The influence of modified audit opinion on the stock ...

The influence of modified audit opinion on the

stock market and cost of debt: U.S. evidence

Student name: Carmen Necula

Student number: 10622756

Supervisor: Dr. Alexandros Sikalidis

MSc Accountancy and Control, Accountancy Track

Faculty of Economics and Business

Academic year: 2013-2014

June 22, 2014

The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence

2

Abstract

This study examines the impact of the announcement of a modified audit opinion on the market,

more specifically on the stock returns and on the cost of debt, and the way it is perceived by the

investors and creditors. The sample contains publicly held companies from U.S. with collected

data from 2012, that had a continuous auditing, excluding those from the financial and real estate

sector. The main focus was on the cumulative abnormal return and the interest rate for the

analysis of stock market and respectively the cost of debt. Contrary to the majority of previous

studies, the results suggest that there is no significant influence of a modified audit opinion over

the stock returns and the cost of debt, since the investors and creditors do not perceive this

information as value relevant for their decisions. However, the results may be biased by other

concurrent information, by the methodology approach or the sample might not be representative

for this research.

Key words: modified audit opinion, stock market, cost of debt, abnormal return, interest rate,

U.S., information content, value relevance


3

Contents

1. Introduction ......................................................................................................................................... 4

1.1Background .......................................................................................................................................... 4

1.2 Research question ................................................................................................................................ 6

1.3 Motivation ........................................................................................................................................... 7

2. Literature review and hypotheses development ............................................................................... 8

2.1 Theoretical background ...................................................................................................................... 9

2.1.1 Auditor opinion ............................................................................................................................. 9

2.1.2 Stock market ............................................................................................................................... 10

2.1.3. Cost of debt ................................................................................................................................ 11

2.2 Literature review ............................................................................................................................... 12

2.3 Hypotheses development ................................................................................................................... 16

2.3.1 Hypothesis I ................................................................................................................................ 16

2.3.2 Hypothesis II ............................................................................................................................... 17

3. Research methodology ...................................................................................................................... 18

3.1 Sample selection ................................................................................................................................ 18

3.2 Variables measurement ..................................................................................................................... 20

3.2.1. Dependent variables .................................................................................................................. 20

3.2.2 Independent variables ................................................................................................................ 21

3.2.3 Control variables ........................................................................................................................ 21

3.3 Regression models ............................................................................................................................. 22

4. Results................................................................................................................................................. 24

4.. The stock market reaction over the announcement of a modified audit opinion ................................ 24

4.2 The effect of modified audit opinion on the cost of debt .................................................................... 30

5. Limitations ......................................................................................................................................... 35

6. Summary and conclusion .................................................................................................................. 36

References .................................................................................................................................................. 38

Appendices ................................................................................................................................................. 41


4

1. Introduction

1.1 Background

Nowadays, many companies are disclosing the audit report either voluntarily for improving their

relationship with their stakeholders, or because they are required to do that, in order to give a fair

assurance over the financial statements. The audit report is not always in the auditee‟s favor,

because the auditor may find some inconsistencies that can affect the real image of the company.

Depending on their significance, these are included in the explanatory notes to an unqualified

audit opinion. No matter the type of the auditor‟s opinion is, this brings new information into the

stock market attention. This can lead to some changes in stock prices so the value relevance of

the auditor‟s opinion could be an important aspect that deserves to be analysed. Another aspect

about this, is the information decision usefulness, more precisely, the way in which the auditor‟s

opinion influences the investors‟ decision making process, about buying, selling or holding

stocks within a specific company. Another category of users that could make use of the audit

report is represented by the creditors, who have to be aware of the financial position of a

company when deciding to give them credits.

The relationship between stock market and auditor‟s opinions has been studied by other

authors too, using different samples and analyzing specific aspects of this topic. One of them is

the going concern opinion, as part of a modified audit opinion.

For instance, Ogneva and Subramanyam (2007) examines the returns following disclosure

of going concern opinions using a sample of U.S. and Australian firms, but they didn‟t find any

pricing anomaly related to going concern opinion in either of these countries. This can be

interpreted as the lack of under-reactions of the stock market following the disclosure of a going

concern opinion.

Different results related to this topic, are emphasized in Taffler et al. (2004), which found

a highly significant adverse price reaction over 1 year period, after a going concern modified

audit report, between -24% and -31%, based on expected return benchmark used. They did find

significant market under-reaction associated with a going concern opinion in U.K., but this

conclusion is consistent with irrational investor behavior.

The information content is analyzed in Frederick Jones (1996), where the U.S. sample is

used to prove that the independent auditor‟s going concern evaluation provides information to

investors and supports the requirement of disclosing those uncertainties within the audit report.


5

Another interesting study about the information content of auditor‟s opinion is Dodd et al.

(1984) because they exclude the adverse opinion from their sample, containing New York Stock

Exchange firms. In their analysis, they took into consideration only qualified opinions and

disclaimer of opinion and the results suggest that audit opinions have little impact on the value of

common stock, but this doesn‟t mean they are less important.

One of the few studies that focused on the difference between the unqualified and the

qualified opinions is Chen et al. (2000). The conclusion stated in this paper is that there is a

negative association between MAOs and cumulative abnormal returns. Furthermore, they found

no difference between market reaction to qualified opinions and market reaction to unqualified

opinions with explanatory notes.

The cost of capital with its both cost of debt and cost of equity, has been in the main

attention of many researchers from many years, as well.

One recent paper where the debt contracting has been the main focus is Chen et al (2012).

The authors have examined the effect of qualified audit opinions on private debt contracts,

proving that there is an association: “a qualified audit opinion is associated with an average

increase of 18 basis points in the interest rate of loan facilities issued in the year following a

QAO.”1 This have consequences in the future too, as they observed the interest rate effects of a

QAO persist for three years, even after a clean audit report.

There are also studies that have made an analysis on the audit status of companies and the

influence of it on the cost of debt. A relevant study in this concern is Kim et al (2007), based on

privately held Korean companies, that are not required to get an external audit, but some of them

are voluntarily doing it. They found that those firms with an external audit, pay a significantly

lower interest rate on their debt as opposed to firms without an external audit. This is also

supported by the fact that a change in a company‟s audit status from no audit to external audit

(either voluntarily or mandatory) leads to significant savings in the cost of borrowing.

The relationship between accounting, disclosure quality and debt contracting is another

main topic for a large number of papers. Bharath et al (2004) has examined the commercial bank

loan contracts of publicly traded US firms and it has emphasized that “poor accounting quality

1 Chen, Peter F.; Tenho, Shaohua; Ma, Zhiming; Stice, Derrald E, 2012. Qualified audit opinions and debt contracting. The 3rd International

Conference of The Japanese Accounting Review, Kyoto, Japan, p. 6


6

reflects limited information about borrowers‟future operating cash flows”2. This is translated by

higher risks, which encourage the bank to increase their loan transaction cost in order to

compensate for the information risk. Since the accounting quality is closely related to a quality

audit report, I expect that a poor audit quality have similar effects on the interest rate.

These expectations are met in Karjalainen (2011), which examined a large sample of

private Finnish firms in order to emphasize the value relevance of the audit quality in debt

pricing. Their findings indicate that Big 4 audits correspond with a decreased cost of debt, and

that for firms with modified audit reports this is higher than for firms with a clean audit report.

Regarding the level of disclosure, Jere et al (2005) and Sengupta (1998) both have proved

there is an inverse relationship between interest cost of issuing debt and the quality of corporate

disclosure. Considering this, I assume that a high quality audit report will provide significant

information for the creditors, and their decision making process will be more accurate and the

level of riskiness decreases significantly.

Considering there is no much evidence of the difference between the effects of both clean

and modified audit opinions on the stock market reaction in the US market, I think my research

will bring a significant contribution into the literature and also a societal one, offering a better

overview over the auditor‟s opinion. As respects the cost of debt, there is a significant

contribution as well, since this is the first study to analyse the modified audit opinion influence

on cost of debt for U.S firms.

1.2 Research question

In my study, I want to focus on the effects of the auditor‟s opinion on the stock market and on the

cost of debt, considering the unqualified or clean opinion and the modified audit opinion. Some

other purposes related to this research question are investigating the value relevance of the

auditor‟s opinion and the usefulness of information disclosed within the audit report, for the

investors when, making their decisions.

Based on the above discussion this study examines the following research questions:

- How does the auditor‟s opinion over the financial statements influence the stock market?

- What is the effect of the auditor‟s opinion on the cost of debt?

2 Bharath, S.T., Sunder, J., Sunder, S., 2008. Accounting quality and debt contracting. The Accounting Review 83 (1), 1–28


7

1.3 Motivation

The main aim of this research is to bring into investors‟ and creditors‟ attention important

information, given the changes that may happen on the stock market when different types of audit

opinions are disclosed. The reason for focusing on these two categories of users, is that I consider

them the most important for a company in order to keep their business profitable. Investors can

significantly increase the profitability and creditors can help the companies make investments

that have future important benefits. Furthermore, considering that debt financing is the

predominant form of external financing for publicly traded firms in U.S. (Sengupta 1998), I

assume my sample will be relevant for analysing the influence of a modified audit opinion.

