The Governance Role of Private Debt and the Monitoring Role of External Auditors: Evidence from Covenant Violations

Abstract

We investigate whether covenant violations function as information mechanisms that lead to the external auditor either exercising closer monitoring or opting to exit. Such responses are expected based on interactive stakeholder monitoring and reaction as described in Triantis and Daniels (1995). Using a hand-collected, comprehensive sample focusing on initial covenant violations during the period from 1996 to 2008, we document that audit fees experience an average increase of about 20% in the year immediately following the violation year, and continue to stay at a high level until three years after the initial violation. Moreover, the increase in audit fees varies positively with leverage and negatively with growth, the proxy for the benefit and cost of closer auditor monitoring respectively. Finally, we find a significant increase in the occurrence of auditor change during the violation year and perform further analysis to show that this is likely due to auditors choosing to exit (resigning) rather than client-initiated auditor change. Overall, the evidence lends support to the interactive corporate governance perspective and adds to previous studies that highlight the importance of corporate governance factors in the pricing of audit services.