Qualified audit opinions and debt contractingPeter F. Chen
School of Business & Management
Hong Kong University of Science & Technology
acpchen@ust.hk

Shaohua He
School of Business & Management
Hong Kong University of Science & Technology
ache@ust.hk

Zhiming Ma
School of Business & Management
Hong Kong University of Science & Technology
accma@ust.hk

Derrald E. Stice
School of Business & Management
Hong Kong University of Science & Technology
acstice@ust.hk

Draft: September, 2012

ABSTRACTWe examine the effect of qualified audit opinions on private debt contracts. Consistent withthe monitoring role of audit opinion on accounting quality, we find that a qualified audit
opinion is associated with an average increase of 18 basis points in the interest rate of loan
facilities issued in the year following a QAO. We find that this effect persists for at least
three years with an average increase of 8 basis points in the interest rate for these loans.
Furthermore, we find evidence that lenders replace financial covenants with non-financial
covenants following a qualified audit opinion of the borrower’s financial statements. We alsofind that qualified audit opinions are associated with decreases in loan size and increases in
the requirement of collateral from the borrower, but we find no evidence that qualified audit
opinions are associated with change in the length of loan maturity. Finally, we find that
qualified audit opinions are associated with decreased use of performance pricing provisions
in debt contracts. A variety of additional tests demonstrate that the effects of a qualified audit
opinion on contractual terms are robust after controlling for other indicators of accounting
quality such as abnormal accruals, volatility of accounting accruals and disclosure of internal
control weakness. These results are not obvious given that private lenders have access to
private information unavailable to most market participants and suggest that auditors play aunique role in debt contracting through monitoring borrowers’ accounting quality.

2

I.

Introduction
A fundamental feature of financial reporting is that an auditor is hired to attest to thequality of the financial statements prepared by management. The economic value of an audit
opinion to users of financial statements is of great interest to academic researchers andaccounting practitioners, especially in times when auditing is under considerable regulatory
and public scrutiny (Francis 2004; DeFond and Francis 2005). In this study, we examine theeconomic role of the audit report by investigating how a qualified audit opinion (QAO,
therefore) affects the subsequent contracting in the private debt market.
The value of accounting information in capital markets, and especially of earnings toequity investors, has been one of the central issues in accounting research since Ball and
Brown (1968) and Beaver (1968). Lev (1989) summarizes the accumulated evidence andconcludes that the usefulness of earnings to equity investors is very limited based on the low
correlation between earnings and stock returns. Lev also conjectures that the low quality ofearnings contributes to this low correlation. Given the unique role that auditors play inattesting to the quality of accounting information, there is surprisingly little evidence of theinformativeness of the audit report to equity investors. The few exceptions examine themarket reactions to first-time QAOs and find mixed evidence that the equity market reacts
negatively, on average, to announcements of a QAO (Dodd et al. 1984; Loudder et al. 1992,
Jones. 1999). The mixed evidence is partially attributable to the difficulty in employing a
research design that can tease out the effects of audit opinions, earnings reports, andinvestors’ expectations (Francis 2004).
In this paper we investigate the role of auditor opinions in private debt contracting.
We direct our investigation into the debt market for several reasons. First, debt covenants
and performance pricing provisions are often contracted on in terms of financial statement3

numbers (Leftwich 1983; Dichev and Skinner 2002; Asquith et al. 2005), and the violation ofthese covenants is costly (Beneish and Press 1993, 1995; Nini et al. 2009; Stice 2012).
However, the usefulness of accounting information in debt contracting is a function of theperceived quality of financial statement information. Bharath et al. (2008) provide evidence
that a borrower’s access to the private versus public debt market and its loan terms depend on
the quality of the borrower’s accounting information. Recently, Costello and WittenbergMoerman (2011) document that lenders trade-off between different monitoring mechanisms
when financial reporting quality is in question. Specifically, they find that when borrowers
disclose material internal control weaknesses (ICW, hereafter), lenders rely less on
accounting and more on non-accounting-based terms in new debt issuances.1 However, thesestudies do not examine the effect of accounting quality changes, and thus it is difficult toinfer causality. Given the unique role of auditors in certifying the quality of financial
statements, investigating the usefulness of audit opinions to lenders in loan contracting canshed further light on the relation between accounting quality and debt contracting.
Second, because debt holders have asymmetric payoffs on firm performance, theirinvestments are more sensitive to negative news (i.e. qualified audit opinions) than equity
investors’ investments. Accordingly, we expect lenders to make significant changes in loan
contract terms following a borrower’s qualified audit opinion. Third, we choose to examine
the role of audit opinions in private debt contracts rather than in public debt contracts because
private debt holders have access to information that is unavailable to public debt holders.
This biases against finding an incremental value of audit opinions in the private debt market.
1

Kim et al. (2011) and Dhaliwal et al. (2011) also investigate the effect of ICW on loan contracting. There areseveral differences between these three studies. While Costello and Wittenberg-Moerman (2011) focus theiranalyses on ICW disclosed under Sarbanes Oxley Act (SOX) Section 302 (unaudited), Kim et al. (2011) andDhaliwal et al. (2011) conduct their tests using ICW reported under SOX Section 404 (audited). Additionally,
while Costello and Wittenberg-Moerman and Kim et al. conduct their analyses using private debt, Dhaliwal et
al. conduct theirs using public debt. All three studies conclude that the disclosure of ICW leads to an increase in
the cost of debt.

4

As a result, our investigation into how private debt holders rely on audit opinions offers
unique insights into the economic value of auditing in debt contracting.
The question we address is whether qualified audit opinions of borrowing firms leadto changes in the debt contract design of subsequent debt issuances. As capital providers,lenders are eager to price protect their investment against the various agency costs that arise
during the life span of the debt. Accounting information plays an important role in reducing
these agency costs during the debt-contracting process (Smith and Warner 1979; Watts andZimmerman 1978, 1986, 1990). The higher the quality of accounting information, the lower
the cost of monitoring the borrower’s behavior for lenders, and the lower the interest rate
demanded by lenders. Therefore, we predict that lenders demand a higher interest rate on
debt following a QAO of a borrower.
In debt contracting, the interest rate alone is not effective in protecting the lenderagainst all agency costs during the life span of the debt. Typically debt contracts containcovenants that can be accounting-based such as debt-to-equity ceilings. Alternatively, thelender can put in place general covenants that restrict capital expenditure, asset sales and soon as ways to prevent asset substitution. An audit opinion is the final outcome of theauditor’s assessment of the financial statement quality; and a QAO is an auditor’s way ofcommunicating with outside investors that the financial statement quality is lower than an
unqualified opinion. Specifically, we predict that lenders choose to rely less on financial
statement numbers after a qualified audit opinion and more on non-accounting monitoringmechanisms.2
In addition to interest rates and covenants, lenders can adjust other terms of the debt
contract to protect their investments. If a QAO leads lenders to suspect that the financial
2

Throughout the paper we use the term “qualified” to denote an audit report that is not unqualified (ie. qualified
opinion, disclaimer of opinion, adverse opinion, and unqualified opinion with additive language).

