Market Reaction to the PCAOB’s Inability to Conduct Foreign Inspections
Joseph V. Carcello (corresponding author)
University of Tennessee
601 Stokely Management Center
Knoxville, TN 37996
jcarcell@utk.edu
(865) 974-1757 (phone)
(865) 974-4631 (fax)
Brian T. Carver
Mississippi State University
P.O. Box EF
Mississippi State, MS 39762
bcarver@cobilan.msstate.edu
(662) 325-1632 (phone)
(662) 325-1646 (fax)
Terry L. Neal
University of Tennessee
601 Stokely Management Center
Knoxville, TN 37996
tneal3@utk.edu
(865) 974-2664 (phone)
(865) 974-4631 (fax)
Acknowledgements: We thank Reneé Adams, Bruce Behn, Scott Bronson, James Chyz,
Brandon Cline, Larry Fauver, Rani Hoitash, Carl Hollingsworth, Ken Lehn, Ken Roskelley, and
Susan Scholz and seminar participants at the University of Missouri’s corporate governance
conference for their helpful comments.
1
Market Reaction to the PCAOB’s Inability to Conduct Foreign Inspections
ABSTRACT: This paper investigates the potential costs to investors of the Public Company
Accounting Oversight Board’s (PCAOB’s) inability to conduct inspections of foreign audit
firms. Specifically, we examine the stock market reaction of companies audited by noninspected foreign audit firms to a series of disclosures by the PCAOB relating to its difficulties in
conducting foreign inspections in European Union countries, Switzerland, China, and Hong
Kong. We find a significant negative stock market reaction, in both the univariate and
multivariate settings, to the PCAOB’s initial disclosure in August 2009 of the names of foreign
auditors that had not been inspected by the PCAOB. These results are driven by companies with
a China-based auditor. Further, we find univariate and multivariate evidence of a significant
negative market reaction to the Board’s February 2010 disclosure of additional audit firm names
(i.e., not named in the August 2009 disclosure) that had not been inspected by the PCAOB. In
addition, we find univariate, but not multivariate, evidence of a significant negative market
reaction to the Board’s May 2010 disclosure of company names whose auditor is located in a
country that does not permit PCAOB inspections. Finally, in both the univariate and multivariate
settings, we find evidence of a significant positive market reaction to the PCAOB’s January 2011
disclosure that registered U.K. audit firms would now be subject to inspection. Together, the
negative market reactions to the Board’s disclosure of its inability to inspect audit firms located
in certain foreign countries and the positive market reaction to the Board’s subsequent disclosure
that inspections would now be permitted in a country (U.K) that previously blocked inspections
provide evidence that the significant resources devoted by the PCAOB to its inspection program
are valued by market participants.
2
1. Introduction
“Investors are willing to pay a premium for shares purchased in U.S. markets and
protected by strong securities regulation and enforcement. The premium will only
survive, though, if investors believe U.S. investor protections are actually enforced. The
laws on the books, including oversight of auditors, won't continue to make a difference
for non-U.S. companies if they don't comply” (Doty, 2011).
“We’re at a time where the integrity of the financial statements of so many companies
has been challenged, that the natural place to look for some reassurance is the regulator
with oversight responsibility,” said Jacob Frenkel, a former SEC lawyer … “But if the
regulator cannot oversee, that in and of itself diminishes confidence” (our emphasis)
(Bloomberg, 2011).
Based on the above quotes, including one from the Chairman of the Public Company
Accounting Oversight Board (PCAOB or Board), we expect the market to react negatively to the
disclosure that certain foreign governments are not allowing the PCAOB to conduct inspections
of audit firms within their borders, given that Board inspections of auditors is the prime
mechanism through which the PCAOB oversees auditors.
We examine whether the market values PCAOB inspections of foreign audit firms by testing
whether there is an abnormal U.S. stock market reaction to a series of PCAOB disclosures
relating to its difficulties in conducting inspections in certain foreign countries. First, in August
2009, the PCAOB disclosed the names of registered foreign audit firms that had not been
inspected, even though the statutory deadline for conducting an inspection had passed. Second,
in February 2010, the PCAOB disclosed the names of additional registered foreign audit firms
that had not been inspected. Third, in May 2010, the PCAOB disclosed the names of foreign
registrants (hereafter companies) whose auditor was located in a country that denied the Board
the ability to conduct an inspection.1 Finally, in January 2011, the PCAOB disclosed that it had
1
The PCAOB released the names of audit firms in August 2009 and February 2010 where more than four years had
passed since the end of the calendar year when the audit firm had first issued an audit report while registered with
the PCAOB. In May 2010 the Board released the names of all companies whose auditor is located in a country that
1
reached an agreement with authorities in the United Kingdom (U.K) that would permit the Board
to inspect U.K.-based registered audit firms.
The issue of whether the market values PCAOB inspections is important because the
market’s reaction to the absence of an inspection provides some measure of the cost to investors
of the Board’s inability to conduct inspections of foreign audit firms and, thus, an indication of
the appropriateness of the Board’s actions in attempting to perform foreign inspections. The
Sarbanes-Oxley Act (SOX, 2002) requires the PCAOB to inspect registered accounting firms,
regardless of the accounting firm’s domicile, yearly if the accounting firm audits more than 100
issuers or triennially if the accounting firm regularly audits one or more issuers,2 but the
governments of the EU-member states, Switzerland, and China (including Hong Kong if any of
the auditor’s clients have operations in mainland China) have denied PCAOB inspectors the
ability to inspect audit firms domiciled in these areas (Goelzer, 2010a).3 PCAOB board
members and PCAOB advisory groups view the Board’s inability to inspect foreign audit firms
as a serious threat to the ability of the Board to fulfill its statutory mission (Goelzer, 2010b;
Carcello et al., 2010) to “protect the interests of investors and further the public interest in the
preparation of informative, accurate and independent audit reports” (SOX, 2002). This position
is indirectly supported by Dee et al. (2011), who imply that investors value the PCAOB
inspection process for domestic firms. The perceived value of PCAOB inspections of foreign
audit firms, however, remains an open question.
denies the Board access to conduct inspections (e.g., EU countries, Switzerland, and China (including Hong Kong))
regardless of whether the auditors for these companies were yet scheduled for their inspection.
2
The PCAOB has expanded the SOX requirement to conduct inspections to also include accounting firms that play
a substantial role in the preparation or furnishing of an audit report with respect to at least one issuer (PCAOB Rule
4003).
3
As of December 31, 2010, the PCAOB has conducted inspections in 35 foreign jurisdictions, including Argentina,
Australia, Canada, India, Israel, Japan, Korea, Mexico, New Zealand, Norway, Russia, Singapore, South Africa, and
Taiwan (see http://pcaobus.org/International/Inspections/Pages/default.aspx).
2
Since the PCAOB is in some sense the “auditor of the auditors,” the Board’s inability to
conduct inspections in certain countries might suggest that audit quality is lower in these
countries. Prior research finds that audit quality affects financial reporting quality (Becker et al.,
1998; Francis et al., 1999). To the extent that financial reporting quality is affected by audit
quality, information risk should increase where auditor performance is not subject to evaluation
and to efforts to remediate deficient quality. As a result of increased information risk, investors
should apply a higher discount rate to evaluate the present value of the cash flow stream
associated with an equity investment. Prior research finds that disclosure quality and the quality
of accounting information affect a company’s cost of capital (Botosan and Plumlee 2002;
Lambert et al. 2007). Moreover, Easley and O’Hara (2004) demonstrate analytically that
information quality affects asset prices, and Easley et al. (2002) confirm that this result holds in
an empirical setting. Easley and O’Hara (2004) particularly demonstrate that information quality
matters to uninformed investors, and U.S. investors in foreign equities are more apt to be
uninformed than U.S. investors in domestic equities or foreign investors in foreign equities.4
Therefore, when the PCAOB discloses its inability to inspect certain foreign auditors, we expect
the stock price of companies audited by these firms to decline.
Consistent with our expectations, we find a significant negative abnormal stock market
reaction to the PCAOB’s August 2009 disclosure of the names of foreign auditors that had not
been inspected even though the statutory deadline for conducting an inspection had passed. That
is, companies audited by these non-inspected auditors experience a significant negative abnormal
return. Importantly, the negative abnormal return experienced by companies audited by noninspected auditors is significantly more negative than the abnormal return experienced by our
4
For example, Ayers et al. (2011) find that the ability of institutional investors to monitor financial reporting quality
is affected by the geographic distance between the institutional investor and the company.
