Description
The purpose of this paper is to review the archival literature on market reactions to
qualified audit reports and to seek to identify the different approaches used in those studies. In
addition, the paper discusses the strengths and weaknesses of different approaches, summarizes key
findings, and provides suggestions for future research.
Accounting Research Journal
Market reactions to qualified audit reports: research approaches
Kim Ittonen
Article information:
To cite this document:
Kim Ittonen, (2012),"Market reactions to qualified audit reports: research approaches", Accounting
Research J ournal, Vol. 25 Iss 1 pp. 8 - 24
Permanent link to this document:http://dx.doi.org/10.1108/10309611211244483
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Market reactions to quali?ed
audit reports: research
approaches
Kim Ittonen
Department of Accounting and Finance, University of Vaasa, Vaasa, Finland
Abstract
Purpose – The purpose of this paper is to review the archival literature on market reactions to
quali?ed audit reports and to seek to identify the different approaches used in those studies. In
addition, the paper discusses the strengths and weaknesses of different approaches, summarizes key
?ndings, and provides suggestions for future research.
Design/methodology/approach – The paper reviews articles examining the relevance of quali?ed
audit reports published between 1972 and 2010.
Findings – First, the review suggests that there are three main approaches used in the literature: the
short-window approach, the long-window approach, and the indirect approach. Each approach has
both strengths and signi?cant weaknesses that should be acknowledged. Second, as a whole the
empirical ?ndings in this area are mixed. A more detailed analysis reveals that only the indirect
approach has consistently found support for the relevance of quali?ed audit reports.
Research limitations/implications – This paper shows that in future, researchers in this area
should strive to identify the correct information release date, because it is the most critical step in
conducting event studies. In addition to the event date identi?cation, the effect of simultaneous
information releases during the event period must be considered. Last, it is suggested that researchers
include other stock market measures besides abnormal returns in their analysis, because measures like
change in volatility, volume, bid-ask spread, and systematic risk could provide information that
abnormal returns do not offer.
Originality/value – This paper provides a review of the current state of knowledge on whether
audit reports convey new information to the stock markets.
Keywords Quali?ed audit reports, Market reactions, Event study, Literature review, Stock markets,
Audit reports
Paper type Literature review
1. Introduction
Does the audit report announcement provide new information that is important for
?nancial statement users’ decision-making and does this information have an effect on
stock markets? The general public opinion and the empirical evidence from prior
research provide con?icting answers. The question of the relevance of audit reports to
?nancial statement users has been studied in archival and experimental studies. The
experimental literature mostly examines the relevance of audit opinions in the
decision-making process of ?nancial statement users, while archival studies focus on
stock market reactions around the announcement of the audit report. This paper reviews
the literature onstock market reactions to quali?ed audit reports. In particular, the paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The author gratefully acknowledges the helpful suggestions of Natalie Gallery (the Editor), two
anonymous referees, Aasmund Eilifsen, Stefan Sundgren, and Sami Va¨ha¨maa.
ARJ
25,1
8
Accounting Research Journal
Vol. 25 No. 1, 2012
pp. 8-24
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309611211244483
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aims to identify and discuss the main approaches the literature has adopted to study
whether the content of the audit report affects stock prices.
Auditing plays a key role in the communication process between a ?rmand the users
of its ?nancial statement. Theoretically, the relevance of the audit report in such cases
where the auditor decides to issue a quali?ed audit report is obvious. This is because
considerable evidence supports the simultaneous or delayed correlation between
earnings announcements and stock price changes (Ball and Brown, 1968; Bernard and
Thomas, 1989; Jegadeesh and Livnat, 2006). Furthermore, Lev (1989) documents that
earnings explain only a fraction of the change in returns on the earnings announcement
date, and consequently, accounting research has also focused on explaining the
relationship between stock markets and other ?nancial information (Ou and Penman,
1989; Livnat and Zarovin, 1990; Sloan, 1996). One other source of ?nancial information is
the audit report, since audit reports have the potential to change the market
responsiveness to earnings by adding noise or reducing the persistence of reported
earnings (Choi and Jeter, 1992).