5

statement are less reliable predictors of future financial positions of the borrower, we predictthat lenders will reduce the size of the loan, shorten the maturity of the loan, and be more
likely to demand collateral. Finally, because lenders frequently use performance pricing
provisions to control agency costs in debt contracts (Asquith, et al. 2005) and many
performance pricing provisions use financial statement ratios; we predict that lenders are lesslikely to use financial ratio-based performance pricing provisions in debt contracts if theborrower received a QAO.
We test our hypotheses using a comprehensive sample of firms with a QAO during
the period from 1992 to 2009. We examine loan terms 1) during the QAO period, (from thefirst QAO until the first unqualified audit opinion is issued) 2) during the after-QAO period,(the three years after the QAO period) and 3) during all other periods (non-QAO period,
hereafter). We find that the cost of debt issued after a QAO is higher than it was before the
QAO. The interest spread (above LIBOR) of loans issued after a QAO but before a clean
audit report is almost 18 basis points more than it was during the period prior to QAO,
controlling for all other determinants of the interest rate. Additionally, the interest spread ofloans issued within three years of the first clean audit report after a QAO is 8.6 basis points
higher than loans before a QAO, indicating that the interest rate effects of a QAO persist evenafter a clean audit report. Consistent with our hypothesis, we find that lenders decrease theuse of financial covenants and increase the use of general covenants after a QAO.
Specifically, lenders decrease the use of financial covenants by 4.4% during the QAO period,and increase the use of general covenants by 2.6%.
In testing our hypotheses regarding other terms of debt contract, we find that lenders
reduce loan size and increase the likelihood of requiring collateral, but we do not find any
evidence that lenders shorten the maturity of the loan. Finally, we find that lenders reduce6the inclusion of financial ratio-based performance pricing provision in debt contracts.
Specifically, lenders are less likely to include a performance pricing provision based on afinancial ratio. Loan terms in the after-QAO period are also less favorable than the before
QAO period, indicating that there are long-term reputation effects after a QAO. We view thisas evidence that lenders regard a QAO as an event which decreases the reliability of thefinancial statements in debt contracting and therefore trade off accounting-based contract
components in favor of components not as affected by the change in perceived financial
reporting quality.3
This study contributes to the literature in several ways. First, we extend the priorliterature that investigates the role of auditors in capital markets. Auditors play an importantrole in an economy by providing a third-party assessment of publically traded firms. This
allows investors to make investment decisions more efficiently by not requiring them toinvestigate each company individually. While the importance of auditors is widely accepted,
there is little empirical evidence that directly examines whether auditors increase theperceived credibility of financial statements (Healy and Palepu 2001). It is not clear how
much information a QAO conveys that is not already known to the market (Dodd et al. 1984;
Dopuch et al. 1986). We add to this literature by providing evidence that when auditors
signal to the market that financial reporting quality is potentially low by issuing a qualified
audit opinion, lenders drastically change the way that they use accounting information fordebt contracting purposes, even after controlling for the information contained in the3

Additionally, we predicted that a QAO a would lead to an increase in information asymmetry between thelead arranger and other syndicate loan members and that this increase would lead to an increased pressure fromsyndicate members for the lead arranger to hold a higher proportion of the loan (Leland and Pyle 1977;
Holmstrom and Tirole 1997; Ball, Vasvari, and Bushman 2008). The lead arranger of a syndicate role plays alarge role in both performing the due diligence before a loan issuance as well as in monitoring the loan
afterward. This places the lead arranger in the best position to understand the possible consequences of a QAO
on a borrowing firm. We found no evidence consistent with these predictions.

7financial statements and its quality. This is not an obvious result in the private debt market.
Loan syndicate members have access to private information unavailable to other market
participants. Our finding that lenders change their contract design choices after a QAO
indicates that auditors may be providing valuable information to a segment of the capital
markets previously unidentified.
Our paper also extends the findings of Pittman and Fortin (2004) who find that the
reputation of an audit firm, defining big six audit firms as those with best reputations, reduces
the cost of debt in a sample of young firms after IPO. However, our study differs from theirs
in several key ways; we use audit opinions directly as indicators of financial statement
quality, and our research design allows us to infer causality between accounting information
quality and cost of debt. We find no significant difference between large (reputable) audit
firms and small (less reputable) audit firms in the effect of a QAO on interest rate, the use ofcovenants, and on other terms of the debt contracts. In other words, conditional on a QAO
being issued, we do not find a different economic impact of Big 4 versus non-Big 4 audit
opinions on the contractual terms of private loans. As discussed later, this does notnecessarily mean that our results contradict their findings since reputation may be conveyed
through the differential willingness to issue QAOs between large versus small auditors.
Furthermore, their sample of young firms is considerably different from our sample of firms.
Second, we add to the growing literature that examines the role of accounting, andspecifically financial reporting quality, in debt contracting. Armstrong et al. (2010) call forfurther research exploring the effect of accounting quality on lenders’ choice of monitoringmechanisms and the effects of accounting quality on borrowers’ ability to access the debt

8

markets.4 We view our study as adding to the body of knowledge in this area. Costello andWittenberg-Moerman (2011) show that a disclosure of internal control weakness under SOX
Section 302 leads lenders to tradeoff between accounting and non-accounting debt
contracting mechanisms. We provide further evidence that lenders tradeoff different control
mechanisms using a setting of qualified audit opinions as a proxy for low financial reporting
quality. Like Costello and Wittenberg-Moerman (2011), we find that a QAO, as a proxy for
low quality of the reported financial statements, leads lenders to charge a higher interest rate,use fewer financial covenants, more likely to require collateral, and are less likely to include
accounting-based performance pricing provisions. However, unlike their study, we findevidence that lenders increase the use of general covenants as replacing financial covenants.
This is likely arises from the fact that a QAO signals an explicit deficiency in financial
statement quality as compared with a disclosure of internal control weakness.
Our study also contributes to the current debate about measures of financial statement
quality. Since we include several indicators of accounting quality such as abnormal accruals
and internal control weakness along with QAO in our final analysis, we find that the effects
of a QAO are robust to controlling for these other indicators of accounting indicators. At thesame time, we find that QAO does not subsume the effect of these other indicators oncontract terms of the loan. This result suggests that abnormal accruals, internal control
weaknesses, and QAOs capture different aspects of accounting quality and they do not
subsume each other, at least in the context of private debt contracting.
In the next section we develop our hypotheses. We describe the sample selection
procedures and variables used in this study in section III. Section IV presents the empirical4

In their review of 20 years of research in accounting, finance, and economics, Armstrong et al. (2010) wereunable to locate any papers that examine whether attributes of firms’ financial reports influence their ability toaccess the debt markets.

9results and section V presents the results of additional analyses. A summary and conclusions
are provided in section VI.

II.

Background and Hypothesis Development
Financial statements are an important source of firm-specific information available tolenders at the contract date (Tirole 2007). Accounting numbers have been used extensively
to predict the likelihood of borrower default (e.g., Beaver 1966; Altman 1968; Ohlson 1980).
Research has shown that accounting measures can predict the losses that will be sustained bylenders at the time of borrower default (Varma and Cantor 2005; Acharya et al. 2007), andrecent work has demonstrated that accounting numbers also possess significant ability to
predict future loss given default at the debt issuance date (Amiram 2012).
We predict that a QAO will affect the use of accounting information in debt contracts
through two distinct channels: ease of contracting and uncertainty. First, financial statements
provide lenders information that can be easily used ex ante in debt contracting and ex post in
debt monitoring. If lenders doubt the quality of financial statements then the cost ofmonitoring the borrower’s behavior increases; and consequently, lenders demand a higher
interest rate on the loan, all else equal (Jensen and Meckling 1976; Smith and Warner 1979).
Francis et al. (2005) and Bharath et al. (2008) show empirically that firms with higher
accounting quality have a lower cost of debt. Several recent studies (Costello andWittenberg-Moerman 2011; Kim et al. 2011; Dhaliwal et al. 2011) use disclosed ICWs under
the Sarbanes-Oxley Act as a proxy for low financial reporting quality and find that disclosed
ICWs lead to an increase in the cost of debt.
Second, financial statement information decreases uncertainty about a borrower’s
creditworthiness. Borrower default is not the only risk that lenders face. Duffie and Lando10

(2001) model information risk as separate from risk of default. Easley and O’Hara 2004 andLambert et al. 2007 predict that information risk will affect the cost of capital. Debt
covenants based on accounting numbers allow for a pre-contracted on transfer of control
rights in the event of a debt covenant violation. Debt covenant violation is common andcostly.5 However, lender response to covenant violation varies widely and presumably
depends on lenders’ determination of borrower factors.6 Additionally, Roberts and Sufi 2009find that 90% of long-term debt contracts are renegotiated at least once before maturity. If
lenders use borrowers’ financial statements to reduce uncertainty and to facilitate decision
making both before and after debt issuance, then a reduction of perceived financial statement
reliability may increase uncertainty and information asymmetry between borrowers andlenders.
Our study examines the effect of a qualified opinion by an auditor on these two usesof financial statements in debt contracting by decreasing the perceived reliability of aborrower’s accounting information. Auditors play a central role in conveying information
about firms to the market by certifying that a client’s accounting numbers accurately reflect
the state of the firm under the relevant set of accounting rules. Leftwich 1983 finds thatbanks require audited financial statements from private borrowers that are not required byregulation to have audited financial statements. Mansi et al. 2004 find that auditor quality is

5

Dichev and Skinner (2002) find that 30% of the loans in their sample are in violation of at least one covenant
during the term of the loan. Beneish and Press (1995) find that announcements of violation are associated witha -3.52% return in the three-day period surrounding announcements of debt covenant violation, and Stice (2012)provides evidence that market participants react negatively to earnings announcements that indicate a highlikelihood of covenant violation, even without formal disclosure of violation.
6
Dichev and Skinner (2002) find that the most common lender response to covenant violation is to waive theviolation or renegotiate the loan. Nini et al. (2009) find that covenant violations are associated with anincrease in CEO turnover and corporate restructuring and a decrease in capital expenditures and debt usage.

