No abstract

SUMMARY In this study, we examine the proposition that the auditor's going-concern modified opinion is a valuable risk communication to the equity market that results in a shift of the market's perception of financially distressed firms. Specifically, our analyses reveal that the market valuation is significantly altered from a focus on both the income statement and balance sheet to a balance sheet-only focus in the year a company receives a first-time going-concern modified opinion. These results hold even after controlling for several common measures of financial distress and when examining a larger control sample of distressed firms. We also document that the market devalues a company's inventory and places increased weight on cash, receivables, and long-term assets and liabilities as a result of the auditor's modification. This indicates that the going-concern modification provides incremental information specifically related to abandonment or adaptation risk. Our results provide evidence that the market interprets the going-concern modified audit opinion as an important communication of risk that results in a substantial shift in the structure of the market valuation for distressed firms. Data Availability: All data are available from public sources. JEL Classifications: M41.

The recent passing of the Sarbanes-Oxley Act of 2002 resulted in restrictions being placed on the so-called “revolving door,” where a company hires a senior financial reporting executive directly from its external audit firm. This legislative action, despite a lack of empirical research into the practice, reflects concerns about possible impairment of auditor independence through the hiring of personnel from the company's external auditor. Our study examines a sample of firms where financial reporting executives such as the CFO, VP-Finance, or Controller were hired by a public company directly from their external audit firm. Our results indicate that earnings management, in the form of increased accounting accruals, is no greater immediately before or after hiring in the companies engaging in this hiring practice compared to three separate control groups hiring individuals from other sources or retaining their incumbent financial reporting executives. We also find that changes in accruals surrounding the hiring of these former auditors is relatively stable over the 11-year period studied. Overall, our results with respect to changes in levels of reported accounting accruals generally do not support regulators' concerns of significantly impaired auditor independence in these hiring situations.

The Sarbanes-Oxley Act (SOX) restricted the hiring of accounting and finance officers directly from a company's external audit firm, reflecting concerns that such "revolving door" appointments had impaired the quality of audited financial statements. However, it was also argued that companies may have benefited from hiring individuals already familiar with their systems, organization and personnel. To determine how shareholders viewed revolving door appointments, we examine three-day cumulative abnormal returns around the announcements of newly appointed accounting and finance officers. We find that the proportion of revolving door hires is low (only 6.1 percent of all hires in our sample) and that the market valued the revolving door appointments more positively than other appointments. Further tests reveal that the positive market reaction to revolving door appointments is driven mainly by smaller companies, and that revolving door appointments are not associated with higher levels of subsequent discretionary accruals and are negatively related to a company's subsequent receipt of an Accounting and Auditing Enforcement Release (AAER). Overall, the low frequency of occurrence, investors' positive perceptions, and the lack of association with deteriorated reporting quality indicate that the SOX restriction on revolving door appointments may do little to protect shareholders. Classification codes: G38, M42

Newly public companies must disclose significant risk factors in the offering prospectus. These disclosures are examples of “soft” or ambiguous information. Ambiguity models predict that investors will alter their portfolio weights and react to subsequent signals about such information. We test for these effects in a sample of 1,398 initial public offerings (IPOs) using word count ratios between soft and hard information as measures of ambiguity. We find a significant relationship between the soft information on risk and both initial and ex post measures of returns. These results support the view that soft information embeds ambiguity and that it influences investors’ portfolio choices.