In this study, I will take a different approach from prior literature, which has primarily

focused on the stock market reaction by analyzing either the unqualified and qualified opinions or

the going concern opinions of auditors. There are few studies which actually highlight the

differences between types of opinions and the way they are perceived by investors and creditors,

which encouraged me to focus on two types of opinions: the unqualified opinion and the

modified audit opinion. The reason I chose these two types of opinions, is that the modified audit

opinion can be viewed as a bad news and the unqualified opinion as a good news so they can be

considered being opposite. The interesting part here is to analyze if the stock market reaction on

auditor‟s opinion differs after disclosing one type of opinion or another and in which way.

Regarding the approach for analyzing the effect on the cost of debt, I did not find many

studies regarding its relationship with the modified audit opinion, so I consider it would be

interesting to show whether the effect of disclosing such an opinion is similar with those from

Karjalainen (2011), already mentioned in the Background. Furthermore, I will also consider the

BIG4 variable in my model in order to emphasize the influence of auditor‟s rank on the cost of

debt, and the value relevance of audits to creditors.

This research will contribute to prior literature in a significant way, because it will bring

into the reader‟s attention the differences in the market reaction following those types of opinions

and the changes regarding the debt contracting. Also, through answering the research questions,

the value relevance of the auditor‟s opinion and the usefulness of the information provided will

be clearly emphasized.

Taking into consideration the previous papers, which are not aligned with the same

conclusion regarding the effect of the audit opinion over the stock market, I think extending the


8

analysis to another more recent period - 2012 - and using as sample firms listed on U.S. market,

will bring another contribution, from a scientific point of view. The paper will analyze recent data

from U.S. which, although it has been analyzed before, there have been found contradictory

results of the going concern opinion.

The stock market reaction to an auditor‟s opinion is important for both the company and

for its stakeholders. This study could bring into stakeholders‟ attention that there are some other

factors that can influence the reaction of stock market, besides auditor‟s opinion, so they should

analyze other determinants too, when making their decisions.

The cost of debt is another important aspect for every company since loans are one of the

way to get external financing. The extent to which a modified audit opinion could influence the

cost of debt, would increase the accuracy in decision making of the lenders when evaluating debt

covenants and the financial statements of a specific firm.

The rest of the paper is organized as it follows: section 2 reviews prior literature regarding

the audit opinion and its influence on the market, provide some theoretical background for the

most important concepts, and present the hypotheses of this research; section 3 develops the

methodology used for this study and the empirical models; section 4 describes the reports and

analyzes the results of the regression models; section 5 contains the limitations of the analysis;

and finally, section 6 presents the summary and the conclusion of this study.

2. Literature review and hypotheses development

The structure of this chapter is as it follows:

I will first provide some theoretical concepts that are most important to know for

understanding the relationships for the analysis;

Then I will present some key papers that have studied important aspects related to the

research questions and I will rely on their results to find an easier way to my own

findings;

The final section will describe the hypotheses I want to develop in this study.


9

2.1 Theoretical background

In my research, I will focus on two types of auditor‟s opinion: the unqualified opinion, which is

the best opinion a company can receive, and the modified audit opinion, which can be

unfavorable for the company, depending on the importance of the explanatory notes included in

the report. The purpose of this comparison is to better highlight the differences between the two

types of auditor‟s opinions and between their effects on the stock market returns and cost of debt.

2.1.1 Auditor opinion

The auditor‟s report is known as a primary means of communication between the auditor and the

stakeholders of the audited entity, according to IAASB. The users of audited financial statements

rely on the audit report and they consider it meaningful for their decision making process. But,

since the global financial crisis began, the users are increasingly asking for more inside

information to be included within the audit report, for a better transparency.

One of the most important part of the audit report is the auditor‟s opinion because it

represents the assurance over the financial statements. The audit opinions can be classified as it

follows: unqualified opinion, modified unqualified opinion, qualified opinion, adverse opinion

and disclaimer opinion.

The unqualified opinion, also known as a clean opinion, states that the financial

statements are representing in a fair and accurate way the view of the business,

according to the accounting principles.

The modified unqualified opinion, also known as the standard auditor‟s report

with explanatory notes is used when the auditor wants to bring some specific

information into users‟ attention which may affect their decision making process.

A very known opinion in this case is the going concern report, which states that

the auditor has great doubts about the ability of the company to remain in

business.

A qualified opinion contains some misstatements detected by the auditor,

considered to be material but not pervasive.

For an adverse opinion, the auditor has found enough evidence to prove that the

misstatements are material and pervasive.


10

The disclaimer opinion states that the auditor didn‟t find sufficient evidence over

the financial statements and is unable to complete the audit mission.

I chose to focus on two types, more precisely, on the unqualified opinion and the modified

unqualified opinion, because first of all, they are the most common among companies and

secondly, because I consider they bring different information that could matter in a way or

another for the constituencies. This means that it‟s expected to get different results with respect to

the effects of their disclosure on the stock returns and cost of debt.

2.1.2 Stock market

In order to better understand the relationship I want to analyze, I will provide an explanation for

stock market concept.

The stock market, also known as the equity market, is the market in which shares of

publicly held companies are issued and traded through exchanges, giving investors a part of

ownership and allowing them to participate in the achievements of the companies they own

shares, but they are also exposed to the risk of losing money if the company suffers losses. By

stock market reaction we can understand the changes that are happening in the market, through

the movement in the price, volume or returns of stocks.

There have been studies, as mentioned in the Background, that proved the stock market

underreacts following the going concern audit opinion disclosure. For instance, Taffler et al.

(2007) is one of the papers that brings into discussion this anomalous market behavior, consisting

in firms that are underperforming various return benchmarks. This is caused by “denying the bad

news conveyed by a going concern audit opinion and trading at prices inconsistent with

underlying value”3, which is explained by the existence of irrational or naïve investors. This fact

is inconsistent with the market efficiency concept, which states that prices fully reflect all the

publicly available information. The measurement procedure for this under-reaction of stock

market is represented by the difference between returns when the investors take into

consideration the going concern audit opinion and the returns when investors are ignoring this

disclosure.

3Taffler, R.J., Lu, J., Kausar, A., 2004. In denial? Stock market underreaction to going-concern audit report disclosures. Journal of Accounting

and Economics 38, 263–285


11

The question that comes next is whether there are possible over-reactions of the stock

market and the answer could be affirmative as well. One representative study on this topic is

Schaub (2006), which explains this concept as the phenomenon through which investors initially

compound the true impact of new information on the firm, in this case the disclosure of going

concern opinion, determining stock prices go too low following bad news or too high, based on

good news. This concept of overreaction is also against the stock market efficiency, as long as the

investment is not profitable. The results show that greater initial price reactions are followed by

larger stock price adjustments, which is consistent with the over-reaction hypothesis.

The aspect I want to emphasize here, is that the stock market efficiency is only a theory

which can hardly be applied in an imperfect economic environment and that stakeholders should

expect anomalies to happen.

2.1.3. Cost of debt

Capital is a fundamental element of a company for its business survival and for a high turnover.

There are two major ways to raise money for a company: debt financing and equity financing, but

the predominant one among companies is the debt financing.

Jensen and Meckling (1976) provides an important theoretical background over the cost

of debt and its particular aspects, like the incentive effects associated with highly leveraged firms,

the monitoring costs and the bankruptcy and reorganization costs.

For the incentives, they explain that creditors would not borrow a company for an amount

much higher than the entrepreneur‟s investment, because the latter tends to engage in activities

with a high profitability but a low probability of success, since he will benefit of most of the

gains if the things turn out well, and if not, the creditors will bear the most of the costs.

In order to limit this managerial behaviour, the creditors could ask for covenants with

provisions that impose constraints on management‟s decisions, including limitations of the

riskiness of the investment project. All the costs associated with these type of covenants are the

monitoring costs.

In case of bankruptcy or litigation the cost of debt increases, because there is much more

risk involved for the lenders and they will pay for fixed claims for a price inversely related to the

probability of the incurrence of these costs to probability of bankruptcy.


12

According to Sengupta (1998) there are two alternative measures of cost of debt:

- the yield to maturity on new debt issues, and

- the total interest cost of new debt issues

In my study, I will consider the cost of debt as the interest rate, determined as the interest

expense scaled by total liabilities.

2.2 Literature review

The subject of this paper is a difficult and controversial one, because there were different findings

that came out of related studies regarding the effect of audit opinion over the stock market, as I

have already mentioned in the Background. Regarding the connection with the cost of debt, this

is quite a new topic since there were few studies that focused on it, as far as I documented.

One important study that outlines the stock market reaction to a going concern opinion is

Herbohn et al. (2007), which focuses on the information content of the audit report, but also

investigates the stock market anomaly following the going concern opinion, using Australian

firms. The authors state that a going concern opinion of an audit report “is a significantly

unambiguous „badnews‟ event for stock market participants and an adverse stock market reaction

is expected.”4. But this expectation wasn‟t proved through their study, because they did find that

the stock market has a significant negative reaction in the pre-event period rather than the post-

event period. They explain this by Australian markets being well informed, so the announcement

of a going concern opinion is a culmination of multiple prior events, and disclosing it doesn‟t

actually give additional information to the market. I consider this study a interesting one, as long

as the results are not consistent with the ones expected at the beginning.