11

negatively associated with the cost of debt of public firms, and Pittman and Fortin 2004 findthat this benefit is especially pronounced for young firms.7
The ultimate output provided by an auditor is the auditor’s report. The audit opinion
is the only channel through which an auditor communicates her assessment on the quality offinancial statements to outside investors. When auditors are able to give an unqualified
opinion of a client’s financial statements, rather than a QAO, market participants may be
more likely to rely on the financial statements when making investing decisions. Choi andJeter (1992) find that earnings response coefficients decrease significantly after the issuanceof a qualified opinion indicating that equity investors react less to earnings announcements offirms with a QAO.
Recently, several studies have used weaknesses in internal controls disclosed under
the Sarbanes-Oxley Act as a proxy for low financial reporting quality and found that ICWs
lead to an increase in the cost of debt (Costello and Wittenberg-Moerman 2011; Kim et al.
2011; Dhaliwal et al. 2011). One advantage of focusing our study on qualified opinions isthat we are able to examine the effects of financial reporting quality on debt contracting overa much longer time period than previous studies and beyond the context of the SarbanesOxley Act of 2002.8 Additionally, while several studies have examined the relation between
accounting quality and the costs of equity and debt (see Francis et al. 2004; Bharath et al.
2008), these studies rely on models of accrual quality that are often criticized (Dechow et al.
2010). A QAO is a more direct proxy for low earnings quality because it allows for auditors

7

Fortin and Pittman (2007) suggest that this benefit may exist only for publicly-traded firms; they find noevidence that private firms’ cost of debt is affected by auditor quality. These studies use Big 6 audit firms as aproxy for high quality auditors.
8

Our sample period begins in 1992 while Costello and Wittenberg-Moerman 2011 use a sample beginning in
2002; Kim et al. 2011 use a sample beginning in 2005; and Dhaliwal et al. 2011 use a sample beginning in 2004.

12

to use their private information about their clients and relies on auditors not wanting tojeopardize their valuable reputations (DeAngelo 1981).
We first formally test the effect of a QAO on loan spreads. Consistent with thepreceding discussion, we predict that a QAO will affect loan pricing by decreasing the abilityof lenders to use accounting for contracting purposes and by increasing uncertainty aboutborrower creditworthiness. If lenders view a QAO as an indication of low financial
reporting quality they will be reluctant to use accounting numbers in debt contracts,
specifically in financial covenants. Lenders will trade-off a decrease in the use of financial
covenants with an increase in the interest spread (Jensen and Meckling 1976; Smith andWarner 1979). Additionally, if lenders view a QAO as conveying less reliable financial
statement quality than an unqualified opinion, then a QAO will lead to a higher interest rateon the loan. Formally, we predict:

H1:

A qualified audit opinion leads to an increase in loan spreads for borrowers.

Debt covenants are an important disciplining force in debt contracts. They provide acontractible way for lenders to monitor loans after issuance, and they are included in debt
contracts to reduce lender risk by reducing managers’ ability to extract rents from debt
holders and by giving lenders control of the firm during bad economic states of the firm.9
Debt holders are affected negatively by borrowers’ economic losses, but they receive
relatively little benefit from borrowers’ economic gains, so lenders prefer to gain control ofthe borrowing firm as quickly as possible when their investment is at risk (see e.g., Aghion
and Bolton 1992). Debt covenant inclusion is costly to borrowers (Core and Schrand 1999),
9

Jensen and Meckling (1976) list several actions that debt covenants can help to prevent: unwarranted
distributions to shareholders, issuance of higher priority debt claims, and investments in negative net present
value projects for purposes of empire building and diversification.

13

but the ex ante commitment to turn over firm control to lenders during bad states generates
more favorable contract terms for borrowers (Bradley and Roberts 2004).
Lenders face a choice between including financial covenants, based on accounting
numbers, and general covenants, not dependent on accounting information. If lenders choose
to include financial covenants then financial statements must be reliable to be useful forcontracting purposes. Costello and Wittenberg-Moerman (2011) find that the disclosure ofan ICW leads to a decrease in the use of financial covenants in debt contracts. They positthat lenders view financial statement information to be less valuable in contracting after
disclosure of an ICW decreases the perceived reliability of financial statements.10
Additionally, lenders may choose to include general covenants that do not rely on
accounting information. General covenants often specify events that will require theborrower to pay down the balance of their loan such as: periods of excess cash flow (asdefined in the contract), asset sales, additional debt issuance, equity issuance, and insurance
settlements. General covenants often dictate the conditions under which dividends may be
paid to shareholders and the allowed amount. Additionally, a general covenant may specify
the allowed uses of the borrowed funds. Lenders usually include both general and financial
covenants in debt contracts. If lenders view a QAO as decreasing the value of including
financial covenants they may compensate by increasing the number of general covenants.
Alternatively, if financial and general covenants are independent in purpose, the optimal
number (and type) of included general covenants may already be included and no change will

10

If lenders view a QAO as increasing overall information uncertainty, they may react by increasing thenumber of financial covenants (Bradley and Roberts 2004). Kim et al. (2011) present evidence consistent withthis prediction and find that firms that disclose an ICW have a higher number of financial covenants. Costello
and Wittenberg-Moerman (2011) attribute these results to the research design choice of comparing ICW firms to
non-ICW firms. We follow the approach of Costello and Wittenberg-Moerman and conduct our tests using onlya sample of QAO firms. We discuss our research design and its implications in the next section.

14

be observed. Our second hypothesis relates to the use of both general and financial
covenants. Presented in the alternative form, our second hypothesis is:

H2:

A qualified audit opinion is associated with a decrease in the number of financial
covenants or an increase in the number of general covenants contained insubsequent debt contracts.

To assess the total effect on contract design of a QAO, it is important to consider the
many different contract components that lenders can choose from (Gigler et al. 2009). Up
until this point we have only considered the use of spread and covenants in contract design.
In reality, lenders have other options to consider when designing a firm-specific contract. We
consider the effects of a QAO on three additional contracting options available to lenders:loan size, requiring collateral, and the length of the loan contract. We view a QAO as adisclosure event that reduces financial statement reliability, and we predict that lenders will
be more likely to use these non-accounting contracting mechanisms after a QAO. Stated in
the alternative form, we predict that:

H3:

A qualified audit opinion is associated with decreases in the size of loans granted toborrowers, increases in the likelihood that lenders will require collateral fromborrowers, and decreases the average length of maturity in subsequent debt
contracts.
Our last formal hypothesis explores the use of financial accounting ratios in

performance pricing provisions. Performance pricing provisions increase interest spreads
when credit quality deteriorates and decrease spreads when credit quality improves. Asquith
et al. (2005) find that performance pricing provisions are more likely to be included when
prepayment is more likely or more costly and when moral hazard costs are higher. The
inclusion of a performance pricing provision is associated with lower spreads in debt
15

contracts and they are usually based on financial ratios or credit ratings. Costello andWittenberg-Moerman (2011) find that performance pricing provisions have a lower
probability of being based on a financial ratio after an ICW. Consistent with lenders
believing that a QAO indicates lower financial reporting quality, we predict that:

H4:

A qualified audit opinion is associated with a decrease in the likelihood that aperformance pricing provision is based on a financial ratio in subsequent debt
contracts.

III.

Sample and Research Design
Sample Selection
Our empirical strategy is to investigate whether lenders change the terms of debt

contracts after a borrower receives a qualified opinion from their auditor. We focus ouranalysis on a sample of firms that received a QAO during our sample period. We separate
firm observations in to three distinct categories: the period during which a firm receives aqualified opinion from its auditor, QAO period; the three years after a firm receives aqualified opinion from its auditor, after-QAO period; and all other firm year observations,non-QAO period.11 The purpose of separating the QAO and non-QAO periods is obvious.
We include the after-QAO period in an attempt to capture the lingering reputation effects thatborrowers may experience after a QAO, despite receiving clean audit reports. Costello andWittenberg-Moerman (2011) find that changes to the perceived quality of financial
statements have a lingering effect on debt contract design. Consequently, we investigate the11

Note that the “non-QAO” period encompasses time periods potentially both before and after a firm receives a
QAO. In untabulated robustness tests we confirm that our results are not dependent on this design choice.
Results are robust to redefining the “non-QAO” period to only include observations before the QAO andomitting all other observations. Additionally, the choice of defining the “after-QAO” period as three years isnecessarily ad hoc. Results are robust to redefining the “after-QAO” period as the two years and one year after
a QAO.

