The Impact of Financial Reporting Quality on Debt Contracting: Evidence from Internal Control Weakness Reports

Costello, Anna M.; Moerman, Regina Wittenberg

doi:10.2139/ssrn.1455985

Cited by 161 publications

(222 citation statements)

References 99 publications

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“…We further show that the severity of internal control weaknesses (company-level versus account-specific) influences CDS spreads and that remediating internal control MWs reduces CDS spreads. These findings improve our understanding of the findings of Dhaliwal et al (2011) and Costello and Wittenberg-Moerman (2011).…”

Section: Introductionsupporting

confidence: 61%

“…Although Kim et al (2011) demonstrate that bank loan rates are higher for companies with internal control MWs than for firms without such MWs, Dhaliwal et al (2011) find that there is no association between reporting internal control MWs and increased bond spreads in their study of companies monitored by banks or rating agencies (essentially large firms). Moreover, Kim et al (2011) show that the remediation of internal control MWs is related to decreased credit spreads, but Costello and Wittenberg-Moerman (2011) find no evidence for such a remediation effect. Furthermore, Kim et al (2011) find that credit spreads are higher for companies with company-level internal control MWs than for companies with account-specific internal control MWs, but Dhaliwal et al (2011) find no such difference.…”

Section: Introductionmentioning

confidence: 90%

“…Conversely, Costello and Wittenberg-Moerman (2011) and Kim et al (2011) document that loan spreads are higher for firms reporting internal control MWs among bank-monitored companies.…”

mentioning

confidence: 97%

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Internal Control Quality and Credit Default Swap Spreads

Tang

Tian

Yan

2015

Accounting Horizons

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i Internal Control Quality and Credit Default Swap SpreadsSYNOPSIS: This paper presents the first study on the effects of internal control quality on derivatives pricing. Specifically, we utilize data from the credit default swap (CDS) transactions of well-monitored companies to examine the relationship between the quality of internal control and the cost of debt. The CDS data we employ are advantageous for our analysis because CDS contracts are comparatively more homogeneous, standardized, and liquid than bank loans and public bonds. We find that CDS spreads increase around the disclosure of internal control material weaknesses (MWs) and that, all else equal, companies experiencing MWs with respect to internal control have higher CDS spreads than companies with effective internal control.Moreover, companies with company-level MWs have higher CDS spreads than those with less severe, account-specific MWs. In addition, remediating internal control MWs is associated with a decrease in CDS spreads. Our study offers a new perspective on the relationship between the quality of internal control and the cost of debt. These conflicting results may be due to heterogeneous characteristics and measurement issues in using bank loans and public bonds to measure credit spreads. Covenants, embedded optionalities (such as callability and convertibility), and other complicating factors associated with bank loans and public bonds may distort the relationship between credit risk and internal control quality. Furthermore, because information on bank loans is only available when companies receive new loans, researchers are relegated to three-or four-year windows in their observations of changes in loan spreads (Dahilwal et al. 2011). By contrast, CDS contracts are relatively homogeneous and standardized, and CDS spreads reflect credit risk better than loan or 3 bond spreads (Shivakumar et al. 2011;Callen et al. 2009) because the CDS market is not as plagued with the liquidity issues that affect the public bond and bank loan markets. Therefore, CDS spreads are a superior means of examining the impact of internal control quality on credit pricing.We expect CDS spreads to be positively related to internal control MWs for two reasons.First, a firm that is experiencing MWs in internal control suggests that its financial reporting may be unreliable, which thereby increases the perceived information risk from the perspective of a credit investor. Such information risk related to unreliable information sources leads an investor to charge a higher credit risk premium (e.g., Duffie and Lando 2001;Lambert et al. 2007).Second, internal control MWs make it easier for managers to misappropriate a company's assets, which increases the default risk. For example, Skaife et al. (2013) report that the profitability of insider trading is significantly greater in firms with internal control MWs, which suggests the risk of expropriation of outside shareholders when there are weak internal controls.In an examination of the period from November 15, 2004, ...

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Section: Introductionsupporting

confidence: 61%

Section: Introductionmentioning

confidence: 90%

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Internal Control Quality and Credit Default Swap Spreads

Tang

Tian

Yan

2015

Accounting Horizons

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“…They find that firms with restated financial statements agree to additional covenants in their subsequent loans as a way to address lenders' increased concerns about information problems associated with the borrower. Costello and Wittenberg-Moerman (2010) extend this paper by investigating the effect of internal control weaknesses on loan covenant packages. They find that after the disclosure of an internal control weakness, banks decrease their reliance on the use of accounting-based covenants and performance pricing metrics.…”

Section: Association Between Financial Reporting and The Design Of Dementioning

confidence: 90%

The role of information and financial reporting in corporate governance and debt contracting

Armstrong

Guay

Weber³

2010

Journal of Accounting and Economics

1,091

350

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Abstract:We review recent literature on the role of financial reporting transparency in reducing governance-related agency conflicts among managers, directors, and shareholders, as well as in reducing agency conflicts between shareholders and creditors, and offer researchers some suggested avenues for future research. Key themes include the endogenous nature of debt contracts and governance mechanisms with respect to information asymmetry between contracting parties, the heterogeneous nature of the informational demands of contracting parties, and the heterogeneous nature of the resulting governance and debt contracts. We also emphasize the role of a commitment to financial reporting transparency in facilitating informal multi-period contracts among managers, directors, shareholders, and creditors.Keywords: financial accounting; corporate governance; board structure; contracting; executive compensation; debt contracts; informal contracts We thank the following for helpful comments and suggestions:

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“…On the other hand, information in financial statements is particularly fundamental in debt contracting (Costello and Wittenberg-Moerman, 2011).…”

Section: Financial Reporting Quality (Frq)mentioning

confidence: 99%

Consequences of financial reporting quality on corporate performance: Evidence at the international level

Martínez‐Ferrero

2014

Estudios de Economía

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This paper examines the consequences of Financial Reporting Quality (FRQ) on Corporate Performance, using three proxies of FRQ: (i) earnings quality;(ii) conservatism; and (iii) JEL Classification: M41 Resumen Este trabajo examina las consecuencias de la Calidad de Información Financiera (FRQ) en el desempeño empresarial, con tres alternativas de FRQ: (i) earnings quality, (ii) conservadurismo, y (iii) accruals quality. Nuestro objetivo es analizar el efecto de la FRQ en el rendimiento financiero (FP) medido por el valor de mercado. A tal efecto, las hipótesis propuestas son testadas para

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The Impact of Financial Reporting Quality on Debt Contracting: Evidence from Internal Control Weakness Reports

Cited by 161 publications

References 99 publications

Internal Control Quality and Credit Default Swap Spreads

Internal Control Quality and Credit Default Swap Spreads

The role of information and financial reporting in corporate governance and debt contracting

Consequences of financial reporting quality on corporate performance: Evidence at the international level

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