The going concern opinion has also been analyzed from another point of view,

specifically the ability to predict the bankruptcy, as stated in Chen and Church (1996). This can

show a significant level of information usefulness for investors, who didn‟t know about the real

situation of the company where they own shares. The authors found that, as opposed to receiving

unqualified opinions, firms that receive going concern opinions “experience less negative excess

returns in the period surrounding bankruptcy filings”5. They focused only on one financial

4Herbohn, K., V. Ragunathan& R. Garsden (2007). The horse has bolted: revisiting the market reaction to going concern modifications of audit

reports, Accounting and Finance, 47:3, 473–493 5 Chen, K.C., & Church B.K. (1996). Going concern opinions and the market’s reaction to bankruptcy filings. The Accounting Review, Vol. 71

(1), pp. 117-128.


13

difficulty occurring after disclosing a going concern opinion, in order to prove the value

information, but there are others too, like quarterly losses, suspension of dividends, default on

debt etc.

Another view over information usefulness of the going concern opinions is given by

Dennis O‟Reilly (2010), which shows the importance of disclosure for valuing company‟s stocks

by investors. What makes this study more interesting is the fact of being the first one that uses an

experimental approach for reaching the findings. More precisely, U.S. financial analysts were

required to participate by email at two stock price estimates of a financial distressed company,

one before and one after including the auditor‟s opinion. The author found significant stock price

reductions, after receiving a going concern opinion, and the usefulness of the auditor‟s opinion is

proved to be “greater when it provides a signal that differs from that which the market is

expecting”6. It will be interesting to see whether a qualitative research like this one is consistent

with my conclusion, also based on the US sample.

Chen et al. (2000) focused on the differences between the qualified and unqualified

opinions, by analyzing the valuation effect of modified audit opinions (MAOs), in the Chinese

stock market. The environment here has some specific characteristics, which differ from the ones

in U.S.. Some of them are related to the Chinese investors, who are not experienced in using

financial information, others to Chinese auditors who usually disclose an unqualified opinion

with explanatory notes instead of a qualified opinion, and other characteristics are related to the

regulators, who are more strict and more offended in case of GAAP violations. By analyzing

different forms and contents of modified audit opinions, the authors want to emphasize the role of

the auditor in the market. They found that in an emerging market like the Chinese one, MAOs are

negatively associated with the returns but there is no difference observed between the qualified

opinion and the unqualified opinion with explanatory notes. Furthermore, investors don‟t react

negatively until the second year after disclosure.

Allen et al. (2011) focused on the auditor‟s going concern opinion as a communication of

risk investors are exposed to. This leads to a substantial shift in the structure of the market

valuation for firms financially distressed and more importantly, “the results hold even after

6 Dennis M. O'Reilly, (2010) Do investors perceive the going-concern opinion as useful for pricing stocks?, Managerial Auditing Journal, Vol. 25

Iss: 1, pp.4 - 16


14

controlling for several other measures of financial distress”7. The analysis is conducted with

firms that are receiving for the first time the going concern opinion, which as opposed to the

other firms, have a greater valuation weight of the book value of equity. The authors succeed to

prove the value relevance of this type of opinion, as long as it brings up to investors the potential

risk of abandonment or adaption of firm assets.

As I noticed, there are many studies developed on one specific modifed report meaning

the going concern opinion, but less on the modified audit opinion as a whole, under all its

circumstances, as stated in Syou-Ching et al. (2009):

- going concern consideration

- change in the application of accounting principles for financial reporting as required under law

- change in the application of accounting principles for financial reporting on a voluntary basis

- uncertainty of events that may have significant impact on the future financial condition of the

firm

- the adoption of another auditor‟s audit report for the current year audit.

The reason for which the going concern opinion has got more attention from researchers

could be that the information provided is much more relvant for investors as opposed to the one

given by other issues, which may not influence in the same way the investment decisions. This

assumption is proved by Syou-Ching et al. (2009) which mentioned that “of the five

circumstances mentioned above, the one based on the going concern consideration had the

highest significant impact on stock prices”8. In their research, the authors have adopted Ohlson‟s

model for investigating the information content of MAO, in order to control for concurrent

information that could bring significant biases to the analysis, since they consider the event

approach a “validity trap”.

As Firth (1978) states, investors react differently to the various types of audit

qualification, meaning the type of audit opinion gives different information, and that the price

reactions occurred in the expected direction, immediately after releasing the audit reports. This is

an important study, that appears as reference for many recent articles, and that‟s one more reason

7Allen D. Blay, Marshall A. Geiger, David S. North (2011) The Auditor's Going-Concern Opinion as a Communication of Risk. A Journal of

Practice & Theory: May 2011, Vol. 30, No. 2, pp. 77-102. 8 Syou-Ching Lai, Cecilia Lin, Hung-Chih Li, Frederick H. Wu (2009). The Information Contents of Modified Unqualified Audit Opinions under

the Control of Concurrent Information: The Case of Taiwan, Journal of Accounting and Corporate Governance, Volume 6 Number 1, June 2009

pp.31-56


15

to mention it, for proving the differences between the two types of audit opinions I chose to

analyze.

One of the main articles I have relied on in my research is Chen et al (2012), that came

with significant findings regarding the audit opinion influence on the debt costing. They have

focused only on the qualified audit opinion, which is associated with decreased use of

performance pricing provisions in debt contracts. They also bring into discussion the importance

of the quality accounting information, with an inverse relationship: the higher the quality is, the

lower the cost of monitoring the borrower, supported by lenders, which leads to a lower interest

rate demanded by them. Since the qualified audit opinion is giving outside investors a signal over

the financial statement quality as being lower than a clean opinion, this will determine lenders to

rely less on the financial statement numbers, and make use of other monitoring mechanisms, that

imply higher costs.

Another study I have considered in my research is Karjalainen (2011), which has

emphasized that both audit quality and the auditor‟s opinion is perceived as value relevant

sources of information in debt pricing. The author has also identified a mixed evidence in the

prior literature regarding the extent to which the auditor opinion can affect stock prices and cost

of debt. This can be explained by the methodological problems as “identifying the first day of

trade on the audit report information”9 and also the “difficulty of isolating the market reaction to

the information content of the auditor‟s opinion from the reaction to other concurrent

information”10

.

The relationship between the auditor choice and debt pricing, was analysed in Pittman and

Fortin (2004), and later in 2007, the authors extended their research from publicly to private

traded companies. In the first paper, they have defined the cost of debt as the interest rate on the

debt of the firm, calculated as the interest expense for the year divided by the average short and

long term debt during the year. But in the second one, they used as a dependent variable the yield

spread as “the difference in basis points between the at-issue yield to maturity on the corporate

bond and that of a U.S. treasury bond issued on the same date with comparable maturity”11

.

9 Karjalainen, J. (2011), Audit Quality and Cost of Debt Capital for Private Firms: Evidence from Finland. International Journal of Auditing, 15: 88–108 10 Manuel Cano-Rodríguez (2010). Big Auditors, Private Firms and Accounting Conservatism: Spanish Evidence, European Accounting Review,

19:1, 131-159 11 Fortin, S. and Pittman, J. A. (2007), The Role of Auditor Choice in Debt Pricing in Private Firms. Contemporary Accounting Research, 24:

859–896


16

As opposed to their first research, they were unable to support the value relevance of

BIG4 audits in pricing bond issues. They concluded that the auditor characteristics are irrelevant

to the debt-contracting process for the private firms: “neither the presence of BIG4 auditor nor

auditor tenure explains debt pricing12

”.

One recent article that got my attention is Armitage and Marston (2014) which focuses on

the views of finance directors about the link between disclosure and the cost of capital, using a

qualitative methodology, through conducting 16 semi-structured confidential interviews. The

main question was whether greater disclosure to a rating agency or bank would affect the cost of

a bond issue or a bank loan. In most of the cases the answer was affirmative: nine of the

interviewees said that providing more information would increase the availability of debt or

reduce the cost of debt, one said it would have no effect and the rest of six were not sure.

Considering these views, I assume that providing an external audit, would have the same effect,

since this could be one way of increasing the corporate disclosure, especially when the auditor is

from Big4.

2.3 Hypotheses development

In order to provide a clear answer for each of the two research questions of my study, I will

develop two separate hypotheses that will be explained later in this section. The link between

them is the modified audit opinion, which remains the aim of the research along the whole study,

since I want to emphasize the differences from a clean opinion.

2.3.1 Hypothesis I

The first effect of a modified audit opinion I want to measure is the one on the stock

market, by analysing the daily returns based on stock prices.

As I noticed in previous studies, Chen and Church (1996) and Allen et al. (2011), the

going concern opinion is seen as a bad news because it announces financial difficulties of the

company, but the question is whether the unqualified opinion is considered by investors a good

news, which could encourage them to buy the specific stocks.