16effects of a QAO in the QAO and after-QAO periods in an attempt to determine whether
reputation effects linger in debt contract design.
We obtain audit opinion data from COMPUSTAT and Audit Analytics and matchthese data with public firms in the Dealscan database provided by the Loan Pricing
Corporation (LPC). The private debt contracts in the Dealscan database represent a large
source of corporate funds for these publicly-traded companies. Sufi (2007) reports thatapproximately 90% of the 500 largest nonfinancial firms in COMPUSTAT obtained a loan
through private channels during his sample period of 1994 to 2002 and that the market forthese loans reached $1 trillion during this period. The value of private deals grew to over $1.5
trillion by 2005 (see Bharath et al. 2008) and to $1.69 trillion in 2007 (see Kim et al. 2011).
We eliminate firms without a QAO during our sample period of 1992 to 2009. We
make this design choice following Costello and Wittenberg-Moerman (2011) and argue that
conducting our analyses within a sample of QAO firms is a stronger design choice thanincluding both QAO and non-QAO firms in our tests. We also require all sample firms tohave at least one loan during the non-QAO period and one loan in either the QAO or afterQAO period to mitigate the concern that changes in sample over time drive our results.
Table 1 presents our sample selection process. After the requirements mentioned above andafter eliminating observations with missing data needed in our analyses, our final sample
includes 11,205 loans for 1,663 borrowers.12
Descriptive Statistics
Table 2 Panel A reports descriptive statistics for the sample data, we define ourvariables in Appendix A. On average our sample firms are large, average assets of $2,703
12

Syndicated loans often bundle multiple facilities in to one transaction. These different facilities havedifferent contract terms but are syndicated as a single transaction. Consistent with other work in this area, weconduct our tests at the individual facility level (see Costello and Wittenberg-Moerman 2011).

17

million; profitable, average ROA (EBIDTA divided by total assets) of 0.12; and highly
levered, average long-term debt to assets of .31. The loans in our sample have a mean spread
above LIBOR of 212 basis points. This is slightly higher than the 199.6 average spread ofloans included in the Dealscan database, providing some evidence that QAO firms aredifferent than non-QAO firms. The average loan size is $287M and matures in an average of
47.75 months. Debt contracts include an average of 2.51 financial covenants and 5.35
general covenants. Most loans include a performance pricing provision (64.5%), require
collateral (73.5%), and are a revolver (61%). The QAO period accounts for 36.1% ofobservations, 20.7% of observations fall in to the after-QAO category, and the remaining
43.2% of observations are non-QAO observations.
Table 2 Panel B provides a correlation matrix. Many of the contracting terms are
significantly correlated. Spread is positively associated with the number of financial andgeneral covenants in the univariate, and it is negatively related with including a performancepricing provision, requiring collateral, and the number of lenders included in the syndicate.
This is consistent with lenders having many different mechanisms through which to design
contracts (Melnik and Plaut 1986), not just through spread. We expect lenders to change theway they use accounting information in contract design when a change in financial statement
reliability occurs.
Research Design
We predict that lenders will view a QAO as a decrease in the contracting reliability offinancial statement information. To examine the effect of a QAO on contract design, we
follow the approach of Costello and Wittenberg-Moerman (2011) and estimate the following
model:
Contractual Term = α + β1 QAO + β2 After_QAO + ∑ βi (Controli)18(1)where QAO is an indicator variable equal to one if a loan is issued during the QAO period
and zero otherwise. After_QAO is an indicator variable equal to one if a loan is issued in thethree year period after a QAO. Contractual Term is a variable representing the specificcontracting mechanism that we investigate in each of our tests, and it includes interest spread,the number of financial covenants, the number of general covenants, whether or not a loan issecured, the maturity length of a loan, and whether or not a loan includes a performancepricing provision based on a financial ratio.13
We include a variety of control variables found to be important determinants of debt
contracting terms in the previous literature. Firm size, profitability, and capital structure areassociated with information asymmetries and the cost of debt (Bharath et al. 2007); longer
maturity loans are associated with the probability of default (Demiroglu and James 2010);
and the likelihood of inclusion of a performance pricing provision increases when adverse
selection and moral hazard costs are higher (Asquith et al. 2005). We also control forwhether the facility is an institutional loan, a revolver, requires collateral and the size of theloan and the number of syndicate members (Beatty et al. 2002; Sufi 2007; Costello andWittenberg-Moerman 2011).
We also examine whether a long-term relationship between a borrower and lender canmitigate the effects of a QAO (Diamond 1984; Sufi 2007; Bharath et al. 2009; Costello andWittenberg-Moerman 2011). We include indicator variables for whether any syndicate
member has participated in a loan with the borrower in the previous five years(Previous_Lender) and whether the lead arranger was the lead arranger on a loan within theprevious five years (Previous_Lead_Arranger). We include these indicator variables and13

In additional tests presented later in the paper, Contractual Term also represents the proportion of the loan
held by the lead arranger, the presence in a loan contract of a performance covenant, and the proportion offinancial covenants to total covenants.

19

interact them with our variables of interest, QAO and After_QAO. Additionally, we include
an indicator variable for whether or not the borrower has a credit rating and interact it with
our variables of interest.

IV.

Empirical Results
Financial Reporting Quality and the Cost of Debt
Table 3 presents results from the interest spread OLS regression. We regress loan

spread on QAO, After_QAO, and a variety of control variables. Our first hypothesis predicts
that if lenders view a QAO as a signal of lower financial reporting quality then debt issued
during the QAO period will have a higher interest rate. Additionally, if there is a long term
reputation effect, then debt issued during the after-QAO period will have a higher spread aswell. Table 3 presents results consistent with this hypothesis. In Column 1, the coefficient
on QAO is positive and statistically significant; loans issued during the QAO period have a
spread over LIBOR that is 17.90 basis points higher than loans issued during the non-QAO
period. This represents an increase in the cost of debt of 8.4%. Furthermore, the coefficienton After_QAO is positive and statistically significant, and it indicates that loan issued during
the after-QAO period have an average spread 8.59 basis points higher than loans issued
during a non-QAO period. This provides evidence consistent with lenders viewing a QAO as
an increase in uncertainty and increasing loan spreads in the QAO period accordingly. The
fact that loans have a higher spread in the after-QAO period indicates that lenders view
borrowers cautiously for up to three years after an auditor issues a clean opinion.
Many of the included control variables are statistically significant. Spreads arenegatively associated with borrower profitability, firm size, loan size, the inclusion of aperformance pricing provision, the number of lenders, and whether or not the loan is a20