3
control group of cross-listed companies audited by an auditor located in a foreign country that
permits PCAOB inspections. Our results hold in a multivariate model where we control for other
determinants of stock market return. Further analysis suggests these results are driven by noninspected audit firms from China. That is, when we separately analyze the non-inspected audit
firms – those firms located in China and firms located in other countries that do not permit
PCAOB inspections, we find a significant negative abnormal stock price reaction for companies
audited by China-based auditors but no significant abnormal stock price reaction for companies
audited by firms located in other countries that do not permit inspections.5
We find a significant negative abnormal stock market reaction to the PCAOB’s February
2010 disclosure of the names of additional foreign auditors that had not been inspected even
though the statutory deadline had passed. Additionally, the negative abnormal return was
significantly more negative than returns experienced by our control group in two out of the three
event windows tested. More importantly, in our multivariate tests, we find that companies
audited by these non-inspected auditors experience a significant negative abnormal return. Since
no additional non-inspected auditors from China were disclosed in the February 2010
announcement, these results are unrelated to companies using a China-based audit firm.
In addition, we find a significant negative abnormal stock market reaction to the PCAOB’s
May 2010 disclosure of the names of foreign companies whose auditor is located in a country
that does not permit PCAOB inspections and where these companies could not be explicitly
linked6 to their auditor based on the Board’s August 2009 or February 2010 disclosures.
5
The lack of an abnormal stock price reaction for companies audited by firms located in countries, besides China,
that do not permit inspections may be due to a lack of power. The PCAOB’s August 2009 announcement only
included 22 companies with auditors located in a country, other than China, that do not permit inspections.
In the PCAOB’s May 2010 press release, the Board named all foreign companies registered with the SEC whose
auditor was located in a country that does not allow PCAOB inspections regardless of whether the auditor was
previously named in either the Board’s August 2009 or February 2010 press releases.
6
4
However, the negative abnormal return was significantly more negative than the abnormal
returns experienced by our control group in only one out of the three event windows tested, and
we fail to find a difference in stock market reaction in our multivariate model. It is important to
note that by May 2010 the Board’s inability to conduct inspections in certain foreign countries
had been well publicized, and companies audited by a firm located in a country that does not
permit PCAOB inspections -- even though the auditor had not yet been named by the Board
because the auditor was not yet due for its inspection -- may have already been determined by
market participants.
Finally, although we do not find a significant abnormal positive market reaction to the
PCAOB’s January 2011 disclosure that registered U.K. audit firms would now be subject to
inspection, a comparison of the abnormal stock market reaction for companies using a U.K.
auditor to our control group indicates that the abnormal stock market reaction for companies
using a U.K. auditor is significantly more positive than for our control group. This result holds
in a multivariate setting.
Overall, our results indicate that the market reacts to the absence of a PCAOB inspection for
companies in a manner consistent with the market viewing PCAOB inspections as value
enhancing. This result is important given the substantial resources the PCAOB devotes to its
inspection program, and supports the Board’s continuing efforts to seek cooperation from foreign
countries in allowing the Board to conduct inspections and, where that cooperation is not
forthcoming, to publicize the names of foreign auditors and their SEC registered clients.
The rest of the paper is organized as follows. In the next section, we provide further
institutional background on the PCAOB inspection process, including challenges the Board has
experienced in conducting foreign inspections in certain countries, and we develop our research
5
expectations. Section 3 presents our research method, and Section 4 includes our results.
Section 5 presents additional analyses and robustness tests. The last section includes a summary
and a discussion of the paper’s implications and limitations.
2. Background and research expectations
2.1 PCAOB inspection program
Although the PCAOB has responsibilities related to registration, standard setting, and
enforcement, the Board believes that its inspection process is its primary vehicle for improving
the quality of auditing practice (Gillan, 2005; Goelzer, 2006; McDonough, 2005). As discussed
previously, PCAOB inspections are conducted yearly for audit firms that audit more than 100
issuers annually and triennially for firms that have audited, or played a substantial role in
auditing, at least one issuer during the preceding three years (PCAOB Rule 4003). The PCAOB
inspection process is quite robust in that: (1) PCAOB inspectors are full-time employees of the
Board and the inspected firm has no voice in choosing the inspectors assigned to their
engagement, (2) the PCAOB can devote the resources needed to perform thorough firm
inspections since the Board sets its own budget, and (3) the PCAOB can inspect all of a firm’s
engagements, even those engagements subject to litigation or enforcement actions (Goelzer,
2006). Finally, the scope of a PCAOB inspection is quite extensive, including reviewing: (1) the
firm’s compliance with GAAP, PCAOB auditing standards and rules, rules of the U.S. Securities
and Exchange Commission (SEC), and the firm’s own quality control guidelines (Gillan, 2005),
(2) firm management, including how employees are selected, trained, monitored, and rewarded
(Gillan, 2005), and (3) a large sample of audit engagements, using a risk-based methodology to
identify those engagements most likely to contain errors (McDonough, 2005). In addition, if a
Board inspection finds poor quality work, the inspectors will review additional audits involving
that partner and engagement team (McDonough, 2005). Moreover, extant research finds that the
6
PCAOB inspection process is rigorous (Lennox and Pittman, 2010), that PCAOB inspections
improve audit quality among smaller auditors (DeFond and Lennox, 2011), that PCAOB
inspection reports are correlated with the quality of an audit firm’s practice (Gunny and Zhang,
2009), and that the market for audit services is, in certain circumstances, sensitive to the nature
of the inspection report issued (Abbott et al., 2008). In addition, Carcello et al. (2011) find that
the PCAOB inspection process is associated with an improvement in audit quality.
Lennox and Pittman (2010) conclude that “PCAOB inspectors are tougher than peer
reviewers in terms of detecting and reporting problems at audit firms” (p. 89), as 27 percent of
the 545 inspection reports issued by the Board through December 31, 2007 reported multiple
audit firm deficiencies. DeFond and Lennox (2011) find that PCAOB inspections improve audit
quality among smaller auditors (auditors with fewer than 100 SEC clients). Gunny and Zhang
(2009) find that clients of auditors receiving inspection reports with serious (GAAP-based)
deficiencies have a higher level of income increasing current accruals and are more likely to
restate their financial statements than are auditors receiving inspection reports with no
deficiencies identified (a clean inspection report). Abbott et al. (2008) find that companies with
a higher level of agency costs and with better audit committees are more likely to switch auditors
if the auditor receives an inspection report with a serious (GAAP-based) deficiency than a clean
inspection report.7 Moreover, Carcello et al. (2011) find a significant decline in client abnormal
accruals in the year after the first two PCAOB inspections of Big 4 firms and that this result is
stronger for those auditees reporting positive abnormal accruals before the first PCAOB
7
Lennox and Pittman (2010) fail to find a relation between deficiencies identified in PCAOB inspection reports and
auditor changes. Although Lennox and Pittman and Abbott et al. (2008) find different results as to the relation
between PCAOB inspection reports and auditor changes, they make a number of different design choices. For
example, Abbott et al. examine the relation between inspection reports and auditor changes contingent on the level
of agency variables and audit committee characteristics whereas the Lennox and Pittman paper examines the relation
between inspection reports and auditor changes on an overall basis. In addition, Lennox and Pittman consider both
Big 4 and non-Big 4 firms, whereas the Abbott et al. analysis is based on non-national CPA firms.
7
inspection. These results suggest that the PCAOB’s inspection process is rigorous, that it
improves audit quality, and that the market for audit services reacts to these inspection reports.
Finally, Dee et al. (2011) find a significant negative stock market reaction for clients of Deloitte
after a PCAOB enforcement action, and these authors attribute this result primarily to the
revelation of deficiencies in Deloitte’s quality control procedures that would be included in part
II of a PCAOB inspection report.8 However, these prior studies were based primarily, if not
exclusively, on public companies domiciled in the United States.
2.2 Foreign inspections
The PCAOB is required by SOX to inspect audit firms even if the auditor is not
domiciled in the U.S.9 As stated previously, the PCAOB has been denied the ability to conduct
inspections by the governments of EU-member states, Switzerland, and China (including certain
audit firms in Hong Kong).10 As of April 27, 2010, 932, or 38 percent, of the 2,478 firms
registered with the PCAOB were domiciled in foreign countries (Carcello et al., 2010).
Approximately 200 of these foreign auditors would be subject to inspection on a triennial basis
8
Part I of PCAOB inspection reports include accounting and auditing deficiencies identified on specific audit
engagements and part I findings are public. Part II reports deficiencies in the audit firm’s system of quality control
and remains private if the audit firm remediates these deficiencies to the Board’s satisfaction within one year (SOX
2002).
9
Although audit regulatory bodies exist in European Union countries, China, and Switzerland, these regulatory
bodies are sometimes not independent of the accounting profession, the resources devoted to the inspection process
are much smaller than the resources devoted by the PCAOB and, as a result, the number and rigor of inspections are
less (Carcello et al., 2010). As a result, we do not expect investors in U.S. markets to view oversight by foreign
audit regulators as an effective substitute for PCAOB inspections.
