The Role of Audit Verification in Debt Contracting: Evidence from Covenant Violations

Abstract

We investigate the role of audit verification in the resolution process following debt covenant violations. Using two sets of proxies for demand, namely, audit fees and the independence and diligence of audit committees, we find evidence that covenant violations result in a demand for differentially higher levels of audit verification. Further analyses demonstrate the link between the increased demand for audit verification and the mechanisms designed to control agency costs in debt contracts. We document cross-sectional variations in the observed fee differential with respect to the level of reliance on financial covenants, the type of covenants being violated, and waiver decisions. Moreover, we find that the observed audit fee increases are associated with more favorable movements in borrowing costs and the adoption of more conservative investment policies post violation. Collectively, our findings suggest that covenant violations increase the demand for higher levels of audit services to help control contracting costs post violation.