revolver. Spreads are positively associated with leverage, whether or not the loan is secured,
and whether or not the loan is institutional. The variables of interest and the control variables
capture much of the variation in the dependent variable; the r-squared is over 48%.
Columns 2 and 3 present results from our specifications that attempt to capture theeffect of a long-term relationship between a borrower and lender. While QAO andAfter_QAO are still positive and statistically significant, the interaction terms between QAO
and After_QAO with Previous_Lender are negative and significant at -15.96 and -12.41,
respectively. This interaction effect is even stronger when the lead arranger(Previous_Lead_Arranger) of the syndicate was the lead arranger of a loan issued within theprevious five years, at -20.61 and -17.11 respectively. These results indicate that lenders thathave prior lending experience with borrowers face less uncertainty after a QAO and do notincrease spreads to compensate as much as lenders without a relationship with a borrower.
Financial Reporting Quality and the Use of Debt Covenants
Table 4 presents results related to the inclusion of financial covenants in loan
contracts. Hypothesis 2 predicts that lenders will be less willing to rely on financial
covenants in debt contracts after the reliability of the financial statements is brought in toquestion a qualified opinion by an auditor. The first column in Table 4 provides evidence
that the number of financial covenants included in a debt contract is lower in the QAO andafter-QAO periods than the non-QAO period. The coefficients on QAO and After_QAO are .11 and -.11 and are statistically significant. These decreases represent a decrease in the useof financial covenants of 4.2% and 4.5% respectively. H2 also predicts that lenders will be
more likely to include general covenants. Column 4 provides evidence consistent with thishypothesis. The coefficient on QAO is .14 and statistically significant. This finding provides
some evidence consistent with our prediction that when lenders are less willing to use
21accounting in debt contracts, they will increase the non-accounting contracting mechanismsthat they have at their disposal. Interestingly, the coefficient on After_QAO is positive .05
but insignificant. The long-term effects of a QAO do not seem to affect general covenants asseverely as financial covenants.
Columns 2, 3, 5, and 6 investigate the effects of long-term lender relationships on theuse of debt covenants after a QAO. There does not seem to be a strong effect on the use offinancial covenants when a lender has had a previous relationship with a borrower. Overall,these results suggest that while a prior lending relationship with the borrower can reduce theuncertainty costs associated with a QAO, it does not greatly increase the willingness oflenders to use financial covenants for contracting purposes. On the other hand, for the generalcovenant results (Column 6), the prior lending relationship with the borrower by the leadarranger leads to significant decreases in the number of general covenants included in debt
contracts.
Financial Reporting Quality and the Use of Additional Loan Components
Table 5 presents results of Hypothesis 3. H3 predicts that lenders will include more
stringent non-accounting loan terms after a QAO to compensate for both an increase inuncertainty about the borrower’s credit risk as well as the reduced efficiency of using
financial statement information for contracting purposes. We investigate three nonaccounting mechanisms that lenders can employ in debt contracts: loan size, requirement ofcollateral, and loan maturity. The results are reported in Table 5. In Column (1) of Table 5,
we provide strong evidence that lenders decrease the loan amounts offered to borrowers after
a QAO. The coefficients on QAO and After_QAO in Column 1 are -.06 and -.03 respectively
and statistically significant in each specification of the model. This finding is consistent withthe credit rationing literature (see ex. Jaffee and Russell 1976 and Stiglitz and Weiss 1981)22

and provides evidence consistent with lenders reacting to an increase in uncertainty and adecrease of perceived financial statement quality by decreasing the amount of capitalprovided to borrowers. Economic theory on credit rationing (Stiglitz and Weiss 1981) would
suggest that some firms will not obtain loans when a QAO increases information asymmetry
and uncertainty. Our empirical results are based on firms that have obtained a loan in theevent of a QAO. As a result, our estimate of the effect of QAO on debt terms underestimates
the true cost of a QAO because borrowers are likely to pay higher costs of financing if they
are denied a loan from lenders because of the QAO. We also find that the likelihood of
requiring collateral in a loan contract increases significantly after a qualified opinion in boththe QAO and after-QAO periods. Table 5 Column 4 indicates that the probability ofrequiring collateral increases during the QAO and after-QAO periods. The probability ofrequiring collateral increases by 7% and 3% during these respective periods and is
statistically significant.
Our last test of H3 investigates loan maturity choices that lenders make at thecontract inception date. If lenders believe that a QAO increases uncertainty they may shorten
the length of loans issued after an auditor offers an opinion that is not unqualified. In each of
the model specifications, Columns (7), (8) and (9), we find no evidence that this is the case.
The coefficients of QAO and After_QAO in Table 5 Column 7 are indistinguishable fromzero. Loan maturity length does not seem to be the tool that lenders use to deal with adecrease in a borrower’s financial statement reliability. This result is similar to that reported
in Costello and Wittenberg-Moerman (2011).
Financial Reporting Quality and the Structure of Performance Pricing Provisions
Table 6 presents the results of our last formal hypothesis. Hypothesis 4 predicts that
lenders will be less willing to include performance pricing provisions that are based on a23

financial ratio after a QAO. Performance pricing provisions can be based on financial ratiosthat use accounting numbers or on credit ratings provided by independent rating agencies.
Credit rating agencies act as an additional source of information that is available to lenders
and other market participants. We predict that a decrease in financial statement reliability
will lead lenders to increase their use of credit ratings in performance pricing provisions.
Table 6 presents results consistent with this prediction.
In Table 6 Column 1 QAO has a coefficient of -.16 which is statistically significant
and indicates that lenders are 4% more likely to base a performance pricing provision on acredit rating in the QAO period. We find no evidence that the likelihood of basing aperformance pricing provision on a credit rating increases during the after QAO period.
Columns 2 and 3 present the performance pricing provision results after controlling for the
relationship between a lender and a borrower. The coefficients on QAO*Previous_Lenderand QAO*Previous_Lead_Arranger are -0.18 and -0.26 respectively and both are statisticallysignificant. They suggest that the decreases in performance pricing provisions are greater if
the lender has a prior lending relationship or if the lender has been a lead arranger of a loan in
the last five years. As in the previous specification, there does not seem to be any effectduring the after-QAO period. This provides some evidence that changes to performancepricing provisions do not last as long after a QAO as many of the other contractual
mechanisms we have investigated.

24

V.

Additional Analyses
The Incremental Impact of Auditor Opinion on Loan Terms after Controlling for
Accrual Quality
Our study investigates the role that auditors play in providing information to the debt

market about the usefulness of accounting information for debt contracting purposes. We
provide compelling evidence that after a qualified opinion from an auditor lenders decrease
their reliance on accounting numbers and increase their use of non-accounting contracting
mechanisms. However, up until this point in our paper our tests have ignored another crucial
output of the audit process, the financial statements themselves. It may be that lenders areable to infer low financial statement reliability when they observe the accounting numbers
produced in the same period as the qualified opinion. If this is the case, then the audit
opinion is not informing lenders directly; the financial statements themselves inform lenders
that accounting numbers will be less useful for contracting purposes and lenders adjust loan
terms accordingly.
Prior research in the earnings management literature has documented an association
between various characteristics of accruals and earnings quality (Healy 1985; DeAngelo
1986; Jones 1991). 14 Bartov et al. 2001 provide evidence that accruals information can beused to predict qualified opinions from auditors. We attempt to determine if the earnings
quality from a qualified audit period informs lenders about the financial statement reliabilityof a firm with a QAO. We focus on two measures of accruals quality employed in theliterature: abnormal accruals (Abnormal_Accruals) as defined in Ashbaugh-Skaife et al. 2008
without controlling for the effects of conditional conservatism on accruals quality (Dechow etal. 1995; Kothari et al. 2005) and accruals noise (Accruals_Noise) follows Dechow and

14

See Dechow et al. 2010 for a review of the earnings quality literature.

25

Dichev 2002 and Kothari et al. 2005. We add these measures to our original specifications
for interest spread and the number of financial covenants and present the results in Table 7.
Table 7 Panel A provides a correlation matrix of Abnormal_Accruals,
Accruals_Noise, QAO, interest spread, and the number of financial covenants. Our measuresof accruals quality are decreasing in quality; higher values imply lower accruals quality.
Both measures are positively correlated with QAO, though only the correlation with
Accruals_Noise is statistically significant. Panel B presents the interest spread results fromH1 with the addition of the accruals quality variables. The coefficient on Abnormal_Accruals
is not statistically significant, but the coefficient on Accruals_Noise is positive andstatistically significant. Importantly, the coefficient on QAO remains positive andstatistically significant across all specifications. Panel C presents results for the use offinancial covenants in debt contracts after controlling for accruals quality. The coefficientson Abnormal_Accruals and Accruals_Noise are both positive and significant in these
specifications. The coefficient on QAO remains negative and is significant in the
Abnormal_Accruals specification but not the Accruals_Noise specification. Overall, Table 7
provides evidence that lenders are not changing their use of accounting numbers in debt
contracts based solely on the information contained in the financial statements. Lenders
appear to be less willing to use accounting information in debt contracts after an auditor gives
a QAO, even after controlling for the information in the financial statements.
Financial Reporting Quality and Internal Control Weaknesses
Our study has been partly motivated by recent work investigating the effect that an
ICW, as a proxy for low financial reporting reliability, can have on the use of accounting in
debt contracting (Costello and Wittenberg-Moerman 2011; Kim et al. 2011; Dhaliwal et al.
2011). Our primary analysis similarly documents that a QAO decreases the use of26

