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Cushioning the Blow

A new study delves into the correlation between engaged auditors and the negative impact of announcing internal-control weaknesses at 336 companies.

2Feb

Choose your auditor wisely — in tough times, that choice may protect your stock price.

At least that's what the authors of a new study from Indiana University concluded after delving into the correlation between material weaknesses and engaged auditors in some 336 companies. Specifically, the study found that the negative impact of announcing an internal-control weakness could be cushioned by using one of the Big Four auditors.

"It's a second-order effect," says Leslie Hodder, former CFO of Levy Bancorp and an assistant professor at Indiana's Kelley School of Business who co-authored the study. She says the Big Four impact is mostly one of perception. Investors, explains Hodder, are more apt to believe top firms have the most thorough auditing practices, which "can help companies maintain investor confidence when problems arise."

Of the companies that reported an internal weakness in 2004, those with smaller auditors had a 3 percent negative impact on their stock, while the overall impact ranged from 1.5 to 2 percent. For example, Technology Flavors and Fragrances Inc., which employs BDO Seidman LLP as its auditor, experienced a three-day cumulative drop of 13 percent in stock price after reporting weaknesses in internal controls. In contrast, Bioanalytical Systems Inc., with Ernst & Young as its auditor, experienced a 2 percent drop in stock price after reporting internal-control weaknesses.

James Pajakowski, managing director of Protiviti Inc., cautions, however, that other factors help determine the impact of internal disclosures on stock price. "The impact of disclosures depends on investor confidence," says Pajakowski, "which could be based on [faith] in the managing team, the nature of the disclosures, and how many disclosures are made at one time, as well as the auditor you choose." Moreover, he says, the Big Four have become pickier in choosing clients and are basing their choices on how companies manage their risk.

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