Auditor Attestation Research Articles

“Surprise” material weakness disclosures: Effects on audit fees and audit report lags

Prior research shows that many of the companies that disclose material weaknesses in internal control (MWs) do not disclose such weaknesses in earlier quarterly 10-Q filings for the same year—i.e., the year-end MW disclosures are “surprise” disclosures. I first show, using data from 2009 to 2019, that such surprise MWs continue to be the majority of MW disclosures as late as 2019. I find that accelerated filer companies with surprise MWs pay lower fees compared to companies with no-surprise MWs; however, this finding does not hold for non-accelerated filers. I also find that there are no significant differences in the audit report lag of surprise and no-surprise MW disclosers. Thus, the lower audit fee paid by surprise MW disclosure companies may offer a possible explanation for the widespread prevalence of surprise MW disclosures. The results also highlight the importance of the external auditor in public disclosures of MWs. The findings have public policy relevance given the ongoing efforts to expand the set of companies that would be exempt from the auditor attestation of internal controls.

Securities-Based Crowdfunding by Startups: Does Auditor Attestation Matter?

ABSTRACTWe examine financing outcomes for small businesses seeking to sell public securities in a setting characterized by high information asymmetry, weak requirements for auditor participation, and a complete absence of Big N auditors. Issuers that raise capital from small, unsophisticated investors through crowdfunding, under the Securities and Exchange Commission's Regulation Crowdfunding (RegCF), often need no auditor attestation or need only weak attestation in the form of reviews, not audits, of their financial statements. We find that auditor reviews are positively associated with both the probability of crowdfunding success and the total amount raised. Further, we compare outcomes for issuers that procure auditor reviews voluntarily and mandatorily, and document that issuers with voluntary reviews have better outcomes. We conjecture that for issuers that voluntarily procure reviews, the reviews serve as signals of high future prospects. Finally, the positive effect of reviews is concentrated in PCAOB-registered auditors.JEL Classifications: G18; M41; M42; M48.

Internal control effectiveness, textual risk disclosure, and their usefulness: U.S. evidence

This paper investigates the impact of internal control effectiveness (ICE) on the level of textual risk disclosure (TRD; including aggregate risk disclosure and its tone of good news and bad news about risk). Our findings suggest that firms with an ineffective internal control system exhibit significantly lower levels of TRD than firms with effective internal controls. Besides, we show a significant change in TRD behavior provided by managers of firms with recurrent ineffective internal controls. Pursuant to agency theory, this behavior change is prompted to reduce the expected public uncertainty and agency problems. We also investigate the usefulness of ICE reporting and TRD to the market. Results suggest that firms reporting ineffective internal controls are likely to have higher investor-perceived risk than firms reporting effective internal controls. Furthermore, TRD improves firms' market liquidity, and such improvement is principally driven by good news rather than bad news about risk. Collectively, our results fill an apparent gap in the literature on the importance of ICE, as well as the usefulness of the external auditor's attestation on a firm's internal controls and management TRD.

Securities-Based Crowdfunding by Startups: Does Auditor Attestation Matter?

We examine financing outcomes for small businesses seeking to sell public securities in a setting characterized by high information asymmetry, weak requirements for auditor participation, and a complete absence of Big N auditors. Issuers that raise capital from small, unsophisticated investors through crowdfunding, under the Securities and Exchange Commission’s Regulation Crowdfunding (RegCF), often need no auditor attestation or need only weak attestation in the form of reviews, not audits, of their financial statements. We find that auditor reviews are positively associated with both the probability of crowdfunding success and the total amount raised. Further, we compare outcomes for issuers that procure auditor reviews voluntarily and mandatorily, and document that issuers with voluntary reviews have better outcomes. We conjecture that, for issuers that voluntarily procure reviews, the reviews serve as signals of high future prospects. Finally, the positive effect of reviews is concentrated in PCAOB-registered auditors.