10
On January 10, 2011 the PCAOB announced an agreement with the auditor oversight body in the United
Kingdom, the Professional Oversight Board, that will allow the PCAOB to inspect U.K. audit firms that are
registered with the PCAOB. We examine the stock market reaction to this agreement later in the other analyses
section of the paper. In addition, on April 6, 2011 the PCAOB announced a similar agreement with the auditor
oversight body and securities regulator in Switzerland. We do not examine the stock price reaction to the Board’s
agreement with the Swiss regulators as there are only eight SEC registered foreign companies with an auditor
domiciled in Switzerland.
8
(Carcello et al., 2010).11 As of December 31, 2009, approximately 70 of these 200 foreign
auditors had yet to be inspected even though more than four years had passed since the end of the
year in which the auditor first issued a report while registered with the PCAOB (Carcello et al.,
2010). Moreover, foreign companies are typically audited by non-U.S. auditors and the total
market capitalization of foreign companies listed in the U.S. is significant – for example, the
total market capitalization of foreign companies from the European Union, Switzerland, and
China and Hong Kong are over $500 billion, $75 billion, and $75 billion, respectively (Carcello
et al., 2010). In addition, the audit work for foreign subsidiaries of U.S.-based multinationals is
typically performed by non-U.S. based auditors. This amount of audit work is likely significant
given the mean revenue from foreign operations to total revenue of Fortune 100 companies
reporting international revenues is approximately 36 percent (Carcello et al., 2010). Taken
together, the number of foreign auditors that have not yet been inspected and the scope of audit
work performed by these auditors for foreign and domestic issuers may expose U.S. investors to
the risk of substandard audit quality and, consequently, the risk that financial information is of
lower reliability.
In cases where the PCAOB cannot conduct an inspection, the Board has the statutory
authority to deregister an audit firm. Since any issuer registered with the SEC must have an
audit conducted by a firm registered with the PCAOB, deregistering an audit firm would be
tantamount to causing clients of the deregistered audit firm to violate SEC rules and exchangelisting standards and could result in these issuers being delisted from U.S. exchanges. Such a
step could lead to non-trivial economic and political repercussions. As a result, the PCAOB has
chosen a more measured approach in dealing with audit firms where the Board has been denied
11
A large number of audit firms registered with the PCAOB, both foreign and domestic, do not audit any SEC
registrants, or play a substantial role in auditing any SEC registrants, and are therefore not required to be inspected.
9
the ability to conduct inspections. The PCAOB initially delayed the deadline for conducting
these inspections (PCAOB 2008, 2009a). Then, in August 2009 and February 2010, the PCAOB
released the names of registered accounting firms where a required inspection had not yet been
performed even though more than four years had passed since the end of the calendar year when
the audit firm had first issued an audit report while registered with the PCAOB (i.e., the statutory
inspection time period) (PCAOB 2009b, 2010a).12 Finally, in May 2010, the Board released the
names of issuers registered with the SEC whose audit firm was located in a country that denies
the Board the ability to conduct inspections (PCAOB 2010b).13
2.3 Research expectations
Given that prior studies find that PCAOB inspections are rigorous (Lennox and Pittman,
2010), are associated with client financial reporting quality (DeFond and Lennox, 2011; Gunny
and Zhang, 2009), and are related to improvements in client financial reporting quality (Carcello
et al., 2011), we expect investors to value the PCAOB inspection process. Moreover, Dee et al.,
(2011) provide indirect evidence that investors value the PCAOB inspection process for
domestic firms. Dee et al. interpret the negative abnormal stock market reaction experienced by
Deloitte clients after a PCAOB enforcement action as driven by the market’s receipt of new
information related to quality control defects in Deloitte’s practice, revealed when the Board
Audit firms named in the PCAOB’s August 2009 press release should have been inspected by December 31, 2008,
and firms named in the Board’s February 2010 press release are additional firms that should have been inspected by
December 31, 2009 (i.e., the audit firms listed in each press release are different). See Exhibit 1 for additional
description of the auditors / companies included in each of the three PCAOB press releases (disclosures) that we are
examining.
12
Companies named in the PCAOB’s May 2010 press release include all SEC registrants whose auditor is located in
a country that does not permit PCAOB inspections, regardless of whether the audit firm was included in either the
Board’s August 2009 or February 2010 announcements. An audit firm may not have been included in either of
these previous announcements because the statutory period for conducting the PCAOB inspection had not yet lapsed
as of December 31, 2009.
13
10
published its enforcement release against Deloitte. While quality control defects are not publicly
disclosed in PCAOB inspection reports, the Board’s identification of quality control defects
during its inspection process results in these defects being remediated, or, when not remediated,
these defects are publicly disclosed in the next PCAOB inspection report. As such, the Board’s
identification of quality control defects creates a powerful incentive for firms to remediate these
defects, which serves to improve audit quality. 14 Thus, the role of the PCAOB inspection
process in identifying and remediating audit firm quality control deficiencies appears to be
valued by the market as evidenced by the stock market reaction to new information about
Deloitte’s quality control deficiencies included in the PCAOB enforcement release. However, if
the Board is denied the ability to conduct inspections of foreign audit firms, quality control
problems in these firms are less likely to be identified and are therefore less likely to be
remediated.
While investors may value the PCAOB inspection of domestic audit firms, they may
place an even greater value on the inspection of foreign audit firms because other mechanisms to
monitor audit firms may be weaker in Europe and China and, at least for China, the audit
profession is less developed than it is in the U.S. For example, La Porta et al. (1998) find that
investor rights are weaker in continental European countries, the majority of the countries
denying the PCAOB inspection rights, than in the U.S., and Doidge et al. (2004) conclude that
investors are extremely well protected in the U.S. compared to the rest of the world.15 In
14
No large firm has ever had quality control defects identified by the PCAOB in an inspection report. Therefore, it
appears that quality control defects identified by the Board’s inspection process were always sufficiently remediated
by the audit firm.
15
Although all of the companies in our sample are registered with the SEC, most of our sample companies are
foreign, and the protections afforded investors in these foreign companies are generally weaker than the protections
afforded investors in entities with U.S. auditors. Many of the governance protections afforded U.S. investors are a
function of state corporate law but foreign companies typically do not reincorporate in a U.S. state (Doidge et al.,
2004). Moreover, protections afforded investors under U.S. federal law may be less effective for investors in
11
addition, the threat of litigation acts as a deterrent to substandard audit practice, and the litigation
exposure of accounting firms in continental Europe is much lower than in the U.S. (Mueller et
al., 1994). Given these differences between foreign markets and the U.S., investors may be more
reliant on external audits in foreign countries as compared to the U.S., because other protections
afforded investors are weaker; however, the quality of external audits in these foreign countries
may be lower than in the U.S. due to the weaker threat of litigation against the audit firm.
Hence, investors may be particularly dependent on the actions of regulators to ensure audit
quality, with the PCAOB now being the primary regulator of the public accounting profession.
Moreover, unlike the U.S., the accounting profession is not well developed in China – there is
both a shortage of professionally qualified auditors and a culture of investor protection that is not
institutionalized (Pierce, 2006; Ryan, 2008; McMahon and Rapoport, 2011). Thus, in countries
where the audit profession is less developed, the need for active regulatory oversight to ensure
audit quality is more pronounced. Therefore, when the PCAOB discloses the names of auditors
that are located in countries that deny the Board the ability to conduct an inspection, we expect
companies audited by these firms to experience a significant negative abnormal stock price
reaction.
Our primary test of the market’s reaction to the PCAOB’s disclosure of the noninspection of certain foreign registered auditors is based on the Board’s August 2009 disclosure.
The Board’s August 12, 200916 disclosure serves as the basis for our primary tests because this
foreign companies cross listed in the U.S. because collecting a judgment awarded by a U.S. court may be difficult
where the firm’s U.S. assets are small relative to the damages (Siegel, 2003). In addition, a recent U.S. Supreme
Court decision has made it increasingly difficult for shareholders to apply U.S. federal securities law on an
extraterritorial basis (Morrison v. National Australia Bank, 2010).
The PCAOB’s disclosure on August 12, 2009 was released after the markets closed in New York. As a result, we
use August 13, 2009 as day 0. The PCAOB’s disclosures on February 3, 2010 and May 18, 2010 also were released
after the markets closed in New York; therefore, we use February 4, 2010 and May 19, 2010 as day 0 in testing these
PCAOB disclosures.
