Do debt covenant violations serve as a risk factor of ineffective internal control?

Jun Guo, Pinghsun Huang, Yan Zhang

Research output: Contribution to journalArticlepeer-review

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.

Original languageEnglish
Pages (from-to)231-251
Number of pages21
JournalReview of Quantitative Finance and Accounting
Volume52
Issue number1
DOIs
Publication statusPublished - 2019 Jan 15

All Science Journal Classification (ASJC) codes

  • Accounting
  • Business, Management and Accounting(all)
  • Finance

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