Does Auditor Choice Affect Financial Debt Covenants?
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I examine the effects of auditor choice on debt contracting, particularly in regards to the number and types of financial covenants included in debt contracts. Using four audit quality proxies previously identified in the literature, I predict and find that higher quality auditors act as substitutes for lender monitoring via financial covenants, thereby decreasing the number of financial covenants. Furthermore, I predict that firms with higher quality auditors are likely to receive contracts with more performance (income statement based) covenants relative to capital (balance sheet based) covenants as performance covenants require a higher degree of contractible accounting information. Here, however findings are mixed with only one of the audit quality proxies being associated with an increase in performance covenants relative to capital covenants while two other proxies show the opposite effect. I also examine the effect of switching auditors on financial covenants. I predict and find that firms that recently switched auditors have more total covenants and relatively fewer performance covenants than those that did not recently switch auditors. I further find that amongst firms that have recently switched auditors, the number and type of financial covenants vary depending on the perceived quality of the previous and new auditors. Additional tests are employed to study if these effects change from the pre- to post- SOX era as well as the pre- and post- financial crisis years. This study adds to the literature by examining the ramifications of auditor choice on an important feature of debt contracting.