Debt Contract Strictness and Auditor Specialization

26 Pages Posted: 27 May 2020

See all articles by Carolyn M. Callahan

Carolyn M. Callahan

University of Louisville - College of Business

Gary F. Peters

University of Arkansas at Fayetteville

Joseph Zhang

University of Memphis

Date Written: May/June 2019

Abstract

The conflicts of interest among managers, shareholders and creditors resulting in agency costs, can be mitigated by restricting managers’ adverse behavior, through financial covenants to better align the various stakeholder interests. Thus, debt contract strictness represents an important aspect of agency costs between creditors, shareholders, and management that is not always captured by interest rates. The contract setting provides a unique opportunity to investigate how creditors may rely on auditors to alleviate information uncertainty stemming from reliance on management's financial reporting and thus alleviate the creditor's potential loss of invested capital. After controlling for borrower risks, loan characteristics, and audit factors, we show that auditor industry specialization is significantly associated with a reduction in the strictness of debt contracts, consistent with creditors viewing certain industry expert auditors as effective monitors against financial reporting manipulation aimed at the avoidance of debt covenant triggers that protect creditors against potential loss. Further, we find that the association between loan strictness and auditor specialization is attenuated by stronger corporate governance systems, external monitors, and prior lender relationships.

Keywords: auditor specialization, corporate governance, loan strictness

JEL Classification: G21, G34, M41, M42

Suggested Citation

Callahan, Carolyn M. and Peters, Gary F. and Zhang, Joseph, Debt Contract Strictness and Auditor Specialization (May/June 2019). Journal of Business Finance & Accounting, Vol. 46, Issue 5-6, pp. 686-711, 2019, Available at SSRN: https://ssrn.com/abstract=3604478 or http://dx.doi.org/10.1111/jbfa.12380

Carolyn M. Callahan (Contact Author)

University of Louisville - College of Business ( email )

Dean's Office
Louisville, KY 40292
United States
(502) 852-6443 (Phone)
(502) 852-7557 (Fax)

Gary F. Peters

University of Arkansas at Fayetteville ( email )

Sam M. Walton College of Business
Department of Accounting
Fayetteville, AR 72701

Joseph Zhang

University of Memphis ( email )

FAB 200
School of Accountancy
Memphis, TN Tennessee 38152
United States

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