Private lenders' demand for audit

- Auditors are sometimes required to report to lenders on covenant compliance.
- Empirical evidence on covenant compliance assurance clauses is presented.
- Clauses are associated with borrower and loan characteristics informed by agency and contracting theory.
- Contractual adjustments to GAAP net income are key determinants of audit demand.

We study clauses in private lending agreements requiring auditors to assure lenders of borrowers' compliance with financial covenants. Auditors are required under general purpose financial reporting to review covenant compliance. However, by informing lenders directly that they have no knowledge of default, auditors may increase their litigation risk. We find that auditor covenant compliance assurance clauses are significantly associated with more complex contractual adjustments to net income, the extent of reliance on accounting information in the contract, intangibility of borrowers' assets, the number of lenders and loan maturity. We provide novel evidence of the audit market enhancing efficient contracting.