The Impact of Disclosures of Internal Control Weaknesses and Remediations on Investors' Perceptions of Earnings Quality

We hypothesize and find that firms making SOX‐mandated disclosures of material weaknesses in internal control over financial reporting (ICOFR) exhibit lower investor‐perceived earnings quality (IPEQ) than nondisclosers. We measure IPEQ using e‐loading, a market‐returns–based representation of earnings quality developed by Ecker, Francis, Kim, Olsson, and Schipper (2006). Firms do not exhibit decreases in IPEQ after initially disclosing material weaknesses. This is consistent with investors having anticipated ICOFR strength based on observable firm characteristics. However, firms exhibit increases in IPEQ after receiving their first clean audit reports that confirm the remediation of previously disclosed weaknesses. This indicates that, although investors do not find initial weakness disclosures to be incrementally informative, SOX motivates firms to remediate weak controls and provides a venue for credible remediation disclosures, thus enhancing investors' perception of financial reporting reliability. These findings are consistent with the existence of regulatory benefits associated with SOX's internal control disclosure and audit requirements.     

Is there a relation between audit fee cuts during the global financial crisis and banks’ financial reporting quality?

As a result of the global financial crisis (GFC), several audit clients were able to negotiate lower audit fees for the years 2008 and 2009. However, the PCAOB has expressed concern that lower audit fees might lead to lower audit effort and lower audit quality and financial reporting quality. This study examines the relation between audit fee cuts and banks’ financial reporting quality. Specifically, we focus on earnings management via loan loss provisions (LLP), the relation between current period LLP and future loan charge-offs, i.e., LLP validity, and the timely recognition of loan losses. For banks audited by Big 4 auditors, we find that income-increasing abnormal LLP are decreasing in audit fee cuts and LLP validity is increasing in audit fee cuts. For banks audited by non-Big 4 auditors, LLP validity is higher for banks that received a fee cut of more than 25% relative to other banks audited by non-Big 4 auditors. We do not observe an association between timely loan loss recognition and cuts in audit fees except for banks audited by non-Big 4 auditors and exempt from internal control audits where a fee cut of more than 25% is associated with less timely loan loss recognition. Overall, the findings suggest that Big 4 auditors constrained earnings management via LLP in banks that received cuts in audit fees. Our findings have important implications for regulators, investors, and others.     

Earnings management,incentive contracts and private information acquisition

This paper analyzes the optimal design of compensation contracts in the presence of earnings management incentives, and its interplay with investors’ information acquisition decisions. We consider a setting in which compensation contract is based on both accounting earnings and stock price when an agent engages in predictable, pernicious earnings management and stock price is endogenously determined in a Noisy Rational Expectations Equilibrium (NREE) that reflects both the public information from reported earnings and a costly, noisy signal privately acquired by investors. We show that an increase in the precision of the firm’s financial reporting system could reduce the informativeness of stock price and exacerbate the agency problem by inducing lower productive effort and higher earnings management, implying that the firm may not choose a more precise financial reporting system.     

Institutional investor inattention and audit quality

We hypothesize and provide empirical evidence that higher institutional investor inattention is associated with lower audit quality. We employ an inattention measure that captures the extent to which institutional investors are distracted by attention-grabbing events irrelevant to the focal firm. Results suggest that a higher degree of institutional investor inattention is associated with a lower propensity of a going-concern opinion, a lower probability of the auditor reporting a material internal control weakness, and a higher likelihood of the audit client misstating the financial statements. Further analyses show that these associations vary by auditor litigation risk, their workload pressure, auditor industry expertise, and analyst coverage. Overall, our findings reveal that while institutional investors play an important monitoring role, the distractions they face undermine the quality of monitoring they provide.     

Audit committee equity holdings,the risk of reporting problems,and the achievement of earnings thresholds

There is conflicting evidence on whether audit committee equity holdings enhance or undermine committee effectiveness. Some researchers contend that equity holdings motivate audit committees to minimize the risk of reporting problems, while others believe equity holdings align the committees’ incentives with management. To reconcile these seemingly contradictory positions, I hypothesize that the influence of audit committee equity holdings depends upon the risk of reporting problems. I contend that when the risk of reporting problems is low (high) equity holdings motivate audit committees to give managers greater (less) discretion over reporting policies because the expected benefits from giving the discretion is greater (less) than the expected cost of the reporting problems that might occur from giving the discretion. I test whether the influence of audit committee equity holdings varies with the risk of reporting problems using a sample of 1370 firm-observations with earnings near the prior year’s earning level and a sample of 2389 firm-observations near analyst forecasts. I find the influence of audit committee equity holdings on the likelihood that a firm meets the prior year’s earnings level varies with the CEO’s equity incentives and the level of high-risk assets. I also find the influence of audit committee equity holdings on the likelihood that a firm meets analysts’ forecast varies with the CEO’s equity incentives and the effectiveness of internal controls. Collectively, my results suggest equity holdings enhance audit committee effectiveness by increasing a committee’s responsiveness to risk factors.     

