Do Debt Covenant Violations Serve as a Risk Factor of Ineffective Internal Control?

Posted: 13 Jan 2017 Last revised: 21 Feb 2018

See all articles by Jun Guo

Jun Guo

Rutgers, The State University of New Jersey - Rutgers University, Camden

Pinghsun Huang

National Cheng Kung University

Yan Zhang

State University of New York at Binghamton - School of Management

Date Written: February 20, 2018

Abstract

We examine whether debt covenant violations serve as an important determinant of material weaknesses in internal control over financial reporting. Motivated by the debt covenant hypothesis, we posit that the probability of ineffective internal control is expected to be significantly higher for firms with debt covenant violations than for firms without the violations. Equivalently, a covenant violation implies an increasingly unseen firm risk related to internal control ineffectiveness: violating firms can previously select inappropriate but undetected accounting techniques more extensively to delay the current covenant violation or exploit opportunistic accounting methods to prevent further debt covenant violations. Consistent with this notion, our empirical evidence indicates that firms violating debt covenants are more likely to have internal control weaknesses. We also uncover that the positive association between the violations and internal control weaknesses is more pronounced for firms that fail to remediate violations by fiscal year-end. Further, the connection between debt covenant violations and ineffective internal control intensifies with the severity of internal control problems. Our results are robust to a variety of controls, alternative measures, different disclosure regimes, and propensity score matching approach. Overall, our results suggest that debt covenant violations can serve as a risk factor of internal control breakdown.

Keywords: Internal Control Weakness; Debt Covenant Violation; Information Risk; Agency Cost

JEL Classification: M41; M14

Suggested Citation

Guo, Jun and Huang, Pinghsun and Zhang, Yan, Do Debt Covenant Violations Serve as a Risk Factor of Ineffective Internal Control? (February 20, 2018). Review of Quantitative Finance and Accounting, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2897879

Jun Guo (Contact Author)

Rutgers, The State University of New Jersey - Rutgers University, Camden ( email )

Camden, NJ 08102
United States

Pinghsun Huang

National Cheng Kung University ( email )

1 Ta-Hsueh Road
Tainan, 701
Taiwan
+886 6 275 7575 ext 53441 (Phone)
+886 6 274 4104 (Fax)

Yan Zhang

State University of New York at Binghamton - School of Management ( email )

P.O. Box 6015
Binghamton, NY 13902-6015
United States
607-777-6195 (Phone)
607-777-4422 (Fax)

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