accounting and changes the use of non-accounting information in subsequently issued debt
contracts. A disclosed ICW is more likely to result in a QAO, but not all QAOs are causedby an ICW. In our sample, 10.4% of our QAO observations disclose an ICW. In Table 8 weinclude the disclosure of a material weakness in internal controls in our interest spread andfinancial covenant specifications to determine whether or not the QAO effect we document isincremental to the ICW effect previously presented in the literature.
Firms were not required to report an ICW until 2004. To accurately assess theincremental effect of an ICW on our sample, we limit our sample to firms that disclose an
ICW or a QAO during the period 2004 to 2009. Table 8 Panel A presents a correlation
matrix of QAO, interest spread, the number of financial covenants and an indicator variable
for a disclosed weakness of internal controls (ICW). While QAO and ICW are positively
correlated, the correlation is only .032. Panel B presents our interest spread specification andincludes an indicator variable for whether or not an ICW was disclosed. Consistent with theprevious literature, the coefficient on ICW is positive and significant across all specifications.
Our variable of interest, QAO, remains positive and significant. Panel C investigates theeffect of a QAO on the use of financial covenants in debt contracts incremental to an ICW.
The coefficient on ICW is not statistically significant and QAO remains negative andsignificant across all specifications. Overall, Table 8 provides evidence that a QAO informs
lenders about the usefulness of accounting in debt contracting incremental to a disclosure of a
weakness in internal controls.
Until now we have considered the effects on debt contracting of qualified opinions
and disclosed weaknesses in internal controls. Additionally, auditors may disclose their
doubt that a firm will remain a going concern. The issuance of a going concern opinion israre, serious, and associated with an increased likelihood of future financial failure (Campbell
27

and Mutchler 1988; Chen and Church 1996). Costello and Wittenberg-Moerman (2011) andKim et al. (2011) investigate the impact of the seriousness of an ICW on the loan term effectthat document. In general, they document larger effects of an ICW in loan contracting for
more serious ICWs.15 In our sample of QAO observations, 125 also disclosed a going
concern opinion. In untabulated results we interact a going concern indicator variable withQAO in our main specifications. The coefficient on this interaction is statistically significant
in the predicted direction for both the interest spread and financial covenant specifications
and indicates that a going concern opinion exacerbates the QAO effect previously
documented.
The Impact of Financial Reporting Quality on the use of Performance Covenants
We also investigate whether lenders perceive accounting reliability to vary acrossdifferent financial covenant types. Christensen and Nikolaev (2012) explore the monitoringroles of two different types of financial covenants: capital covenants and performancecovenants. Building on contract theory (Aghion and Bolton 1992), they argue that capitalcovenants reduce agency problems by aligning lender and shareholder interests and that
performance covenants serve as tripwires that transfer control rights when their investment is
at risk. Capital covenants are balance-sheet-based and require borrowers to keep sufficient
capital inside the firm; performance covenants are income-statement-based and employ
accounting numbers as timely measures of borrowers’ economic performance.
Prior research has shown that when financial reporting quality is in question, income
statement items, specifically earnings, are most likely to be the primary focus of manager

15

Based on Doyle et al. (2007) these studies define an ICW as “serious” if it is a company-level material
weakness, as opposed to an account-level material weakness.

28

manipulation (Barton and Simko 2002).16 We predict that the perceived contracting
efficiency of capital and performance covenants will change when a QAO reduces financial
statement reliability. In previous tests we have documented that the use of financial
covenants decreases after a QAO; we predict that this effect will be exacerbated for
performance covenants, those covenants that may be most susceptible to targeted
manipulation. In untabulated tests we find evidence that the likelihood of including aperformance covenant in a debt contract decreases following a QAO, even after controlling
for the use of capital covenants. This finding is consistent with the differing monitoring rolesof capital and performance covenants and suggests that while lenders decrease the overall use
of financial covenants following a QAO, they also view the relative benefits of capital andperformance covenants to change as well.
The Impact of Financial Reporting Quality on the Lead Arranger
Ball et al. (2008) provide evidence that accounting information can play a significant
role in affecting the relationship between lead arrangers and other syndicate loan members.
Lead arrangers earn substantial fees for performing due diligence before and for monitoring
after a loan is issued. This arrangement creates an information asymmetry between leadarrangers and other syndicate members who do not have the same access to private
information. As information asymmetry increases, so does the demand of syndicate members
for lead arrangers to hold a higher proportion of the debt. Ball et al. (2008) predict and findthat when the debt-contracting value of accounting is low that information asymmetry will behigher and lead arrangers will hold a higher proportion of the loan. We investigate whether a
QAO leads to an increase in information asymmetry between lead arrangers and other16

While the balance sheet reflects the effect of income statement item manipulation through net assets, we view
managers manipulating earnings as attempting to primarily change the accounting outcome of income statement
items, not the balance sheet items that are also affected.

29

syndicate members and therefore and increase in the proportion of the loan held by the leadarranger. In untabulated results we do not find any evidence that a QAO changes the
proportion of a loan held by the lead arranger, regardless of that lead arranger’s previous
relationship with the borrower.
The Effect of Big Audit versus Small Audit Firms
Prior studies find that large auditors (Big 4) have greater reputation assets than small
auditors, and therefore have higher incentives to provide a high audit quality. Large auditors
are used as a proxy for audit quality (Pittman and Fortin 2004). We investigate whether a
QAO from a large audit firm causes a greater impact on the contractual terms of thesubsequent debt contracts than a QAO from a small audit firm. Our results (untabulated)suggest no significant difference on any of the debt contract terms we have examined.
Therefore, conditional on a QAO being issued, we do not find any significant difference inthe effects on contracts terms between large and small auditors. This does not necessarily
contradict the conclusions drawn in prior studies that big audit firms have higher audit quality
because the propensity to issue a QAO may be different across large and small auditors or
there may be endogeneity in the match between auditor size and client quality.
For our sample of 11,205 observations, 93.8% of the total observations are audited by
the big auditors. The propensity to issue a QAO for the big auditors is 36.5%, and is 30.1%
for small auditors. This result, while providing neither necessary nor sufficient evidence, isconsistent with big auditors yielding less to client pressure and providing higher audit quality.
Furthermore, Pittman and Fortin (2004) focus on a sample of recent IPO firms for which thesignaling value of hiring a big auditor is likely to be higher than for our sample of firms thatare relatively large and mature.

30

VI.

Summary and Conclusions
In this paper we empirically investigate the effect of qualified audit opinions on

private debt contracts using a comprehensive sample of QAOs from 1992 to 2009.
Consistent with the monitoring role of audit opinions on accounting quality, we find that a
qualified audit opinion is associated with an average increase of 18 basis points in the interest
rate of loan facilities issued within the same year. We find that this effect persists for at least
three years following a restored clean opinion with an average increase of 8 basis points in
the interest rate for these loans. Furthermore, we find evidence that lenders replace financial
covenants with non-financial covenants following a qualified audit opinion of the borrower’s
financial statements.
We also find a qualified audit opinion is associated with a decrease in loan size and anincrease in the likelihood of requirement of collateral from a borrower, but we find noevidence that a qualified audit opinion is associated with a change in the length of loan
maturity. Finally, we find that a qualified audit opinion is associated with a decreased use of
performance pricing provisions in debt contracts that are based on financial ratios. A varietyof additional tests demonstrate that the effects of a qualified audit opinion on contractual
terms are robust to controlling for other indicators of accounting quality such as abnormal
accruals, volatility of accounting accruals and disclosure of an internal control weakness.
In contrast to the mixed evidence of stock market reactions to audit opinions, we finda strong and economically significant response of debt contracting to qualified audit opinions.
These results are not obvious given that private lenders have access to private information
unavailable to most market participants and suggest that auditors play a unique role in debt
contracting through monitoring borrowers’ accounting quality. Our research contributes toour understanding of the economic value of auditing in an important market that has, up until31now, received little attention. The strong results from our investigation point to additional
research in this area. As an example, future research can extend the investigation into
whether and how a QAO affects a borrower’s ability to access to the public versus private
debt market.

32

33

Table 1 presents our sample selection process.
1. We require firms to have nonmissing DealScan and Compustat data for each of ourloan- and firm-level control variables.
2. We require that a firm has at least one facility in the non-QAO period and at least
one facility in the QAO or After-QAO period.
3. The sample period begins in 1988 with the changes made to the issuing of audit
opinions, but we drop the observations before 1992 due to a very limited sample size in
those years.

