Recent auditing regulations decrease preliminary reports reliability

first_imgAddThis ShareCONTACT: Jessica StarkPHONE: 713-348-6777EMAIL: stark@rice.eduRecent auditing regulations decrease preliminary reports’ reliabilityStandards create trade-off between timeliness and accuracyThe very standards designed to improve public companies’ annual earnings reports are increasing the likelihood that preliminary earnings numbers are not as reliable as they were before the standards, according to research from Rice University, the University of Kansas and Michigan State University. The new study finds the 2004 implementation of the Public Company Accounting Oversight Board (PCAOB) Auditing Standards No. 2 (AS2) and No. 3 (AS3) has increased the length of time between the fiscal year-end and the audit report by about 15 days; in 2005, audits were completed, on average, about 65 days after the end of the fiscal year.Because of market demand for timely disclosures, most companies have kept the same date to release their preliminary earnings report, despite the increased audit report lag. Before the implementation of AS2 and AS3, 70 percent of companies waited to release their preliminary numbers until after their audit was complete; in 2005, only 20 percent waited. “We’re seeing that preliminary earnings information is not as reliable as it once was,” said K. Ramesh, professor of accounting in Rice’s Jones Graduate School of Business. “It’s an unintended consequence of the new regulations. Companies are facing a trade-off in providing value-relevant information on a timely basis and the potential loss of reliability in releasing the information prior to the audit being completed.” Since the new regulations, the number of preliminary earnings announcement (PEA) revisions — cases in which the preliminary earnings announcement differs from what’s reported in the 10-K filing — increased from 12 revisions in 2000 to 186 revisions in 2005. The research team found that PEA revisions would have been 35 percent lower during 2005 if the companies had waited until after audit completion to make the preliminary earnings announcement. ”The negative association between completion of audit and PEA revisions provides direct archival evidence on the value of the financial statement audit,” Ramesh said.The researchers — Ramesh from Rice University, Scott Bronson from the University of Kansas and Chris Hogan and Marilyn Johnson from Michigan State University — also examined the market reaction to the disclosure of the revisions. They found that revisions disclosed in 10-K filings are generally smaller in absolute magnitude than revisions disclosed in earnings press release and 8-K filings. “The negative stock market reaction to corporate announcements of forthcoming PEA revisions points to the economic significance the market attaches to the reliability of information in PEAs,” Ramesh said. “Any change in reliability of PEAs has important implications, given that capital market participants have historically placed greater emphasis on salient and timely disclosures in earnings press releases than disclosures in periodic reports.”The research paper, “The Unintended Consequences of PCAOB Auditing Standards Nos. 2 and 3 on the Reliability of Preliminary Earnings Releases,” will be published in a forthcoming issue of the Journal of Accounting and Economics.A working version of the paper is available at:

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