Abstract
We examine whether debt covenant violations serve as an important determinant of material weaknesses in internal control over financial reporting. Motivated by the debt covenant hypothesis, we posit that the probability of ineffective internal control is expected to be significantly higher for firms with debt covenant violations than for firms without the violations. Equivalently, a covenant violation implies an increasingly unseen firm risk related to internal control ineffectiveness: violating firms can previously select inappropriate but undetected accounting techniques more extensively to delay the current covenant violation or exploit opportunistic accounting methods to prevent further debt covenant violations. Consistent with this notion, our empirical evidence indicates that firms violating debt covenants are more likely to have internal control weaknesses. We also uncover that the positive association between the violations and internal control weaknesses is more pronounced for firms that fail to remediate violations by fiscal year-end. Further, the connection between debt covenant violations and ineffective internal control intensifies with the severity of internal control problems. Our results are robust to a variety of controls, alternative measures, different disclosure regimes, and propensity score matching approach. Overall, our results suggest that debt covenant violations can serve as a risk factor of internal control breakdown.
Similar content being viewed by others
Notes
For every firm-quarter observation in the Compustat universe, Nini et al. (2012) match the observation to its respective 10-Q or 10-K with available Compustat data. Using these matches, they employ a text-search algorithm to search the actual filings for reports of violations. They first locate the word “covenant” in the filing. Conditional on finding “covenant,” then they search for the following five terms within seven lines surrounding the initial hit: “waiv,” “viol,” “in default,” “modif,” and “not in compliance.”
Our results remain when we examine material weaknesses under SOX 302 for our sample period of 2004–2007.
References
Ashbaugh-Skaife H, Collins D, Kinney W (2007) The discovery and consequences of internal control deficiencies prior to SOX-mandated audits. J Account Econ 44(1–2):166–192
Baird D, Rasmussen R (2006) Private debt and the missing lever of corporate governance. Univ Pennsylvania Law Rev 152(5):1209–1251
Beneish M, Press E (1993) Costs of technical violation of accounting-based debt covenants. Account Rev 68(2):233–257
Bhaskar L, Krishnan G, Yu W (2016) Debt covenant violations, firm financial distress, and auditor actions. Contemp Account Res 34(1):186–215
Chava S, Roberts M (2008) How does financing impact investment? the role of debt covenants. J Finance 63(5):2085–2121
DeFond M, Jiambalvo J (1994) Debt covenant violation and manipulation of accruals. J Account Econ 17(1–2):145–176
Dichev I, Skinner D (2002) Large-sample evidence on the debt covenant hypothesis. J Account Res 40(4):1091–1123
Doyle J, Ge W, McVay S (2007) Determinants of weakness in internal control over financial reporting. J Account Econ 44(1–2):193–223
Feng M, Li C, McVay S (2009) Internal control and management guidance. J Account Econ 48(2–3):190–209
Ferris S, Jagannathan M, Pritchard A (2003) Too busy to mind the business? monitoring by directors with multiple board appointments. J Finance 58(3):1087–1111
Franz D, HassabElnaby H, Lobo G (2014) Impact of proximity to debt covenant violation on earnings management. Rev Account Stud 19(1):473–505
Gao Y, Khan M, Tan L (2017) Further evidence on consequences of debt covenant violations. Contemp Account Res 34(3):1489–1521
Ge W, McVay S (2005) The disclosure of material weaknesses in internal control after the Sarbanes–Oxley Act. Account Horiz 19(3):137–158
Graham JR, Harvey C, Rajgopal S (2005) The economic implications of corporate financial reporting. J Account Econ 40(1–3):3–73
Guo J, Huang P, Zhang Y, Zhou N (2016) The effect of employee treatment policies on internal control weaknesses and financial restatements. Account Rev 91(4):1167–1194
Holthausen R (1981) Evidence on the effect of bond covenants and management compensation contracts on the choice of accounting techniques. J Account Econ 3(1):73–109
Holthausen R, Leftwich R (1983) The economic consequences of accounting choice. J Account Econ 5(1):77–117
Huang P, Guo J, Ma T, Zhang Y (2015) Does the value of cash holdings deteriorate or improve with material weaknesses in internal control over financial reporting? J Bank Finance 54(5):30–45
Hung C, Banerjee A, Meng Q (2017) Corporate financing and anticipated credit rating changes. Rev Quant Finance Account 48(4):893–915
Jaggi B, Mitra S, Hossain M (2015) Earnings quality, internal control weakness and industry-specialist audits. Rev Quant Finance Account 45(1):1–32
Li C, Sun L, Ettredge M (2010) Financial executive qualifications, financial executive turnover, and adverse SOX 404 opinions. J Account Econ 50(1):93–110
Maddala G (1983) Limited dependent and qualitative variables in econometrics. Cambridge University Press, Cambridge
Moody’s Investors Service (2004), (2006), (2007) First year, second year, and third year Section 404 reports on internal control: impact on ratings depend on nature of material weaknesses reported, New York
Nini G, Smith D, Sufi A (2012) Creditor control rights, corporate governance, and firm value. Rev Financ Stud 25(6):1713–1761
Petersen M (2009) Estimating standard errors in finance panel data sets: comparing approaches. Rev Financ Stud 22(1):435–480
Roberts M, Sufi A (2009) Control rights and capital structure: an empirical investigation. J Finance 64(4):1657–1695
Sarkar S, Zhang C (2016) Loan-commitment borrowing and performance-sensitive debt. Rev Quant Finance Account 47(4):973–986
Smith C (1993) A perspective on accounting-based debt covenant violations. Account Rev 68(2):289–303
Spiceland C, Yang L, Zhang J (2016) Accounting quality, debt covenant design, and the cost of debt. Rev Quant Finance Account 47(4):1271–1302
Sweeney A (1994) Debt covenant violations and managers’ accounting responses. J Account Econ 17(3):281–308
Watts R, Zimmerman J (1986) Positive accounting theory. Prentice Hall, Englewood Cliffs
Xu L, Tang A (2012) Internal control material weakness, analyst’s accuracy and bias, and brokerage reputation. Rev Quant Finance Account 39(1):27–53
Yoo T, Lee J, Chang J (2014) Distinctive features of BBB- and BB-graded firms using earnings management and conservatism: evidence from the Korean market. Rev Pac Basin Financ Mark Policy 17(1):1–31
Zender J (1991) Optimal financial instruments. J Finance 46(5):1645–1663
Zhang Y, Zhou J, Zhou N (2007) Audit committee quality, auditor independence, and internal control weaknesses. J Account Public Policy 26(3):300–327
Author information
Authors and Affiliations
Corresponding author
Appendix
Appendix
See Table 13.
Rights and permissions
About this article
Cite this article
Guo, J., Huang, P. & Zhang, Y. Do debt covenant violations serve as a risk factor of ineffective internal control?. Rev Quant Finan Acc 52, 231–251 (2019). https://doi.org/10.1007/s11156-018-0708-7
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11156-018-0708-7