The Value-Add of an Audit in a Post-SOX World

Abstract

Although researchers commonly acknowledge that public-company audits should add value by improving the precision of financial information via reduced estimation errors, prior literature correctly notes that there is little direct archival evidence to support this assertion. Moreover, regulatory changes beginning with SOX attempt to change managers’ behaviors by increasing their incentives to produce high-quality, low-error financial statements. If these regulations are effective in reducing pre-audit errors, then the role of the audit in error reduction will decline. Using the Amiram, Bozanic, and Rouen (2015) Financial Statement Divergence score as a measure of financial statement error, we examine the role of the audit in reducing public companies’ financial statement error in the post-SOX era. Despite substantial regulatory changes from SOX (and subsequent regulation) that might usurp from auditors the opportunity to improve financial statement precision, we find that an audit continues to be associated with reduced financial statement error and that the size of the effect is economically significant. More importantly, we find that this impact is magnified in the presence of observable company characteristics that increase the opportunity for error to occur (presumably because the audit plan can be adapted to mitigate the risks associated with these company characteristics). In the presence of increased incentives to misreport, the relation is attenuated, but only slightly—suggesting that the audit remains effective in reducing error even when managers have incentive to work at cross-purposes with auditors.

Keywords: Audits, Auditing, Financial Statement Error, Accounting Errors, Incentives, SOX, PCAOB, Earnings Quality, Earnings Management

JEL Classification: M41, M42