Qualified Audit Opinions and Debt Contracting

We examine the effect of qualified audit opinions on private debt contracts. Consistent with the monitoring role of auditor 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 in the following year. We find that this effect persists for an additional three years in the interest rate for new loans. We also find evidence that lenders replace financial covenants with non-financial covenants following a qualified audit opinion of the borrower's financial statements. Furthermore, we also find that a qualified audit opinion is associated with a decrease in loan size and an increase in the likelihood of requiring collateral from the borrower, but we find no evidence 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 financial ratios in performance pricing provisions. 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 proprietary information unavailable to most market participants and suggest that auditors play a unique role in debt contracting through monitoring borrowers' financial reporting quality.