CBR Briefing #48

Mar 30, 2018

Sections Accounting

How regulation increases credibility
Public audit oversight enhances investor trust in financial reports

Investors reacted more strongly to earnings surprises following government inspections of public companies’ audit firms.
  • 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.