Audit Quality, SOX, and Asymmetric Information

• In Event: Earnings Management and Information Asymmetry

Abstract

As IPO firms are subject to information asymmetries, external stakeholders such as investors rely on auditors’ expertise to verify the credibility of financial reports of the companies. We hypothesize that audit quality plays a role in reducing asymmetric information, and in turn affecting the valuation of the IPOs on the stock market. We investigate the relationship between audit quality, measured by auditor reputation and independence, and IPO underpricing and long-term performances and provide insights on the impact of the enactment of Sarbanes-Oxley Act (SOX) on their relationships. Results show auditor independence has a negative effect on IPOs’ underpricing, SOX significantly reduces IPO underpricing, and the IPO market had anticipated the necessity of an Act such as the SOX Act. Auditor independence reduces IPO underpricing, while auditor reputation does not significantly affect the underpricing. SOX and auditor independence have a joint effect on the underpricing. Greater auditor independence lowers IPO underpricing both before and after the enactment of SOX, and the effect of auditor independence on the underpricing after SOX is smaller than that before SOX and continues to be significant. This suggests that even after the passage of SOX, which is purposely to enhance auditor independence, the variation in auditor independence during the post-SOX period continues negatively affecting the IPO underpricing. We further find that auditor independence has a positive relation with IPO firm’s long-term performance, measured by Buy and Hold Abnormal Return (BHAR), survival probability, and the less biased calendar time portfolio analysis. Auditor independence has a much stronger effect on the IPO long-term performance for firms that go public after SOX. Finally, evidence shows that underpricing is mainly caused by asymmetric information problem. If auditor independence and SOX lowers IPO underpricing because they increase information transparency, IPO firms with smaller underpricing would have lower risk after going public. Results show that a firm’s IPO underpricing is positively associated with its post IPO beta. We observe that SOX and auditor independence are directly associated with the reduction of beta, but the relationship are quite moderate. Results of our study support the notion that the passage of the SOX Act enhances auditor independence, reduces asymmetric information of the IPO firms, and therefore improves the efficiency of the capital markets.

Authors

• Dona Siregar, State University of New York at Oneonta

• Kai Chen, State University of New York at Oneonta