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Published in: Review of Accounting Studies 4/2018

05-10-2018

Costs and benefits of internal control audits: evidence from M&A transactions

Authors: Todd D. Kravet, Sarah E. McVay, David P. Weber

Published in: Review of Accounting Studies | Issue 4/2018

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Abstract

To inform the debate on the merits of internal control audits, we examine managers’ decisions to temporarily exempt newly acquired businesses from Section 404 of the Sarbanes-Oxley Act. We document that managers are more likely to elect the exemption when expected compliance costs are higher, such as when acquisitions are larger and occur later in the year. We find only modest evidence that managers use the exemption to avoid scrutiny of value-destroying deals. Exemption use, however, is associated with negative post-acquisition outcomes, including lower return-on-assets and higher likelihoods of goodwill impairments and financial statement restatements. These results comport with compliance providing benefits by facilitating timely identification and correction of control problems in the newly acquired business. Finally, we document negative abnormal stock returns at the time exemption use is announced and over the subsequent 3 years, suggesting that investors view exemption use negatively and that their initial price reactions are incomplete.

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Appendix
Available only for authorised users
Footnotes
1
Section 404 has two components. Section 404(a) requires that management document and test internal controls, reaching a summary assessment of “effective” or “ineffective” in the annual report; Section 404(b) requires that auditors also assess and opine on the effectiveness of internal controls in the annual report. Section 302 requires quarterly public reporting on the effectiveness of and changes in disclosure controls but is more limited in scope and does not prescribe formal documentation and testing.
 
2
The SEC delayed the effective date of Section 404 for small firms (non-accelerated filers with a public float of less than $75 million), and these firms were ultimately permanently exempted from Section 404(b). Newly public firms that qualify as “emerging growth companies” are allowed a number of disclosure exemptions including exemption from Section 404(b).
 
3
The audit requirement of Section 404 is not mandated for non-accelerated filers or emerging growth companies, which potentially creates an opportunity to study compliance in those settings. As we describe in Section 2, however, these firms rarely voluntarily comply, and they face unique circumstances related to internal controls that are unlikely to generalize to the general population of accelerated filers.
 
4
See question 3 from the frequently asked questions answered by the SEC: “… we acknowledge that it might not always be possible to conduct an assessment of an acquired business’s internal control over financial reporting in the period between the consummation date and the date of management’s assessment. In such instances, we would not object to management referring in the report to a discussion in the registrant’s Form 10-K or 10-KSB regarding the scope of the assessment and to such disclosure noting that management excluded the acquired business from management’s report on internal control over financial reporting. If such a reference is made, however, management must identify the acquired business excluded and indicate the significance of the acquired business to the registrant’s consolidated financial statements.” (Available here: http://​www.​sec.​gov/​info/​accountants/​controlfaq1004.​htm.)
 
5
Although our sample is reasonably representative of other accelerated filers, we acknowledge that some differences exist between acquirers and non-acquirers. Firms with large acquisitions in our sample tend to be slightly larger and more profitable (untabulated). Although research suggests M&As create internal control problems (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007b), in our sample, acquirers have the same rate of material weaknesses as non-acquirer accelerated filers (7%; not tabulated).
 
6
Research suggests that audit firms respond to PCAOB-identified deficiencies by undertaking costly remediation efforts and that the additional costs are, in part, passed on to clients as higher audit fees (Acito et al. 2018; DeFond and Lennox 2017). Survey evidence also indicates that the PCOAB’s inspection emphasis on internal controls has spurred auditors to require more documentation and testing of controls, which in turn has increased compliance costs for clients by increasing both audit fees and time dedicated to internal compliance (e.g., FERF 2015; Protiviti 2015). These general trends are likely to be magnified with newly acquired businesses, potentially affecting acquirers’ exemption decisions. For example, survey respondents indicate that the inspections have increased costs by leading auditors to intensify their focus on testing system reports and review of controls, selecting controls to test, evaluating identified deficiencies, and addressing IT considerations. These are all important considerations when integrating a newly acquired business and evaluating its controls for the first time.
 
7
For example, Hochberg et al. (2009) provide evidence that insiders lobbied against SOX to protect their private benefits (i.e., for agency-related reasons), and a long line of research recognizes that agency frictions can lead to value-destroying acquisitions (Jensen 1986; Morck et al. 1990; Lang et al. 1991; Grinstein and Hribar 2004; Harford and Li 2007; Malmendier and Tate 2008; Harford et al. 2012; Harford and Schonlau 2013).
 
8
For example, the area under the ROC curve for our main determinants model increases 0.25% when including our agency conflicts variable, while it increases 5.19% when including our two indicator variables for whether the acquisition is completed in the fourth or first quarter (not tabulated).
 
9
Our return-on-assets measure is based on operating income before depreciation and thus is not confounded by goodwill impairments.
 
10
Carnes et al. (2018) examine future restatements as evidence that investors’ perceptions are justified, similarly finding that exemption use is associated with a higher likelihood of restatements. Our study provides a more comprehensive analysis of the consequences of exemption election by also examining goodwill impairments and changes in profitability.
 
11
Additional exemptions from SOX 404 continue to be debated (e.g., Rapoport 2017). On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017, which would eliminate 404(b) for firms with public float of less than $500 million (from $75 million) and defer 404(b) for up to 10 years for companies with revenue of less than $50 million (https://​www.​congress.​gov/​bill/​115th-congress/​house-bill/​10). Our discussion in this section focuses on the prior papers most relevant for our study; the interested reader can find a more thorough review of the overall SOX literature by Coates and Srinivasan (2014).
 
