The impact of loan covenants on audit delays and audit fees

• Published date: 01 October 2022
• Author: Mohinder Parkash,Rajeev Singhal,Yun (Ellen) Zhu
• Date: 01 October 2022
• DOI: http://doi.org/10.1002/jcaf.22561

Received:  March  Accepted:  April 

DOI: ./jcaf.

RESEARCH ARTICLE

The impact of loan covenants on audit delays and audit fees

Mohinder Parkash Rajeev Singhal Yun (Ellen) Zhu

Department of Accounting & Finance,

Oakland University, Rochester,

Minnesota, USA

Correspondence

Yun (Ellen) Zhu, Department of

Accounting & Finance, Oakland

University, Rochester,MI , USA.

Email: Zhu@oakland.edu

Abstract

We provide evidence on the impact of loan covenants on audit delays and audit

fees. We find that for most covenants, firms with a particular covenant have

longer audit delays than firms without that covenant. On average, we observe

that adding one more loan covenant will delay the audit report by at least  day.

We also found that adding one more loan covenant increases audit fees by .%.

KEYWORDS

audit delay, audit fee, loan, covenants

1 INTRODUCTION

Many researchers show that covenants in debt contracts

may discipline managers’ behavior and, as a result, alle-

viate conflicts between shareholders and bondholders,

reduce attendant agency costs, and increase firm value.

The aforementioned research supports the agency theory

of covenants (ATC) developed by Jensen and Meckling

(), Myers (), and Smith and Warner(), among

others. Consistent with the ATC,DeAngelo et al., and Hop-

per Wruck () study the case of L.A. Gear from  to

 and find evidence that the use of debt covenants is

a better way to discipline managers than the requirement

to meet cash interest payments. Comparing S&P  fam-

ily firms and non-family firms, Bagnoli et al., and Watts

() find evidence that family firms increase the use of

restrictive loan covenants to reduce agency costs, support-

ing the ATC because family firms are commonly consid-

ered to have a lower conflict of interest between managers

and shareholders. Chava and Roberts () observe that

firms reduce investments after loan covenant violations

due to the threat of accelerating loans from creditors. They

further find that the reduction in investment is concen-

trated in firms where agency problems are more severe.

Conversely, while debt covenants may reduce agency

costs between shareholders and bondholders, they may

impose on firm costs associated with violations of debt

covenants. Beneish and Press () studied the costs

related to debt covenant violations in detail. They report

higher refinancing costs, restructuring costs, operation-

modifying costs, and more lender control following debt

covenant violations. DeFond and Jiambalvo () study

debt covenant violations and provide evidence of account-

ing accrual manipulation before and in the year of debt

covenant violations. Bhaskar et al., and Yu ()find

that firms with debt covenant violations have significantly

higher audit fees. They further observe that the positive

relationship holds for both financially distressed and non-

distressed firms. Finally, Jiang and Zhou () show that

loan covenant violations increase the demand for a higher

level of audit verification, leading to a higher audit fee.

The extant literature has focused on the costs to a com-

pany arising from the violation of loan covenants. How-

ever, whether costs also arise from the mere presence of

a loan covenant, irrespective of whether it is violated, is

a question that has not been answered. In a recent study,

Bradley and Roberts () show that the presence of loan

covenants reduces the promised yield of corporate debt

and that smaller firms, growth firms, firms with less long-

term debt, firms with fewer tangible assets, and firms with

more volatile cash flows are more likely to issue loans and

use more loan covenants. Nikolaev () find firms with

more public debt covenants take more time to recognize

the economic losses in accounting earnings. These find-

ings are consistent with the implications of ATC.

In this study, wehypothesize that the presence of corpo-

rate loan covenantsimayresult in audit delays and increase

audit fees. Audit delay affects a firm in two ways. First,

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