Material weakness disclosures and restatements: value of external auditor attestation

PurposeThe purpose of this study is to examine the value of auditor attestation in internal control over financial reporting (ICFR) disclosures. The authors argue that internal control material weakness (ICMW) disclosures issued without auditor attestation by non-accelerated filers provide weaker signal to the impaired financial reporting quality compared to those issued with auditor attestation by accelerated filers.Design/methodology/approachThis study investigates the differences in the association between ICMW disclosures and impaired financial reporting quality, as proxied by financial statement restatements, for accelerated and non-accelerated filers. The authors use propensity score matching to find control groups for both accelerated and non-accelerated filers.FindingsThe authors find that ICMW disclosures signal impaired financial reporting quality for both accelerated and non-accelerated filers, but such signaling is weaker for non-accelerated filers compared to accelerated filers.Research limitations/implicationsAlthough propensity score matching was used to match firms with and without ICMW disclosures, any unobservable fundamental differences between these groups may affect the results of this study.Originality/valueThis study shows that auditors’ involvement in the assessment of internal control effectiveness improves the signaling effect of ICMW disclosures on impaired financial reporting quality. As approved by the House Financial Services (HFS) Committee on November 4, 2009, non-accelerated filers are permanently exempt from auditor attestation requirement. This study provides some evidence that the exemption of non-accelerated filers from auditor attestation may have unintended consequences, and these results should be of interest to regulators and investors.

Does Attestation of the effectiveness of Internal Control over Financial Reporting Discourage Earnings Management? Evidence from China

To improve financial reporting quality, the Chinese government issued the Basic Standard for Enterprise Internal Control in 2008 and other related guidelines/regulations in the following years (hereafter China SOX). The scope of China SOX is broader but similar to Section 404 of the Sarbanes-Oxley Act (SOX) in the U.S. Formal adoptions of China SOX requires management and external auditor’s report on the effectiveness of internal control over financial reporting (ICFR). A company’s ICFR, if effective, should provide reasonable assurance that the company’s financial statements are reliable and prepared in accordance with the applicable accounting standards. The purpose of this study is to investigate whether China external auditor attestation of ICFR discourage earnings management, an indicator of financial reporting quality. By analyzing a sample of Chinese public firms during 2011 to 2013, we find that: (1) Chinese firms that disclose audited ICFR reports exhibit lower earnings management than firms that do not; (2) Chinese firms that are mandated to disclose audited ICFR reports exhibit lower earnings management than firms that voluntarily disclose audited ICFR reports. Our empirical results seem to suggest that attestation of the effectiveness of ICFR discourages earnings management and therefore improve financial reporting quality.

To exempt or not to exempt non-accelerated filers from compliance with the auditor attestation requirement of Section 404(b) of the Sarbanes–Oxley Act

We examine the stock market reaction to the SEC announcement to permanently exempt non-accelerated filers from compliance with Section 404(b) of the Sarbanes–Oxley Act. Mandatory compliance with auditor attestation under Section 404(b) is highly controversial. Using a sample of non-accelerated issuers for 2006–2011, we find a negative market reaction to the November 4, 2009 exemption announcement. However, most of the negative returns accrue to non-accelerated filers that do not voluntarily comply with Section 404(b), suggesting that auditor attestation enhances firm value. The use of a Big 4 auditor, strong analyst following, and superior internal controls over financial reporting (ICFR) are associated with positive/less negative market responses. Voluntary compliers with Section 404(b) are more likely to have a Big 4 auditor, stronger analyst coverage, effective ICFR, stronger firm performance and lower information asymmetry. Our results are consistent with firms using voluntary compliance with SOX 404(b) as a signal of superior operating performance and ICFR quality to overcome information asymmetry and therefore mitigate the negative valuation impact of the permanent exemption from auditor attestation.

Estimating the Compliance Costs of Securities Regulation: A Bunching Analysis of Sarbanes-Oxley Section 404(B)

An extensive literature has analyzed the Sarbanes-Oxley (SOX) legislation enacted in 2002, but its social welfare consequences remain controversial. One of the most significant provisions of SOX – auditor attestation of internal controls under Section 404(b) – has been applied only to firms that have a public float (i.e. the market value of shares held by non-insiders) of at least $75 million. Public float is not reported in standard databases; this paper “scrapes” public float data from 10-K filings, resulting in about 161,000 observations at the firm-year level for the universe of reporting entities for fiscal years 1993-2015. The analysis compares the number of public float observations immediately below the $75 million threshold to a smooth counterfactual density estimated using a flexible polynomial fitted to the observed density away from the threshold. In the pre-SOX period, there is no detectable divergence between the actual and counterfactual density around $75 million. Since the enactment of SOX, there is substantial and statistically significant “bunching” below the threshold, exhibiting a bimodal pattern. The magnitude of bunching implies that firms around the threshold reduce their public float by about $1.7 million. This estimate is consistent with SOX 404(b) imposing a net compliance cost of about $4-$6 million (in present value terms) on firms in the region of the threshold. The results are robust to considering various alternative explanations for bunching, including the possibility that firms’ insiders avoid crossing the threshold in order to continue extracting private benefits of control. The paper also explores potential financial and economic consequences of bunching, in particular on the debt financing and investment choices of firms close to threshold.