There are two primary reasons why an audit report might affect stock prices. First,
the audit report may contain information that affects either the estimation of the
magnitude of future cash ?ows and/or the riskiness of future cash ?ows. Any
information that affects these components is relevant to the investors. Second, the audit
report can contain substantial information about the viability of the ?rm, in the form of
the going concern audit report. The audit report should at all times re?ect the auditor’s
access to inside information such as forecast data and management plans, and, taking
this into account, the auditor’s reporting decision also reveals some private information
(Mutchler, 1984).
An alternative view is expressed by Mutchler (1985) and Dopuch et al. (1987) who
suggest that the going concern audit report is a function of publicly available
information, and therefore its contents can be predicted. Predictable ?nancial
information is likely to be of low or insigni?cant value to ?nancial statement users.
Additionally, Melumad and Ziv (1997) proposed in their theoretical model of market
reactions to quali?ed audit reports that the reaction to avoidable and unavoidable
quali?ed audit reports is different. An avoidable audit report, which the management
could have avoided by making a change in reporting, could result in either a positive or a
negative reaction. Whereas an unavoidable quali?ed audit report, which the
management could not have avoided, is expected to result in a negative reaction.
The purpose of this paper is to review the archival literature on market reactions to
quali?ed audit reports and to identify the different approaches used in these studies. In
addition, the paper discusses the strengths and weaknesses of different approaches,
summarizes key ?ndings, and provides suggestions for future research.
The main ?ndings of this reviewcan be summarized as follows. The paper identi?es
three different approaches used to examine the existence of abnormal stock returns to
quali?ed audit report disclosures. First, traditional short-window event studies analyze
the instant market reaction after the audit report disclosure. An instant reaction is
expected based on the ef?cient market hypothesis, which implies stock prices re?ect all
past public information and adjust instantaneously to newinformation. This is the most
commonly used approach and in theory it should be a very powerful test if the event date
can be identi?ed, the predictability of the report can be estimated, and the concurrent
disclosures can be controlled for. Second, the long event window approach has been
Quali?ed audit
reports
9
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applied to investigate the market under-reaction to announcements of audit reports over
a 12-month period. For example, it has been suggested that market frictions create
limits-to-arbitrage conditions that slow down the market response to new information
(Zhang, 2006) or expectations of the market regarding a quali?ed audit report have, to an
extent, already been conditioned before the disclosure of the audit report and therefore a
short event window reaction is not observable (Herbohn et al., 2007). Third, indirect
approaches have been used to study the relevance of audit reports by examining market
reactions to related disclosures while controlling for the content of the audit report.
Speci?cally, while audit reports are commonly disclosed as a part of the annual
?nancials, researchers have used related disclosures, such as bankruptcy ?lings and
audit quali?cation withdrawals, to overcome the problem of disentangling the effect of
the audit report from other annual ?nancial information disclosures.
The empirical ?ndings in the literature are mixed. A more detailed analysis of the
approaches and event dates used in the papers reveals that only the indirect approach
has consistently found support for the hypothesis that quali?ed audit reports are
relevant to investors. Researchers conducting and analyzing research in this ?eld
should acknowledge that certain environmental and institutional factors, such as
clarity of the event date, concurrent disclosures, predictability of the report, trading
volume and availability of daily quotes of the underlying stocks, frequency, recurrence
and type of quali?ed audit reports, and availability of related disclosures, signi?cantly
affect the measurement of stock market reactions and interpretation of the empirical
?ndings.
2. Market reactions to quali?ed audit reports
The reaction of stock markets to quali?ed audit report announcements has been
studied extensively in the literature. Table I summarizes the key features of the papers
published in this area between 1972 and 2010. The main research question addressed
in these studies is whether the information contained in quali?ed audit reports affects
stock markets and thus provides evidence on the relevance of quali?ed audit reports.
Market reaction studies have used a number of methods and approaches in the
empirical examinations. There are several reasons for the variability of approaches.