16
12
disclosure was the first time the Board specifically identified either auditors or companies that
had not been inspected because of difficulties encountered with certain foreign governments in
conducting inspections. Although the Board’s August 2009 announcement serves as the basis
for our primary analysis, we also test the market’s reaction to the PCAOB’s February and May
2010 disclosures. However, since the PCAOB’s difficulties in conducting certain foreign
inspections were better known by these later dates, any abnormal stock market reaction may be
weaker on one or both of these dates.
3. Research method
3.1 Sample
Table 1 presents information on our sample. Across the PCAOB’s three announcements
(August 2009 and February and May 2010), there are 422 companies audited by a firm located in
a country that denied the Board the ability to conduct inspections. Returns data is not available
on Datastream for 98 companies. Of the remaining 324 companies, 60 were audited by a firm
included in the Board’s August 2009 press release, and 76 were audited by a firm included in the
Board’s February 2010 press release. The remaining 188 companies were named explicitly by
the PCAOB in its May 2010 press release.17 Our control sample is made up of cross-listed
companies located in a country that allows PCAOB inspections and that files a Form 20F with
the U.S. Securities and Exchange Commission.18
Insert Table 1
17
The sample size for the multivariate models is slightly smaller due to either missing company-specific returns or
Compustat data (Compustat data are needed for the control variables in our multivariate model).
18
Our control sample is developed by identifying cross-listed companies (ADRs) that file a Form 20F with the SEC
and are domiciled in countries that have not barred the PCAOB from conducting inspections of audit firms. We
examine the SEC filings of these companies to ensure they are audited by a foreign auditor located in a country that
allows the Board to conduct inspections of audit firms.
13
3.2 Test of overall abnormal stock market reaction
3.2.1 Univariate testing
We use a similar method to that employed by Chaney and Philipich (2002) and Nelson et
al. (2008) to examine the cumulative abnormal stock market return experienced by these
companies at the time the PCAOB disclosed that their auditors could not be inspected. We first
test the market reaction to the PCAOB’s press release in August 2009 by examining the
abnormal market returns of companies audited by firms identified by the Board as not having
been inspected even though the statutory inspection deadline had passed, and we compare these
abnormal stock returns to those experienced by foreign companies whose auditor is located in a
country that permits PCAOB inspections. We compute daily abnormal returns as the difference
between a foreign company’s actual return and its expected return. We use the following market
model to compute abnormal returns:
Rit = αi + βiRmt + µit
where:
Rit =
return for company i on day t
αi =
intercept
βi =
beta for company i
14
Rmt =
return on the value-weighted S&P American Depository Receipts (ADR) Index on day t
(the estimation window is 255 trading days beginning at day -21; each company is
required to have at least 40 trading days with available returns data) 19
µit =
error term
The abnormal return on day t is computed as:
𝐴𝑅𝑖𝑡 = 𝑅𝑖𝑡 − (𝛼̂𝑖 + 𝛽̂𝑖 𝑅𝑚𝑡 )
The cumulative abnormal return (CAR) is defined as:
𝑇
𝐶𝐴𝑅 = ∑ 𝐴𝑅𝑖𝑡
𝑡=0
Consistent with Chaney and Philipich (2002), we test the significance of the abnormal
returns using a corrected version of the Z-test that accounts for serial correlation of returns
within the event window.
A stock price decline experienced by companies after the disclosure by the PCAOB of
the names of these foreign auditors might simply reflect a more general market decline on those
dates. As indicated previously, to control for this possibility, we compare the CARs for
companies audited by a non-inspected auditor to the CARs for all cross-listed companies in
jurisdictions that permit PCAOB inspections.
3.2.2 Multivariate testing
We use a cross-sectional regression to test whether our univariate results hold after
controlling for other variables that might affect the abnormal market return. We include in our
19
The S&P ADR index is based on the non-U.S. stocks of the S&P Global 1200, which comprises six non-US
indices: S&P Europe 350, S&P TOPIX 150, S&P/TSX 60, S&P/ASX All Australian 50, S&P Asia 50, and S&P
Latin America 40.
15
regression companies with foreign auditors located in countries that do not permit PCAOB
inspections and cross-listed companies with auditors domiciled in countries that do permit
PCAOB inspections. This design allows us to examine whether there is a differential abnormal
stock market reaction after the PCAOB’s August 2009 press release for companies with auditors
located in countries that do not permit inspections compared to companies with auditors located
in countries that do permit inspections after controlling for other determinants of the abnormal
stock market return. More specifically, we estimate the following model:
CARit =β1 + β2NON_INSPECT + β3COUNTRYRSK + β4SIZE + β5SALESGRWTH +
β6LEV + β7BIG4 + β8CONSUMER + β9MFG + β10TECH + β11HEALTH + µit
where:
CARit
= cumulative mean abnormal return (two-, three-, or four-day windows)
NON_INSPECT
= 1 if the company is audited by a firm domiciled in a country that does
not allow PCAOB inspections (i.e., the non-inspected sample), 0 if the
company is audited by a firm domiciled in a country that allows PCAOB
inspections (i.e., the inspected sample)
COUNTRYRSK
= measure of country-specific risk, based on IHS Global Insight’s sixfactor country risk rating
SIZE
= natural log of the market value of equity
SALESGRWTH
= the percentage growth in sales in the year immediately prior to the
applicable announcement
LEV
= total debt divided by total assets
BIG4
= 1 if the company is audited by a Big 4 firm, 0 otherwise
16
CONSUMER
= 1 if the company is a member of the Consumer Goods industry, 0
otherwise
MFG
= 1 if the company is a member of the Manufacturing industry, 0
otherwise
TECH
= 1 if the company is a member of the Technology industry, 0 otherwise
HEALTH
= 1 if the company is a member of the Health Care industry, 0 otherwise
Given that our test sample (companies audited by firms located in a non-inspection
country) and control sample (companies audited by firms located in an inspection country) are
drawn from different countries and because we do not have a sufficient number of observations
to match, the companies in our test and control samples are likely to differ on country-risk, size,
growth, leverage, industry, and auditor type. Thus, these differences may affect abnormal stock
market returns. We control for country-specific risk using IHS Global Insight’s six-factor
country risk ratings.20 The six factors are: (1) political analysis (institutional permanence,
internal political consensus, external political consensus); (2) regulatory analysis (legislation and
business laws, transparency of legal procedures, independence and impartiality, experience and
quality of the legal system); (3) tax laws and impacts (coherence of the taxation system, fairness
of taxation burden, effectiveness of tax collection); (4) operational conditions (attitudes to
foreign investment, bureaucracy and corruption, infrastructure quality); (5) security risk analysis
(civil unrest, crime rate, external security threats); and (6) economic data, forecasting and
analysis (degree of market orientation, policy consistency and forward planning, macroeconomic
As a sensitivity test, we control for country-specific risk using Transparency International’s Corruption
Perceptions Index (CPI). Our results are essentially unchanged (see the robustness section of the paper). In
addition, we attempted to measure country risk following the approach in Francis et al. (2011), but of the 32
countries in our sample the Francis et al. paper only presented data for 17. Moreover, the country-risk measures
from Francis et al. were measured using 2002 and 2004 data. The IHS Global Insight measure is based on data from
2010, and the Transparency International’s CPI uses data from 2009.
20
17
fundamentals). We expect a positive relation between abnormal return and country risk (Fama
and French 1993). We control for company size, sales growth, leverage, and Big 421 auditor.
We expect negative relations between abnormal return and size, growth, and leverage (Fama and
French 1992), and we do not predict a sign on the relation between abnormal return and Big 4.
Finally, given our modest sample sizes, we are limited in how many industry dummy variables
we include in our model. As a result, we use the more aggregated Fama and French five industry
portfolio approach, which is derived from their 48 industry portfolio approach (Fama and French
1997).22
4. Results
4.1 Univariate analysis
Table 2 presents the CARs surrounding the PCAOB’s press release in August 2009.23
We compare the results for companies whose auditor was identified in the August 2009 PCAOB
announcement as having not been inspected to those for our sample of cross-listed companies
whose auditor is located in a country that permits inspections. For the non-inspected companies,
we find a significant and negative abnormal market reaction for the event windows (0, +1), (0,
+2), and (0, +3) (p-value < 0.05). However, we do not find a similar negative abnormal market
reaction for our sample of companies whose auditor is subject to inspection (p-value > 0.10 for
all event windows). The differences in the CARs between the inspected and non-inspected
companies are statistically significant (p-value < 0.05 for the (0,+1) and (0,+3) windows, and p-
21
Big 4 firms include audit firms that are affiliated with a Big 4 auditor.
See Kenneth French’s website
(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/det_5_ind_port.html) for a description of the
industry classification system (i.e., how particular SIC codes are classified).
22
23
Although Table 1 describes a total of 123 inspected firms with returns data, one company was dropped from this
analysis due to missing returns data for the August 2009 PCAOB announcement date.