Estimating the Compliance Costs of Securities Regulation: A Bunching Analysis of Sarbanes-Oxley Section 404(b)

An extensive literature has analyzed the Sarbanes-Oxley (SOX) legislation enacted in 2002, but its social welfare consequences remain controversial. One of the most significant provisions of SOX – auditor attestation of internal controls under Section 404(b) – has been applied only to firms that have a public float (i.e. the market value of shares held by non-insiders) of at least $75 million. Public float is not reported in standard databases; this paper “scrapes” public float data from 10-K filings, resulting in about 161,000 observations at the firm-year level for the universe of reporting entities for fiscal years 1993-2015. The analysis compares the number of public float observations immediately below the $75 million threshold to a smooth counterfactual density estimated using a flexible polynomial fitted to the observed density away from the threshold. In the pre-SOX period, there is no detectable divergence between the actual and counterfactual density around $75 million. Since the enactment of SOX, there is substantial and statistically significant “bunching” below the threshold, exhibiting a bimodal pattern. The magnitude of bunching implies that firms around the threshold reduce their public float by about $1.7 million. This estimate is consistent with SOX 404(b) imposing a net compliance cost of about $4-$6 million (in present value terms) on firms in the region of the threshold. The results are robust to considering various alternative explanations for bunching, including the possibility that firms’ insiders avoid crossing the threshold in order to continue extracting private benefits of control. The paper also explores potential financial and economic consequences of bunching, in particular on the debt financing and investment choices of firms close to threshold.

Auditor Attestation under SOX Section 404 and Earnings Informativeness

SUMMARYSection 404 of the Sarbanes-Oxley Act requires managers to assess, and their auditors to express an opinion on, the effectiveness of internal controls over financial reporting (ICFR). Policymakers expect the ICFR audits to enhance the credibility of firms' financial statements. Prior research argues that audit characteristics that enhance the credibility of financial reporting are associated with stronger earnings-return associations. We examine whether earnings accompanied by the first-time Section 404 ICFR reports were associated with higher informativeness compared with earnings in the prior year when only financial statement audit reports were available. We conduct our analysis for a test sample of accelerated filers with clean ICFR reports and clean previous Section 302 disclosures. Using a difference-in-differences approach, we compare the change in earnings informativeness for the test sample with that for a control sample of non-accelerated filers. We find that earnings informativeness for companies with clean internal control reports was greater in the Section 404 adoption year than in the previous year, while there was no change in earnings informativeness for the non-accelerated filers. Also, there is no difference in the increase in earnings informativeness across firms with small and large compliance costs (measured by change in audit fees), suggesting that both groups benefited from the Section 404 ICFR audits.

Do Compensation Committees Pay Attention to Section 404 Opinions of the Sarbanes‐Oxley Act?

Abstract: This study examines whether compensation committees adjust CEO/CFO compensation using the auditor opinions on internal control effectiveness (SOX 404 opinions), and whether the emphasis on internal controls depends on the level of compensation committees’ financial expertise. Following SOX 404, a firm's CEO and CFO are required to evaluate the effectiveness of internal controls over financial reporting, subject to the auditor's attestation. In light of recent accounting fraud, we expect and find that compensation committees adjust CEO/CFO compensation by reference to the SOX 404 opinions. Using different measures of financial expertise, we also find that the relationship is more pronounced in firms with higher levels of financial expertise. Our results suggest the importance of including directors with financial expertise on compensation committees.

