Do Auditors Play a Positive Role in the Resolution of Debt Covenant Violations?

Abstract

We investigate whether auditors exercise closer monitoring and thus charge higher fees in response to debt covenant violations. Using a hand-collected sample focusing on initial covenant violations, we document that audit fees experience an average increase of about 20 percent in the year immediately following the violation year and continue to stay at a high level until three years after the initial violation. Difference-in-differences analysis shows that the increase in audit fees in response to covenant violations is more (less) pronounced when the benefit (cost) of closer auditor monitoring is likely to be higher. Further analysis links the observed increase in audit fees with the improvement in audit committee independence and diligence in response to covenant violations. Our findings provide new evidence that auditors play a positive role in the resolution of debt covenant violations and highlight the importance of corporate governance factors in the audit process.

Keywords: corporate governance, debt covenant, audit committee, audit fee

JEL Classification: M40, M41