34This table presents the descriptive statistics for the total sample. See the appendix for the variable definition.
We have three periods: QAO, After-QAO, and non-QAO.
1. QAO is equal to 1 when the firm receives a qualified opinion, and 0 otherwise.
2. After_QAO is equal to one three years after a QAO, and 0 otherwise.
3. Non-QAO periods occur when both QAO and After_QAO are equal to 0.

35

Panel C: Correlation Matrix

Number of Financial Covenants
Number of General Covenants
Number Lenders
Loan Size (in millions)
Maturity (in months)
PP Indicator
SecuredPrevious_Lender
Previous_Lead_Arranger
Institutional Investor
Revolver
QAO
After_QAO

Interestrate# of
FinCov# of
GenCov

0.16
0.25
-0.24
-0.17
-0.01
-0.36
0.50
-0.18
-0.12
0.25
-0.21
0.06
-0.06

0.39
-0.05
-0.14
0.12
0.16
0.23
0.00
-0.02
0.15
-0.04
-0.10
-0.03

0.11
0.00
0.34
0.17
0.35
0.14
0.06
0.33
-0.19
0.07
0.00

#Lenders

0.30
0.17
0.18
-0.20
0.32
0.21
0.06
-0.07
0.04
0.03

Loan
Size

Maturity

0.02
0.08
-0.20
0.15
0.07
0.04
-0.05
0.08
0.00

0.11
0.17
0.10
0.06
0.34
-0.06
0.03
0.05

36

PP
Ind.

-0.19
0.16
0.08
-0.20
0.19
-0.03
0.02

SecuredPrev_Lender

Prev_Lead

-0.13
-0.08
0.20
-0.05
-0.01
-0.01

0.62
0.06
-0.03
0.11
0.02

0.05
-0.02
0.08
0.02

Inst.
Inv.

-0.44
0.04
0.00

Revolver

QAO

0.00
0.02

-0.39

This table presents the Pearson correlation matrix of selected variables. The correlations in bold are significant at the 5% level. All variables are defined in
the appendix.

37

Table 3 presents the results from the estimation of the following interest rate model:Interest Rate = α + β1 QAO + β2 After_QAO + β3 Institutional Investor + β4 Revolver+β5 Financial
Covenants + β6 Loan Size + β7 Maturity+β8 Number Lenders + β9 PP Indicator + β10 Secured + β11 Firm
Size + β12 Leverage + β13 Profitability + ε
We regress the interest rate on QAO, After_QAO, loan- and firm-specific control variables in Column 1.
We include a connected lender indicator and interact it with QAO and After_QAO to test whether the
impact of financial reporting quality on the interest rate is mitigated if the loan is issued by a relationshiplender in Column 2. We include a connected lead lender indicator and interact it with QAO andAfter_QAO to test whether the impact of financial reporting quality on the interest rate is mitigated if theloan is issued by a relationship lead lender in Column 3. Firm-specific financial variables are winsorized
at 0.01 level.
Regressions include year fixed effects and standard errors are heteroskedasticity robust, clustered at thefirm level. P-values are reported in parentheses. ∗∗∗, ∗∗, ∗ denote significance at the 1%, 5%, and 10%
levels, respectively. See appendix for the variable definition.

40

Table 4 presents the results from the estimation of the following financial covenant model:
Financial Covenants = α + β1 QAO + β2 After_QAO + β3 Institutional Investor + β4 Revolver+β5 Interest
Rate + β6 Secured+ β7 Loan Size + β8 Maturity+β9 Number Lenders + β10 PP Indicator + β11 Firm Size +β12 Leverage + β13 Profitability + ε
We regress the number of financial covenants on QAO, After_QAO, loan- and firm-specific control
variables in Column 1. We include a connected lender indicator and interact it with QAO and After_QAO
in Column 2. In Column 3 and 4, we use Perfinance as the dependent variable which is defined as thenumber of financial covenants divided by the total number of the covenants. Firm-specific financial
variables are winsorized at 0.01 level.
General Covenants == α + β1 QAO + β2 After_QAO + β3 Institutional Investor + β4 Revolver+β5 Interest Rate + β6
Secured+ β7 Loan Size + β8 Maturity+β9 Number Lenders + β10 PP Indicator + β11 Firm Size + β12 Leverage + β13
Profitability + ε
We regress the number of general covenants on QAO, After_QAO, loan- and firm-specific control variables inColumn 4. We include a connected lender indicator and interact it with QAO and After_QAO in Column 5. We
include a connected lead lender indicator and interact it with QAO and After_QAO in Column 6.

Regressions include year fixed effects and standard errors are heteroskedasticity robust, clustered at thefirm level. P-values are reported in parentheses. ∗∗∗, ∗∗, ∗ denote significance at the 1%, 5%, and 10%
levels, respectively. See appendix for the variable definition.

41

Table 5: Financial Reporting Reliability and Other Loan Characteristics

(1)

(2)

(3)

(4)

(5)

(6)

Variables

Loan Size

Loan Size

Loan Size

SecuredSecuredSecured

QAO-0.06***(0.008)-0.03***(0.010)-0.06***(0.010)-0.03**(0.011)-0.02***(0.008)0.00(0.008)-0.01(0.013)-0.06***(0.010)-0.03***(0.012)0.20***(0.057)
0.12**(0.058)0.26***(0.067)0.09(0.069)0.03(0.054)-0.12*(0.068)0.05(0.082)0.27***(0.073)0.10(0.074)After_QAOPrevious_Lender
QAO*Previous_Lender
After_QAO*Previous_Lender
Previous_Lead_Arranger

0.05***(0.011)0.09***(0.006)0.05***(0.011)0.09***(0.006)-0.02**(0.009)0.01(0.012)0(0.016)0.05***(0.011)0.09***(0.006)

1.12***(0.168)-0.46(0.337)

1.11***(0.168)-0.13(0.344)

1.11***(0.168)0.27(0.339)-0.07***(0.017)-0.07***(0.017)-0.07***(0.017)QAO*Previous_Lead_Arranger
After_QAO*Previous_Lead_Arranger
InstitutionalInvestor
Revolver
Loan Size
Maturity
Number of Lenders
Firm Size
Leverage

1.39***(0.134)-0.01(0.036)-0.15***(0.027)0.01***(0.001)0.01**(0.003)-0.40***(0.027)
1.54***(0.134)

1.39***(0.134)-0.01(0.036)-0.15***(0.027)0.01***(0.001)0.01**(0.003)-0.40***(0.027)
1.54***(0.135)0.01(0.066)-0.13(0.092)0.05(0.103)
1.39***(0.133)-0.01(0.036)-0.15***(0.027)0.01***(0.001)0.01**(0.003)-0.40***(0.027)
1.54***(0.134)

(7)

(8)

(9)

Log_Maturity Log_Maturity Log_Maturity
0.01(0.019)0.00(0.020)0.02(0.022)0.00(0.024)-0.05***(0.018)-0.03(0.022)0.01(0.029)0.01(0.023)-0.01(0.025)0.61***(0.026)
0.21***(0.023)0.08***(0.009)0.61***(0.026)
0.21***(0.023)0.08***(0.009)-0.06***(0.021)0.01(0.029)0.04(0.035)0.61***(0.026)
0.21***(0.023)0.08***(0.009)0.01***(0.002)-0.05***(0.009)0.32***(0.034)0.01***(0.002)-0.05***(0.009)0.33***(0.034)0.01***(0.002)-0.05***(0.009)0.33***(0.034)

Profitability

0.35***(0.056)0.08***(0.028)0.07***(0.008)0.03***(0.008)0.01**(0.003)0.36***(0.056)0.07**(0.028)0.07***(0.008)0.04***(0.008)0.01**(0.003)0.35***(0.056)0.08***(0.028)0.07***(0.008)0.04***(0.008)0.01**(0.003)-3.23***(0.326)-3.24***(0.327)-3.23***(0.326)

0.45***(0.098)-0.02(0.083)0.23***(0.020)0.25***(0.019)0.06***(0.007)

0.46***(0.098)-0.03(0.083)0.23***(0.020)0.25***(0.019)0.06***(0.007)0.45***(0.097)-0.03(0.083)0.23***(0.020)0.25***(0.019)0.06***(0.007)

Constant

0.06**(0.027)0.08***(0.027)0.07***(0.027)

