Internal Control Weakness and Bank Loan Contracting

The following post comes to us from Jeong-Bon Kim, Professor of Accountancy at City University of Hong Kong; Byron Song of the Department of Accounting at Concordia University; and Liandong Zhang of the Department of Accountancy at City University of Hong Kong.

In our paper, Internal Control Weakness and Bank Loan Contracting: Evidence from SOX Section 404 Disclosures, forthcoming in The Accounting Review, we compare various features of loan contracts between firms with ICW and those without ICW. To provide evidence of the impact of ICW on various features of loan contracts, we construct a sample of 3,164 loan facility–years for borrowers that filed SOX 404 disclosures with the SEC during 2005–2009. We then compare various features of loan contracts with ICW borrowers with those with non-ICW borrowers, after controlling for borrower- and loan-specific characteristics deemed to affect the contract terms.

First, we find that the loan spread is higher for ICW firms than for non-ICW firms by about 28 basis points (bps) in the full-model regressions, after controlling for other factors influencing loan terms, default risk, credit quality, and internal control quality. This finding is consistent with the notion that banks take into account internal control over financial reporting when setting the price term of loan contracts. That is, banks view ICW as an incrementally significant information risk factor above and beyond traditional credit risk factors that increases pre-contract information uncertainty as well as post-contract monitoring and re-contracting costs. Our results suggest that the quality of the financial reporting system plays an important role in private debt contracting and that information risk incurred by weak internal controls cannot be removed by lenders’ access to borrowers’ inside information.

Second, we find that the nature or severity of material weakness in internal control matters in loan contracting. Specifically, we find that borrowers with more severe, company-level ICW (e.g., organizational control or governance flaws) pay higher loan rates than those with less severe, account-level ICW (e.g., inventory recording flaws and lease accounting problems). This finding suggests that lenders are able to differentiate more severe ICW problems from less severe ones when designing loan contracts. To some extent, it implies that the comparative advantages that banks have in accessing inside information help them reduce, but not completely eliminate, the information risk associated with account-level control problems, but lenders have more difficulty obtaining useful inside information that can help mitigate information risk associated with company-level control problems.

Third, we find that lenders impose tighter non-price terms on ICW borrowers than on non-ICW borrowers. In particular, we find that the likelihood of a loan being secured by collateral is higher for ICW borrowers than for non-ICW borrowers. We also provide evidence that collateral and restrictive covenants are used more intensively in loan contracts involving borrowers with company-level control problems than in those involving borrowers with account-level control problems. Fourth, we find that the number of lenders in each loan is smaller for loans to ICW borrowers than for those to non-ICW borrowers, consistent with the theory that information asymmetries between the borrower and potential lenders attract fewer lenders in a loan syndicate (e.g., Sufi 2007).

Fourth, using a sample of firms that initiate similar loans both before and after their first-time internal control disclosures under SOX 404, we conduct within-firm analyses and find that the loan spreads charged to ICW firms significantly increase after SOX 404 disclosures, while the loan spreads charged to non-ICW firms significantly decrease after SOX 404 disclosures. This suggests that SOX 404 disclosures provide new information to the private debt market regarding a borrower’s information risk. Moreover, we show that firms enjoy a meaningful reduction in the cost of bank loans after they remediate previously reported ICW problems, consistent with the equity market evidence documented by Ashbaugh-Skaife et al. (2009).

Finally, we find that the number of financial covenants imposed on loans to both ICW and non-ICW firms decreases after SOX 404 disclosures. In a concurrent study, Costello and Wittenberg-Moerman (2011) find that the number of financial covenants decreases after a firm discloses ICW under SOX Section 302 (SOX 302). The authors interpret this result as evidence that ICW disclosure per se leads to decreased use of financial covenants. However, because Costello and Wittenberg-Moerman (2011) include only ICW firms in their sample, their within-firm analysis seems to be missing a control condition, which could limit the inferences they may draw from their analysis. We conjecture that the decreased use of financial covenants for both ICW and non-ICW firms could be driven, at least partially, by a general regulatory effect of SOX.

The full paper is available for download here.

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