The Market's Perception of the Regulatory Change from Auditing Standard No. 2 to Auditing Standard No. 5

Abstract

I investigate the stock market's reaction to events related to the Public Company Accounting Oversight Board's (PCAOB) development and enactment of Auditing Standard No. 5 (AS 5). The change from Auditing Standard No. 2 (AS 2) to AS 5 was debated in the business press at length. The PCAOB stated that the goal of AS 5 was to reduce the prohibitive costs of the Sarbanes-Oxley Act of 2002 - Section 404 and AS 2 (Krishnan et al. 2008) while maintaining the effectiveness of the internal control audits required by those policies. However, there was concern that internal control audit quality would decrease under AS 5. My study examines how investors perceived this change by considering stock market reaction around 10 event dates related to PCAOB and Securities and Exchange Commission (SEC) actions with regard to the development and enactment of AS 5. I find evidence that the market's reaction to key AS 5 events was significantly negative, which is consistent with investors perceiving AS 5 as a significant decrease in internal control audit quality. I also study these investor reactions cross-sectionally to further examine the two potential effects of AS 5 (decrease in compliance costs and decrease in internal control audit quality) and how they relate to firm characteristics (size, complexity, litigation risk, and fraud risk). I find evidence consistent with my main finding: investors' perceived increase in information risk under AS 5 is apparent when considering firm characteristics. Finally, I consider ex-post financial reporting quality under AS 5 and find no significant change in financial reporting quality compared to under AS 2. This study contributes to accounting research by being the first to study the stock market's perception of this significant policy change archivally and the first to consider the effectiveness of AS 5 with regard to financial reporting quality.