First, due to advances in the research methods used and the wider availability of stock
market data over the years, the empirical approaches have changed. Second,
research approaches have also improved due to observed weaknesses in previous
studies. For example, the literature clearly indicates that determining the relevant event
date, controlling for coinciding ?nancial information disclosures and controlling for
investors’ expectations have beenchallenging. Accordingly, researchers have developed
approaches to overcome or at least control for those dif?culties. Third, because this
stream of research utilizes quali?ed audit reports issued to publicly listed clients, the
availability of such reports has directed the archival research to areas and markets
where a suf?cient number of quali?ed reports is available, and to those types of audit
reports that public clients ?le. In this respect, research has bene?ted from recessions
(resulting in more going concern audit reports) and regulatory changes (e.g. the
enactment of SOX and the requirements of the PCAOB resulted in more quali?ed audit
reports issued to clients; and requirements for auditors to report on the effectiveness of
internal controls introduced a new type of quali?ed audit report). Finally, some of the
differences in approaches are due to varying theoretical views. For example, approaches
ARJ
25,1
10
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)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
u
n
e
x
p
e
c
t
e
d
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
Y
e
s
F
r
o
s
t
(
1
9
9
4
)
A
J
P
T
U
S
1
9
8
3
-
1
9
8
8
2
3
4
(
0
,
þ
1
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
u
n
c
e
r
t
a
i
n
t
y
-
m
o
d
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
?
n
a
n
c
i
a
l
d
i
s
t
r
e
s
s
Y
e
s
C
h
e
n
a
n
d
C
h
u
r
c
h
(
1
9
9
6
)
T
A
R
U
S
1
9
8
1
-
1
9
8
8
4
2
(
2
1
0
,
þ
1
0
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
b
a
n
k
r
u
p
t
c
y
?
l
i
n
g
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
g
o
i
n
g
c
o
n
c
e
r
n
o
p
i
n
i
o
n
s
Y
e
s
(
c
o
n
t
i
n
u
e
d
)
Table I.
Studies on the relevance
of quali?ed audit reports
to the stock markets
Quali?ed audit
reports
11
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
4
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
u
t
h
o
r
s
/
y
e
a
r
J
o
u
r
n
.
a
O
b
s
.
m
a
r
k
e
t
T
i
m
e
p
e
r
i
o
d
e
x
a
m
i
n
e
d
N
o
.
o
f
M
A
O
o
b
s
.
P
r
i
m
a
r
y
e
v
e
n
t
w
i
n
d
o
w
-
m
o
n
t
h
/
w
e
e
k
/
d
a
y
(
m
/
w
/
d
)
b
C
o
n
t
r
o
l
g
r
o
u
p
a
n
a
l
y
s
i
s
M
a
i
n
t
e
s
t
S
u
p
p
o
r
t
f
o
r
R
Q
J
o
n
e
s
(
1
9
9
6
)
J
A
P
P
U
S
1
9
7
9
-
1
9
8
8
6
8
(
2
2
,
þ
2
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
i
n
v
e
s
t
o
r
s
’
e
x
p
e
c
t
a
t
i
o
n
s
Y
e
s
C
a
r
l
s
o
n
e
t
a
l
.
(
1
9
9
8
)
Q
J
B
E
U
S
1
9
8
1
-
1
9
8
8
8
8
(
2
2
,
þ
2
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
o
n
c
u
r
r
e
n
t
d
i
s
c
l
o
s
u
r
e
s
Y
e
s
F
a
r
g
h
e
r
a
n
d
W
i
l
k
i
n
s
(
1
9
9
8
)
J
B
F
A
U
S
1
9
7
2
-
1
9
9
2
1
1
0
(
2
2
0
0
,
þ
2
0
0
)
d
a
y
s
N
o
S
y
s
t
e
m
a
t
i
c
a
n
d
u
n
s
y
s
t
e
m
a
t
i
c
r
i
s
k
c
h
a
n
g
e
s
a
r
o
u
n
d
a
u
d
i
t
q
u
a
l
i
?
c
a
t
i
o
n
s
a
n
d
q
u
a
l
i
?
c
a
t
i
o
n
w
i
t
h
d
r
a
w
a
l
s
Y
e
s
C
h
e
n
e
t
a
l
.
