How regulation increases credibility
Public audit oversight enhances investor trust in financial reports
- Government oversight and regulation is routinely disparaged in boardrooms, but research by Chicago Booth’s Christian Leuz and Mark G. Maffett and Booth PhD candidate Brandon Gipper suggests that investors trust a company’s accounting figures more if regulators are watching the company’s auditors—and this trust may carry significant capital-market benefits for the company.
- In the United States, audit firms of publicly-traded companies are subject to inspection by the Public Company Accounting Oversight Board (PCAOB), created as part of the Sarbanes-Oxley Act of 2002. The researchers examined the stock-market reaction to company earnings announcements before and after PCAOB inspections, using data from 2001 to 2008.
- They find that investors reacted more strongly to earnings surprises following government inspections of public companies’ audit firms. The stock-price response to high unexpected earnings was larger after PCAOB inspections than before inspections were carries out (see chart).
- The results suggest that strict government oversight of audits is not just about compliance costs; there is also a significant, quantifiable benefit to the company. Enhanced reporting credibility is priced in capital markets, reducing the company’s cost of capital.