Audit committee financial expertise and properties of analyst earnings forecasts

An important role of financial accounting information is to aid financial statement users in forming expectations about the firm's future earnings. Prior research finds that accounting financial expertise of the audit committee is associated with higher financial reporting quality. We extend this literature by examining the association between audit committee financial expertise and analysts' ability to anticipate future earnings. We find a significant association between accounting financial expertise on the audit committee and analyst earnings forecasts that are more accurate and less dispersed. In contrast, we do not find a significant association between non-accounting financial expertise (i.e., supervisory expertise) and forecast accuracy or forecast dispersion. These findings contribute to our understanding of the benefits of accounting expertise in audit committees by demonstrating an association between accounting financial expertise and improvements in analyst earnings forecasts.     

The Future of Financial Reporting: Insights from Research

Research offers insights that, if heeded and built upon, could improve financial reporting, thereby contributing to a more prosperous society. In particular, research suggests improvement could stem from greater use of fair value; a performance statement designed to reveal the information embedded in changes in fair value; better information to help investors assess the value of intangible assets; more specific information about risk and uncertainty; information that is unbiased, rather than conservative; acceptance of a degree of earnings management together with a determination of how much earnings management is acceptable; and a financial reporting package designed to convey information users need, which presumably is broader than today's financial statements.     

Audit opinion improvement and the timing of disclosure

Companies have been found to report positive information more quickly than they report negative information (i.e., good news early, bad news late). This paper investigates the potential impact of audit opinion change on the timeliness of financial disclosures, with improvements in audit opinion considered to be “good news.” We take both the direction and the magnitude of audit opinion change into consideration, with magnitude measuring how far the opinion is from an unqualified opinion (i.e., an unqualified opinion with explanatory paragraph is closer to an unqualified opinion than a qualified opinion is). We find that firms experiencing an improvement in their audit opinions disclose their financial results earlier, while those with audit opinion deteriorations report their financial results later, and that these effects were related to the magnitude of the opinion change. What's more, there is an asymmetric response to good audit opinion news vs. bad audit opinion news, with bad audit opinion news having a larger effect on earnings timeliness than the effect on earnings timeliness of good audit opinion news. Overall, our results support the “good news early, bad news late” notion. Finally, we also find that overall earnings timeliness has improved in China since the enactment of new reporting regulations in 2006.     

The relevance of quantifiable audit qualifications in the valuation of IPOs

How useful are audit qualifications to financial statement users? We analyze a sample of 204 firms that went public at the Athens Stock Exchange over the period 1987–2002. For 149 of these firms, auditors report quantitative estimates of the amount by which assets are overstated and/or liabilities are understated in reported financial statements. We find that underwriters and their affiliated analysts do not incorporate the negative information provided by these qualifications into offer prices and earnings forecasts. Investors, however, appear to efficiently impound the negative implications of the audit qualifications into stock market prices within the first day of trading. The results suggest that underwriters tend to align their interests with the interests of their clients, the old stockholders, at the expense of the new stockholders. They also suggest that the practice of reporting quantifiable qualifications in audit reports is valuable to investors given that they are disclosed by an expert.     

The value relevance of inflation-adjusted and historical-cost earnings during hyperinflation

In Israel, publicly traded companies have been required to present financial statements based on the real purchasing power of the Israeli currency since 1985. Supplementary historical-cost data are provided in detailed notes to the financial statements including the balance sheet and the income statement. In the U.S., the FASB (1986) made the requirement to disclose the effect of price changes on earnings optional (SFAS 89). Consequently, publicly traded companies began suppressing inflation-adjusted earnings (IAE) disclosures. Most studies conclude that current cost earnings and constant dollar earnings provided marginal or even no information content in the U.S. This study examines the value relevance of unexpected IAEs and historical-cost earnings (HCE) in the Israeli hyperinflationary environment. A sample of 106 publicly traded manufacturing firms is used. The sample comprises over 97 percent of the publicly traded manufacturers in Israel during the mid-1980s. Cross-sectional annual and pooled regression models are estimated across the triple-digit annual inflation rates from 1984 through 1985 and the double-digit rates from 1986 through 1988. The results show that unexpected IAEs are value-relevant beyond unexpected HCEs, which are not value-relevant to investors in the hyperinflationary Israeli economy. The findings tend to be statistically significant when unanticipated inflation rates are notably high.     

