The Effects of Auditor Opinions on Debt Contracts
Auditors’ reports convey information about a firm’s financial health, including the private information discovered by auditors, but they can only produce two opinions: unqualified, or unqualified with explanatory language (also called an MAO – modified audit opinion). This has led to criticism from financial analysts and regulators that auditors’ reports have little communicative value. But a new study argues that the language used to support these opinions contains highly useful information that can have financial impacts on firms.
The study, by Peter F Chen, Shaohua He, Zhiming Ma and Derrald Stice, focuses on potential lenders to firms and how they react to the finer details in auditors’ reports through such measures as loan spreads and other non-price terms attached to loans.
They looked at US firms that had at least one MAO between 1992 and 2009 and compared the nature of their loan terms just after an MAO (either the year of or within three years following the first “clean” opinion after an MAO), and loan terms outside that window (before an MAO or more than three years after the “clean” opinion).
“Debtholders should react to the information in MAOs for both pricing and monitoring purposes because MAOs are likely to communicate negative news about clients’ financial reporting quality and creditworthiness. Thus, examining lenders’ responses to MAOs can enhance our understanding of the usefulness of auditor reporting,” they said.
The MAOs were collected and classified into two kinds: inconsistency, which was triggered by an accounting change or restatement which may alert readers to the incomparability of the data in the financial statements; and inadequacy, which expressed more serious concerns related to potential unrecognised losses and risks.
The latter were considered more serious because they arose from either material uncertainty about the resolution of future economically-relevant unknowns such as litigation risk and contingent liabilities, or “going concern” (GC) risks, meaning the firm’s entity status within a fiscal year was currently a worry and its financial statements may not be a useful tool for lenders to assess or monitor the firm.
The findings indicated that lenders did indeed take note of the auditors’ opinions, leading to higher loan spreads for loans initiated after MAOs of an average 17 basis points. For firms with GC opinions, the spread was 107 basis points.
The nature of covenants attached to loans also changed with MAOs. There were 3.8 per cent fewer financial covenants and 4.2 per cent more general covenants, which do not rely on accounting information, triggered by the auditor’s concerns. General covenants usually specify events that would require the borrower to pay down the balance of their loan, dictate whether dividends may be paid and define the allowed use of borrowed funds. This result was stronger for MAOs related to GC opinions and accounting change.
Loan sizes also decreased overall with MAOs, with GC opinions leading to the largest decreases, and the likelihood of requiring collateral increased.
The authors broke down the GC opinions further to whether the concerns were caused by poor financial performance or operating problems, by financing problems, or by other reasons such as litigation risk. The performance/operational factor was associated with a decrease in debt covenants and the financing factor with an increase in general covenants.
The results suggest that the auditor’s opinions were informative to lenders when designing debt contracts. In other words, loan officers do read the explanatory languages associated with MAOs within the audit report for financial reporting quality. Moreover, GC opinions communicated the auditor’s private information about the client’s credit risk that was not available elsewhere.
“We do not claim causality between auditor reporting and debt contracting, but our results do suggest that auditor reporting is relevant and valuable to lenders in debt contracting, with the relevance increasing with the severity of concerns communicated in an MAO,” they said.
“For regulators, our empirical results may also be useful in informing the current debate on regulatory initiatives to include disclosures of ‘critical audit matters’ in the audit report.”