Audit Report Restrictions in Debt Covenants

Abstract: While the debt contracting literature has extensively examined financial covenants, there has been little attention paid to audit-related covenants. We focus on a covenant that restricts the borrower from receiving a going-concern audit report (GCAR covenant). We hypothesize that a debt agreement is more likely to include a GCAR covenant as the borrower's credit quality decreases and the length of the loan period increases, and that it is more likely to impose a covenant restricting the choice of auditor when the debt includes a GCAR covenant. Also, we expect that an audit client with a GCAR covenant will be charged a higher audit fee and is more likely to receive a going-concern audit report. We test these hypotheses on a sample of firms that issue private debt. Our results generally support our hypotheses. Our study suggests that lenders rely on the auditor's assessment in contracting, and audit-related covenants influence auditor behavior