Employing a large sample of private loan agreements from 2000-2013, we examine lenders’ demand for audit information and the role of auditors in debt contracting beyond traditional audit opinions. We provide direct evidence that lenders value audit information and often specify multiple auditor-related provisions in privately negotiated loan agreements. We also examine audit fee and audit quality implications for the borrower. Using both levels and changes analyses, we find that auditor-related provisions are associated with higher audit fees, which is consistent with auditors responding to the litigation risk these provisions impose. In cross-sectional tests, we find evidence that the increase in audit fees associated with auditor-related provisions is exacerbated in states with more expansive third-party liability regimes, i.e., the extent to which auditors can be held liable by third parties for negligence. Finally, we find no evidence that auditor-related loan provisions lead to higher audit quality for borrowers. Our study answers DeFond and Zhang (2014), who call for a deeper understanding of the factors that drive the demand for auditing in a private contract setting, where supply and demand are not mandated by regulation. We also provide new insight to the literature by examining the supply-side impact these auditor-related provisions have on audit fees and audit quality and by improving our understanding regarding the role of non-client third-party liability in determining audit fees.
Lin Cheng is an assistant professor of Accouting from Eller College of Management, the University of Arizona. Lin’s research work involves corporate disclosure, debt contracting, labor economics, auditing, and textual analysis. Lin’s research is published in accounting and finance conferences as well as at peer reviewed journals, such as Journal of Accounting, Auditing, and Finance, The Accounting Review, Accounting Horizons. Lin received his Ph.D. in Accounting & MIS from Fisher College of Business, The Ohio State University.