Several prominent accounting scandals at the turn of this century, involving such companies as Enron and Waste Management, led to restrictions of practices that were assumed to impair financial reporting quality. One of these practices was "revolving door" hires, in which companies hire accounting and finance officers from their auditors. The verdict on whether these appointments were harmful was inconclusive at the time, and now a study suggests that it may have been unnecessary to restrict them.

Marshall Geiger, Clive Lennox and David North reviewed hirings of senior accounting and financial officers in the years leading up to the 2002 Sarbanes-Oxley Act (SOx), which ushered in the restrictions on revolving door hires. They find such appointments were uncommon and when they did occur, they were favorably received by the market. Moreover, financial reporting quality - the main motivator behind the SOx restriction - was not compromised.

"'Revolving door' hires were restricted by SOx because in several prominent accounting scandals, such as Enron, senior accounting and finance officers previously worked for their companies' external audit firms, raising concerns that such appointments present a threat to audit and financial reporting quality," the authors say.

"If such appointments did significantly impair the credibility of financial reporting, shareholders likely would have viewed them unfavorably, in which case the market reaction would have been negative. Ultimately, then, this is an empirical question about whether shareholders viewed the appointments positively or negatively."

The authors looked at 3,176 newly-hired accounting and finance officers between January 1985 and July 2002, just before SOx took effect, and found only 193 officers or 6.1 per cent were directly hired from the company's own audit firm. Rather than seeing this as detrimental, the market reacted favorably. The mean positive cumulative abnormal return for firms with revolving door hires was +1.2 per cent against +0.2 per cent for all firms in the sample. The impact was greatest among smaller firms, reaching +2.2 per cent.

This response reflected the perceived benefits of revolving door appointments. A former auditor may be the most suitable candidate for the job because of his or her familiarity with the company's systems, personnel and reporting issues. And their acceptance of employment sends a positive signal to the market about the company's future.

"The positive market reaction to revolving door appointments by small companies, even after controlling for other characteristics, suggests that these companies were rewarded by the market for hiring from their audit firms," the authors say.

"When the market reaction is combined with the low frequency of revolving door appointments, it suggests the sweeping SOx restrictions on these hires may have been unnecessary and even unfortunate, at least from the perspective of shareholders."

It may still have been possible that these appointments reduced financial quality, but the authors found no evidence of this. They looked first at signed discretionary accounting accruals immediately after the appointment, which might have been expected to increase if the revolving door hires had a negative impact on the credibility of financial reporting. The frequency of discretionary accruals was similar between both revolving door firms and others.

Then they looked at issuances of Accounting and Auditing Enforcement Releases for materially misleading financial statements. Here, the frequency among revolving door hires was lower, at 0.5 per cent, than non-revolving door firms at 3.1 per cent, providing strong evidence that revolving door hires did not harm the quality of financial reporting.

The authors conclude, "Our study reveals that revolving door appointments occurred infrequently in the pre-SOx period, the market reacted positively when they did occur, and there does not appear to be a significant reduction in the quality of financial reporting after these appointments. Thus, our results suggest the SOx ruling may not be an effective protection for shareholders."