18
value < 0.01 for the (0,+2) window), and are consistent with our expectation that the market
would react negatively to the PCAOB announcement in August 2009.
Insert Table 2
4.2 Regression analysis
Although the univariate results provide some initial support for our expected relation
between abnormal market returns and the PCAOB announcement in August 2009, we use a
cross-sectional regression to further investigate this relation. An analysis of our control variables
indicates there are few differences between non-inspected and inspected companies (not tabled).
Non-inspected companies have greater sales growth (p-value < 0.01), less leverage (p < 0.01),
and were more (less) likely to be in the health care (consumer goods) industry (p-value < 0.10
and p < 0.05, respectively).
Table 3 presents the results of our primary regression model.24 As expected, the
coefficient on our variable of interest (NON_INSPECT) is negative and significant (p-value <
0.05 for the (0,+1) and (0,+2) windows, and p-value < 0.10 for the (0,+3) window), which
suggests that non-inspected companies experienced a significantly negative abnormal stock price
reaction to the PCAOB’s August 2009 announcement. 25 This result is consistent with the
univariate results previously discussed and provides strong support for our research expectations.
Insert Table 3
5. Additional analyses and robustness tests
24
The sample sizes in our regressions are slightly smaller than the initial sample described in Table 1. This is due to
observations that are dropped because the necessary Compustat data is not available for those companies.
25
Our inferences in this analysis and in additional analyses are unchanged when we account for non-synchronous
trading in the market model following Scholes and Williams (1977).
19
5.1 Additional analyses
5.1.1 Subsequent announcements of additional firms by the PCAOB
In addition to the PCAOB’s initial disclosure in August 2009 of the names of audit firms
that had not been inspected even though the statutory time deadline for conducting the inspection
had passed, the Board released a second list of such firms in February 2010 (PCAOB, 2010a).
Furthermore, in May 2010 the Board disclosed the names of over 400 companies whose auditor
was located in a country where inspections had been denied (PCAOB, 2010b). Although the
initial announcement by the Board in August 2009 clearly alerted investors to the potential
problem of the Board’s inability to inspect audit firms located in certain countries, it is possible
that the market would further react to these subsequent announcements. We examine this by
replicating our univariate and regression analyses on these subsequent announcement dates.
Table 4, Panel A presents the CARs surrounding the PCAOB’s press release in February
2010 for a sample of 76 companies whose auditor was named in this press release. For these
non-inspected companies, we find a significant and negative abnormal market reaction for all
event windows (p-value < 0.05 for the (0, +1) and (0, +3) windows, and p-value < 0.10 for the
(0,+2) window). However, we find a similar negative abnormal market reaction for our sample
of inspected companies for the (0,+1) window (p-value < 0.05), while the (0,+2) and (0,+3)
windows are not significantly different from zero. The differences in the CARs between the
inspected and non-inspected companies are statistically significant for the (0,+2) and (0,+3)
windows (p-value < 0.05 and p-value < 0.01, respectively). These univariate results suggest that
the market did react negatively to the PCAOB announcement in February 2010, although this
reaction is limited to the (0,+2) and (0,+3) event windows.
Insert Table 4
20
Table 4, Panel B presents the CARs surrounding the PCAOB’s press release in May 2010
for a sample of 188 companies named in this press release.26 For these non-inspected
companies, we find a significant negative abnormal market reaction of approximately 2.5 percent
for all event windows (p-value < 0.01 for the (0, +1) and (0, +2) windows, and p-value < 0.05 for
the (0,+3) window). However, we also find a similar negative abnormal market reaction for our
sample of inspected companies for all event windows (p-value < 0.01). The differences in the
CARs between the inspected and non-inspected companies are not statistically significant for the
(0,+1) and (0,+2) windows, but the difference in the CARs is significant for the (0,+3) window
(p-value < 0.05). These univariate results provide limited evidence that the market reacted
negatively to the PCAOB announcement in May 2010, with the only significant abnormal
reaction being detected in the (0,+3) event window.
We next apply our cross-sectional regression model to the February 2010 and May 2010
announcements. For the February 2010 announcement, our regression results are found in Table
5. Our test variable of interest (NON_INSPECT) is negative and significant (p-value < 0.05) for
all three event windows, which suggests that non-inspected companies whose auditor had not
been previously identified in the PCAOB’s August 2009 announcement experienced a
significantly negative abnormal stock price reaction to the PCAOB’s February 2010
announcement.
Insert Table 5
Due to a lack of results and in the interest of parsimony, we do not table our regression
results for the May 2010 announcement. Our test variable of interest (NON_INSPECT) is not
significant (p-value > 0.10) for any of the event windows, which suggest that the market did not
26
Our sample of non-inspected companies for the May 2010 announcement includes only those companies whose
audit firm had not been included in either the August 2009 or February 2010 announcement.
21
react to the May 2010 announcement by the PCAOB. Taken together with the univariate results
discussed above, our analyses provide evidence of a significantly negative abnormal stock
market reaction to the February 2010 announcement, and only limited univariate evidence of a
significantly negative abnormal stock market reaction to the May 2010 announcement.
5.1.2 Announcement of joint inspection agreement with the United Kingdom
On January 10, 2011, the PCAOB announced a joint inspection agreement with the U.K.,
which would remove the barriers that had prevented the PCAOB from inspecting audit firms in
the U.K. This provides another opportunity to examine the market’s reaction to a potential
change in the PCAOB’s ability to inspect certain audit firms. In this case we would expect a
more positive abnormal market reaction for the non-inspected companies since the agreement
opens the door for inspections to occur. Therefore, we examine the abnormal market reaction for
a sample of companies whose U.K. auditors would now be able to be inspected by the PCAOB
as a result of the joint inspection agreement announced in January 2011.
Table 6 presents the CARs surrounding the PCAOB’s press release in January 2011 for a
sample of 44 companies with auditors located in the U.K. For these non-inspected companies,
we find a positive but insignificant abnormal market reaction for each of the event windows (p >
0.10), while we find a significant negative abnormal market reaction for the inspected companies
in event windows (0,+2) and (0, +3) (p-value < 0.01). Interestingly, the differences in CARs
between the non-inspected and inspected companies are significant for each event window (pvalue < 0.10), with the CARs for the non-inspected companies being more positive. These
results provide some evidence that the market did react favorably to the PCAOB’s
22
announcement in January 2011 for the companies whose auditor was previously prevented from
being inspected.27
Insert Table 6
We next run our cross-sectional regression model for the January 2011 announcement.
The results of this model are found in Table 7. Our test variable of interest (NON_INSPECT) is
positive and significant (p-value < 0.05 for the (0,+1) window, and p-value < 0.10 for the (0,+2)
and (0,+3) windows). Thus we find multivariate evidence of a significant positive abnormal
market reaction to the PCAOB’s announcement that U.K. audit firms would be subject to
inspection. Taken together with our univariate results, the evidence suggests the market reacted
positively to the announcement that a country formerly prohibiting the PCAOB from conducting
inspections would now allow those inspections to go forward.
Insert Table 7
5.1.3 Separation of non-inspection companies into Chinese and other
There has been a significant amount of discussion in the media recently about accounting
and auditing problems with Chinese companies listed in the U.S. Furthermore, it is widely
believed that the accounting profession in China is not well developed, as evidenced by a
shortage of professionally qualified auditors, and that the Chinese have not developed a culture
of strong investor protection. James Doty, PCAOB chairman, has described the Board’s inability
to inspect registered audit firms in China as “a gaping hole in investor protection” (Stein, 2011).
Since the lack of PCAOB inspections in China appears to be viewed as potentially more
problematic than in other non-inspected countries, we split our NON_INSPECT variable into
27
We excluded one outlier from the inspected sample for our analyses of the January 2011 announcement. This
company reported a CAR that ranged from 65%-86% during the event windows. Our results are sensitive to the
inclusion of this outlier.
23
two variables, CHINA and OTHER, and rerun our regression model for the August 2009
announcement to examine whether the stock market’s reaction to the PCAOB announcement was
more severe for Chinese companies. Table 8 presents the results of this analysis. Our test
variable for companies with a China-based auditor (CHINA) is negative and significant for each
window (p-value < 0.01 for the (0,+1) and (0,+2) windows, and p-value < 0.05 for the (0,+3)
window). However, our test variable for companies with a non-China based auditor (OTHER) is
not significant (p-value > 0.10 for each window). These results suggest that the market did react
more severely to the PCAOB’s announcement in August 2009 for companies with a China-based
auditor.28
Insert Table 8
5.2 Robustness tests
We conduct a series of untabulated robustness tests on our primary analysis of the August
2009 PCAOB announcement to see if our results are sensitive to certain design choices that we
have made, including our measurement of country risk, our approach to measuring CARs, and
the potential for test misspecification or the exclusion of a correlated variable.
