Debt Covenant Violations and Auditor Monitoring

Abstract

We present new evidence on debt covenant violation (DCV) consequences that have not previously been examined in the literature. In particular, we show that a DCV triggers significant information asymmetry and uncertainty on the part of shareholders and auditors as reflected in higher bid-ask spreads, return volatility, and audit fees. Further, these consequences occur even when lender-imposed costs are relatively lower, consistent with the act of default itself triggering shareholder and auditor uncertainty. The results highlight costs to the firm of having bright-line rules in contracts, and add to an understanding of the consequences of DCVs.