Academic journal article International Management Review

How Do Regulation Changes Impact the Bondholders' Perception of Auditor Choice and Managerial Ownership? Evidence from the Sarbanes-Oxley Act Adoption

Academic journal article International Management Review

How Do Regulation Changes Impact the Bondholders' Perception of Auditor Choice and Managerial Ownership? Evidence from the Sarbanes-Oxley Act Adoption

Article excerpt

[Abstract]

This paper explores how US bondholders value the auditor choice and managerial ownership of firms and investigates whether regulation changes affect these perceptions. Using the Sarbanes-Oxley Act (SOX) as a major regulation shift, we find that during the pre-SOX period, bondholders value the services of one of the Big Four auditors but not after the Act adoption. As for managerial ownership, we find that bondholders ask for higher bond yields after the Act enactment from firms with higher executive ownership whereas they do not before SOX. The overall evidence suggests that auditor choice and managerial ownership have lost their "disciplinary" power since the adoption of the SOX Act.

[Keywords] Auditor choice; big four; managerial ownership; bond costs; Sarbanes-Oxley Act

Introduction

It is commonly argued that investors value the quality of corporate governance of the firms in which they invest their money. Previous studies have suggested that managerial ownership and auditor choice play a vital role among the firm's governance structure. According to the agency theory, managers, who are naturally an "imperfect" agent for shareholders, would be more affected by the firm's value if they are themselves owners of the firm (Jensen & Meckling, 1976). Hence, giving them the opportunity to be owners may align their interests with those of shareholders. Moreover, accounting literature has attributed to the auditor a crucial role in ameliorating the quality of the firm's financial reporting. Among the auditors, the Big Four are supposed to be more effective in assuming this role. This is mainly because the reputation of the Big Four auditors induces them to fully perform their monitoring task.

The market perception of managerial ownership and auditor choice (and more generally of corporate governance mechanisms) is an extremely important topic that needs to be explored. Actually, this perception affects the cost of external capital that the firm needs to undertake its projects and generates values for its stakeholders. This external capital assures that the firm remains thriving in the long run. Debt market is considered the most important source of external finance around the globe. To get access to loans with lower costs and at the needed time, firms should understand (and comply with) the perceptions the debt market participants have of the firms' governance structure.

Related studies have analyzed the effect of some governance mechanisms on corporate debt characteristics (which reflect the debt market perceptions of the firm's governance structure). Anderson, Mansi, and Reeb (2003) observe that ownership concentration in the hands of the founding family reduces the cost of debt. They interpret this finding by the concern of this type of investor to create value and to pass the firm into subsequent generations. Bhojraj and Sengupta (2003) explore the effect of institutional ownership and outside directors on bond ratings and yields. Their results point to lower corporate bond costs and higher credit ratings for firms with greater institutional ownership and a large proportion of outside directors. More recently, Boubakri and Ghouma (2007), in an international framework, find that the likelihood of expropriation (as measured by the voting/cash-flow rights wedge of the major shareholders) increases bond costs and reduces bond ratings. The authors also investigate the effect of legal protection on these two corporate bond characteristics. Their results show that both bondholders and rating agencies value a good legal environment, particularly law enforcement.

The findings of this handful of studies on this topic suggest that the bond market is sensitive to some corporate governance practices. This paper aims to extend this literature by analyzing two more governance mechanisms. It seeks to shed more light on the impact of auditor choice and managerial ownership on corporate bond costs. …

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