12 Fortin, S. and Pittman, J. A. (2007), The Role of Auditor Choice in Debt Pricing in Private Firms. Contemporary Accounting Research, 24:

859–896


17

The Chen et al. (2000) paper has a similar purpose, more precisely, analyzing if this type

of information provided through disclosing a modified audit opinion can be evaluated by

investors in a proper and timely way. According to Chen et al. (2000) there are differences

between the qualified opinion and unqualified opinion but these may not be observed by the

investors. The authors refer to one article from news to emphasize the “difference between the

two types of opinions as lawful but unreasonable (unqualified with explanations) versus unlawful

(qualified opinions)”13

. One problem here would be that some of the auditors are choosing an

unqualified opinion with explanatory notes – referred to as the modified audit opinion – instead

of a qualified opinion in order to keep their clients and in the same time conforming with auditing

standards. This assertions is made for the Chinese environment, which has an emerging market.

Based on this, the first hypothesis is as it follows:

H1: Ceteris paribus, the announcement of modified audit opinions is negatively

associated with market returns.

2.3.2 Hypothesis II

Another important effect of the auditor‟s opinion over the market that worths to be analysed is

the change in the cost of debt. This relationship between auditing and cost of debt has not been

studied by too many researchers, as most of the papers are focusing on the connection with the

accounting quality given by the way of disclosing the information to the market, as already

mentioned in the Literature review.

The qualified audit opinion has been proved to have a negative reaction among creditors,

which implicitly lead to a higher cost of debt, according to Chen et al (2012). Pittman and Fortin

(2004) examines the impact of auditor choice on debt pricing and concludes that the services

provided by Big 4 Auditors leads to enhancing the credibility of financial statements, which

reduces the debt monitoring costs.

Another factor besides the auditor choice is the auditor opinion, as the main subject of this

study. So I found it interesting to research on this relationship. The interest rate is the variable

that need to be analysed in order to figure out the direction towards it moves, when the auditor‟s

13 CHEN, C. J. P., SU, X. and ZHAO, R. (2000), An Emerging Market's Reaction to Initial Modified Audit Opinions: Evidence from the Shanghai

Stock Exchange. Contemporary Accounting Research, 17: 429–455


18

opinion is unqualified or modified. Considering that both auditor‟s choice and auditor‟s opinion

represent a direct influence over the audit quality, I expect that when the auditor opinion is

modified - there are some issues in providing a fair image of the financial statements that need to

be explained in the notes - the interest rate used by the company to pay its current debts,

increases.

That being said, the second hypothesis is stated as it follows:

H2: Ceteris paribus, there is a negative relationship between the modified audit opinions

and cost of debt.

These two hypotheses show, in my opinion, the most important aspects of the relationship

between auditor‟s opinion and the market, and also the differences between the two types of audit

opinions I want to analyze. By supporting the hypotheses, a significant contribution will be

brought to the prior literature, considering that there is little evidence of a comparison between

opinions.

3. Research methodology

For this study, I will develop a quantitative methodology using statistical models to

understand the assumptions stated in the hypotheses. The sample I used for examining the

variables is extracted from firms that were continuously audited for the 2011 and 2012.

In order to give have a clear image about the methodology, I will separately present it for

the two hypotheses, when there is the case.

Later in this chapter, I will present the steps for the selecting the sample, I will give an

overview over the variables used and their measurement and finally the empirical models will be

explained.

3.1 Sample selection

In order to keep the consistency in my study, I will use the same sample for proving both

hypotheses, with the focus on the audit opinion, which is present in both empirical models as an

independent variable.


19

The sample is based on the changes happened in 2012, for US companies. Since there are

few papers that analyse the recent period, I consider this study will bring a big contribution to the

literature. However, I took into consideration the previous year as well, in order to select only the

companies that were continuously audited and to identify the companies that first disclosed a

modified audit opinion. Moreover the changes in earnings are also computed based on the

difference between those two years. More about the measurement of each variable is provided

later in this section.

Regarding the statistical procedure, I got data from Audit Analytics and I selected only

the observations that met some of the mandatory conditions, like having a valid date for the audit

opinion, which is represented by the “Signature date of opinion” variable. Other important

variables that I collected from this database, refer to the identifiers for the auditors and companies

selected. Since I first started collecting data from this databases, taking into considerations the

restrictions above mentioned, I got for the initial sample 14,659 firm year observations for 2012

and 2011, out of which only 6192 refer to the focus year of this study, 2012.

I used Compustat database for collecting financial and accounting data like assets,

liabilities, net income, equity and cash flow from operating activities. Besides these, the codes for

the auditor and auditor opinion are also available in Compustat, which give a more detailed

information regarding the type of opinion, since there are all included.

In order to assure the consistency in the selection of companies, I have used only the

company identifiers of the firms obtained from Audit Analytics, and after this, the sample was

reduced to 3,921. But in order to assure the validity of the research, I have applied some other

restrictions, regarding the following:

- the stock ownership code 0 for publicly traded companies

- the SIC codes excludes the 6 category for the financial and real estate sector

- the GIC industry code was also restricted, by eliminating the financial area (the category 40)

- the unaudited companies were excluded, since the focus of this study is given by the auditor

opinion

- the status of the company has to be active, since I am looking at the impact over the stock

market

After applying the restrictions afore-mentioned and after excluding those observations

with missing data regarding the financial variables like interest expense, cash flow from


20

operating activities, liabilities, common shares outstanding and others, the sample was reduced to

663 firm observations for both years, but only 332 for 2012.

Next step in the sample selection, was to collect data from CRSP regarding the daily stock

data for each of the companies identified before. After removing the missing values among

observations and after merging all data from the 3 databases, there were left 287 firm

observations of 2012. Because of the limited number of observations, the final sample, has only

the codes 1 and 4, for the auditor opinion variable, where 1 is for a clean opinion and 4 is for a

modified audit opinion. Considering this, the only difference that can be analysed here is the one

between these two types of opinion.

As stated in prior studies like Jones (1996) and Herbohn et al. (2007), it is important to

consider only the first time going concern audit reports, because this is the best way to analyze

the information content of the disclosure. For successive going concern audit reports, the

usefulness of the announcement is reduced, because the market is already aware of the real

situation of the firm from previous years. This will make necessary the examination of previous

audit report for each firm. Because is quite difficult to follow the historical data for each

company, I will implement this restriction only by considering the previous year in order to get a

more accurate data. Since the going concern is one cause for a modified audit opinion, I will

consider the same approach as in the papers mentioned above by determining the companies that

first have a modified audit opinion, considering the previous year as well.

3.2 Variables measurement

In this section I will explain the measurement of each variable (more in Appendix no. 1),

dependent and independent, as well as the rationale behind the control variables included, and for

this I will separately consider the two hypotheses.

3.2.1. Dependent variables

In order to reflect the real impact of disclosing the auditor opinion for the investors, so basically

the influence on the stock prices, the most used proxy is the cumulative abnormal returns, which

is the dependent variable for the first hypothesis.

For calculating this, the abnormal returns around the announcement date of the audit

opinion, will be determined. To reflect the immediate effect of disclosing the audit opinion, I


21

considered the abnormal returns one day before and one day after the event, given by the date of

disclosing the audit opinion. The abnormal return is determined after running a regression where

the return of the firm i on day t is the dependent variable, explained by the market return on the

day t. The period taken into consideration is from day (-120) to day (-30) as in Chen et al (2000).

The reason for choosing this period is to control for the effect of other external factors that could

increase the noise in the model.

Another aim of this study is to show the impact of auditor opinion over the cost of debt, as

stated in the second hypothesis, and for this I will use another dependent variable, the interest

rate, measured as the interest expense divided by the average short and long term debt (total

liabilites).

3.2.2 Independent variables

For the first hypotheses, one of the independent variables is given by the ΔEPS which reflects the

change in earnings per share (EPS2012 – EPS2011) scaled by the beginning price at day (−1).

Another independent variable is given by the interaction term OP*ΔEPS, where the OP takes

value of 1 if there is a modified audit opinion and 0 otherwise.

For the second hypothesis, I included as independent variables the leverage (LEV) as the

book value of total short- and long-term debt deflated by firm market value, the cash flow (CF)

from operations scaled by total assets, and the assets structure (ASSET_STR) measured as the

total property, plant and equipment scaled by total assets.

3.2.3 Control variables

In order to mitigate the effects of other factors on the dependent variables, I will consider some

control variables.

For the first and second hypothesis related to the influence of auditor opinion over the

stock market, I will use the following control variables:

Firstly, I used a dummy variable for the audit opinion (OP) which takes the value 1 for a

modified audit opinion and zero otherwise. The focus of this study is on the modified audit

opinion so this is the reason why I will control the regression by this variable.

Secondly, I added the dummy variable DIV, which equals 1 for the modified audit

opinions followed by a decrease in dividends between 2012 and 2011.


22

Finally, I included a dummy control variable REPEAT which takes the value 1 for the

firms that have a modified audit opinion in the previous year as well, and 0 otherwise. This helps

to better reflect the impact of a new information for the investors and over the stock prices.

For the second hypothesis, regarding the relationship between audit opinions and cost of

debt I took into consideration some other control variables.

Firstly, the same dummy variable OP is for expressing the modified audit opinion, when it

takes the value of 1, and 0 otherwise.

Secondly, I included a dummy variable to control for firms that have an auditor from

one of the Big 4 audit firms (BIG4), which takes the value of 1 if this is the case, and 0 otherwise.