5.2.1 Measurement of country risk
Our original measure of country risk is based on the IHS Global Insight six-factor
country risk rating. However, since our results may be sensitive to our choice of risk measure,
we replace this measure of risk with Transparency International’s Corruption Perceptions Index
(CPI). The CPI ranks countries based on the perceived level of public corruption in each country
28
We only perform this analysis of Chinese companies for the August 2009 announcement because there were no
Chinese firms included in the samples for the February 2010 and January 2011 announcements, and we did not find
a significant reaction to the May announcement in our earlier analysis.
24
and is based on information gathered from 13 separate surveys or assessments from 10
independent organizations. Our results using the CPI as the measure of COUNTRYRSK are
unchanged from our original analysis in Table 3, suggesting that our results are not sensitive to
our measure of country risk.
5.2.2 Measurement of CARs
The S&P ADR Index is used to estimate the market model for purposes of this study, due
to the alignment of its construction with the make-up of our sample. Our results, however, may
be specific to this market return measure. To address this issue, we re-estimate the market model
using both a value-weighted S&P 500 index and the Russell 3000 index and then examine the
CARs surrounding the August 2009 disclosure by the PCAOB relating to its difficulties in
conducting foreign inspections. Consistent with prior analyses, univariate results indicate that
non-inspected companies experienced significant, negative abnormal returns in August 2009 and
that these abnormal returns were more negative than the CARs of inspected companies for that
date. Multivariate analyses using CARs derived from re-estimating the market model also
provide results that are consistent with those presented in Table 3. Overall, these analyses
suggest that our results are not sensitive to the market return measure used in estimating the
market model.
Fama and French (1992) find that, in addition to β, the risk factors of size and value play
an important role in describing the returns of a company. Consequently, we use the FamaFrench (1993) three factor model to calculate abnormal returns for the August 2009
announcement. Results for the univariate analysis are consistent with results previously reported
in Table 2. In the multivariate setting, our variable of interest (NON_INSPECT) remains
25
negative and significant for all event windows (p-value < 0.05 for the (0,+1) window, and pvalue < 0.10 for the (0,+2) and (0,+3) windows).
5.2.3 Monte Carlo Simulation
Our multivariate test is premised on the idea that the CARs for August 2009 are related to
the disclosure of the names of registered foreign audit firms that had not been inspected by the
PCAOB. Our result, however, may be due to test misspecification or to a correlated, omitted
variable. To deal with this possibility, we follow the Monte Carlo approach used in Larcker et
al. (2011). We randomly select a non-event date from the (-30,+30) window, excluding the (5,+5) window, and re-estimate our regression model for the August 2009 event date. We repeat
this process 1,000 times, retaining the estimated coefficients each time. We then compare the
respective coefficients from our original regression model in Table 3 (β) to the average
coefficient from this same regression using the 1,000 randomly selected non-event dates (E[β]).
Our results indicate the estimated coefficient (β) of our variable of interest (NON_INSPECT) is
significantly less than its estimated average coefficient (E[β]) (p-value < 0.01 for each event
window). This suggests that the results presented in Table 3 are unique to our event date and are
not the result of test misspecification or of a correlated, omitted variable.
We also performed each of these robustness tests on our ‘additional analyses’ (i.e., the
February 2010 and January 2011 announcement dates, and the China vs. Other analysis).29 Our
results are generally consistent with or stronger than those reported in Tables 4-8, with the
following exception. For the January 2011 announcement, our results were slightly weaker using
the CPI measure for country risk as the (0,+3) window was no longer significant.
29
We do not perform our robustness tests on the May 2010 announcement date because the results for this event
were generally not significant in our original analysis.
26
Overall, the results of our robustness tests suggest that our results are relatively robust to
certain design choices that we have made, including our measurement of country risk, our
approach to measuring CARs, and the potential for test misspecification or the exclusion of a
correlated variable.
6. Summary, implications, and limitations
The Sarbanes-Oxley Act (SOX) of 2002 created the PCAOB to oversee auditors of public
companies. The centerpiece of the PCAOB’s oversight of auditors is the Board’s inspection
program, which applies to both domestic and foreign audit firms registered with the PCAOB.
However, the PCAOB has been denied the ability to conduct inspections of registered foreign
audit firms by the governments of European Union countries, Switzerland, China, and, in some
cases, Hong Kong. Therefore, audits of companies by these firms are not subject to inspection,
potentially exposing investors to substandard audit work on these engagements. We examine the
abnormal stock market reaction to a series of disclosures by the PCAOB relating to its
difficulties in conducting certain foreign inspections. We document univariate and multivariate
results consistent with a significant negative abnormal stock market reaction to the PCAOB’s
August 2009 and February 2010 disclosures of the names of foreign auditors that had not been
inspected due to foreign governments barring the PCAOB from conducting these inspections.
We find some evidence of a significant negative abnormal market reaction to the Board’s May
2010 disclosure of company names audited by a firm located in a non-inspection country in our
univariate analyses, but no evidence of a negative abnormal reaction in a multivariate model.
Finally, we find univariate and multivariate evidence indicating a significant positive abnormal
market reaction to the PCAOB’s January 2011 disclosure that registered U.K. audit firms would
now be subject to inspection.
27
The significant abnormal market reactions to the Board’s disclosures regarding its
inability to inspect audit firms located in certain foreign countries, especially the negative
abnormal market reaction the first time an auditor was identified, either in August 2009 or
February 2010, and the positive abnormal market reaction to the Board’s disclosure in January
2011 that inspections would now be permitted for U.K. firms, provide evidence that the
significant resources devoted by the PCAOB to its inspection program are valued by market
participants. The market’s significant abnormal reactions to the Board’s disclosures of events
relating to its inspections of foreign audit firms is consistent with the PCAOB’s continuing
efforts to gain access to those markets that continue to deny the Board inspection authority and,
where cooperation with foreign regulators and governments is not forthcoming, to take a series
of increasingly aggressive actions to protect the interests of U.S. investors -- the specific mandate
given the Board in SOX. The Board first extended the deadline for conducting certain foreign
inspections in the hopes of reaching agreements with foreign authorities that would permit its
inspection process to go forward. When that effort failed, the PCAOB decided to provide more
transparent disclosure to investors of the registered foreign audit firms that were not inspected
even though the statutory deadline for conducting the inspection had passed. Finally, the Board
disclosed the names of companies whose auditor is located in a country that does not permit
PCAOB inspections. In addition, the PCAOB worked with Congress to include a provision in
the Dodd-Frank Act to permit the Board to share its inspection findings with foreign audit
regulators, which previously had been prohibited by SOX. The Board’s inability to share its
inspection findings with foreign audit regulators was the reason given by the European Union
(E.U.) for denying the Board the ability to conduct inspections of a PCAOB-registered firm
located in an E.U. member state. Since the passage of the Dodd-Frank Act, two countries, the
28
U.K. and Switzerland, have reached agreements with the PCAOB that will allow the Board to
conduct inspections of registered firms located in these countries. The process of reaching
similar agreements with other E.U. countries will potentially be more problematic, and the
prospect of reaching an agreement with China is particularly problematic as the Chinese
authorities view PCAOB inspections as encroaching on Chinese sovereignty. However, perhaps
due to the increasing media coverage of accounting and auditing problems associated with
Chinese companies listed in the U.S., and resultant regulatory attention, representatives of the
PCAOB, China’s Ministry of Finance, and China’s Securities Regulatory Commission have
begun to meet in an attempt to develop a protocol that would allow the PCAOB to inspect
registered firms located in China (McMahon and Rapoport, 2011).
The PCAOB’s advisory groups (SAG and IAG) have discussed other steps that the
Board might take if certain foreign countries continue to deny the Board the opportunity to
conduct inspections. The PCAOB might require the auditor to indicate in the audit report
whether it is located in a country that denies the Board the ability to conduct inspections, and/or
the company might indicate in its SEC filings whether its auditor is located in a country that does
not permit PCAOB inspections. The SEC’s Division of Corporation Finance could inspect
filings of companies with a non-inspected auditor more frequently and/or more thoroughly. The
Board could and, recently has, denied a new Chinese audit firm from registering with the
PCAOB (Lawrence and Hamilton, 2011). Finally, the PCAOB is statutorily empowered to
deregister an audit firm where it cannot conduct an inspection but, to the extent that the PCAOB
takes such action for all audit firms located in a particular country, foreign companies located in
that country would either have to engage an auditor from outside the country, which may not be
permitted by the foreign company’s country of domicile, or the foreign company would have to
29
engage a non-registered audit firm. Since the SEC requires all foreign companies to use a
PCAOB-registered firm, a foreign company’s decision to use a non-registered audit firm would
presumably lead to the foreign company being delisted from the U.S. markets, absent a waiver
by the SEC of its current requirements. The PCAOB obviously faces difficult decisions in
navigating these issues and our paper does not recommend any specific policy action for the
Board to pursue; however, our paper provides empirical support that the market reacts negatively
to the disclosure of the names of auditors and companies that are not inspected, and that the
market reacts positively to news that a foreign jurisdiction that previously denied the Board
inspection authority has reached an agreement to permit future inspections.
