Could changes in SEC policies reduce the chance of a stock crash or bankruptcies and possibly improve stock returns? What if higher quality audits resulted in incentives to benefit the long-term health of a firm?
Mikhail Pevzner, assistant professor of accounting at George Mason University School of Business, set out this summer to answer these questions with funding awarded by George Mason University and the School of Business.
Early Disclosure Could Improve Stock Returns
Pevzner examined the impact of delaying the disclosure of information about negotiated audit fees that could impact market participants. The dilemma is this: auditors are privy to confidential client information, which they cannot divulge. This information affects the auditors’ risk assessment. Meanwhile, the same information is released at the end of the firm’s fiscal year, which causes the market to potentially lose profit opportunities.
Pevzner said, “Audit fee changes potentially capture undisclosed private information known to the auditor and the client, but not to outside parties. This is because audit fees are negotiated in the early part of the year, but are not disclosed in the proxy statement until the end of the year. Hence, auditors have the ability to capture increases in firms' idiosyncratic risk in their fees before the rest of the market participants. Thus, if audit fees capture these special risks, early disclosure of the negotiated audit fees would be valuable information to market participants.”
Pevzner and his colleagues at Vanderbilt University, Nicole Jenkins and Karl Hackenbrack, examined this by looking at whether audit fee changes predict future changes in firm risk, particularly in the presence of stock crashes and extreme negative stock performance, and whether audit fee changes are associated with positive abnormal stock returns.
Pevzner said, “We also find evidence that audit fee changes are positively associated with the presence of contemporaneous and future securities litigation, and contemporaneous increases in implied probabilities of bankruptcy.”
To make changes to the current disclosure practice, the SEC could mandate earlier disclosure of negotiated audit fees. By making this change, the study suggests that this would decrease the frequency of crashes occurring.
Pevzner concluded, “Our results support the notion that prompt disclosure of this information would lead to a reduction in information opacity and perhaps more timely communication of changes in idiosyncratic risk.”
Effects of Higher Audit Quality
Pevzner is also researching whether higher audit quality could provide incentives to managers to reduce the manipulation of discretionary expenses.
Pevzner said, “In another project, we look at unintended consequences of higher audit quality. Prior research shows that higher audit quality reduces the extent of opportunistic accounting manipulation. However, higher audit quality does not remove managers’ incentives to take actions which can be detrimental to the long term health of their firms.” Prior research has already identified this as being an issue, but Pevzner and his colleagues Ling Lei (George Mason) and Wuchin Chi (National Chengchi University, Taiwan) delve into it to a deeper degree by examining various metrics of audit quality and their effect on real earnings management.
Reducing discretionary expenses (such as R&D, overproducing inventories, or pushing sales by reducing prices), has shown to be detrimental to firms in the long-term. Yet managers may manipulate these items since auditors have no influence over them. Whether higher quality audits, i.e. audits performed by auditor specialists, auditors with longer tenure, and bigger auditors, effectively provide managers with incentives to switch to such activities is not a well-examined question.
Although higher auditing quality may improve the long-term health of firms, Pevzner said, “Investors should be more aware of the potential "downsides" of better audit quality, i.e. better audits also have higher costs.”
Mikhail Pevzner has been with George Mason University since 2007. He specializes in empirical capital markets and auditing research. He has published papers in Contemporary Accounting Research and Journal of Accounting and Public Policy.