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Auditor Quality and Debt Covenants

This study examines the impact of auditor quality on debt covenants. We conjecture that high-quality auditors have two related effects on debt covenants: (i) they encourage fewer and less restrictive covenants by providing assurance to lenders at contract inception and, consequently, (ii) they ensure a lower probability of eventual covenant violations. Consistent with the conjectures, we find that auditor quality is negatively associated with the intensity and tightness of covenants when debt contracts are initiated. Additionally, we find that auditor quality is negatively associated with the likelihood of covenant violations. In an ancillary test, we provide evidence that high-quality auditors mitigate the detrimental effect of covenant violations on the cost of borrowing. Together, these findings highlight the important role of auditors in debt contracting.