Investor Perceptions of Government Deregulation: The Repeal and Replacement of Auditing Standard No. 2
41 Pages Posted: 21 Sep 2017
Date Written: September 20, 2017
We investigate the stock market’s reaction to events preceding the Public Company Accounting Oversight Board’s (PCAOB) decision to repeal and replace Auditing Standard No. 2 (AS2) with Auditing Standard No. 5 (AS5). AS5 was heavily debated in the business press and represented a form of deregulation for the auditing industry. The stated goal of AS5 was to reduce the costs of compliance with Section 404 of the Sarbanes-Oxley Act, while maintaining the effectiveness of the integrated audit of internal control over financial reporting (ICFR). We examine abnormal returns surrounding key dates leading to the passage of AS5, and offer two main findings. First, investors reacted negatively to key AS5 event dates, suggesting that investors viewed the deregulation as likely to reduce financial reporting quality rather than to drive audit efficiencies. Second, we find that the negative market reaction is larger when audit quality should matter most – when firms are larger, more complex, have higher litigation risk, and higher fraud risk. In additional analysis, we find that restatements increase in the post-AS5 time period, consistent with investors’ concerns that the effect of the legislation would be a reduction in audit effectiveness. Overall, our results suggest that, contrary to conventional wisdom, investors prefer stronger government regulation when it comes to the audits of public-company financial statements and internal controls.
Keywords: regulation; internal control quality; financial reporting quality; audit quality
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