It has been proved that services provided by Big4 auditors give a plus of credibility among

creditors.

Thirdly, the negative book equity dummy indicates if the book value of equity is negative,

which is an important indicator for the creditors when considering to lend or no a specific

company.

3.3 Regression models

For the first hypothesis I used an event-study methodology in order to investigate stock market

reaction to the auditor‟s opinion, based on U.S. listed firms.

The descriptive data will be divided in two periods: the pre-event period and the post-

event period, where the event in this research is the disclosure of the auditor‟s opinion. In order to

better emphasize the effect of auditor opinion I think it is better to analyse the immediate changes

in the stock prices because in this way, the chances of other events‟ influences decrease

significantly.

In order to estimate the daily abnormal returns, I will use the model developed in Chen et

al. (2000) paper which is using the following formula:

𝑅𝑖𝑗𝑡 = 𝛼𝑖𝑗 + 𝛽𝑖𝑗𝑅𝑚𝑗𝑡 + 𝜀𝑖𝑗𝑡 (1)

where

Rijt= the return of firm i in year j on day t, and

Rmjt= the market return in year j on day t.


23

The stock returns (Ri) need to be calculated from changes in stock price (already adjusted

for dividends), using the following formula:

𝑅𝐸𝑇𝑡 = (𝑃𝑅𝐼𝐶𝐸𝑡 − 𝑃𝑅𝐼𝐶𝐸𝑡−1)/𝑃𝑅𝐼𝐶𝐸𝑡−1

The firm-year specific parameters of the model (𝛼 and 𝛽) are estimated over a 120-day

period, ending 30 days before the announcement date. The 3-day (from day −1 to day 1)

cumulative abnormal return (CAR) is calculated as follows:

𝐶𝐴𝑅𝑖𝑗 = 𝑅𝑖𝑗𝑡1𝑡=−1 − 𝑎𝑖𝑗 + 𝑏𝑖𝑗𝑅𝑚𝑗𝑡 (2)

where

CARij= the 3-day cumulative abnormal return for firm i in year j

aij and bij= firm-year specific parameters estimated by using equation 1

Based on the model implemented by Chen et al. (2000) for the first hypothesis, I will

develop the new model adapted to the sample of firms and considering only one year of analysis,

2012.

Therefore, the adjusted model looks like it follows:

𝐶𝐴𝑅𝑖𝑗 = 𝛼0 + +𝛼1𝑂𝑃𝑖𝑗 + 𝛼2∆𝐸𝑃𝑆𝑖𝑗 + 𝛼3𝑂𝑃𝑖𝑗 ∗ ∆𝐸𝑃𝑆𝑖𝑗 + +𝛼4𝐷𝐼𝑉𝑖𝑗 + 𝛼5𝑅𝐸𝑃𝐸𝐴𝑇𝑖𝑗 + 𝜀𝑖𝑗 (3)

where,

CAR = 3-day cumulative abnormal return from day −1 to 1,

OP = a dummy variable with a value of 1 for MAOs and 0 otherwise,

ΔEPS = change in earnings per share scaled by beginning price at day −1,

DIV = 1 for MAOs with dividend decreases and 0 otherwise,

REPEAT = 1 for non-initial MAOs and 0 otherwise

For the second hypothesis, which implies the effect of a modified audit opinion on cost of

debt, I will consider the model from Pittman and Fortin (2004), in order to adapt it for my case.

The following regression model will be used in order to analyse the relation between

auditor‟s opinion and the cost of debt:

𝐼𝑁𝑇_𝑅𝐴𝑇𝐸𝑖𝑡 = 𝛽 + 𝛽1𝑂𝑃𝑖𝑡 + 𝛽2𝐵𝐼𝐺4𝑖𝑡 + 𝛽3𝐿𝐸𝑉𝑖𝑡 + 𝛽4𝐶𝐹𝑖𝑡 + 𝛽5𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽6𝐴𝑆𝑆𝐸𝑇_𝑆𝑇𝑅𝑖𝑡 +

𝛽7𝑁𝐸𝐺_𝐸𝑄𝑈𝐼𝑇𝑌𝑖𝑡 + 𝜀𝑖𝑡

where,


24

𝐼𝑁𝑇_𝑅𝐴𝑇𝐸𝑖𝑡 - Interest rate is interest expense divided by the average of total short and long term

debt during the year,

OP = dummy variable with a value of 1 for MAOs and 0 otherwise,

𝐵𝐼𝐺4𝑖𝑡 - it has a value of one when the firm retains a Big 4 auditor; zero otherwise,

𝐿𝐸𝑉𝑖𝑡 - the book value of total short- and long-term debt deflated by firm market value (sum of

the market value of equity and the book value of total debt),

𝐶𝐹𝑖𝑡 – is cash flow from operations scaled by total assets,

𝑆𝐼𝑍𝐸𝑖𝑡 - firm size is the natural logarithm of one plus total assets,

𝐴𝑆𝑆𝐸𝑇_𝑆𝑇𝑅𝑖𝑡 - asset structure is total property, plant and equipment scaled by total assets,

𝑁𝐸𝐺.𝐸𝑄𝑈𝐼𝑇𝑌𝑖𝑡 - the negative book equity dummy indicates if the book value of equity is

negative.

4. Results

The focus of this study is on the modified audit opinion for U.S. companies in 2012.

Considering this, I expect that all the variables used differ between companies when they disclose

a clean opinion or a modified audit opinion. In order to show this difference, I will provide later

in this section some relevant tables. Each of the two hypotheses try to explain a different

influence of the auditor opinion, one over the stock market and the other over the cost of debt. In

order to show a better overview, this section is presenting separately the results of each

hypothesis.

4.1. The stock market reaction over the announcement of a modified audit opinion

As mentioned in the methodology part, I used for the first hypothesis an event research, which

consists on the analysis before and after the event, which in this case is the announcement date of

the auditor opinion. For this, it is necessarily to determine the abnormal returns for each

company, depending on its unique date of announcement, and right after that, the cumulative

abnormal returns over the 3 days window (-1,+1) are computed. This is the dependent variable,

which will remain in the discussion for the analysis.

In order to determine the way in which the cumulative abnormal returns are caused by the

type of audit opinion – clean or modified - it is important to take into consideration some other


25

variables which may or may not depend themselves on the type of opinion. Table 1 presents the

descriptive statistics of these variables, for each case: when there is a clean opinion, OP equals 0

and for a modified audit opinion the same variable takes the value of 1. As it can be seen below, I

had included some other important variables, that are not part of the model, like TA (total assets),

NI (net income), ROE (return on equity), AR (abnormal returns for the day 0) and also the two

numeric and continuous variables of the model, CAR (cumulative abnormal returns) and ∆EPS

(the difference between earnings per share for two consecutive years, 2011 and 2012 scaled by

the beginning price of day -1). The reason for including in the table these variables, is because

they represent important financial indicators for the company, which are of a big interest for the

investors. This is why I expect to notice a difference, but this doesn‟t mean that this is totally due

to the difference in audit opinions. Anyway, it is interesting to have an overview of the main

statistics for each of these variables.

The variables are corresponding with the 2012 year, except the last one, which states the

difference among years in the earnings per share. Considering this, we can see a significant

difference between the TA of the two groups, where the MAO firms are bigger in size, as

evidenced by the mean and median values. They are also more profitable, as the mean and

median of ROE are lower for the clean opinion group, which is contradictory with the Chen et.al

(2010). However, the MAO group exhibits a more negative mean and median change in earnings

per share than the clean group, fact that was also noticed for the chinese companies in the paper

afore-mentioned. Moreover, the abnormal returns show higher mean and median values for the

MAO group.

Having said that, apparently the firms that received a modified audit opinion are bigger

and more profitable, but this success over the other group of firms, comes with its shortcummings

like more risks, and more debts, which can cause the auditor to modify the audit opinion, with

some explanatory notes of a significant importance for the investors.


26

Table 1

Descriptive statistics for main variables

OP Variable Mean sd p1 p25 Median p75 p99

0 TA 10,243.99 31,223.97 12.861 715.655 2,144.358 6,733.45 132,244

NI 630.9751 2,200.18 -985 23.706 109.768 449.7605 10,925

ROE 0.1345337 0.3711082 -0.7426036 0.0733614 0.1363148 0.1953806 1.17987

AR 0.0020013 0.0267145 -0.0738255 -0.0084635 0.0001363 0.0085047 0.1090047

CAR -2.842219 2.774461 -7.505228 -3.940635 -3.007319 -1.884142 1.151975

∆EPS 0.0035035 0.1626191 -0.6953125 -0.0136327 0.0041084 0.0167856 0.312

1 TA 22,848.22 41,546.75 6,955 1,026.317 5,356.978 20,405.3 144,810.5

NI 1,808.556 4,060.8 -441 7.371 260.213 1,226 15,417

ROE 0.2106174 0.7505479 -1.46713 .1047595 0.1443036 0.1810418 3.595.745

AR 0.0083655 0.028134 -0.0498975 -0.004116 0.003105 0.0174242 0.0996667

CAR -3.021553 1.763847 -6.057692 -0.418.663 -3.135211 -1.866331 0.380801

∆EPS -0.0209531 0.1083877 -0.2700403 -0.0318934 -0.0046982 0.0097703 0.3

Next, I will focus only on the variables that are part of the regression model. As I already

mentioned in the Research methodology, most of them are dummy variables, which can take

either the value of 1 or 0, depending on the situation applicable to each company. Table 2 shows

the descriptive statistics of each of these variables, in order to get an idea about the structure of

the sample. As you can see below, there are few companies that had a modified audit opinion, out

of which 12 were followed by a decrease in dividends and 17 were having a modified audit

opinion in the previous year as well.


