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Debt contract strictness and auditor specialization

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  • Carolyn M. Callahan
  • Gary F. Peters
  • Joseph H. Zhang

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.

Suggested Citation

  • Carolyn M. Callahan & Gary F. Peters & Joseph H. Zhang, 2019. "Debt contract strictness and auditor specialization," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 46(5-6), pages 686-711, May.
  • Handle: RePEc:bla:jbfnac:v:46:y:2019:i:5-6:p:686-711
    DOI: 10.1111/jbfa.12380
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    Cited by:

    1. Theophilus Lartey & Albert Danso, 2022. "CEO overconfidence and debt covenant violations," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 45(1), pages 162-199, March.
    2. Weng, Tzu-Ching & Chi, Hsin-Yi, 2024. "Family succession and cost of bank loans: Evidence from China," International Review of Economics & Finance, Elsevier, vol. 89(PB), pages 638-655.
    3. Xiaolu Xu & Leo L. Yang & Joseph H. Zhang, 2022. "How do auditors respond to client firms’ technological peer pressure? Evidence from going‐concern opinions," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 49(9-10), pages 1553-1580, October.
    4. Zhiming Ma & Derrald Stice & Christopher Williams, 2022. "What's my style? Supply‐side determinants of debt covenant inclusion," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 49(3-4), pages 461-490, March.

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