The Information Role of Audit Opinions in Debt Contracting

54 Pages Posted: 29 Apr 2015 Last revised: 17 Mar 2016

See all articles by Peter F. Chen

Peter F. Chen

Hong Kong University of Science & Technology (HKUST) - Department of Accounting

Shaohua He

Lancaster University

Zhiming Ma

Peking University - Guanghua School of Management

Derrald Stice

The University of Hong Kong - School of Business; HKU Business School, The University of Hong Kong

Date Written: February 1, 2016

Abstract

This study examines the relevance of modified audit opinions (MAO) in private debt contracting. We use the auditor’s explanatory language to partition MAOs into Inconsistency opinions, resulting from an accounting change or a restatement; and Inadequacy opinions, arising from a material uncertainty or a going concern (GC) opinion. Using the loan contracts of firms with MAOs; we find that, compared with loans issued in the year after a clean opinion, loans issued in the year after an MAO are associated with higher interest spreads (17 basis points on average), fewer financial covenants, more general covenants, smaller loan sizes, and a higher likelihood of requiring collateral. We find that the effect on loan spreads (as well as on other non-price terms) varies by the type of MAO, ranging from no effect for an accounting change to an average increase of 107 basis points for a GC opinion. Additional analyses of GC opinions find that auditors communicate incremental information to lenders about clients’ credit risk. Overall, our empirical results suggest that lenders incorporate the information contained in MAOs into debt contracting.

Keywords: Debt Contracting, Audit Opinions, Going Concern Opinions, Explanatory Language

JEL Classification: G01, M4, M49

Suggested Citation

Chen, Peter Fusheng and He, Shaohua and Ma, Zhiming and Stice, Derrald, The Information Role of Audit Opinions in Debt Contracting (February 1, 2016). Journal of Accounting and Economics (2016) 61: 121-144, Available at SSRN: https://ssrn.com/abstract=2599886

Peter Fusheng Chen

Hong Kong University of Science & Technology (HKUST) - Department of Accounting ( email )

Clear Water Bay
School of Business & Management
Kowloon
Hong Kong PRC
852-2358-7572 (Phone)

Shaohua He

Lancaster University ( email )

Lancaster LA1 4YX
United Kingdom

Zhiming Ma

Peking University - Guanghua School of Management ( email )

Peking University
Beijing, Beijing 100871
China

Derrald Stice (Contact Author)

The University of Hong Kong - School of Business ( email )

Meng Wah Complex
Pokfulam Road
Hong Kong
China

HKU Business School, The University of Hong Kong ( email )

Hong Kong
China

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