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The impact of SEC investigations and accounting and auditing enforcement releases on firms’ cost of equity capital

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Abstract

I study the impact of an SEC investigation (as captured by accounting and auditing enforcement releases) on a firm’s cost of equity capital. AAERs are often used in accounting literature as a proxy for fraudulent financial reporting. Fraudulent financial reporting should lead to an increase in cost of equity capital as a firm’s future cash flows become less certain. Overall, this study provides evidence of changes in cost of equity capital for firms targeted by an SEC AAER on the date the investigation is first made public.

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Notes

  1. e.g., Dechow et al. (1996), Beneish (1997, 1999), Hennes et al. (2008) and Dechow et al. (2011).

  2. For example, the SEC recently announced the creation of teams of specialists focused on specific types of fraud in response to criticisms that its current, more general staff has difficulty identifying fraud involving complex transactions (Scannell 2009).

  3. Bonner et al. (1998) suggest an increase in revenue or decrease in expenses as an example of common fraudulent activities, as opposed to overstating accounts payable as an example of uncommon fraudulent behavior.

  4. The Sarbanes–Oxley Act of 2002 barred “revolving door” hires by preventing audit firms from auditing firms in which a company executive performed audit services for the firm within the previous one-year period (SEC 2003).

  5. ‘Market message’ is defined by the ability of the investigation to address current and emerging disclosure issues as well as the targeted firm’s level of visibility in the market (Feroz et al. 1991).

  6. Success rate is determined by litigation successfully levied against the offender (SEC 2008). The SEC preempts litigation with an investigation at the target firm. If the SEC finds no evidence of wrong-doing, they do not proceed with litigation, thereby skewing the SEC’s litigation success rate.

  7. All AAERs are assigned an associated litigation number by the SEC. A manual check confirmed that all AAERs within the sample contain an associated litigation number. Furthermore, a manual search of the targeted firms confirmed that no targeted firm was first targeted by SEC litigation which preempted the AAER.

  8. Other ‘trigger events’ documented by KLM include ‘investigations by other federal agencies…, delayed SEC filings, management departures, whistleblower charges, and routine reviews by the SEC.’ (Karpoff et al. 2008, p. 587).

  9. Murphy et al. (2009) define corporate misconduct as “the subject keywords adopted by The Wall Street Journal Index such as, antitrust, breach of contract, bribery, business ethics, conflict of interest, copyright/patent infringement, fraud, kickbacks, price-fixing, securities fraud, and white-collar crime” (Murphy et al. 2009, p. 5).

  10. Initiation by the company or auditor increases the cost of equity capital beyond increases associated with SEC initiation or an unidentified initiator.

  11. Because my sample employs AAER issuances to identify firms, my study does not capture information related to firms investigated by the SEC that do not receive a subsequent AAER.

  12. A deferred prosecution agreement includes a form of settlement without court proceedings, similar to the agreement reached between KPMG, the Department of Justice, and the IRS in 2005. KPMG admitted to creating phony tax shelters and agreed to pay $456 million in restitution (IRS 2005). Thanks to Professor Lance Cole for indicating deferred prosecution agreements as an alternative to AAERs as an investigation resolution.

  13. The 156 firms exist in both Compustat and CRSP, I check for the exact required data at a later stage.

  14. For example, Sunbeam contains the necessary forecasts and accounting data when the SEC investigation is announced. However, the SEC investigation and related restatements cause Sunbeam to enter bankruptcy and subsequent delisting (Atlas and Tanner 2001) before the SEC issues its AAER. Sunbeam is included in the investigation announcement date sample, but not in the subsequent issue date sample.

  15. Nine of the firms in the investigation announcement sample eventually declared bankruptcy (identified via CRSP delisting codes 552, 560, 561, 570, 574 and 584), four of which declared bankruptcy before the AAER issue date. The remaining five bankrupt firms are included in both samples.

  16. No observations were dropped as a result of there being available information in the month prior to the event, but missing data in the month directly subsequent the event. Observations dropped due to missing information subsequent to the event could introduce a survivorship bias to the results.

  17. Firms’ cost of capital is not restricted to equity capital. Modern finance theory often employs the Weighted Average Cost of Capital (WACC) when considering the cost of capital for a firm. WACC is calculated as Cost of Equity × (Equity/(Debt + Equity)) + Cost of Debt × (1 − Tax rate) × (Debt/(Debt + Equity) (Ogier et al. 2004, p. 8). Because the cost of equity is a core component in calculating WACC, any change in WACC will impact the firm’s Cost of Equity. Therefore, a change in cost of equity is sufficient in signifying a change in a firm’s WACC.

  18. Examples include Dhaliwal et al. (2007), Hail and Leuz (2006) and Li (2010).

  19. This paper is not intended to evaluate criticisms surrounding the various cost of equity capital measures.

  20. As outlined in the conclusion to this paper, once the impact of SEC AAERs on cost of equity capital is established, future research could use this setting to evaluate the four measures of cost of equity capital, or subsequently proposed measures from future studies.

  21. Cost of equity capital is often associated with more explanatory measures that utilize historic information to forecast future cost of equity capital (e.g., CAPM or APT). Accounting research is often concerned with measuring the current cost of equity capital being applied by the market, which is the main objective of the models described in this paper. This measure is often referred to as the ‘implied cost of equity capital applied by the market’.

  22. See Ehrhardt (1994) for information on the origin and derivation of the dividend growth model. The model is also referred to throughout this section as the dividend discount model.

  23. See Gode and Mohanram (2008) for a discussion of the assumptions and mathematical transformations necessary to derive the economy-wide growth model.

  24. GAO database information is provided, with permission, from Andy Leone’s website: (http://sbaleone.bus.miami.edu/), including the ‘irregularity versus error’ classification outlined in Hennes et al. (2008).

  25. I assume that any restatement issued in close proximity to the SEC investigation announcement or AAER is an associated restatement. It is possible that a restatement in this period is unrelated. My assumption is based on the reverse argument in Hennes et al. (2008) that a restating firm with an AAER has engaged in ‘irregular’ reporting.

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  1. School of Management, Bucknell University, One Dent Drive, Lewisburg, PA, 17837, USA

    Curtis Nicholls

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Nicholls, C. The impact of SEC investigations and accounting and auditing enforcement releases on firms’ cost of equity capital. Rev Quant Finan Acc 47, 57–82 (2016). https://doi.org/10.1007/s11156-014-0494-9

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