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Compliance : Sarbanes Oxley : Auditing : Continuous Auditing
Sarbanes-Oxley Disclosures Matter To Investors
By
Peter Rooney
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Peter Rooney
Asst. Prof. of Accounting
Indiana University
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Investors punish firms that disclose internal control weakness as required by Sarbanes Oxley provisions, but having a Big Four auditor mitigates the negative price hit, perhaps because post-SOX, the highest quality auditors have the lowest risk client portfolios, new research shows.
The findings, which appear in two separate research papers by Leslie Hodder, assistant professor of accounting at Indiana University's Kelley School of Business, can be seen as an empirical rebuke to arguments that new "SOX" provisions are a waste of firm's time and money on issues that are of no consequence to investors.
"If that's true," Hodder says, "we shouldn't see the market response to a firm's disclosure of material weakness that we did. Instead, our research shows that the market does care."
In a study coauthored with Messod Beneish and Mary Billings, also of Indiana University, Hodder found "significant abnormal negative returns," in the range of 1.5 to two percent of market capitalization, over three trading days for 336 firms that disclosed internal control weaknesses in 2004, as required by SOX regulations.
The negative reaction occurs even when auditors are not saying they found anything wrong with the numbers, Hodder stresses. In these cases, they're saying there was a problem with the process of arriving at those numbers.
Called internal control weaknesses, these would include, for example, inadequate separation of duties, such as an employee who receives cash also being the person who records cash receipts in financial statements.
"If auditors uncover enough of these problems, they have to say a company has internal control problems," Hodder says. "And it turns out that investors truly do care about these disclosures."
Hodder suspects that stock prices declines after SOX disclosures because analysts and investors factor in the perceived cost of remediation, and also consider a company with internal control problems to be a riskier investment.
That said, companies reporting internal control problems experienced a milder stock price hit if a Big Four firm conducted the audit.
The largest four audit firms include PriceWaterhouseCoopers, KPMG, Ernst & Young and Deloitte Touche. These firms audit approximately 80 percent of publicly registered companies in the United States, Hodder estimates.
"The negative impact overall is 1.5 to 2 percent, but it's about 3 percent if you don't have a large auditor," Hodder says.
This finding suggests that the large fees charged by large audits may be worth it, at least for public companies.
?Engaging one of the big four firms seems to increase perceived credibility and reduce perceived risk," Hodder says, "and that can help companies to maintain investor confidence when reporting problems arise."
Even if firms can afford high-priced auditors, not all firms can engage one. In additional work, not yet released, Hodder and coauthor Derek Oler are investigating auditor. The two and observe that larger accounting firms appear increasingly choosy about their clients in the post-Sarbanes era.
"We are seeing significant migration of riskier large audit firm clientele to smaller auditors, consistent with rationing of services," Hodder says. Some publicly traded firms are dealing with the tight audit market by choosing to delist and go private.
Peter Rooney
Asst. Prof. of Accounting
Indiana University
The Accounting Department is pleased to have Leslie D. Hodder join its faculty as Assistant Professor this fall.
Leslie earned her Bachelor?s of Business Administration, as well as her MBA and Master?s of Accounting, at the University of New Mexico, and her PhD at the University of Texas, Austin. She comes to the Kelley School from the Stanford Graduate School of Business, where she has been teaching since 2001.
Before entering a career in academic accounting, Leslie worked as a CPA at KPMG Peat Marwick , at Earnst & Young, and in consulting. She was also Controller at Jack Clifford & Co., Chief Financial Officer at Levy Bancorp, and Director and Finance Chair at Carpinteria Sanitary District in California from.
Leslie describes her research interests as broad and eclectic, reflecting her variety of experience in public accounting and industry. Her current projects involve assessing the relevance and reliability of risk measurement and valuation.
In another project, she is ?attempting to answer the question of whether banks price their loans to compensate for borrower-specific risk,? she says.
Leslie?s research has appeared in Financial Analysts Journal, Accounting Horizons, and Contemporary Accounting Research.
After just two years in academia, her work has already made an impact: at a recent conference, Leslie found out that one of her articles led an analyst to revise his valuation models, and a student to choose its topic for her dissertation.
At IU, Leslie will be teaching Intermediate Accounting (A311) this fall. When asked to describe her teaching philosophy, Leslie says that she doesn?t really believe in teaching but in providing opportunities for students to learn.
?My job is to help students to develop discipline-related knowledge structures? Graduates of a quality accounting program like the one at the Kelley School of Business shouldn?t learn to follow the rules. Adapting to change means understanding what makes accounting rules meaningful,? she explains.
Leslie graduated from high school in a town of 4,000 people in New Mexico. Becoming an accountant seemed like a natural decision for her, since the business profession runs in her family. ?My dad is a CPA and has his own firm, and my sister is a CPA working in industry.
I majored in chemical engineering for the first two years of my undergraduate program, but I guess I couldn?t escape my destiny to be a CPA,? Leslie says. Leslie?s father passed the skills of his second occupation?ranching?on to his children, as well. ?I can drive a tractor and know quite a bit about composting?believe it or not those skills still come in handy,? Leslie says.
Leslie now has four children of her own, aged 19, 21, 5 and 7?all enriching her life and continuing her education, she says.
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