On May 16th, 2018, Lin Cheng (University of Arizona) presented his current research topic "Auditor-related Provisions in Private Loan Agreements, Audit Fee, and Audit Quality" (co-authored with Jacob Jaggi, Paul N. Michas and Jeffrey Schatzberg from the University of Arizona) at the WHU Research Seminar in Finance & Accounting.
Employing a large sample of private loan agreements from 2000-2013, the authors examine lenders’ demand for audit information and the role of auditors in debt contracting beyond traditional audit opinions. They provide direct evidence that lenders value audit information and often specify multiple auditor-related provisions in privately negotiated loan agreements. They also examine audit fee and audit quality implications for the borrower. Using both levels and changes analyses, the authors 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, they 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, they find no evidence that auditor-related loan provisions lead to higher audit quality for borrowers. Their 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. They 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 their understanding regarding the role of non-client third-party liability in determining audit fees.