Prior research reveals that the accrual component of profitability is less persistent than the cash flow component, and that investors fail to fully appreciate their differing implications for future profitability (Sloan 1996). However, accruals are a component of growth in net operating assets as well as a component of profitability. Just as we can disaggregate profitability into accruals and cash flows from operations, we can disaggregate growth in net operating assets into accruals and growth in long-term net operating assets. We find that, after controlling for current profitability, both components of growth in net operating assets—accruals and growth in long-term net operating assets—have equivalent negative associations with one-year-ahead return on assets. This result is consistent with conservative accounting and diminishing marginal returns on investments. We also find that, after controlling for current profitability, the market appears to equivalently overvalue accruals and growth in long-term net operating assets relative to their association with one-year-ahead ROA. Our evidence suggests that the accrual anomaly documented in Sloan (1996) is a special case of what could be viewed as a more general growth anomaly.
An increasing number of firms have restated previously issued financial statements in recent years. Legislators, regulators, and others speculate that restatements are associated with fees received by auditors for nonaudit services (nonaudit fees). The current study provides empirical evidence on the association between firms that restate financial statements and the nonaudit service fees received by incumbent auditors during reporting periods that required restatement. We identify a sample of 110 firms that restated financial statements previously filed with the SEC for fiscal years 2000 or 2001, and provided relevant audit and nonaudit fee data. The SEC requires firms to disclose these fee data beginning in proxy statements filed on or after February 5, 2001. We compare the fees paid by the restatement sample with fee data for 3,481 firms that filed proxies with the SEC from February 5, 2001 to August 31, 2001 and develop benchmarks for expected nonaudit fees, fee ratio, and total fees. Using these benchmarks, we calculate the unexpected values for these measures and investigate whether restatement firms differ from the control firms. Our findings of no significant differences between the restatement and control samples for unexpected nonaudit fees, fee ratios, and total fees do not support concerns that either nonaudit fees or total fees inappropriately influence the audit and lead to restatements.
In this paper we investigate whether voluntarily disclosed reasons for auditor-client realignments (as encouraged by the SEC) have information content for investors. After classifying realignment reasons into two types—verifiable and non-verifiable, with the latter representing disclosures about the auditor-client relationship not evident from alternative sources—we find that, as predicted by the “good news” precept of theoretical signaling models, non-verifiable realignment reasons are positively associated at the time of their announcement with abnormal returns. We also investigate whether voluntarily disclosed realignment reasons are associated with the relative size of the predecessor or successor auditor. We find that clients are more likely to cite service-related (non-verifiable) reasons when dismissing large predecessor auditors, and are more likely to cite fee-related (non-verifiable) reasons when choosing small successor auditors. These findings are consistent with auditors competing for the clients of large auditors by offering better or broader services, and with smaller auditors competing based upon price. All of our findings are robust to controlling for mandatory auditor change disclosures (auditor-client disagreements, reportable events, and goingconcern opinions), and operating, financing, and investing activities found in prior research to be associated with auditor changes.
This study investigates the information content of FRR No. 31 reportable events (SEC 1988) communicated by auditors to clients in the two fiscal years and interim period preceding auditor changes. Reportable events identify weaknesses in internal control and problems related to the reliability of management representations and/or financial statement reliability. We examine 1,264 auditor changes (with available stock price data) over the period 1993 to 1996, including 118 companies with reportable events. Our findings suggest that reportable events disclosed in Form 8-K filings of auditor changes are considered by investors to have information content. We find a −2.75 percent (−5.53 percent) cumulative abnormal return over a three-day (seven-day) announcement period surrounding the disclosure of reportable events in Form 8-K filings. The conclusion that reportable events offer useful information to investors is robust to alternative specifications of expected returns and to controls for other disclosures (resignations and disagreements) made when auditor changes occur. Further tests also highlight differential information content among the types of reportable events. Specifically, stock prices act as if investors find reportable events about reliability issues more informative than reportable events about internal control weaknesses.
We document postevent negative abnormal returns to the (implicit) sell recommendations of a group of fundamental analysts. We also find statistically significant deterioration in the financial performance of the identified firms in the year after the recommendations. Together the results are consistent with the claim of fundamental analysts that they are able to identify firms that are successfully masking operational problems with aggressive accounting. The sample in this study comprises 373 firms identified over a four-year period by the Center for Financial Research and Analysis (CFRA). The CFRA offers to subscribers a monthly report identifying approximately 10 firms that CFRA claims are experiencing operational problems and particularly those that employ unusual or aggressive accounting practices to mask the problems. The CFRA analysts rely on traditional techniques of fundamental analysis, including mechanical screens and more time-consuming analyses of footnotes and other public disclosures. Their data sources include only publicly available information, primarily SEC filings. We conclude that CFRA's apparent success in identifying firms with deteriorating performance provides evidence about the usefulness of traditional financial statement analysis. The results also provide a strong rationale for future research to identify specific techniques of fundamental analysis that can be employed to detect operational problems masked by aggressive accounting practices.
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