The Contractibility of Accounting Information and Debt Covenants: Evidence from PCAOB International Inspections

Description

The Public Company Accounting Oversight Board (PCAOB) was mandated by the Sarbanes-Oxley Act of 2002 (SOX) to inspect all auditors that audit companies registered with the Securities Exchange Commission (SEC), including non-US auditors of SEC registered companies located abroad. Recent studies show that the foreign clients (SEC registered or not) of the PCAOB inspected foreign auditors all exhibit improved accounting quality post PCAOB inspections. The proposed study aims to exploit the international inspection program introduced by the PCAOB to examine the relation between accounting quality and the use of accounting measures in debt covenants. The evidence from extant studies regarding the relation between accounting quality and the use of accounting covenants in debt contract is rather puzzling. While some studies find that poor accounting quality is associated with a reduction of accounting covenants in debt contracts (e.g., Costello and Whittenberg-Moerman 2011; Chen, He, Ma and Stice 2016), other studies find poor accounting (audit) quality increases accounting covenants (Kim, Song and Zhang 2011; Robin, Wu and Zhang 2017). The mixed evidence is largely caused by the positive relation between a firm’s accounting quality and its financial health. Compared to financially distressed firms, financially healthy firms are less likely to use covenants in order to preserve their flexibility in investing and financing. As a result, it is likely to find financially distressed firms with lower accounting quality associated with more use of accounting covenants, although the contracting value of poor quality accounting information should be lower. The PCAOB international inspections provide a shock to the accounting quality of the foreign clients of PCAOB inspected foreign auditors. Using a difference-in-difference (DiD) design, we will utilize PCAOB international inspections as a shock to the accounting quality of the foreign clients of PCAOB inspected foreign auditors and provide causal evidence on the relationship between accounting quality and accounting covenant use in debt contracts. Armstrong, Guay and Weber (2010) point out that there is a lack of understanding regarding the role and design of accounting covenants and call for more research on how attributes of financial reports affect features of the covenant package such as the number of accounting covenants. In addition, the findings from this study will provide policy implications regarding the consequence of strengthened regulation of the audit profession. This study will also add to our understanding about cross-country variations in the use of accounting covenants.