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Study: Credible auditors help companies raise funds

When company’s auditor gets OK from regulators, debt and investment rise

September 17, 2015

Associate Professor Nemit Shroff Associate Professor Nemit Shroff

Companies can expect to boost both long-term debt and capital expenditures by more than 10 percent once government regulators inspect and thus establish the credibility of the auditors that prepare their financial statements.

“Regulatory oversight of the auditor helps improve reporting credibility, which in turn facilitates corporate investment by increasing firms’ external financing capacity,” writes Nemit Shroff, an associate professor of accounting at the MIT Sloan School of Management, in a working paper [PDF].

The disclosure of these Public Company Accounting Oversight Board inspection reports, Shroff says, increases the credibility of financial statements for companies audited by board-inspected auditors. This, in turn, helps companies build “incremental trust” with investors who rely on those statements to decide whether to invest.

Strong impact on debt, investment

Shroff’s analysis, based on nearly 20,000 company-year observations across 22 countries, indicates that companies increase their long-term debt by 11.5 percent and their capital expenditure investment by 10.9 percent following the news that the company’s auditor was inspected by the board. The effect is more pronounced for companies that Shroff described as “financial[ly] constrained,” as well as for those not audited by one of the “Big Four” accounting firms of Deloitte, Ernst & Young, KMPG, and PricewaterhouseCoopers.

The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board to inspect the work of public accounting firms who audit the financial statements of companies registered with the Securities and Exchange Commission. This replaced the prevailing practice of peer-review of auditors.

Under Sarbanes-Oxley, foreign auditors are subject to board inspections if they audit foreign companies that raise capital in the United States and are therefore registered with the SEC.

This scenario presented Shroff with an opportunity to determine if an auditor inspection by the board and any subsequent activities had any economic significance for clients of the inspected auditors.

Since all U.S. companies are subject to Sarbanes-Oxley and board oversight, it’s unclear if a U.S. company’s changes in long-term debt and investment are the result of the auditor inspection, the other provisions of Sarbanes-Oxley, or larger macroeconomic trends, Shroff says. However, if two companies do business in the same country at the same time, and belong to the same industry, but only one has an auditor that is subject to oversight by the PCAOB, then it’s possible to determine if the release of a PCAOB report leads to better access to external funds and additional investment.

Shroff’s analysis compared the change in long-term debt and investment for a treatment company in the years before and after a board report became public to the change in long-term debt and investment for a control company not subject to a board report over the same timeframe.

Though the research examined companies outside the U.S., Shroff says his findings can be applied to American companies as well.

Audit credibility may have greater impact than audit quality

Research into the economic effect of report credibility marks an important step forward from existing literature that focuses largely on the effect of report quality. Improvements in reporting quality seem to go unobserved by investors until the PCAOB releases its inspection report, which typically takes more than two years.

“Unless investors know you’ve improved quality, it doesn’t make a difference,” Shroff says.

The PCAOB has come under criticism for the way it treats auditors and the focus of its inspections, but Shroff says his research points to a positive impact of the agency’s work.

“Having a public regulator oversee the auditing process can be beneficial in terms of increasing reporting credibility and ultimately facilitating firm financing and investment,” he writes.