The effects of Section 404 of Sarbanes‐Oxley Act of 2002 on the audit fees of foreign firms listed on US exchanges

Purpose – The purpose of this study is to examine the change in audit fees for US‐listed foreign firms in their first year of providing Section 404 auditor attestation reports for fiscal years ending between July 15, 2006 and July 14, 2007.Design/methodology/approach – During the sampling time period, foreign large accelerated filers had to provide both auditor and management Section 404 reports while the foreign accelerated filers only had to provide management Section 404 reports without the auditor attestation reports. Foreign non‐accelerated filers did not have to provide any Section 404 report. This research design and sample allows the authors to control for the general market‐wide increases in audit fees. The paper examines the annual change in audit fees from the preceding year to the first year of Section 404 compliance.Findings – It is found that foreign large accelerated filers have an average increase of 74 percent in audit fees in this first year of Section 404 compliance, while the foreign a...

Do Small Firms Benefit from Auditor Attestation of Internal Control Effectiveness?

SUMMARYWhile auditor attestation of the effectiveness of internal control over financial reporting (ICFR) is required for firms with a public float of at least $75 million (accelerated filers), the Securities and Exchange Commission (SEC) has delayed auditor attestation for non-accelerated filers several times. The Dodd-Frank Act of 2010 exempts non-accelerated filers from auditor attestation. We examine the relation between auditor attestation and revenue quality for a sample of non-accelerated filers and small accelerated filers. We find that discretionary (abnormal) revenues, our proxy for revenue quality, are lower by about 1.5 percent of total assets for accelerated filers relative to non-accelerated filers. This finding holds even among firms whose management has certified their ICFR to be effective. Overall, the findings support the notion that auditor attestation of the effectiveness of ICFR benefits small accelerated filers via higher revenue quality. We believe our findings are timely and potentially informative to regulators, investors, and others.

The Valuation Effect and Motivations of Voluntary Compliance with Auditor's Attestation Under Sarbanes-Oxley Act Section 404 (B)

On November 4th 2009, non-accelerated filers have been permanently exempted from compliance with SOX Section 404(b) (404 (b)) which called for independent auditor attestation. While compliance with 404(b) had never been mandatory, a number of companies voluntarily comply with it despite the compliance costs and risks associated with ICW discovery. This study develops a signaling model to explain what motivates non-accelerated filers to voluntarily comply with 404(b); examines the valuation effect of the permanent exemption; and examines the determinants of the valuation effects in terms of signaling effect, quality of firms’ internal control over financial reporting (ICOFR) and liquidity enhancement. We find evidence that auditor attestation serves as a signaling mechanism to certify firm quality of ICOFR; companies voluntarily submit to auditor’s attestation to signal their superior quality of ICOFR. This signal is credible because it’s costly, in terms of additional compliance costs and the risks of discovery of material weaknesses of internal control; companies that comply with 404(b) have lower bid-ask spread, less return volatility, followed by more analysts, more likely to be audited by Big4 auditing firms, higher liquidity, more effective internal control, and less restatements; market response to the announcement of permanent exemption is significantly negative and it’s more negative for non-compliance firms; cross-sectional and logistic regression reveals that voluntary compliance with 404(b) improves the quality of ICOFR, liquidity and signals firm superior quality.

Koss Corporation Case: Trouble in Brew City

ABSTRACT This instructional case provides auditing students an opportunity to examine an interesting real-life embezzlement and financial statement fraud occurring at a publicly traded company in the post-Sarbanes-Oxley (SOX) era. The case focuses on independent auditors' and senior management's reporting responsibilities related to internal control over financial reporting involving smaller public companies (nonaccelerated filers). While all public companies are subject to external auditor and management attestation on the effectiveness of internal control over financial reporting following SOX, the Securities and Exchange Commission (SEC) granted nonaccelerated filers numerous extensions for the effective date of required auditor attestation. In 2010, President Obama signed legislation to permanently exempt nonaccelerated filers from auditor attestation. The case also highlights inherent risk assessments by the independent auditor when one individual holds multiple C-level titles (Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, etc.) within the organization concurrent with membership on the board of directors, and requires students to recommend internal control policies and procedures designed to prevent or detect the embezzlement.

‘Post-Sarbanes–Oxley changes in the composition of boards: Have they impacted spending for audit services?’