27

Table 2

Descriptive statistics: dummy variables

Variables Freq. Percent Mean Std. Dev.

OP

0.0940767 0.2924453

0 260 90.59

1 27 9.41

Total 287 100.00

DIV

0.0418118 0.2005086

0 275 95.82

1 12 4.18

Total 287 100.00

REPEAT

0.0522648 0.2229493

0 272 94.77

1 15 5.23

Total 287 100.00

Table 3 presents the descriptive statistics for the other 3 variables of the model.

It can be seen that the cumulative abnormal return has a negative mean value, which

prevent the investors about the financial distress and can influence their decision making process.

These kind of signs can be caused by many external or internal factors, but in this study I want to

focus only on the effect the audit opinion has on the returns, and implicitly on investors reaction.

Table 3

Descriptive statistics: continuous variables

Variable Obs Mean Std. Dev. Min Max

CAR 287 -2.85909 2.693792 -7.82156 33.1095

∆EPS 287 0.0012027 0.1583274 -1.210686 1.791667

OP*∆EPS 287 -0.0019712 0.0332496 -0.2700403 0.3


28

The correlations between variables are also important in proving the validity of the

implemented model. The results of this analysis are showed in Table 4, with Pearson correlations

presented below the diagonal and Spearman correlations presented above the diagonal. I have

chosen to run for two types of correlations in STATA in order to enhance the certainty over these

relationships. The values reported are not equal, but most of them are close enough and the

direction of influence is the same (positively or negatively).

Table 4

Pearson (below) & Spearman (above) correlations

Variable CAR OP ∆EPS OP*∆EPS div_MAO Repeat_MAO

CAR 1.0000 -0.0210 0.0151 0.0442 0.0553 -0.0006

OP -0.0195 1.0000 -0.0998 -0.1109 0.3501* 0.7287*

∆EPS 0.0954 -0.0452 1.0000 0.2988* -0.0567 -0.0529

OP*∆EPS 0.0238 -0.1843* 0.2112* 1.0000 -0.1691* 0.0526

DIV 0.0204 0.3501* -0.0487 -0.2553* 1.0000 0.1856*

REPEAT -0.0093 0.7287* -0.0279 -0.1104 0.1856* 1.0000

* significant at the 0.01 level

As we can see in the table above, CAR is positively correlated with ∆EPS but negatively

correlated with the dummy variable for MAOs (OP). The CAR is positively correlated with the

change in earnings and negatively correlated with OP. Another negative correlation is between

∆EPS and DIV, since a modified audit opinion caused by a decrease in dividends has a negative

impact on the earnings as well. However these correlations are not significant. For a significance

level of 0.01 we can see positive correlations between OP and the other 2 dummy variables DIV

and REPEAT, which is not surprising, but the OP are negatively correlated with the interaction

term OP*∆EPS, which can be explained by a negative influence of the changes in earnings over

the audit opinion.

In order to reduce any doubts about the multicolinerity of the independent variables, I

used Variance Inflation Factor (vif in STATA) which has the mean value of 1.59, which is less

than 10, and this means the variables are good and there is no need to drop any to be able to

continue with the model. (the output is provided in the Appendix no. 2)


29

For the variables checking, I have performed another test in STATA, the one for

specification error which basically checks whether more variables are needed in order to run the

regression. In order to prove that there is no specification error I have ran the test (linktest in

STATA) and I got a non-significant p-value of _hatsq, which means the model is correctly

specified (the output is provided in the Appendix no. 3).

Another way of showing the difference between groups with clean opinions and groups

with modified audit opinions is by performing a t-test (Table 5) of cumulative abnormal returns

for each of these groups. This test is based on the idea of proving the null hypothesis that both

groups have the same mean change in CAR. The alternative hypothesis is that this difference is

not equal to zero. For this one, the p-value is greater than 0.1 which means the alternative

hypothesis is not supported and implictly the null hypothesis cannot be rejected. Considering

this, we might still wonder whether the sample is representative for the first hypothesis.

Table 5

T-test CAR by OP

Group Obs Mean Std. Err. Std. Dev. [95% Conf. Interval]

0 260 -2.842219 0.1720647 2.774461 -3.181043 -2.503395

1 27 -3.021553 0.3394524 1.763847 -3.719308 -2.323799

combined 287 -2.85909 0.1590095 2.693792 -3.172068 -2.546113

diff

0.1793337 0.545525

-0.8944355 1.253103

The main results of the model for the first hypothesis are presented in Table 6, which shows the

estimated coefficients for each independent variable, mentioning the significant level where is the

case. We can see that the OP is negatively associated with the CAR, but not for a significant

level, since the p-value is quite high (0.684). This means that the hypothesis regarding the

negative influence of the auditor opinion, more specifically of a modified audit opinion, over the

returns is rejected by this model for this particular sample. However the Chen et al. (2000) has

proved that investors react negatively to the announcements of modified audit opinions, showing

in the regression table a consistently negative coefficient for OP at a significant level for the last

two year of their sample (1996 and 1997). The interaction between OP and ∆EPS is positive but

not significant (p>0.1) and the other control variables are not significant either in this model, but

this is also mentioned in Chen et al (2000).


30

Table 6

Regression results

CAR Coef. Std. Err. t P>t [95% Conf. Interval]

OP -0.3444228 0.845156 -0.41 0.684 -2.008063 1.319218

∆EPS 1.603401 1.032965 1.55 0.122 -0.4299314 3.636733

OP*∆EPS 0.6602399 5.107573 0.13 0.897 -9.393722 10.7142

Div_MAO 0.5026697 0.8746699 0.57 0.566 -1.219067 2.224407

Repeat_MAO 0.1754674 1.053281 0.17 0.868 -1.897854 2.248789

_cons -2.857504 0.1685286 -16.96 0.000 -3.189242 -2.525765

One explanation for this concluding remark that the hypothesis is not supported could be

the lack of sufficient data and the different economic period and region. As it is mentioned in

Chen et al (2010), the chinese investors were not that well informed and for them “the auditor‟s

opinions are the only source of financial information for their investment decisions”. But for U.S.

companies in 2012, this is not applicable anymore, and investors are given a lot more options and

reports to found out the information they need, without waiting for an audit report to confirm

their expectations.

4.2. The effect of modified audit opinion on the cost of debt

For the second hypothesis, the attention is directed towards the cost of debt, represented

by the dependent variable interest rate. As I already explained in the methodology, the model for

testing this includes 3 dummy variables: the modified opinion (OP), BIG4 which equals 0 or 1

depending on the auditor‟s rank, and the negative equity (NEG_EQUITY) that equals 1 for a true

statement and 0 otherwise. The other 4 variables are continuous, and they basically represent

important indicators of a firm‟s wealth which is often taken into consideration by creditors in

their decision making process.

In order to be consistent in my study, the same sample period and the same firms were

used for the second hypothesis. There is also one independent variable that is used for this second

model as well, represented by the auditor opinion, which is actually the main focus of this study.

For showing the importance of the modified opinion, I showed in Table 7 the overview on the

variables used, depending on the group which a company belongs to. Overall the differences in


31

variables for the two groups are not that big. If we take a look over the interest rate, the mean and

median values are greater for those firms with a clean opinion but the leverage and the size are

bigger for firms with a modified audit opinion. Furthermore, the mean value of negative equite is

significantly greater for the MAO group, which could be an explanation for the need of auditors

to provide some explanatory notes.

Table 7

Descriptive statistics

For a better overview of the variables, I sorted them in two categories as continuous and

dummy variables, providing separate descriptive statistics to each category as it follows in Table

8 and Table 9.

Table 8 reflects the descriptive statistics for the variables that are of a significant

importance for creditors. These basically represent the firm characteristics and they are supposed

to control for variation in debt pricing.

