The information role of audit opinions in debt contracting

This study examines the relevance of modified audit opinions (MAO) in private debt contracting. We use the auditor's explanatory language to partition MAOs into Inconsistency opinions, resulting from an accounting change or a restatement; and Inadequacy opinions, arising from a material uncertainty or a going concern (GC) opinion. Using the loan contracts of firms with MAOs, we find that, compared with loans issued in the year after a clean opinion, loans issued in the year after an MAO are associated with higher interest spreads (17 basis points on average), fewer financial covenants, more general covenants, smaller loan sizes, and a higher likelihood of requiring collateral. We find that the effect on loan spreads (as well as on other non-price terms) varies by the type of MAO, ranging from no effect for an accounting change to an average increase of 107 basis points for a GC opinion. Additional analyses of GC opinions find that auditors communicate incremental information to lenders about clients' credit risk. Overall, our empirical results suggest that lenders incorporate the information contained in MAOs into debt contracting.