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

Abstract

We examine the effect of financial reporting quality on the trade‐off between monitoring mechanisms used by lenders. We rely on Sarbanes‐Oxley internal control reports to measure financial reporting quality. We find that when a firm experiences a material internal control weakness, lenders decrease their use of financial covenants and financial‐ratio‐based performance pricing provisions and substitute them with alternatives, such as price and security protections and credit‐rating‐based performance pricing provisions. We also find that changes in debt contract design following internal control weaknesses are substantially different from those following restatements, where lenders impose tighter monitoring on managers’ actions, but do not decrease their use of financial statement numbers.

Internal Control Weakness Disclosure and Firm Investment

“…With internal control disclosures, studies have examined the determinants of internal control weaknesses (e.g., Ashbaugh-Skaife, Collins, & Kinney, 2007;Doyle, Ge, & McVay, 2007b), the association between internal control effectiveness and the quality of accruals (e.g., Ashbaugh-Skaife et al, 2008;Chan et al, 2008;Doyle et al, 2007a), market reactions to the disclosures of internal control weaknesses (e.g., Hammersley, Myers, & Shakespeare, 2008), the association between internal control quality and cost of capital (e.g., Ashbaugh-Skaife, Collins, Kinney, & LaFond, 2009;Beneish, Billings, & Hodder, 2008;Costello & Wittenberg-Moerman, 2011;Gordon & Wilford, 2012;Ogneva, Subramanyam, & Raghunandan, 2007), the effect of internal control weaknesses on audit risk and audit fees (e.g., Ettredge, Li, & Sun, 2006;Raghunandan & Rama, 2006), the relation between internal control quality and the accuracy of management earnings guidance (e.g., Feng, Li, & McVay, 2009), and the effect of material weaknesses on shareholders' decision to withhold votes on director re-election (Ye, Hermanson, & Krishnan, 2013). However, there is limited evidence on the consequences of internal control evaluation and disclosure as required by Section 404 of SOX for firms' real decisions (e.g., firm investment).…”

Shareholder Litigation, Reputational Loss, and Bank Loan Contracting

“…Previous work has established that bank terms change adversely after financial reporting problems, such as restatements (Graham, Li, and Qiu (2008)) or internal control weaknesses (ICWs) (Costello and Wittenberg-Moerman (2011), Kim, Song, and Zhang (2011)); firms with relatively poorer accounting quality also experience less favorable loan terms (Bharath, Sunder, and Sunder (2008)). Previous work has established that bank terms change adversely after financial reporting problems, such as restatements (Graham, Li, and Qiu (2008)) or internal control weaknesses (ICWs) (Costello and Wittenberg-Moerman (2011), Kim, Song, and Zhang (2011)); firms with relatively poorer accounting quality also experience less favorable loan terms (Bharath, Sunder, and Sunder (2008)).…”

Negotiated Measurement Rules in Debt Contracts

“…The indirect costs include the negative impacts on the borrower due to restrictions on the borrower’s accounting flexibility and financing, investing, and operating activities. Borrowers are willing to pay a higher interest rate if they have more accounting flexibility (Beatty, Ramesh, and Weber [2002]) or are less restricted by covenants (e.g., Costello and Wittenberg‐Moerman [2009]).…”