The Impact of SEC Comment Letters and Short Selling on the Demand for Audit Quality

• In Event: Research in Auditing

Abstract

The Sarbanes-Oxley Act of 2002 (Section 408) requires the Securities and Exchange Commission (SEC) to conduct periodic reviews of financial statements and related disclosures for publicly traded firms. The reviews are documented in the form of comment letters issued to a company’s management for failure to prepare financial statements in accordance with generally accepted accounting principles (GAAP). Short interest traders are the most sophisticated group of investors providing additional monitoring of firms in the market. In this paper, we examine the impact of SEC comment letters and short selling positions on the demand for audit quality by management of client firms. The demand for audit quality is captured by four proxies – audit fees, discretionary accruals, material weakness and PCAOB inspections deficiencies.
Prior work suggests that comment letters provide a significant signal to SEC registrant companies and their auditors about noncompliance with GAAP and other SEC regulations. As auditors play a critical role in the filing process of a company, they also contribute to the receipt of comment letters by their clients. Additionally, they play a critical role in bridging the information gap between investors and the firm. Furthermore, short sellers monitor firms and could detect upcoming negative event to make profits. In this study we examine the impact of two types of monitoring mechanisms, regulatory and market-based, on the subsequent demand for audit quality by management of client firms.
Based on the sample of unique comment letters from years 2005 through 2015 and the information on the short interest positions, we find varying level of support for the tested hypothesis. Overall results are generally consistent across the proxies used to measure audit quality. Hence, they indicate that both monitoring mechanisms have an impact on the demand for higher quality audits. These findings are robust to controls for client and auditor characteristics.

Authors

• Justyna Skomra, Penn State University - Erie

• Pervaiz Alam, Kent State University