Audit Report Restrictions in Debt Covenants

While the debt†contracting literature has extensively examined financial covenants, there has been little attention paid to audit†related covenants. We focus on a covenant that restricts the borrower from receiving a going†concern audit report (GCAR covenant). We hypothesize that a debt agreement is more likely to include a GCAR covenant as the borrower's credit quality decreases and the length of the loan period increases, and that it is more likely to impose a covenant restricting the choice of auditor when the debt includes a GCAR covenant. Also, we expect that an audit client with a GCAR covenant will be charged a higher audit fee and is more likely to receive a going†concern audit report. We test these hypotheses on a sample of firms that issue private debt. Our results generally support our hypotheses. Our study suggests that lenders rely on the auditor's assessment in contracting, and audit†related covenants influence auditor behavior.