12
This restriction is based on nonmissing values for Compustat’s ADR Ratio variable (ADRR). If we instead eliminate firms based on Compustat’s incorporation code (FIC not equal to “USA”), our inferences are unchanged, with the exception that our announcement return results become slightly stronger (not tabulated).
 
13
Audit Analytics does not provide an identifier of the acquired business being exempted from the internal control audit. We assume the acquisition being referred to in the acquirer’s internal control exemption disclosure relates to (at least) the largest acquisition. Based on a small hand-collected sample, we confirm this assumption holds 85% of the time (not tabulated).
 
14
We also separately examine targets that were stand-alone U.S. public targets and those that were subsidiaries of a U.S. public parent; we find no significant difference in the likelihood of exemption (untabulated).
 
15
These percentages are based on impairments identified using Compustat data. Although widely available and easily replicable, a shortcoming of the Compustat data is that it includes the impairment of any goodwill, whether related to the specific acquisition in our sample or not. It also includes some impairments of other nongoodwill intangibles. In Section 4.2, we also examine a refined measure of goodwill impairments that we manually link to the acquisitions in our sample.
 
16
Our restatements variable here is based on a complete pull from Audit Analytics; in Section 4.2, we also examine refined measures of material restatements and restatements that we can manually link to the acquisitions in our sample.
 
17
In subsequent analyses, we separately examine observations where the exemption use is potentially disclosed earlier in the year in a 10-Q filing. For these observations, abnormal returns around the 10-K filing are not significantly different from zero.
 
18
We examine additional measurement windows for future buy-and-hold abnormal returns in Section 4.3.
 
19
For example, in his letter dated May 29, 2015, Tom Quaadman, vice president of Center for Capital Markets Competitiveness wrote to James Schnurr (chief accountant of the SEC) and James Doty (chairman of the PCAOB) and expressed concern that an unintended consequence of the PCAOB inspection process is to increase the “costs and burdens for work that may in some instances not lead to more effective audits or controls” further noting the existence of “excessive compliance activities that are not understood and where the costs clearly exceed the benefits.”
 
20
There are 24 acquisitions of U.S. public targets where data is not available for these variables, so we exclude these observations when estimating the model for only U.S. public targets.
 
21
Deal size is strongly correlated with exemption in Table 1, Panel B, where we examine smaller deals, and this variable continues to load in a full regression with all of the variables in Column 1 of Table 5, Panel A (not tabulated). In untabulated results, we find that the coefficient on the interaction of LN(RELATIVE_SIZE) × QTR4_DEAL is significantly positive with a z-statistic of 1.75, which suggests that deal size becomes more important late in the year.
 
22
An alternative approach would be to include each of the five indicator variables individually, but this approach results in a large loss of observations. In untabulated analyses, when each of the five indicator variables are included separately, we find that entrenched managers are positively associated with exemptions. When including acquirer free cash flows, acquirer announcement returns, predicted probability of target ineffective controls, and synergy separately as continuous, rather than indicator, variables we find that acquirer free cash flows are positively associated with exemption.
 
23
The lack of evidence of agency-related incentives within U.S. private targets is consistent with research showing that private firms are less likely to be the target of agency-conflict-driven deals (Harford et al. 2012).
 
24
In an untabulated analysis, we separately examine the 168 observations from firms with at least two acquisitions in our sample and with at least one exempted deal and one non-exempted deal. Within this group, deals where the exemption is used are 8.8% more likely to be associated with a related goodwill impairment (SAME_DEAL_IMPAIR) than non-exempt deals in the same firms (p = 0.104, one-tailed), further corroborating our evidence that exemption use is associated with a higher likelihood that goodwill from the deal will later be impaired.
 
25
A drawback of this approach, however, is that restatement disclosures are often insufficiently detailed to unambiguously determine that they relate to a particular acquisition. This likely explains the small number of observations for which RESTATE_TARGET_RELATED = 1 (16 observations) and reduces the power of this test.
 
26
To avoid stale information in long-delayed filings, we require the 10-K filings to occur within 90 days of fiscal year-end for these tests.
 
27
The variable we use is “DC - Acquisition, etc. - integration and/or challenges noted” and consists of instances in which a company is stating that it has acquired another entity and considers the integration of that entity into its existing control system to be material enough to note. Examples where this value is equal to one include that the company has excluded the newly acquired business from its 302 report, it plans to exclude the newly acquired business from the 404 report, or that it is having challenges with integrating or getting information out of a newly acquired company.
 
28
In untabulated analyses, we control for earnings surprises and allow these earnings surprises to vary with whether the earnings announcement coincided with the 10-K filing as well as whether the earnings surprise was negative. Results are not affected by these additional controls.
 
29
Filing returns around 10-Q filings are measured analogously to our main measure around 10-K filings (FILING_RET).
 
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Metadata
Title
Costs and benefits of internal control audits: evidence from M&A transactions
Authors
Todd D. Kravet
Sarah E. McVay
David P. Weber
Publication date
05-10-2018
Publisher
Springer US
Published in
Review of Accounting Studies / Issue 4/2018
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-018-9468-9

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