - Melbourne Business School

Date Written: December 26, 2011

Abstract

We investigate whether covenant violations function as information mechanisms that lead to the external auditor either exercising closer monitoring or opting to exit. Such responses are expected based on interactive stakeholder monitoring and reaction as described in Triantis and Daniels (1995). Using a hand-collected, comprehensive sample focusing on initial covenant violations during the period from 1996 to 2008, we document that audit fees experience an average increase of about 20% in the year immediately following the violation year, and continue to stay at a high level until three years after the initial violation. Moreover, the increase in audit fees varies positively with leverage and negatively with growth, the proxy for the benefit and cost of closer auditor monitoring respectively. Finally, we find a significant increase in the occurrence of auditor change during the violation year and perform further analysis to show that this is likely due to auditors choosing to exit (resigning) rather than client-initiated auditor change. Overall, the evidence lends support to the interactive corporate governance perspective and adds to previous studies that highlight the importance of corporate governance factors in the pricing of audit services.

Keywords: Corporate governance, Covenant violations, Audit fee, Auditor change

JEL Classification: M41, G34

Suggested Citation

Jiang, Liangliang and Zhou, Hui, The Governance Role of Private Debt and the Monitoring Role of External Auditors: Evidence from Covenant Violations (December 26, 2011). Available at SSRN: https://ssrn.com/abstract=1976975 or http://dx.doi.org/10.2139/ssrn.1976975

Liangliang Jiang (Contact Author)

Hong Kong Polytechnic University ( email )

11 Yuk Choi Rd
Hung Hom
Hong Kong

Hui Zhou

University of Melbourne - Melbourne Business School ( email )

200 Leicester Street
Carlton, Victoria 3053 3186
Australia

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