Chan Li

Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements

We examine the impact of adverse auditors’ opinions on clients’ internal control over financial reporting (ICFR), issued under SOX Section 404, on auditor dismissals. Companies receiving adverse ICFR opinions are more likely to subsequently dismiss their auditors. This association between adverse reports and dismissals persists over a four year period beginning with the initial year of SOX 404 reporting. Our evidence also suggests that these dismissals tend to be part of clients’ efforts to improve their overall financial reporting. Clients receiving adverse reports are more likely to switch to higher quality auditors, as proxied by Big 4 membership and two measures of industry specialization, than are clients receiving favorable reports. Further, adverse opinion clients that dismiss auditors and then hire new auditors that specialize in the client’s industry are more likely to receive an improved ICFR report in the next year.

The consequences of information technology control weaknesses on management information systems: the case of Sarbanes-Oxley internal control reports

In this article, the association between the strength of information technology controls over management information systems and the subsequent forecasting ability of the information produced by those systems is investigated. The Sarbanes-Oxley Act of 2002 highlights the importance of information system controls by requiring management and auditors to report on the effectiveness of internal controls over the financial reporting component of the firms management information systems. We hypothesize and find evidence that management forecasts are less accurate for firms with information technology material weaknesses in their financial reporting system than the forecasts for firms that do not have information technology material weaknesses. In addition, we examine three dimensions of information technology material weaknesses: data processing integrity, system access and security, and system structure and usage. We find that the association with forecast accuracy appears to be strongest for IT control weaknesses most directly related to data processing integrity. Our results support the contention that information technology controls, as a part of the management information system, affect the quality of the information produced by the system. We discuss the complementary nature of our findings to the information and systems quality literature.

Are Auditors Professionally Skeptical? Evidence from Auditors’ Going-Concern Opinions and Management Earnings Forecasts

We examine whether auditors exercise professional skepticism about management earnings forecasts when making going-concern decisions. Using publicly issued management earnings forecasts as a proxy for earnings forecasts provided by managers to auditors, we find that management earnings forecasts are negatively associated with both auditors’ going-concern opinions and subsequent bankruptcy. The weight auditors put on management forecasts in the going-concern decision is not significantly different from the weight implied in the bankruptcy prediction model. Moreover, compared with the bankruptcy model, auditors assign a lower weight to management forecasts they perceive as being less credible, including those (1) issued by managers who issued optimistic forecasts in the previous two years, and (2) predicting high earnings increases or high earnings. Taken together, our evidence is consistent with auditors being professionally skeptical about management earnings forecasts when making going-concern decisions.

The Importance of Information Asymmetry to Auditor Choice, Audit Fees, and Going Concern Opinions: Evidence from Exploiting Exogenous Shifts in Analyst Coverage

We analyze whether information asymmetry affects three major aspects of the audit process using an instrumental variables research design that exploits exogenous increases in information asymmetry stemming from brokerage house mergers and closures. Consistent with our predictions, we find that a rise in information asymmetry leads to: (i) a higher (lower) probability that firms switch to a higher (lower) quality auditor, implying that information asymmetry stimulates demand for auditing, (ii) higher audit fees, implying that worse information asymmetry is a priced audit risk, and (iii) a higher probability that auditors render a going concern opinion, implying that auditors’ reporting decisions are sensitive to this risk. In another approach to confronting the endogeneity threat that undermines reliable identification in extant research, our core evidence holds in a difference-in-difference framework that involves examining the three auditing outcomes surrounding the brokerage house merger/closure window.

Executive Director Financial Expertise and IPO Performance

This study investigates the effects on initial public offering (IPO) outcomes of the existence and type of financial expertise (FE) of chief executive officers (CEOs) and chief financial officers (CFOs) serving on their own IPO firms’ boards of directors. For brevity we refer to these executives as executive directors. We investigate the effects of three types of executive director FE: that obtained via accounting-based, user-based, and supervisory-based work experience. We control for the effects of independent (non-executive) director FE disaggregated into the same three types of FE. The IPO-date outcomes examined include underwriting spread and first-day underpricing. We find that among executive directors, accounting-based FE is associated with improved IPO performance. It appears that executive directors having accounting-based experience use that knowledge and experience to decrease information asymmetry at IPO, leading to reduced underwriting spreads and lower underpricing of initial offerings. None of the three types of FE for independent directors helps to improve IPO-date outcome. We also find that the effect of executive directors’ accounting-based FE is stronger when they constitute a larger proportion of total IPO board members (i.e. when IPO firms’ boards are least independent).