December 14, 2006
Carla Hayn Partners with Firm to Explore Financial Transparency
Investors seem to reward firms for transparent reporting and governance
LOS ANGELES - Late one night last November, as Professor Carla Hayn prepared to “close shop” after a long day of teaching and research work, she decided to give one last shot at searching the Web with the keyword “transparency.” Professor Hayn, like many of her colleagues, has struggled with ways to operationalize the notion of financial transparency for empirical testing purposes. She had a specific question in mind: Are stock prices affected by the requirement of the new accounting standard (SFAS No. 123R) to expense the estimated value of stock options granted to employees? If so, are they affected differently as a function of the company’s transparency? A good measure of transparency was badly needed for this research to proceed.
As she was about to “google out” for the night, Professor Hayn’s last search turned up “Audit Integrity LLC,” a company located next door in West L.A. The company claimed to have a measure of financial statement transparency. It was obviously too late to call, but when she did contact the company the next morning, they were as eager as she was to meet and discuss her research interests. After a number of meetings with the company’s top management, Hayn began using Audit Integrity’s measure (known as the Accounting and Governance Risk Rating of AGR) in her research.
“We established a good working relationship,” Hayn says about her contacts with Audit Integrity. “I’ve had the opportunity to sit in on a couple of strategic meetings and consulted with management on various applications of their product.”
Mike Walter (’93) is responsible for marketing Audit Integrity’s services to institutional investors, including various money managers and hedge fund managers. As explained by Walter, Audit Integrity has developed and refined a proprietary database of approximately 1,000 companies that have had a Securities & Exchange Commission (SEC) enforcement action against them in the past 15 years. The company analyzed the accounting and governance practices of these companies and found the relationship between these firm characteristics and the likelihood of SEC action. What they found was that the more open and transparent a company was, the less likely they were to have an SEC investigation.
In a post-Enron world, confirmation of this correlation seemed very valuable. Audit Integrity tracks more than 9,000 public companies based on their accounting and governance practices, assigning a rating to each. Beginning with a score of 100 and subtracting points when companies’ financial statements are more aggressive relating to their past reporting practices and industry peers, conservative companies might have a score as high as 88, while aggressive companies that lack transparency could score down in the teens.
According to Walter, the first clients Audit Integrity attracted were insurance companies offering director and officer insurance. Being able to identify which companies were more likely to be investigated impacted rates. The next clients to come on board were the big accounting firms that were interested in determining which firms were more likely to have to restate their earnings.
Risk, Ratings and Returns
As time went on and Audit Integrity grew, Walter says they began to wonder if the risk rating (which is associated with the level of reporting transparency, disclosure practices and corporate governance attributes) was associated with the firms’ stock returns.
“That’s where Carla Hayn came into the picture,” Walter says. “She has done research on accounting disclosures and stock returns.” Hayn says, “Audit Integrity’s leaders were curious as to whether their product was related to future stock prices. I did some testing on portfolios formed on the basis of Audit Integrity’s transparency measure. The results were surprising. Portfolios of firms with more transparent financial statements performed better over the following one- and two-quarter periods than did their counterparts with less transparent financial statements. This difference was particularly pronounced for smaller firms for which there is less publicly available information.”
The relationship between Hayn and Audit Integrity has evolved over time. It allows for collaboration on research topics of interest to both parties. Occasionally, Hayn is called upon to test some aspect of the models developed by Audit Integrity. She often receives calls from potential clients of the company with questions about the quality of Audit Integrity’s Accounting Governance measure. “I explain to them that, while I have found the measure highly correlated with past returns, I have no guarantee it would perform as well in the future,” says Hayn.
Transparency is Paramount
One of the by-products of the collaboration between Professor Hayn and Audit Integrity is that the company is now one of the sponsors for UCLA Anderson’s Director’s Training and Certification Program, which is offered to corporate directors. “Audit Integrity’s participation in the program gets board members thinking more about accounting issues and the relative transparency of their own firm’s financial statement disclosures,” Hayn says.
Enron and the many other accounting scandals of recent history have brought accounting issues and the need for clear financial statements into the limelight.
“Transparency is paramount now,” Hayn says. “A quantitative measure that effectively encompasses all of the ingredients that are part of what we conceive of as ‘transparency’ is a big step forward.
“Investors appear to be paying attention to transparency and to reward it,” she concludes, based on her research results. “This is an interesting finding and good news for a company like Audit Integrity that has worked hard to develop and validate a measure to gauge the phenomenon.”
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