OP Variable Mean sd p1 p25 Median p75 p99

0 Interest_rate 0.0207625 0.0154843 0.0002008 0.009074 0.0198404 0.0283679 0.0930809

BIG4 0.85 0.3577601 0 1 1 1 1

Leverage 0.532182 0.1901859 0.1475694 0.3918369 0.5365013 0.6547937 1.12824

Cash-flow 0.1068334 0.0756232 -0.0411275 0.0741339 0.1033383 0.1395552 0.3053475

Size 7.659011 1.850382 2.629079 6.574578 7.671056 8.814535 11.79241

Asset_str 0.283388 0.2168861 0.0167108 0.1222447 0.2190149 0.3894942 0.8648329

Neg_equity 0.0192308 0.1376 0 0 0 0 1

1 Interest_rate 0.0196538 0.018974 -0.0106401 0.0050063 0.0158887 0.0262194 0.0754443

BIG4 0.8888889 0.3202563 0 1 1 1 1

Leverage 0.5552865 0.171736 0.2178218 0.4641084 0.5412867 0.6142384 1.0197

Cash-flow 0.0799327 0.1543938 -0.6306254 0.0589993 0.1016327 0.1607889 0.2048676

Size 8.101633 2.631362 2.073801 6.934706 8.586342 9.923599 11.88319

Asset_str 0.2648026 0.2374075 0.0008627 0.0951337 0.1891273 0.3457143 0.8996205

Neg_equity 0.037037 0.1924501 0 0 0 0 1


32

Table 8

Descriptive statistics: continuous variables

Variable Obs Mean Std. Dev. Min Max

Interest_rate 287 0.0206582 0.0158102 -0.0106401 0.0952311

Leverage 287 0.5343556 0.1883689 0.1248841 1.347441

Cash-flow 287 0.1043027 0.0860692 -0.6306254 0.3227785

Size 287 7.700651 1.935689 2.073801 12.83958

Asset_structure 287 0.2816395 0.2185227 0.0008627 0.9200945

Table 9 presents the descriptive statistics for the dummy variables, where it can be

observed the structure of the sample. Most of companies chosen are audited by BIG4 which gives

an increased credibility of the audit report and investors are more willing to rely on it. For the

negative equity variable there are only 6 firms that met this criterion.

Table 9

Descriptive statistics: dummy variables

Variables Freq. Percent Mean Std. dev

OP

0.0940767 0.2924453

0 260 90.59

1 27 9.41

Total 287 100.00

BIG4

0.8536585 0.3540656

0 42 14.63

1 245 85.37

Total 287 100.00

NEG_EQUITY

0.0209059 0.1433193

0 281 97.9

1 6 2.1

Total 287 100.00

For a better prediction of the influences of each variable the correlations of Pearson and

Spearman are provided in Table 10. In order to see whether the correlations between variables are

applicable, the significance for the 5% level is provided.


33

Table 10

Pearson (below) & Spearman (above) correlations

Variable Interest_rate OP BIG4 Leverage Cash-flow Size Asset_str Neg_equity

Interest_rate 1.0000 -0.0438 0.0161 0.4114* -0.0829 0.0456 0.2059* 0.1825*

OP -0.0205 1.0000 0.0321 0.0362 -0.0140 0.0817 -0.0432 0.0363

BIG4 -0.0547 0.0321 1.0000 0.1184* 0.1713* 0.4654* -0.0333 -0.0084

Leverage 0.4342* 0.0359 0.1103 1.0000 -0.2086* 0.3333* 0.0866 0.2478*

Cash-flow -0.2187* -0.0914 0.2507* -0.0640 1.0000 0.1197* 0.0926 0.0400

Size -0.0605 0.0669 0.5093* 0.2879* 0.2611* 1.0000 0.0024 0.0341

Asset_str 0.2267* -0.0249 -0.0430 0.0773 0.1199* 0.0129 1.0000 0.0720

Neg_equity 0.2819* 0.0363 -0.0084 0.4597* 0.0365 0.0245 0.0367 1.0000

* significant at the 0.05 level

Having said that, we can notice that the interest rate is significantly positively correlated

with the leverage and negatively correlated with the cash flow. This is also the way in which I

expected the relationship to be, and consistent with Pittman and Fortin (2004). Furthermore, there

are positive correlations between BIG4 and leverage, cash flow and size. A possible explanation

for this could be that profitable and big companies can afford to pay a BIG4 auditor and in this

way to provide a more trusthy report to the creditors.

In order to mitigate any concerns regarding the multicolinearity of the independent

variables, I have used the variance inflation factor (vif in STATA) and I got a mean value of 1.28,

which is less than 10. This leads to the concluded remark that no variable need to be dropped for

keeping the validity of the model. Another test was for specification error, which has also proved

that the model is correctly specified. (the outputs for the two test are provided in Appendix no. 4

and Appendix no. 5)

The assumption of the regression model that impacts the validity of all tests is that

residuals behave normal. After generating the residuals in STATA I have used the Kernel density

graph to show that they are following a normal pattern. (Figure1)


34

Figure 1

The regression results for testing the second hypothesis are provided in Table 11. The

overall P-value is 0.000 which proves that the model supports the hypothesis and the R square is

0.3 which means the model explains 30% of the variance of the dependent variable: the interest

rate.

Table 11

Regression results

Interest rate Coef. Std. Err. t P>t [95% Conf. Interval]

i.OP -0.0023161 0.0027313 -0.85 0.397 -0.0076926 0.0030605

i.BIG4 0.0016197 0.0026311 0.62 0.539 -0.0035597 0.0067991

Leverage 0.0331596 0.0050889 6.52 0.000 0.0231422 0.043177

Cash-flow -0.0365717 0.0099599 -3.67 0.000 -0.0561777 -0.0169657

Size -0.0011697 0.0005087 -2.30 0.022 -0.002171 -0.0001684

Asset_structure 0.0158078 0.0036747 4.30 0.000 0.0085742 0.0230414

i.Negative_equity 0.0115683 0.0063172 1.83 0.068 -0.0008671 0.0240037

_cons 0.0099026 0.0037457 2.64 0.009 0.0025292 0.017276

0

10

20

30

Density

-.04 -.02 0 .02 .04 .06 Residuals

Kernel density estimate Normal density

kernel = epanechnikov, bandwidth = 0.0038

Kernel density estimate


35

Table 11 shows the specific coefficients for each independent variable. As expected, the

modified audit opinion has a negative influence on the interest rate as well as the cash flow and

the size of the company, but this is not significant since the p-value is greater than 0.1 If we take

a look over the p-values for the independent variables we can see that the leverage, cash flow and

asset structure are highly significant in explaining the interest rate (p-value =0). Furthermore, the

size of the company is also significant at a 5% level, but the influences of the audit opinion and

the presence of a BIG4 auditor are not significant. This leads to the conclusion that the audit

opinion is not statistically significant in explaining the interest rate and implicitly the cost of debt.

This means that the hypothesis regarding the negative influence of the modified audit opinion

over the cost of debt, is rejected according to the significance level of the p-value, which is

contradictory with the related findigs of Karjalainen (2011).

An explanation of this concluding remark could be that the audit opinion is not the main

source of creditor‟s decisions in lending or not a specific company, since there are other financial

indicators more relevant as identified in this model as well (leverage, cash-flow). Having said

that, there is evidence that neither a modified audit opinion has as a consequence a significant

increase in cost of debt nor a Big 4 audit.

5. Limitations

The results of this study are subject to some limitations, considering the results were

contradictory with most of other similar studies.

Firstly, for the statistical analysis, only publicly traded companies have been employed, in

order to follow the same path as in Chen et al (2000), so the results cannot be generalized.

Including privately held companies could have lead to different results for the research, maybe

consistent with previous studies. Furthermore, the sample is not that big, only 287 firm

observations are taken into consideration because of the restrictions imposed, and because of the

missing observations for the variables included in both models. A better way to do this research

could have been to choose different samples for the two hypotheses in order to avoid applying

restrictions needed for one hypothesis to the other as well. Moreover, the period of analysis is

only of one year, so quite short to consider the results generalizable.

Secondly, the methodology approach for the analysis of the first hypothesis, meaning the

event study, could have biased the results since it is quite impossible to exclude the concurrent


36

information around the day of the event. It is difficult as well to determine the exact date when

the audit opinion was publicly announced, since there is not a fixed date when the companies are

mandated to disclose this information. I did consider the signature date of opinion as the date of

event, since it was the only information available on Audit Analytics database. But these dates

were different for each company, so I had to compute the abnormal returns for each of them

separately.

Finally, despite the caveats I already mentioned, this study tries to contribute to the

literature by providing an analysis of U.S. companies that have issued a modified audit opinion in

the recent period and the impact of this on the market, in stock returns and cost of debt.

6. Summary and conclusion

The purpose of this study is divided in two main topics, but they are linked by the audit

opinion. I have focused only on the modified audit opinion, since there were not as many prior

studies to research this, and I was also restricted by the sample I got.

The first one is trying to answer the question of whether there is any influence a modified

audit opinion could have on investors, when making their decisions. More precisely, the attempt

is to analyse the fluctuations of the stock returns, around the announcement date of disclosing the

audit opinion, to see if there is a negative association as expected and proved by prior studies.

The second aim of this paper is to explore the link between auditor opinion and debt

pricing. This time, the point of interest is the creditors, because they decide over the debt

covenants, if the interest rate is appropriate considering the financial statements and the auditor

report of a specific company.

Extant theory and previous studies have proved that a modified audit opinion brings new

relevant information into stakeholder‟s attention that have lead to a negative market reaction,

suggested by significantly negative market returns. Furthermore, the firms with a modified audit

report have recorded a higher interest rate on the debt capital, as opposed to those firms with a

clean audit report.

The sample consists of U.S. publicly traded companies from 2012, that were continuously

audited, considering the previous year. Companies from bank and financial real estate sector have

been excluded for removing biases that could have result as a different application of economic


37

policies. After considering all the restrictions, the final sample reached 287 firms, which was

used for both hypotheses of this study.

The results of this study do not support the hypotheses afore mentioned, which lead to

different findings as comparing to previous studies.