The issue of the importance of the independent auditor's audit to the integrity of corporate financial statements has been a staple of the corporate governance and financial market functioning literature since the Securities Act of 1933 and the Securities Exchange Act of 1934. These acts required auditor attestation of corporate financial statements. Subsequent to the passage of the auditor attestation requirement, occasional financial reporting scandals erupted. None of these had the impact of the Enron/Worldcom scandals of 2001 and 2002. These scandals illustrated the ability of corporate management to game the corporation's financial statements, despite – or perhaps with the tacit concurrence of – the boards of directors of affected firms. Accordingly, much of the 2002 legal response to corporate financial reporting scandals came in the form of new corporate governance requirements on all publicly held firms. The impact of these requirements, however, differed between firms. Some firms had introduced use of independent directors and fully independent committees before their being made compulsory in 2002. One instrument of control over corporate management that the board of directors possesses, in actuality or potentially, is control of the extent of the work of the independent auditors. The auditors’ work can result in the board learning of accounting-related corporate mis-and malfeasance. Accordingly, the extent of the auditor's work is important and the obvious surrogate for this effort is the audit fee. This investigation examines the effect on spending by listed firms for audit services attributable to the Sarbanes–Oxley Act of 2002 and related stock exchange regulations. It uses the difference-in-differences methodology to overcome endogeneity concerns. The results reveal that firms that were compelled by law to change their boards increased their spending on financial statement-related audit services more than did firms that had pre-adopted the Sarbanes–Oxley corporate board composition requirements.

The Effect of SOX Section 404: Costs, Earnings Quality, and Stock Prices

ABSTRACTThis paper exploits a natural quasi‐experiment to isolate the effects that were uniquely due to the Sarbanes–Oxley Act (SOX): U.S. firms with a public float under $75 million could delay Section 404 compliance, and foreign firms under $700 million could delay the auditor's attestation requirement. As designed, Section 404 led to conservative reported earnings, but also imposed real costs. On net, SOX compliance reduced the market value of small firms.

Does Mandatory Audit Firm Rotation Improve or Impair Corporate Investment Efficiency?

We develop a framework with which to analyze the interactions among auditor attestation strategy, corporate investment decision, and capital market valuation. We use this framework to examine mandatory audit firm rotation (Section 207 of the Sarbanes-Oxley Act) and identify its three potential effects: the real (cash flow) effect; the attestation effect; the price effect. In particular, we show that mandatory audit firm rotation impairs corporate investment efficiency for firms with rosy prospects but improves corporate investment efficiency for firms with gloomy prospects.

Auditor Conservatism and Investment Efficiency

ABSTRACT: We develop a theoretical framework to investigate (1) both the determinants and the consequences of auditor conservatism in a capital market setting and (2) the implications of Section 201 of the Sarbanes-Oxley Act for auditor conservatism and investment efficiency. We derive three primary results. First, by adjusting the mix of audit and nonaudit fees, companies with high business risk induce auditor conservatism, while companies with low business risk induce auditor aggressiveness. Second, if auditor conservatism is in force, a greater client pressure on auditors improves audit quality; but if auditor aggressiveness is in force, a greater client pressure on auditors impairs audit quality. Third, the nature of a firm's investment inefficiency (overinvestment or underinvestment) depends on its auditor's attestation (conservative or aggressive). Our analysis also implies that a mandatory restriction of nonaudit services imposed by Section 201 may decrease audit quality and damage investment efficiency.

Costs to Comply with SOX Section 404

This study examines companies' costs to comply with SOX 404 and identifies factors that are associated with these costs. SOX 404 costs can be classified into three categories: internal labor costs, external consulting and technology expenses, and auditor attestation charges. While prior research has examined audit fees associated with SOX 404, we examine both total costs and auditor attestation costs associated with SOX 404. Based on a sample of companies that voluntarily disclosed SOX 404 cost information during the period from January 2003 to September 2005, we find that the mean (median) total compliance costs for Section 404 is $2.2 ($1.2) million. Regression analyses indicate that the total compliance costs are positively associated with firm size, the presence of material internal control weaknesses, the cost of setting up new computer systems and establishing formal internal control policies, the involvement of large auditors, the appointment of new CEOs, and are negatively associated with firms in regulated industries and firms that raised new financing. Firm size and the incidence of material weaknesses are also the drivers of SOX 404 audit costs, one component of total SOX 404 costs.