Nathaniel M. Stephens

External auditor characteristics and internal control reporting under SOX section 302

Purpose - The purpose of this paper is to examine whether external auditor traits influenced the reporting of internal control deficiencies (ICDs) prior to SOX-mandated audits, holding constant the existence of a control weakness. Design/methodology/approach - Data are collected from publicly available sources such as Securities and Exchange Commission filings and Audit Analytics database. Findings - Companies that were audited by industry leading auditors were more likely to disclose ICDs prior to SOX-mandated audits and that companies with longer client-auditor tenure were less likely to disclose ICDs prior to SOX-mandated audits. Originality/value - These findings suggest that while external auditors were not required to participate in internal control evaluation and certifications prior to their audit of internal control for the 2004 fiscal year, they nevertheless influence the likelihood of ICD disclosure prior to their initial audit.

An Examination of Short-Selling Activity Surrounding Auditor Changes

Using a combination of short-selling data made available by Regulation SHO and auditor change data disclosed in companies’ SEC filings, we examine whether short sellers (a) discern between “good news” and “bad news” auditor changes and (b) increase their revenue by trading around auditor change announcements. We find that short sellers systematically increase activity following certain auditor changes, which include auditor downgrades (i.e., change from Big 4 auditor to non-Big 4 auditor), auditor resignations, and auditor changes involving a disagreement between management and the departing auditor. Our results indicate that short sellers are able to generate significant returns by systematically taking short positions pursuant to specific types of “bad news” changes.

Management Bias Across Multiple Accounting Estimates

We examine whether managers appear to aggregate bias in multiple subjective accrual estimates to meet or just beat analyst expectations. We also consider whether the updated language in recent PCAOB auditing standards, focusing auditors on the potential for bias across multiple estimates, impacted this method of managing earnings. Using hand-collected data from a sample of manufacturing firms, we find that meeting or just beating the most recent consensus analyst earnings forecast is positively associated with income-increasing bias aggregated from multiple accounting estimates. We also find that this relation attenuates in the years following the issuance of PCAOB auditing standards focusing auditors on this issue. Further analyses reveal that after these standards were released, firms increased the use of income-increasing, unexpected non-GAAP exclusions to meet or just beat expectations, an alternative technique subject to less auditor scrutiny. Additionally, firms using bias from multiple accounting estimates after the updated guidance in these PCAOB standards do so using bias spread in smaller amounts across more individual estimates. These findings provide important insight into how managers use accruals to meet or just beat an important benchmark as well as the impact of PCAOB auditing standard updates on this earnings management practice.