The media play an important role in capital markets. Media coverage can attract the attention of investors and the public at large and affect the decisions of management. As such, the media can have a corporate governance role in disciplining firms and their managers. For example, prior research indicates that, following negative media exposure, weak boards are more likely to take corrective actions such as replacing the CEO and board chair, increasing the proportion of outsiders on the board, and decreasing the use of staggered boards.

In a recent study, we investigate the possibility that, in addition to this direct role in corporate governance, the media has an indirect role that operates through auditors. In our framework, auditors care about their clients’ overall media coverage because it can magnify the auditor’s business risk through litigation risk and reputational damage. The increase in business risk arises because the media can identify fraudulent reporting, draw attention to the auditor’s involvement in an audit failure, or sensationalize the auditor’s role in the failure.

Consistent with this notion, anecdotal evidence indicates that news articles have been used as evidence in lawsuits against auditors. For example, in a class-action suit against Friedman’s Inc. and its auditor, Ernst & Young, the lead plaintiff included “review of news articles” as a source for evidentiary support. The plaintiff refers to specific articles in the complaint, e.g.:

110. The Atlanta Journal-Constitution published an article entitled “Woes Mount at Friedman’s Jewelry Retailer Faces Probes, Will Restate Earnings,” on November 28, 2003 that discusses Friedman’s restatement and accounting improprieties at great length. In the article, Paul Resnik, an analyst who covers Friedman’s for J.M. Dutton & Associates stated that “[s]omething is definitely very wrong here,” and that what was most surprising about the bad debt issue was that it surfaced less than two months after Friedman’s sold 3.1 million shares of common stock. “When people do any offering, the numbers get looked at by auditors and lawyers” Resnick pointed out. “Why was this not discovered before?” (In Re Friedman’s, Inc. Securities Litigation, No. 52-1, 1:03-CV-3475-WSD, N.D.G., September 23, 2004).

Not surprisingly, it is standard procedure for auditors to refer to media reports when assessing potential litigation and reputation risks associated with a client.

One way that auditors can respond to an increase in business risk is to increase audit effort, and audit fees, to reduce the probability of an audit failure. However, since we cannot observe audit effort directly, we focus on how an auditor’s effort affects the quality of its client’s financial reporting. That is, as an auditor increases effort (e.g., more evidence collection and more audit testing), tit are more likely to detect potential misstatements in a client’s financial reports. We expect that, if auditors increase their fees in response to greater media coverage, some of the fee increase will reflect a greater effort to improve clients’ financial reporting quality.

To examine whether media coverage indirectly affects financial reporting quality through auditors, we conduct a path analysis. Path analysis is an extension of multiple regression that allows researchers to consider more complex models that include both direct and indirect effects. Using data from Thomson Reuters News Analytics, we use the total number of news items reported about a client in a given year to measure media coverage. To measure financial reporting quality, we consider the absolute size of the client’s unexpected adjustments to accruals or the variation in the unexpected adjustments over time. Consistent with our expectation, we find that clients that have higher media coverage in the previous year have higher financial reporting quality in the current year. Further, we find that this effect runs through audit fees, consistent with the auditor’s exerting more effort in response to its client’s media coverage. On the other hand, we find no evidence of a direct effect where media coverage and financial reporting quality are related in the absence of the auditor’s intervention.

To strengthen our findings, we conduct additional analyses to ensure our results are not purely driven by the potential influence of variables omitted from our model. For example, we conduct a quasi-natural experiment relying on an exogenous shock that changed media coverage for some client firms. The shocks we utilize are two local newspaper closures in Colorado and Maryland. On February 27, 2009, the Rocky Mountain News, a daily newspaper published in Denver, Colorado, announced its closure, leaving the Denver Post as the sole large-circulation daily. On February 15, 2009, the Baltimore Examiner, one of the two big dailies in Baltimore, Maryland, published its last issue. We contend that the closures of these two, major local newspapers reduced the media coverage of firms located in Colorado and Maryland but did not affect the media coverage of firms in other states. Our results indicate that the indirect media effect on clients’ financial reporting quality is stronger in Colorado and Maryland than in other states after the newspaper closures.

Overall, the results of our study provide a different perspective on the media’s corporate governance role. In contrast to prior research, which documents that the media have a direct corporate governance effect on firms’ behavior, we find that, in an accounting context, the media have an indirect corporate governance role that operates through auditors. Our findings will be of interest to investors and regulators who have to evaluate the financial reports of firms that are in the media spotlight.

This post comes to us from professors Steven Cahan at the University of Auckland, Chen Chen at Monash University, and Rencheng Wang at Singapore Management University. It is based on their recent article, “Does Media Exposure Affect Financial Reporting Quality Through Auditors?” available here.