Impact of FDICIA internal controls on bank risk taking

The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 was designed, among other things, to introduce risk-based deposit insurance, increase capital requirements, and improve banks’ internal controls. Of particular interest in this study are the requirements for annual audit and reporting of management’s and auditor’s assessment of the effectiveness of internal control for banks with $500 million or more in total assets (raised to $1 billion in 2005). We study the impact of these requirements on banks’ risk-taking behavior prior to the recent financial crisis and the consequent implications for bank failure and financial trouble during the crisis period. Using a sample of 1138 banks, we provide evidence that banks required to comply with the FDICIA internal control requirements have lower risk taking in the pre-crisis period. Specifically, the volatility of net interest margin, the volatility of earnings, and Z score show less risk-taking behavior. Furthermore, these banks are less likely to experience failure and financial trouble during the crisis period.     

Does it pay to remediate? An analysis of the internal and external benefits of remediation

We examine the internal and external benefits associated with the remediation, or correction, of material weaknesses in internal controls over financial reporting. We document that firms that remediate material weaknesses exhibit higher performance and reporting quality than firms that never reported any weaknesses. These results suggest that the remediation of material weaknesses, an indication of an improved internal control system, is associated with internal benefits. Moreover, we find that remediating firms experience significantly lower audit fees and betas (i.e. external costs) than non-material weakness firms. However, these lower external costs are contingent on a firm's level of performance and information quality. These results suggest that remediation offers firms a chance to re-examine and correct their internal controls and this leads to better performance and information quality. Furthermore, external stakeholders are not necessarily swayed by remediation alone but need to observe tangible evidence of the corrected internal control system before reassessing a firm's risk downward.     

Can financial statement analysis beat consensus analysts’ recommendations?

We examine whether investors can exploit financial statement information to identify companies with a greater likelihood of future earnings increases and whether stocks of those companies generate 1-year abnormal returns that exceed the abnormal returns from following analysts’ consensus recommendations. Our approach summarizes financial statement information into a “predicted earnings increase score,” which captures the likelihood of 1-year-ahead earnings increases. We find that, within our sample of consensus recommendations, stocks with high scores are much more likely to experience future earnings increases than stocks with low scores. A hedge portfolio strategy that utilizes our approach within each consensus recommendation level generates average annual abnormal returns of 10.9 percent over our 12-year sample period, after controlling for previously identified risk factors. These abnormal returns exceed those available from following analysts’ consensus recommendations. Our results show that share prices and consensus recommendations fail to impound financial statement information that helps predict future earnings changes.     

Costs and benefits of auditors' disclosure of critical audit matters: Initial evidence from the United States

In an effort to make audit reports more informative to financial statement users, the Public Company Accounting Oversight Board (PCAOB) requires an expanded audit report in which auditors are required to disclose critical audit matters (CAMs). The new standard (AS 3101) became effective for audits of financial statements of large accelerated filers for fiscal years ending on or after June 30, 2019. Using a sample of annual reports of large accelerated filers with and without CAM disclosures, we examine the costs and benefits of the mandatory disclosure of CAMs in auditors' reports. Our evidence suggests that compared to auditor reports reporting no CAMs, the presence of a single CAM disclosure in the auditor's report provides incremental information to equity investors without a significant increase in audit costs. However, using the benchmark of a single CAM disclosure, multiple CAMs in an auditor's report results in higher audit fees and longer audit delays.     

Audited financial reporting and voluntary disclosure as complements: A test of the Confirmation Hypothesis

We examine the “confirmation” hypothesis that audited financial reporting and disclosure of managers' private information are complements, because independent verification of outcomes disciplines and hence enhances disclosure credibility. Committing to higher audit fees (a measure of financial statement verification) is associated with management forecasts that are more frequent, specific, timely, accurate and informative to investors. Because private information disclosure and audited financial reporting are complements, their economic roles cannot be evaluated separately. Our evidence cautions against drawing inferences exclusively from market reactions around “announcement periods” because audited financial reporting indirectly affects information released at other times and through other channels.     

