The effect of auditors’ internal control opinions on loan decisions

Abstract

We examine the effect of internal control reports on lending officers’ assessments of a company’s creditworthiness. We suggest that an adverse internal control opinion can undermine the assurance provided by an unqualified opinion on financial statements taken as a whole and have a negative affect on lenders’ assessments. In addition, we investigate whether auditor size plays a role in determining the effect on lenders’ judgments. We gather data from 111 loan officers and find that their judgments are affected by the auditor’s report on the effectiveness of internal controls. The lenders’ assessment of the risk of extending a line of credit and the probability of extending the line of credit are negatively affected when the company receives an adverse internal control opinion as compared to an unqualified one. We do not find any evidence that the effect is lessened by the use of a Big Four auditor. Additional analyses suggest that an adverse internal control opinion weakens the importance assigned to the balance sheet and income statement in lending decisions and reduces lenders’ confidence that financial statements are presented fairly in conformance with generally accepted accounting principles.