5.39***-0.447

5.40***-0.45

5.38***-0.447

2.25***-0.163

2.22***-0.1642.25***-0.163

Year dummy
Observations
Adj. R-squared

Yes
11,205
0.14

Yes
11,205
0.14

Yes
11,205
0.14

Yes
11,2050.30

Yes
11,2050.30

Yes
11,2050.30

Yes
11,205
0.27

Yes
11,205
0.27

Yes
11,205
0.27

Interest rate
Secured
PP_Indicator
Number of Financial Covenants

The first three columns present the results from the estimation of the following loan size model:
Loan Size (scaled by assets) = α + β1 QAO + β2 After_QAO + β3 Institutional Investor + β4 Revolver+ β5 Loan Size
+ β6 Maturity+β7 Number Lenders + β8 Firm Size + β9 Leverage + β10 Profitability + ε
We estimate the probability that the lenders require a loan to be secured in Column 1. The dependent variable equals
one if the loan is secured, zero otherwise. We include a connected lender indicator in Column 2 and a connectedlead lender indicator in Column 3.
The middle three columns present the results from the estimation of the following general covenant model:
P(Secured=1) = α + β1 QAO + β2 After_QAO + β3 Institutional Investor + β4 Revolver+ β5 Loan Size + β6
Maturity+β7 Number Lenders + β8 Firm Size + β9 Leverage + β10 Profitability + ε
We estimate the probability that the lenders require a loan to be secured in Column 1. The dependent variable equals
one if the loan is secured, zero otherwise. We include a connected lender indicator in Column 2 and a connectedlead lender indicator in Column 3.
The last three columns present the results from the estimation of the following maturity model:
Log (Maturity) = α + β1 QAO + β2 After_QAO + β3 Institutional Investor + β4 Revolver+β5 Interest Rate+β6
Financial Covenants + β7 Secured+ β8 Loan Size +β9 Number Lenders + β10 PP Indicator + β11 Firm Size + β12
Leverage + β13 Profitability + ε
We regress the logarithm of maturity on QAO, After_QAO, loan- and firm-specific control variables in Column 7.
We include a connected lender indicator and interact it with QAO and After_QAO in Column 8. We include aconnected lead lender indicator and interact it with QAO and After_QAO in Column 9. Firm-specific financial
variables are winsorized at 0.01 level. Regressions include year fixed effects and standard errors areheteroskedasticity robust, clustered at the firm level. Robust standard errors are reported in parentheses. ∗∗∗, ∗∗, ∗denote significance at the 1%, 5%, and 10% levels, respectively. See appendix for the variable definition.

Table 6 presents the results from the estimation of the following PP Ratio model:
P(PP Ratio = 1) = α + β1 QAO + β2 After_QAO + β3 Institutional Investor + β4 Revolver+β5 Interest Rate + β6
Secured+ β7 Loan Size + β8 Maturity+β9 Number Lenders + β10 Firm Size + β11 Leverage + β12 Profitability + ε

We estimate the probability of using accounting-based performance pricing provisions inColumn 1. We include a connected lender indicator and interact it with QAO and After_QAO in
Column 2. We include a connected lead lender indicator and interact it with QAO and After_QAO
in Column 3.Firm-specific financial variables are winsorized at 0.01 level. Regressions include
year fixed effects and standard errors are heteroskedasticity robust, clustered at the firm level. Robust standard
errors are reported in parentheses. ∗∗∗, ∗∗, ∗ denote significance at the 1%, 5%, and 10% levels, respectively.
See appendix for the variable definition.

46

Table 7: The Incremental Impact of Auditor Opinion after Controlling for
Abnormal Accruals and Accruals Noise on Loan Terms
Panel A: Correlation Matrix

Panel B: Impact of Auditor Opinion on Interest Rate after Controlling for Information in
the Financial Statements

47

Panel C: Impact of Auditor Opinion on Use of Financial Covenants after Controlling for
Information in the Financial Statements(1)
Variables
QAO
After_QAO

(2)

(3)

(4)

(5)

Financial Covenants Financial Covenants Financial Covenants Financial Covenants Financial Covenants-0.11**(0.048)-0.11**(0.050)Accrual_Noise-0.09*(0.048)-0.11**(0.050)-0.84*(0.446)Abormal_Accruals-0.87***(0.229)-0.88***(0.230)-0.05(0.050)-0.07(0.052)-0.82*(0.447)

Control variables

Included

Included

Included

Included

IncludedConstant

0.48(0.307)0.45(0.318)0.70**(0.310)0.71**(0.309)0.45(0.318)Observations
R-squared
Adj. R-squared

11,205
0.32
0.32

9,803
0.31
0.31

10,6220.32
0.32

10,622
0.32
0.32

9,803
0.31
0.31

48

Table 7 presents effects of different signals. Abnormal_Accruals is the abnormal accruals measured by the absolutevalue of performance-adjusted abnormal accruals and Accruals-Noise is the working capital accruals noise.
Abnormal accruals (Abnormal_Accruals) as defined in Ashbaugh-Skaife et al. 2008 without controlling effect ofconditional conservatism on accruals quality (Dechow et al. 1995; Kothari et al. 2005) and accruals noise(Accruals_Noise) follows Dechow and Dichev 2002 and Kothari et al. 2005.
Panel A presents the Pearson correlation matrix of selected variables. The correlations in bold are significant at
the 5% level. Panel B presents the results from the estimation of the interest rate model same as Table 4. Panel C
presents the results from the financial covenant model as Table 5. Firm-specific financial variables are winsorized at
0.01 level. Regressions include year fixed effects and standard errors are heteroskedasticity robust, clustered at thefirm level. Robust standard errors are reported in parentheses. ∗∗∗, ∗∗, ∗ denote significance at the 1%, 5%, and 10%
levels, respectively. See appendix for the variable definition.

49

Table 8: Lender Response to QAO and Internal Control Weaknesses
Panel A: Correlation Matrix

Panel B: Interest Spread

Variables
QAO(1)
Interest
Rate(2)Interest
Rate(3)Interest
Rate(4)Interest
Rate

15.75***(3.558)ICW

34.35***(9.878)Abnormal_Accruals(6)
Interest
Rate(7)Interest
Rate(8)Interest
Rate(9)Interest
Rate(10)Interest
Rate

15.68***(3.538)34.19***(9.934)12.92***(3.729)15.91***(3.592)

12.84***(3.715)22.83**(8.978)15.84***(3.571)33.33***(10.033)
87.00***(27.567)92.24***(27.697)

Accrual_Noise89.29***(27.471)201.83***(42.510)198.98***(42.677)

194.18***(42.037)

Control variables

Included

Included

Included

Included

Included

Included

Included

Included

IncludedConstant

427.79***(27.717)433.31***(27.790)430.31***(28.899)405.24***(30.076)426.64***(27.601)

399.95***(29.960)

423.48***(28.674)

400.16***(29.896)422.66***(28.544)

10,2770.47
0.47

10,277
0.47
0.47

9,957
0.47
0.47

9,231
0.48
0.48

10,277
0.47
0.47

9,231
0.48
0.48

9,957
0.47
0.47

9,231
0.48
0.48

9,957
0.47
0.47

Observations
R-squared
Adj. R-squared51

Panel C: Covenant Use(1)
Variables
QAO

(2)

(3)

(4)

(6)

(7)

(8)

(9)

(10)

Financial
Financial
Financial
Financial
Financial
Financial
Financial
Financial
Financial
Covenants Covenants Covenants Covenants Covenants Covenants Covenants Covenants Covenants-0.11***(0.039)ICW-0.11***(0.039)0.09(0.084)0.09(0.084)

Abnormal_Accruals-0.09**(0.040)-0.95***(0.213)

Accrual_Noise-0.10**(0.039)-0.09**(0.040)0.12(0.089)-0.93***(0.213)-0.92**(0.381)-0.90**(0.380)-0.10**(0.039)0.09(0.083)-0.93***(0.213)-0.92**(0.379)Control variables

Included

Included

Included

Included

Included

Included

Included

Included

IncludedConstant

3.26***(0.303)3.23***(0.304)

3.34***(0.308)

3.37***(0.316)

3.26***(0.303)

3.40***(0.316)

3.37***(0.308)3.40***(0.316)

3.37***(0.308)Observations
R-squared
Adj. R-squared

10,2770.25
0.25

10,277
0.25
0.25

9,957
0.25
0.25

9,231
0.25
0.25

10,277
0.25
0.25

9,231
0.25
0.25

9,957
0.25
0.25

9,231
0.25
0.25

9,957
0.25
0.25

52

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