We examine the effect of financial reporting quality on the trade‐off between monitoring mechanisms used by lenders. We rely on Sarbanes‐Oxley internal control reports to measure financial reporting quality. We find that when a firm experiences a material internal control weakness, lenders decrease their use of financial covenants and financial‐ratio‐based performance pricing provisions and substitute them with alternatives, such as price and security protections and credit‐rating‐based performance pricing provisions. We also find that changes in debt contract design following internal control weaknesses are substantially different from those following restatements, where lenders impose tighter monitoring on managers’ actions, but do not decrease their use of financial statement numbers.

We investigate the role that regulatory strictness plays on the enforcement of financial reporting transparency in the U.S. banking industry. Using a novel measure of regulatory strictness in the enforcement of capital adequacy, we show that strict regulators are more likely to enforce restatements of banks' call reports. Further, we find that the effect of regulatory strictness on accounting enforcement is strongest in periods leading up to economic downturns and for banks with riskier asset portfolios. Overall, the results from our study indicate that regulatory oversight plays an important role in enforcing financial reporting transparency, particularly in periods leading up to economic crises. We interpret this evidence as inconsistent with the idea that strict bank regulators put significant weight on concerns about the potential destabilizing effects of accounting transparency.