Debt contract strictness and auditor specialization

• Date: 01 May 2019
• Published date: 01 May 2019
• DOI: http://doi.org/10.1111/jbfa.12380
• Author: Carolyn M. Callahan,Gary F. Peters,Joseph H. Zhang

DOI: 10.1111/jbfa.12380

Debt contract strictness and auditor specialization

Carolyn M. Callahan1Gary F.Peters2Joseph H. Zhang3

1College of Business, University of Louisville,

Louisville,Kentucky, USA

2Sam M. WaltonCollege of Business, University

of Arkansas, Fayetteville,Arkansas, USA

3Scool of Accountancy, University of Memphis,

Memphis, Tennessee,USA

Correspondence

JosephH. Zhang, School of Accountancy, Univer-

sityof Memphis, 230 Fogelman College Admin

Bldg,Memphis, TN 38152, USA.

Email:jzhang5@memphis.edu

Abstract

The conflicts of interest among managers, shareholders and credi-

tors resulting in agency costs, can be mitigated by restricting man-

agers’ adverse behavior, through financial covenantsto better align

the various stakeholderinterests. Thus, debt contract strictness rep-

resents an important aspect of agency costs between creditors,

shareholders, and management that is not always captured by inter-

est rates. The contract setting provides a unique opportunity to

investigate how creditors may rely on auditors to alleviate informa-

tion 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 signifi-

cantly 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

1INTRODUCTION

In this paper, we explore the association between auditor industry specialization and loan covenant restrictiveness.

Prior research has largely examined the role of accounting quality in debt contracting, and specifically, in mitigat-

ing information asymmetry and agency conflicts between lenders and their borrowers (Christensen, Nikolaev, &

Wittenberg-Moerman, 2016; Dechow, Sloan, & Sweeney, 1996). In this respect, independent auditors mayserve an

important role in reducing information asymmetry and debt contracting agency costs by assuring the reliability and

validity of the financial reporting reflected in the debt covenant (Anderson, Mansi, & Reeb, 2004; Leftwich, 1983; Lou

686 c

2019 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2019;46:686–711.

CALLAHAN ET AL.687

& Vasvari, 2013; Minnis, 2011; Robin, Wu, & Zhang, 2017). However,there is little systematic evidence on how the

interplay between debt covenant design and auditor expertise and specialization can effectively mitigate borrowers’

agency costs. Tobetter understand the nature of agency costs related to creditor control and information asymmetry,

we examine the role of auditor specialization in alleviatingthe demand for debt contract strictness.

We assert that debt contract strictness represents a unique creditor response to information uncertainty that is

not necessarily captured by debt pricing or the simple number of covenants. Contract strictness, through the use of

covenants, represents significant agency costs for borrowing firms and is a source of control for creditors (Chava &

Roberts, 2008). The strength of such contracts is acutely subject to the uncertainty surrounding the reliability of the

borrowing firm’s information environment. For example,Fields, Fraser, and Subrahmanyam (2012) document a nega-

tive association between the use of financial ratio covenants and the strength of the firm’s board of directors. As the

reliability of the firm’s financial information decreases, the debt contract strictness should also increase. This creates

creditor demand for financial statement audits, due to the agency conflicts between shareholders, creditors, and man-

agers (Jensen & Meckling, 1976).

Therole of financial statement audits, in providing greater access to capital, represents a longstanding subject of dis-

cussion within the accounting and finance literatures. Prior research asserts that auditors provide varying degrees of

servicequality and are diverse in their ability to reduce agency costs (e.g., DeAngelo, 1981; Watts & Zimmerman, 1983).

The auditor differentiation literaturetypically finds that industry specialist auditors deliver higher quality audits due to

theirspecialized knowledge (e.g., Craswell, Francis, & Taylor,1995; Kanagaretnam, Lim, & Lobo,2010; Solomon, Shields,

& Whittington, 1999). Their presence is often deemed a monitor or deterrent to management accounting manipula-

tion, thereby increasing the reliability of financial reports. Giventhe relationship between debt contract strictness and

financial reporting reliability, we consider whether the presence of specialized auditors affects the degree to which

lenders retain control over their investedcapital, through the use of stricter debt contracts.

We use a loan-specific measure of debt contract strictness that captures the ex ante probability of a forced rene-

gotiation between the lender and borrower.We adapt a comprehensive strictness measure, first developed by Murfin

(2012), which reflects the number, slackness, scale, and covariance of debt covenants.1Prior research uses a simple

count of the number of covenants to proxy for loan restrictions (e.g., Nikolaev, 2010), but simple counts can produce

biased measures of debt covenant strictness because financial ratiocovenants are usually interdependent (Demerjian

& Owens, 2016; Murfin, 2012). For example, an agreement that contains maximum debt to EBITDA(earnings before

interest, tax, depreciation, and amortization) and maximum leverage ratios implicitly imposes a variable limit on the

minimum net worth covenant. We use this composite strictness measure, which provides a refined view of the credi-

tor’s reliance on the overall reliability of the firm’s financial statements as a whole. We also expandour tests by con-

sidering alternative debt contract variables found in extantliterature, including a measure of aggregate covenant vio-

lation probability (Demerjian & Owens, 2016), the number of covenants, covenant grace periods, and the extentthat

covenants include restrictions that tighten overtime.

Using a large sample of firm-year observations from Compustat, AuditAnalytics, and TFN-DealScan from 2000

through 2010, we find evidence that debt contract strictness is negativelyassociated with borrowing firms’ audit fees,

debt rating, profitability, and size, while positively associated with the probability of auditor’s issuance of a going-

concern report, debt maturity, financial leverage,and the occurrence of financial restatements. After controlling for

the aforementioned characteristics, we find a significant negative association between debt contract strictness and

auditors’ industry specialization. The findings support the assertion that employing industry specialist auditors is a

means for reducing creditors’ information uncertainty that is not captured by debt interest rates. Moreover, these

associations appear to be conditional upon the presence of alternative monitoring mechanisms (such as board size,

board independence, dedicated institutional ownership, and the number of analysts following the firm).

1Debtholders may include provisions in debt contracts (‘covenants’)that restrict or require certain actions of managers after the debt issuance. That is,

covenants may restrict certain actions (e.g., paying dividends, disposing assets, issuing additional debt), endorse other actions (e.g.,maintai ning the firm’s

properties), or require the maintenance of certain financial ratios(e.g., minimum net worth or interest coverage). Upon violation of covenants, control rights

aretransferred to lenders, granting them the opportunity to intervene in the firm’s investing and financing decisions (Chava & Roberts, 2008).