Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    Debt Covenant Violations, Firm Financial Distress, and...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 12.01 Going Concern Decisions 
    40 Views
    Title:
    Debt Covenant Violations, Firm Financial Distress, and Auditor Actions
    Practical Implications:

    The findings from this study impact firms with debt covenant requirements. Violations from debt covenants occur frequently and are often due to tight restrictions rather than signs of financial distress. These types of violations often lead to renegotations or waivers instead of immediate repayment. However, this study shows that auditors will still have negative reactions regardless of whether or not the violation is due to financial difficulty. It is important for firms to not only consider the financial and lending consequences of a violation, but the auditing consequences as well.

    Citation:

    Bhaskar, Lori Shefchik, G. V. Krishnan, and W. Yu.2017. “Debt Covenant Violations, Firm Financial Distress, and Auditor Actions”. Contemporary Accounting Research 34.1 (2017): 186.

    Purpose of the Study:

    This study investigates auditor actions resulting from debt covenant violations for firms. The violations increase business risk and subsequently cause the auditor to respond negatively. The audit actions examined in this paper are:

    • Adjustments in the audit plan causing higher audit fees.
    • The issuance of a going concern opinion.
    • The resignation of the auditor.

    The authors also consider the financial health of the firms before the violation was given. It is hypothesized that auditors are more likely to have a negative reaction to firms that are already financially distressed.

    Design/Method/ Approach:

    The sample includes 4,267 violations occurring from 2000 to 2008. All of the firms were U.S. nonfinancial public companies. The authors gathered the information from databases such as Compustat and Audit Analytics. The analysis was performed by estimating models of the auditor actions based on different client characteristics.

    Findings:

    The authors find the following:

    • Firms with debt covenant violations have significantly higher audit fees.
    • Firms have an increased likelihood of receiving a going-concern opinion after a violation. This is increased even more for firms that are not financially distressed. The authors attribute this to the fact that auditors tend to act more strongly because the information was inconsistent with prior beliefs.
    • Debt covenant violations lead to an increased likelihood of auditor resignation.
    • There is a positive association between the Big 4 auditors and all three auditor actions listed above.
    Category:
    Accountants' Reporting, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Resignation Decisions
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary