Credible Financial Statements Help Firms Raise Financing and Increase Investment

One of the primary purposes of financial statements is to facilitate the exchange of capital between investors and companies. The extent to which investors rely on the information reported in financial statements depends on the credibility of those financial statements – that is, the trust or faith investors have in the financial statements presented to them. Typically, companies establish the credibility of their financial statements by having an independent auditor verify the accuracy of those disclosures. However, the effect of auditing on financial statement credibility depends on the independence of the auditor and the rigor with which the audit is performed. An increase in reporting credibility can increase the degree to which investors rely on financial statement information for both writing debt (and other) contracts that govern the terms under which capital is exchanged and informing investors about companies’ operations and performance. As a result, an increase in reporting credibility can increase the company’s access to external finance, which can increase its ability to invest in new projects.

In this paper, I use the Public Company Accounting Oversight Board’s (PCAOB) international inspection program as a setting to examine the effect of financial reporting credibility on a company’s financing and investment decisions. The Sarbanes-Oxley Act of 2002 established the PCAOB to inspect the work of public accounting firms who audit the financial statements of companies registered with the Securities and Exchange Commission (SEC). 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. As a result, even though non-U.S. companies are not subject to any SEC/PCAOB regulation, their auditors can be subject to PCAOB inspections if the auditor has one or more clients that are cross-listed in the U.S.

While the PCAOB inspections of non-U.S. auditors do not extend to the audit engagements of non-U.S. companies not registered with the SEC, the inspections include an examination of the overall audit firm-level quality control systems. Specifically, the inspection of audit firm-level quality control systems is designed to evaluate the ‘tone at the top’ and increase confidence that there are systems/incentives in place to ensure that the auditor is independent of the client. Thus, the PCAOB inspections of non-U.S. auditors can serve as an exogenous shock to the financial reporting credibility of non-U.S. companies audited by inspected auditors but who are otherwise free of U.S. regulation.

The PCAOB international inspection setting offers a number of unique advantages that allow me to empirically identify the economic effects of reporting credibility using a difference-in-differences design. First, my treatment sample is comprised exclusively of non-U.S. companies that are free of SEC regulation; thus, any economic consequences of better reporting accruing to these companies are not confounded by the effects of other U.S. regulation. Second, the control sample is comprised of companies that operate in the same country as the treatment companies and thus are subject to the same economic and local regulatory environment as the treatment companies. Third, the PCAOB inspections are staggered over time and thus affect different companies at different points in time. As a result, the benchmark companies not only include companies whose auditors go untreated altogether but also companies whose auditors are not yet treated. Finally, using PCAOB inspections as shocks to reporting credibility side steps the need to explicitly measure this construct, which is notoriously hard to do, increasing the power of my design.

My results based on a difference-in-differences matching estimator suggest that when non-U.S. investors learn about the PCAOB inspection of a company’s auditor via the disclosure of the inspection report, the non-U.S. companies audited by inspected auditors increase their long-term debt by 11.5 percent and investment by 11 percent. Further, these treatment companies also observe an increase in investment efficiency as measured by their responsiveness to investment opportunities. The treatment effects are (i) stronger for financially constrained companies that face greater difficulty raising low cost external capital, and (ii) weaker for companies audited by one of the big-four auditors (i.e., Deloitte, Ernst & Young, KMPG, and PricewaterhouseCoopers) since such companies’ financial statements have higher ex ante reporting credibility by virtue of their auditors global reputation.

I also conduct additional tests that suggest that PCAOB inspections lead to improvements in the accrual quality of non-U.S. companies audited by PCAOB inspected auditors. These improvements in accrual quality occur at the time of the inspection, which is on average 2.5 years before the public release of the inspection report. Further, there is no subsequent improvement in accrual quality when the PCAOB inspection report is released to the public. Interestingly, the data reveal that companies do not change their financing or investing behavior following the inspection despite the increase in accrual quality; rather the financing/investing effects occur only after the public disclosure of the inspection many years later.

Overall, my results suggest that improvements in reporting quality might not have a measurable effect on a company’s financing and investment behavior which contrasts with prior accounting research. However, improvements in reporting credibility have significant effects on both a company’s ability to raise external financing and increase investment. I interpret these results as suggesting that reporting credibility increase companies’ access to external finance, which subsequently leads to an increase in investment and investment efficiency.

The evidence in this paper is important for at least two reasons. First, this paper documents and quantifies the importance of reporting credibility in the capital allocation process. Identifying the economic effects of reporting credibility is very challenging because it is inherently unobservable. The PCAOB inspection setting provides a rare opportunity to identify the economic effects of reporting credibility and also distinguish between reporting quality and credibility. Second, this paper sheds light on the importance of regulatory oversight of auditors. Most studies examining the effect of regulation face identification challenges because of the lack of an appropriate control sample. The PCAOB international inspection setting provides an opportunity to compare two companies that are located in the same country, subject to the same economic and local regulatory environment and are observably similar but are still subject to different levels of regulatory oversight because of their auditors’ other clients.

One word of caution before concluding: my inferences are based on a sample of non-U.S. companies that operate in countries with weaker regulatory and institutional environments than that in the U.S. Thus the results of this paper, especially the economic magnitude of the credibility effects, might not generalize to companies in the U.S.

The preceding post comes to us from Nemit Shroff, Associate Professor of Accounting at MIT Sloan School of Management. The post is based on his recent article, which is entitled “Real Effects of Financial Reporting Quality and Credibility: Evidence from the PCAOB Regulatory Regime” and available here.