Our paper is subject to limitations. Our sample sizes are modest, although they represent
the available population of audit firms and companies included in the PCAOB’s disclosures. In
addition, this is the first paper that examines the market’s reaction to the PCAOB’s disclosure of
foreign auditors and companies that have not been inspected. Future research that replicates and,
hopefully, extends our findings would be helpful to the PCAOB in providing a more solid and
robust empirical basis on which the Board can rely in making, or at least justifying, future policy
decisions.
30
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34
EXHIBIT 1
Description of Auditors/Companies Included in PCAOB’s
August 2009, February 2010, and May 2010 Disclosures
(A)
Foreign Audit Firm
Issues Initial
Audit Report after
Registering with
PCAOB
Year 2003
(D)
Names of
audit firms
in (C) disclosed primary event
of interest
August 2009
(B)
(C)
Foreign Audit
Firm Issues
Initial Audit
Report after
Registering with
PCAOB
More than
4 years have
passed since
foreign audit
firm in (A)
issued initial
audit report inspection overdue
Year 2004
12-31-2008
(E)
More than 4 years
have passed since
foreign audit firms
in (B) issued initial
audit report inspection overdue
12-31-2009
(F)
Names of
audit firms
in (E) disclosed secondary
event of
interest
February 2010
(G)
Disclosure of the names of all
companies audited by a firm
located in a country that does
not allow inspections - Clients
of auditors disclosed in (D)
and (F) excluded for our
purposes -tertiary event of
interest
May 2010
35
TABLE 1
Sample Selection
Panel A. Sample Selection for Non-Inspected Sample
Registrants Identified By PCAOB in May 18, 2010 Announcement
Less:
Companies Not Available on Datastream
Total Non-Inspected Sample
422
(98)
324
Companies associated with August 12, 2009 Announcement
Companies associated with February 3, 2010 Announcement
Companies associated with May 18, 2010 Announcement
Total Non-Inspected Sample
60
76
188
324
Panel B. Sample Selection for Inspected Sample
U.S. Listed ADRs Filing Form 20F - Located in Countries Allowing PCAOB Inspection
Less:
Companies with Auditor in U.S or Non-Inspected Country
Total Inspected Sample
125
(2)
123
36
TABLE 2
Mean Cumulative Abnormal Returns for Companies Whose Auditor Was Identified in the
PCAOB Announcement Dated August 12, 2009 as Not Participating in PCAOB Inspections
and U.S. Listed ADRs with Auditors Domiciled in Countries Permitting PCAOB
Inspections. Event Date is August 13, 2009.
Window
(0,+1)
(0,+2)
(0,+3)
Non-Inspected Firms (N=60)
CAR (%)
-1.58
-2.34
-2.24
Z
-1.96
-2.28
-1.97
**
**
**
Inspected Firms (N=122)
CAR (%)
-0.10
-0.34
-0.63
Z
-0.05
-0.07
-0.56
Difference
Mean
-1.48 **
-2.00 ***
-1.61 **
____________________
** and *** indicate significance at p < 0.05, and p < 0.01, respectively, based on one-tailed tests.
37
TABLE 3
Regression of Sample Companies’ Two-Day (0,+1), Three-Day (0,+2), and Four-Day (0,+3)
Cumulative Mean Abnormal Returns for the August 13, 2009 Event Date on PCAOB
Inspection and Company–Specific Control Variables. Sample Includes Companies Whose
Auditor was Identified in the PCAOB Announcement Dated August 12, 2009 and U.S.
Listed ADRs with Auditors Domiciled in Countries Permitting PCAOB Inspections.
Variable
INTERCEPT
NON_INSPECT
COUNTRYRSK
SIZE
SALESGRWTH
LEV
BIG4
CONSUMER
MFG
TECH
HEALTH
Predicted
Sign
?
Neg.
Pos.
Neg.
Neg.
Neg.
?
?
?
?
?
F-value
Adj. R2
Obs.
(0,+1) CAR
Coefficient
0.0403 *
-0.0132 **
-0.0148
0.0010
-0.0041
-0.0199
-0.0064
-0.0043
-0.0088
-0.0056
-0.0325 **
2.73 ***
0.092
173
(0,+2) CAR
Coefficient
0.0193
-0.0129 **
-0.0151
0.0027
-0.0080 *
0.0169
-0.0106
-0.0049
-0.0027
-0.0075
-0.0135
3.19 ***
0.113
173
(0,+3) CAR
Coefficient
0.0335
-0.0110 *
-0.0159
0.0017
-0.0128 **
0.0018
-0.0101
-0.0103
-0.0022
-0.0141
-0.0244
3.29 ***
0.117
173
____________________
*, **, and *** indicate significance at p < 0.10, p < 0.05, and p < 0.01, respectively, based on one-tailed tests for
variables that we predict an expected difference and two-tailed tests for variables that we do not predict an expected
difference.
Variable definitions:
NON_INSPECT = 1 if the company is audited by a firm domiciled in a country that does not allow PCAOB
inspections, 0 if the company is audited by a firm domiciled in a country that allows PCAOB
inspections.
COUNTRYRSK = measure of country-specific risk, based on IHS Global Insight’s six-factor country risk
rating.
SIZE = natural log of the market value of equity.
SALESGRWTH = the percentage growth in sales in the year immediately prior to the applicable announcement.
LEV = total debt divided by total assets.
BIG4 = 1 if the company is audited by a Big 4 firm, 0 otherwise.
CONSUMER = 1 if the company is a member of the Consumer Goods industry, 0 otherwise.
MFG = 1 if the company is a member of the Manufacturing industry, 0 otherwise.
TECH = 1 if the company is a member of the Technology industry, 0 otherwise.
HEALTH = 1 if the company is a member of the Health Care industry, 0 otherwise.
38
TABLE 4
Mean Cumulative Abnormal Returns for Companies Whose Auditor Was Identified in the
PCAOB Announcements Dated February 3, 2010 and May 18, 2010 as Not Participating in
PCAOB Inspections and U.S. Listed ADRs with Auditors Domiciled in Countries
Permitting PCAOB Inspections.
Panel A. February 4, 2010: Companies Whose Auditor Was Identified in the PCAOB Report Dated
February 3, 2010 and U.S. Listed ADRs with Auditors Domiciled in Countries Permitting PCAOB
Inspections.
Window
(0,+1)
(0,+2)
(0,+3)
Non-Inspected Firms (N=76)
CAR (%)
-0.98
-1.20
-1.92
Z
-2.21 **
-1.67 *
-2.07 **
Inspected Firms (N=123)
Difference
CAR (%)
-0.60
-0.24
-0.25
Mean
-0.38
-0.96 **
-1.67 ***
Z
-2.22 **
-1.07
-0.52
____________________
*, **, and *** indicate significance at p < 0.10, p < 0.05, and p < 0.01, respectively, based on one-tailed tests.
Panel B. May 19, 2010: Companies Identified in the PCAOB Report Dated May 18, 2010 But Whose
Auditor Was Not Identified In PCAOB Reports Dated August 12, 2009 and February 3, 2010 and U.S.
Listed ADRs with Auditors Domiciled in Countries Permitting PCAOB Inspections.
Window
(0,+1)
(0,+2)
(0,+3)
Non-Inspected Firms (N=188)
CAR (%)
-2.43
-2.52
-2.55
Neg. (%)
70.2
73.4
68.1
Inspec
Z
-4.456 ***
-3.693 ***
-2.449 **
Generalized
Sign Z
-3.42 ***
-4.30 ***
-2.83 ***
____________________
** and *** indicate significance at p < 0.05, and p < 0.01, respectively, based on one-tailed tests.
39
CAR
-
TABLE 5
Regression of Sample Companies’ Two-Day (0,+1) , Three-Day (0,+2), and Four-Day (0,+3)
Cumulative Mean Abnormal Returns for the February 4, 2010 Event Date on PCAOB
Inspection and Company–Specific Control Variables. Sample Includes Companies
Identified in the PCAOB Announcement Dated February 3, 2010 But Whose Auditor Was
Not Identified in the PCAOB Announcement Dated August 12, 2009 and U.S. Listed ADRs
with Auditors Domiciled in Countries Permitting PCAOB Inspections.