Regarding the first hypothesis, there was no evidence that the modified audit opinion had

a significant negative impact on the cumulative abnormal returns, which means that the investors

were not affected by the information content of the audit report. This could be due to the

concurrent events that might have been of a higher relevance for investors, or to the biased

publicly announcement date of opinion.

As it concerns the second hypothesis, the results proved that there is no significant

negative effect a modified audit opinion can have on the interest rate, which can be translated as

the creditors do not consider the audit report as the main source of information when they decide

over the employment of a specific debt covenant.

As a recommendation for further research, this study could be extended by considering a

bigger sample and a longer period of time, since it will bring a significant improvement of the

analysis, and maybe the results would be aligned with those of most previous studies. Another

thing that could give more accuracy to the research could be the consideration of the earnings

announcement date, because this is more relevant for investors, and maybe after this date, they do

not look for more information to ensure about the validity of this indicator.

In conclusion, according to the findings of this study, a modified audit opinion turns out

to have negative influence neither on the stock returns nor on the cost of debt, but these results

are applicable only for the chosen sample.


38

References

1. Ahsan Habib, (2013). A meta-analysis of the determinants of modified audit opinion

decisions, Managerial Auditing Journal, Vol. 28 Iss: 3, pp.184 - 216

2. Allen D. Blay, Marshall A. Geiger, David S. North (2011) The Auditor's Going-Concern

Opinion as a Communication of Risk. A Journal of Practice & Theory: May 2011, Vol.

30, No. 2, pp. 77-102.

3. Arber H. Hoti, Hysen Ismajli, Skender Ahmeti and Arben Dermaku, (2012). Effects of

Audit Opinion on Stock Prices: The case of Croatia and Slovenia. EuroEconomica, issue

2(31), pages 75-87

4. Armitage, S & Marston, C (2007), Corporate disclosure and the cost of capital: the views

of finance directors. Institute of Chartered Accountants in England and Wales

5. Bharath, S.T., Sunder, J., Sunder, S., 2008. Accounting quality and debt contracting. The

Accounting Review 83 (1), 1–28

6. Chen, Peter F.; Tenho, Shaohua; Ma, Zhiming; Stice, Derrald E, 2012. Qualified audit

opinions and debt contracting. The 3rd International Conference of The Japanese

Accounting Review, Kyoto, Japan

7. Chen, K.C., & Church B.K. (1996). Going concern opinions and the market’s reaction to

bankruptcy filings. The Accounting Review, Vol. 71 (1), pp. 117-128.

8. Chen, C. J. P., Su, X. and Zhao, r. (2000), An Emerging Market's Reaction to Initial

Modified Audit Opinions: Evidence from the Shanghai Stock Exchange. Contemporary

Accounting Research, 17: 429–455

9. Dodd, P., Dopuch, N., Holthausen, R., Leftwich, R., 1984. Qualified audit opinions and

stockprices. Information content, announcement dates and concurrent disclosures.

Journal of Accounting andEconomics 6 (1), 3–38.

10. Dennis M. O'Reilly, (2010) Do investors perceive the going-concern opinion as useful for

pricing stocks?, Managerial Auditing Journal, Vol. 25 Iss: 1, pp.4 – 16

11. Firth, M. (1978), Qualified audit reports: their impact on investment decisions, The

Accounting Review, Vol. 53 No. 3, pp. 642-50.


39

12. Fortin, S. and Pittman, J. A. (2007), The Role of Auditor Choice in Debt Pricing in

Private Firms. Contemporary Accounting Research, 24: 859–896

13. Herbohn, K., V.Ragunathan& R. Garsden (2007). The horse has bolted: revisiting

the market reaction to going concern modifications of audit reports, Accounting and

Finance, 47:3, 473–493.

14. ISA 705 – Modifications to the Opinion in the Independent Auditor’s Report

15. Jensen, M. C. and Meckling, W. H. (2007) Theory of the Firm: Managerial Behavior,

Agency Costs, and Ownership Structure, in Economic Analysis of the Law: Selected

Readings (ed D. A. Wittman), Blackwell Publishing Ltd, Oxford, UK

16. Jere R. Francis, Inder K. Khurana and Rynolde Pereira (2005), Disclosure Incentives and

effects on cost of capital around the world. The Accounting Review, Vol. 80, No.4, pp.

1125 - 1162

17. Jones, F.L., 1996. The information content of the auditor’s going-concern evaluation.

Journal ofAccounting and Public Policy 13(1), 1–27.

18. Karjalainen, J. (2011), Audit Quality and Cost of Debt Capital for Private Firms:

Evidence from Finland. International Journal of Auditing, 15: 88–108

19. Kim, J.-B., Simunic, D. A., Stein, M. T. and YI, C. H. (2011), Voluntary Audits and the

Cost of Debt Capital for Privately Held Firms: Korean Evidence. Contemporary

Accounting Research, 28: 585–615

20. Manuel Cano-Rodríguez (2010). Big Auditors, Private Firms and Accounting

Conservatism: Spanish Evidence, European Accounting Review, 19:1, 131-159

21. Ogneva, M., and K. R. Subramanyam. 2007. Does the stock market underreact to going

concern opinions? Evidence from the U.S. and Australia. Journal of Accounting and

Economics 43 (2–3): 439–452.

22. Pittman, J.A. & Fortin, S. 2004, Auditor choice and the cost of debt capital for newly

public firms, Journal of Accounting and Economics, vol. 37, pp. 113-136.

23. Ruhani, A., Zamri, A. &Shangkari, V. (2011). Stock market overreaction and trading

volume: evidence from Malaysia. Asian Academy of Management Journal of Accounting

and Finance, 7: 103-119

24. Schaub, M. (2006). Investor overreaction to going concern audit opinion announcements.

Applied Financial Economics, 16(16), 1163–1170.


40

25. Sengupta Partha, (1998). Corporate disclosure quality and the cost of debt. The

Accounting Review, Vol. 73, No. 4 (Oct., 1998), pp. 459-474

26. Syou-Ching Lai, Cecilia Lin, Hung-Chih Li, Frederick H. Wu (2009). The Information

Contents of Modified Unqualified Audit Opinions under the Control of Concurrent

Information: The Case of Taiwan, Journal of Accounting and Corporate Governance,

Volume 6 Number 1, June 2009, pp.31-56

27. Taffler, R.J., Lu, J., Kausar, A., 2004. In denial? Stock market underreaction to going-

concern audit report disclosures. Journal of Accounting and Economics 38, 263–285.


41

Appendices

Appendix no. 1 Variables measurement

Variable name Symbol Measurement

Cumulative abnormal return CAR 3-day cumulative abnormal return from day −1 to 1

Auditor opinion OP a dummy variable with a value of 1 for MAOs and

0 otherwise

Change in earnings ∆EPS change in earnings per share scaled by beginning

price at day −1

Dividends DIV 1 for MAOs with dividend decreases and 0

otherwise

Repeat REPEAT 1 for noninitial MAOs and 0 otherwise

Return on equity ROE net income/year-end total equity

Abnormal return (day 0) AR market model abnormal return on the day of

announcement

Interest rate INT_RATE interest expense divided by the average of total

short- and long term debt during the year

Big 4 audit firm BIG4 1 when the firm retains a Big 4 auditor and 0

otherwise

Leverage LEV book value of total short- and long-term debt

deflated by firm market value (sum of the

market value of equity and the book value of

total debt)

Cash-flow CF cash flow from operations scaled by total assets

Firm size SIZE the natural logarithm of one plus total assets

Structure of assets ASSET_STR total property, plant and equipment scaled by

total assets

Negative equity NEG_EQUITY 1 when there is a negative book equity and 0

otherwise


42

Appendix no. 2 Table Multicolinearity (H1)

Variable VIF 1/VIF

OP 2.39 0.418270

REPEAT 2.16 0.463361

DIV 1.20 0.830740

OP*∆EPS 1.13 0.885966

∆EPS 1.05 0.955293

Mean VIF 1.59

Appendix no. 3 Table specification error (H1)

CAR Coef. Std. Err. t P>t [95% Conf. Interval]

_hat 1.415148 1.655102 0.86 0.393 -1.842675 4.672971

_hatsq 0.0819477 0.3063694 0.27 0.789 -0.521095 0.6849905

_cons 0.5108255 2.524594 0.20 0.840 -4.458465 5.480116

Appendix no. 4 Multicolinearity (H2)

Variable VIF 1/VIF

SIZE 1.55 0.645301

LEV 1.47 0.680847

BIG4 1.39 0.720872

NEG_EQUITY 1.31 0.763227

CF 1.17 0.851344

ASSET_STR 1.03 0.970235

OP 1.02 0.980591

Mean VIF 1.28

Appendix no. 5 Specification error (H2)

INT_RATE Coef. Std. Err. t P>t [95% Conf. Interval]

_hat 0.4853796 0.3034508 1.60 0.110 -0.1109185 1.083678

_hatsq 10.26165 5.79124 1.77 0.077 -1.137551 21.66085

_cons 0.00546 0.0036798 1.48 0.139 -0.001783 0.012703

The influence of modified audit opinion on the stock ...

Documents

Transcript of The influence of modified audit opinion on the stock ...