Innovator Article

Auditors’ Fees Give Clues to Bearish News

Investors and stock analysts should keep an eye on unexplainable increases in companies’ auditors’ fees to avoid losing money in a future drop in stock prices at those companies.

“A rise in audit fees acts to deliver a precursory message about trouble within the company,” said Professor Paul Griffin. “Auditors’ fees, which are reported to the Securities and Exchange Commission and are public, will go up if the auditors are worried about irregularities that can cause them to have legal exposure.”

Griffin’s findings are reported in “Audit Fees Around Dismissals and Resignations: Additional Evidence,” published in the Journal of Contemporary Accounting and Economics (December 2011). The paper is co-authored by Professor David Lont of the University of Otago, New Zealand.

Public companies are required to have independent audits. When a company lacks adequate controls or shareholder protections, and perhaps has weak governance practices, the risk of legal exposure to the auditor rises. To stay in business, the auditor must charge a higher fee to cover the potential risk, and often will eventually resign to avoid further risk.

“An auditor resignation and the attendant adverse publicity typically causes a significant drop in company stock,” Griffin said.

Eye on Stock Short Sellers & Bonds

Savvy investors who follow short sellers to predict bearish news about a company’s stock—and sell their stocks in that company to avoid losses—should keep an eye on the company’s bonds as well, a new study by Griffin and Hyun Hong, assistant professor of accounting at the University of Memphis, suggests.

“Traditionally, traders and academics have focused on analyzing the positions of short sellers as an indication for investors to sell the stock, and therefore to avoid the loss from a further decline in the stock’s value,” Griffin wrote in a working paper, “Price Discovery in the Corporate Bond Market: The Informational Role of Short Interest.”

Griffin and Hong analyzed more than 9,000 bond observations, or sales and purchases of a bond in a given month, from 660 companies from 2005 to 2007. They discovered that bonds showed a similar pattern to short sales. “Bond investors could avert significant losses by following the simple rule of selling bonds based on elevated or rising short interest,” said Griffin.

The excess returns on bonds decrease in the months immediately following a high or increasing “short” position.

Recognition and Presentations

Griffin and Professor David Lont and Kate McClune of the University of Otago’s School of Business, won a best manuscript award at the 2011 Accounting & Finance Association of Australia and New Zealand’s annual conference for their paper “Insightful Insiders? Insider Trading and Stock Return Around Debt Covenant Violation Disclosures.”

Griffin, Lont and Yuan Sun of UC Berkeley won the Peter Brownell Manuscript Award for the best paper published in Accounting & Finance in 2010, “Agency Problems and Auditor Fees: Further Tests of the Free Cash Flow Hypothesis.”

Griffin presented his paper on how companies’ disclosures about greenhouse gas emissions and the impact of climate change affect shareholder value at the 2011 Annual Meeting of the American Accounting Association in Denver, and at seminars in Brisbane, Australia, and Wellington, New Zealand.

Griffin also published an article titled “Climate Change Disclosures Under-GGRT: Should Analysts Care?” in CFA Magazine (November/December 2011). The article advises financial analysts on what to look for when the Environmental Protection Agency makes public considerable information on companies’ greenhouse gas emissions.

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