Variable
INTERCEPT
NON_INSPECT
COUNTRYRSK
SIZE
SALESGRWTH
LEV
BIG4
CONSUMER
MFG
TECH
HEALTH
Predicted
Sign
?
Neg.
Pos.
Neg.
Neg.
Neg.
?
?
?
?
?
F-value
Adj. R2
Obs.
(0,+1) CAR
Coefficient
0.0297 *
-0.0099 **
-0.0154
-0.0018 **
-0.0023
0.0239
0.0105
-0.0068
0.0025
0.0006
0.0007
1.85 *
0.043
190
(0,+2) CAR
Coefficient
-0.0066
-0.0102 **
-0.0070
-0.0007
-0.0002
0.0460
0.0158 *
-0.0125
-0.0008
0.0058
-0.0005
(0,+3) CAR
Coefficient
-0.0218
-0.0120 **
-0.0005
0.0026
0.0030
0.0125
-0.0006
-0.0156 *
-0.0047
-0.0022
-0.0103
2.38 **
0.068
190
2.36 **
0.067
190
____________________
* and ** indicate significance at p < 0.10 and p < 0.05, respectively, based on one-tailed tests for variables that we
predict an expected difference and two-tailed tests for variables that we do not predict an expected difference.
Variable definitions:
NON_INSPECT = 1 if the company is audited by a firm domiciled in a country that does not allow PCAOB
inspections, 0 if the company is audited by a firm domiciled in a country that allows PCAOB
inspections.
COUNTRYRSK = measure of country-specific risk, based on IHS Global Insight’s six-factor country risk
rating.
SIZE = natural log of the market value of equity.
SALESGRWTH = the percentage growth in sales in the year immediately prior to the applicable announcement.
LEV = total debt divided by total assets.
BIG4 = 1 if the company is audited by a Big 4 firm, 0 otherwise.
CONSUMER = 1 if the company is a member of the Consumer Goods industry, 0 otherwise.
MFG = 1 if the company is a member of the Manufacturing industry, 0 otherwise.
TECH = 1 if the company is a member of the Technology industry, 0 otherwise.
HEALTH = 1 if the company is a member of the Health Care industry, 0 otherwise.
40
TABLE 6
Mean Cumulative Abnormal Returns for the PCAOB Announcement of a Cooperative
Agreement with United Kingdom Audit Regulator on January 10, 2011. Sample Includes
Companies Using a U.K. Based Auditor and U.S. Listed ADRs with Auditors Domiciled in
Countries Permitting PCAOB Inspections.
Window
(0,+1)
(0,+2)
(0,+3)
Non-Inspected Firms (N=44)
CAR (%)
1.14
0.54
0.56
Z
0.60
-1.06
-0.84
Inspected Firms (N=122)
CAR (%)
0.04
-0.68
-0.98
Z
-1.48
-3.79 ***
-4.67 ***
Difference
Mean
1.10 *
1.22 *
1.54 *
____________________
* and *** indicate significance at p < 0.10 and p < 0.01, respectively, based on one-tailed tests.
41
TABLE 7
Regression of Sample Companies’ Two-Day (0,+1) , Three-Day (0,+2), and Four-Day (0,+3)
Cumulative Mean Abnormal Returns for the January 10, 2011 Event Date on PCAOB
Inspection and Company–Specific Control Variables. Sample Includes Companies Using a
U.K. Based Auditor and U.S. Listed ADRs with Auditors Domiciled in Countries
Permitting PCAOB Inspections.
Variable
INTERCEPT
NON-INSPECT
COUNTRYRSK
SIZE
SALESGRWTH
LEV
BIG4
CONSUMER
MFG
TECH
HEALTH
Predicted
Sign
?
Pos.
Pos.
Neg.
Neg.
Neg.
?
?
?
?
?
F-value
Adj. R2
Obs.
(0,+1) CAR
Coefficient
0.0864 ***
0.0159 **
-0.0017
-0.0061 ***
0.0008
-0.0068
-0.0400 ***
0.0101
0.0110
0.0104
0.0167
(0,+2) CAR
Coefficient
0.0686 **
0.0158 *
0.0004
-0.0051 ***
0.0005
0.0050
-0.0430 ***
0.0074
0.0079
0.0071
0.0160
(0,+3) CAR
Coefficient
0.1033 ***
0.0162 *
-0.0109
-0.0082 ***
0.0033
0.0157
-0.0308 *
0.0079
0.0086
0.0105
0.0024
3.75 ***
0.147
160
2.85 ***
0.104
160
2.67 ***
0.095
160
____________________
*, **, and *** indicate significance at p < 0.10, p < 0.05, and p < 0.01, respectively, based on one-tailed tests for
variables that we predict an expected difference and two-tailed tests for variables that we do not predict an expected
difference.
Variable definitions:
NON_INSPECT = 1 if the company is audited by a firm domiciled in a country that does not allow PCAOB
inspections, 0 if the company is audited by a firm domiciled in a country that allows PCAOB
inspections.
COUNTRYRSK = measure of country-specific risk, based on IHS Global Insight’s six-factor country risk
rating.
SIZE = natural log of the market value of equity.
SALESGRWTH = the percentage growth in sales in the year immediately prior to the applicable announcement.
LEV = total debt divided by total assets.
BIG4 = 1 if the company is audited by a Big 4 firm, 0 otherwise.
CONSUMER = 1 if the company is a member of the Consumer Goods industry, 0 otherwise.
MFG = 1 if the company is a member of the Manufacturing industry, 0 otherwise.
TECH = 1 if the company is a member of the Technology industry, 0 otherwise.
HEALTH = 1 if the company is a member of the Health Care industry, 0 otherwise.
42
TABLE 8
Regression of Sample Companies’ Two-Day (0,+1), Three-Day (0,+2), and Four-Day (0,+3)
Cumulative Mean Abnormal Returns for the August 13, 2009 Event Date on PCAOB
Inspection and Company–Specific Control Variables. Sample Includes Companies Whose
Auditor was Identified in the PCAOB Announcement Dated August 12, 2009 and U.S.
Listed ADRs with Auditors Domiciled in Countries Permitting PCAOB Inspections. The
Test Variable for Non-Inspection is Split between Companies with a China-based Auditor
and All Other Non-Inspected Companies.
Variable
INTERCEPT
CHINA
OTHER
COUNTRYRSK
SIZE
SALESGRWTH
LEV
BIG4
CONSUMER
MFG
TECH
HEALTH
Predicted
Sign
?
Neg.
Neg.
Pos.
Neg.
Neg.
Neg.
?
?
?
?
?
F-value
Adj. R2
Obs.
(0,+1) CAR
Coefficient
0.0304
-0.0253 ***
0.0005
-0.0090
0.0004
-0.0014
-0.0262 *
-0.0029
-0.0042
-0.0106
-0.0054
-0.0409 ***
(0,+2) CAR
Coefficient
0.0014
-0.0349 ***
0.0117
-0.0045
0.0016
-0.0030
0.0056
-0.0043
-0.0047
-0.0061
-0.0072
-0.0288 *
2.79 ***
0.103
173
3.62 ***
0.143
173
(0,+3) CAR
Coefficient
0.0263
-0.0199 **
-0.0011
-0.0116
0.0012
-0.0108 **
-0.0028
-0.0076
-0.0102
-0.0036
-0.0140
-0.0306 *
3.08 ***
0.117
173
____________________
*, **, and *** indicate significance at p < 0.10, p < 0.05, and p < 0.01, respectively, based on one-tailed tests for
variables that we predict an expected difference and two-tailed tests for variables that we do not predict an expected
difference.
Variable definitions:
CHINA = 1 if the company is audited by a firm domiciled in China, 0 if the company is audited by a
firm domiciled in another country that does not allow PCAOB inspections or in a country
that allows PCAOB inspections.
OTHER = 1 if the company is audited by a firm domiciled in a country other than China that does not
allow PCAOB inspections, 0 if the company is audited by a firm domiciled in China or in a
country that allows PCAOB inspections.
COUNTRYRSK = measure of country-specific risk, based on IHS Global Insight’s six-factor country risk
rating.
SIZE = natural log of the market value of equity.
SALESGRWTH = the percentage growth in sales in the year immediately prior to the applicable announcement.
43
LEV
BIG4
CONSUMER
MFG
TECH
HEALTH
=
=
=
=
=
=
total debt divided by total assets.
1 if the company is audited by a Big 4 firm, 0 otherwise.
1 if the company is a member of the Consumer Goods industry, 0 otherwise.
1 if the company is a member of the Manufacturing industry, 0 otherwise.
1 if the company is a member of the Technology industry, 0 otherwise.
1 if the company is a member of the Health Care industry, 0 otherwise.
44