The Role of Audit Verification in Debt Contracting: Evidence from Covenant Violations

Posted: 6 Jul 2016 Last revised: 23 Jan 2017

See all articles by Liangliang Jiang

Liangliang Jiang

Hong Kong Polytechnic University

Hui Zhou

University of Melbourne - Melbourne Business School

Date Written: June 28, 2016

Abstract

We investigate the role of audit verification in the resolution process following debt covenant violations. Using two sets of proxies for demand—audit fees and the independence and diligence of audit committees—we find evidence that covenant violations result in a demand for differentially higher levels of audit verification. Further analyses demonstrate the link between the increased demand for audit verification and the mechanisms designed to control agency costs in debt contracts. We document cross-sectional variations in the observed fee differential with respect to the level of reliance on financial covenants, the type of covenants violated, and waiver decisions. Moreover, we find that the observed audit fee increases are associated with more favorable movements in borrowing costs and the adoption of more conservative investment policies post violation. Our findings suggest that covenant violations increase the demand for audit services to help control contracting costs post violation.

Keywords: corporate governance, auditor monitoring, covenant violation, audit committee

JEL Classification: M41, G30

Suggested Citation

Jiang, Liangliang and Zhou, Hui, The Role of Audit Verification in Debt Contracting: Evidence from Covenant Violations (June 28, 2016). Review of Accounting Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2803824 or http://dx.doi.org/10.2139/ssrn.2803824

Liangliang Jiang

Hong Kong Polytechnic University ( email )

11 Yuk Choi Rd
Hung Hom
Hong Kong

Hui Zhou (Contact Author)

University of Melbourne - Melbourne Business School ( email )

200 Leicester Street
Carlton, Victoria 3053 3186
Australia

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