This paper contains important applications for borrowing firms wanting to have more favorable loan contract terms. By hiring a high-quality auditor this decreases risks for the creditors and therefore oftentimes reduces the stringency of debt covenants. Subsequently, the borrowing firm will violate the debt covenants less.

Robin, Ashok, Q. Wu, and H. Zhang. 2017. “Auditor Quality and Debt Covenants”. Contemporary Accounting Research 34.1 (2017): 154.

Debt covenants are in place to help mitigate information asymmetry and agency problems between lender and borrower. This study examines whether high-quality auditors decrease the lenders’ demand for strict covenants (contracting effect), therefore reducing the likelihood of covenant violations (violation reduction effect). The assumption is that the information provided by a high-quality auditor would lower information asymmetry and agency problems, and consequently there would be no reason for strict debt covenants. 

There was a sample of 35,181 observations from 1996-2007. Compustat was used to gather annual covenant-violation data and Deal Scan was used to gather U.S. loan facility information.  The authors used an ordinary least squared (OLS) regression model in the analysis.

Overall, the authors find high-quality audits are in fact related with fewer and looser covenants in debt contracts.

Specifically, the authors find the following:

• As auditor quality increases the probability of financial covenant violations decrease. The probability is 1.45% lower for firms audited by industry experts and about 4.98% lower for firms audited by the Big 4.
• High-quality auditors play a role in mitigating the adverse effect of covenant violations on corporate borrowing costs.

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