The value relevance of timely information: The case of comparable store sales growth

Investors and analysts have called for more timely disclosure of corporate information. Responding to these demands, some retail firms issue comparable store sales (CSS) on a monthly or a quarterly basis in addition to an annual basis. This study examines whether a timely disclosure of CSS provides value-relevant information to market participants by examining investors' and financial analysts' responses at the time of CSS disclosures (short-horizon) and over the month or the quarter (long-horizon). We find that both monthly and quarterly CSS are associated with contemporaneous market returns and analyst forecast revisions. More importantly, we find that quarterly CSS news becomes less important to investors when firms provide more timely CSS information, indicating that monthly CSS reports may preempt the information content of quarterly CSS. Additional tests show that investors and analysts rely less on CSS if CSS news and earnings (sales) news are inconsistent.     

Internal control reporting and market liquidity

We investigate the impact of the Sarbanes-Oxley Act of 2002 (SOX) on information asymmetry by analyzing the relation between SOX Sections 302 and 404 control reports and market liquidity using bid-ask spreads. Lower market liquidity indicates higher levels of information asymmetry implying that market participants perceive financial statement misstatement risk is higher. If SOX disclosures contain relevant information, then one would expect firms reporting internal control material weaknesses to have lower market liquidity. Accordingly, we find that market liquidity is lower (i.e., bid-ask spreads are higher) for firms reporting ineffective control compared to firms reporting effective control using either annual SOX 404 internal control reports or quarterly SOX 302 disclosure control reports, which suggests that SOX 302 and 404 reports provide useful information for identifying firms with a higher risk of financial statement misstatement. However, we do not find consistent results using two alternative liquidity measures: trading volume and market quality indices. We then examine whether changes in control reports are associated with changes in market liquidity. We generally do not find that firms with improved (deteriorated) control reports experience a larger decrease (increase) in bid-ask spreads or larger increases (decreases) in trading volume and market quality indices compared to other firms, suggesting that market participants do not discern a change in information asymmetry when the effectiveness of internal controls over financial reporting changes.     

Non-GAAP earnings reporting following going-concern opinions

We examine non-GAAP earnings reporting following a going-concern audit opinion (GCO). Using a propensity score-matched sample, matching first-time going-concern issuing companies with firms in financial distress that did not receive a going-concern report, we find that the likelihood and frequency of non-GAAP earnings reporting are lower following GCOs. In additional analyses, we find the negative association between the announcement of GCOs and the likelihood and frequency of non-GAAP earnings reporting stronger when GCOs are issued by industry-specialist auditors and when GCOs are unexpected, but do not find litigation risk or managers' ability to affect the association. These results are consistent with a decrease in investor demand for non-GAAP earnings disclosures following GCOs.     

Do investors perceive a change in audit quality following the rotation of the engagement partner?

Though Section 203 of the Sarbanes-Oxley Act (SOX) calls for the rotation of the audit partner every five years, we do not know whether investors value audit partner rotation. This is an important issue since many in the auditing profession believe that mandatory rotation of the audit partner is unnecessary and may in fact impair audit quality. We identify a sample of firms that disclosed changes in the engagement partner in the proxy statement and examine whether equity investors perceive a change in audit quality following the partner rotation. We find a significant increase in earnings informativeness following audit partner rotation. We also find that short sellers regard earnings in the post-rotation to be of higher quality than earnings prior to the rotation. Finally, cost of equity capital is lower following partner rotation. Our findings have important implications for the regulators, auditors, and investors.     

The influence of director stock ownership and board discussion transparency on financial reporting quality

Seventy-two active corporate directors participate in an experiment where management insists on aggressive recognition of revenue, but the chief audit executive proposes a more conservative approach. Results indicate interactive effects of director stock ownership and the transparency of director decisions. Stock-owning directors are more likely to oppose management’s attempts to manage earnings when transparency increases. For non-stock owning directors, however, increasing transparency does not affect the likelihood that directors oppose management’s attempts to manage earnings. The current study challenges suppositions that equate director stock ownership with improved financial reporting and higher corporate governance quality, and it provides evidence that increased transparency is beneficial when director compensation plans threaten director independence.