(
2
0
0
0
)
C
A
R
C
H
N
1
9
9
5
-
1
9
9
7
9
6
(
2
1
,
þ
1
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
q
u
a
l
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
o
n
c
u
r
r
e
n
t
a
n
n
o
u
n
c
e
m
e
n
t
s
a
n
d
q
u
a
l
i
?
c
a
t
i
o
n
t
y
p
e
Y
e
s
H
o
l
d
e
r
-
W
e
b
b
a
n
d
W
i
l
k
i
n
s
(
2
0
0
0
)
J
A
R
U
S
1
9
7
5
-
1
9
9
6
1
0
7
(
2
1
,
þ
1
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
b
a
n
k
r
u
p
t
c
y
?
l
i
n
g
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
g
o
i
n
g
c
o
n
c
e
r
n
o
p
i
n
i
o
n
s
Y
e
s
S
o
l
t
a
n
i
(
2
0
0
0
)
I
J
A
F
R
A
1
9
8
6
-
1
9
9
5
5
4
3
(
2
5
,
þ
5
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
q
u
a
l
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
Y
e
s
S
c
h
a
u
b
a
n
d
H
i
g
h
?
e
l
d
(
2
0
0
3
)
J
A
M
U
S
1
9
8
9
-
1
9
9
6
3
6
(
2
1
,
þ
1
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
b
e
f
o
r
e
a
n
d
a
f
t
e
r
t
h
e
a
u
d
i
t
o
p
i
n
i
o
n
n
a
m
e
c
h
a
n
g
e
P
u
c
h
e
t
a
e
t
a
l
.
(
2
0
0
4
)
E
A
R
S
P
A
1
9
9
2
-
1
9
9
5
(
2
1
2
,
þ
1
2
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
q
u
a
l
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
N
o
T
a
f
?
e
r
e
t
a
l
.
(
2
0
0
4
)
J
A
E
U
K
1
9
9
5
-
2
0
0
0
(
þ
1
,
þ
1
2
)
m
o
n
t
h
s
Y
e
s
S
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
f
t
e
r
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
Y
e
s
O
g
n
e
v
a
e
t
a
l
.
(
2
0
0
7
)
J
A
E
U
K
/
U
S
A
U
S
1
9
9
3
-
2
0
0
4
(
þ
1
,
þ
1
2
)
m
o
n
t
h
s
N
o
S
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
f
t
e
r
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
h
o
i
c
e
o
f
e
x
p
e
c
t
e
d
r
e
t
u
r
n
a
n
d
m
o
m
e
n
t
u
m
N
o
H
e
r
b
o
h
n
e
t
a
l
.
(
2
0
0
7
)
A
F
A
U
S
1
9
9
9
-
2
0
0
3
(
2
5
,
þ
5
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
a
n
d
s
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
r
o
u
n
d
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
N
o
(
s
h
o
r
t
)
(
2
1
2
,
2
1
)
m
o
n
t
h
Y
e
s
(
l
o
n
g
)
B
e
n
e
i
s
h
e
t
a
l
.
(
2
0
0
8
)
T
A
R
U
S
2
0
0
4
-
2
0
0
5
3
3
0
/
3
8
3
(
2
1
,
þ
1
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
m
a
t
e
r
i
a
l
i
n
t
e
r
n
a
l
c
o
n
t
r
o
l
w
e
a
k
n
e
s
s
d
i
s
c
l
o
s
u
r
e
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
a
u
d
i
t
o
r
q
u
a
l
i
t
y
,
w
e
a
k
n
e
s
s
t
y
p
e
a
n
d
?
r
m
s
i
z
e
N
o
(
c
o
n
t
i
n
u
e
d
)
Table I.
ARJ
25,1
12
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
4
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
u
t
h
o
r
s
/
y
e
a
r
J
o
u
r
n
.
a
O
b
s
.
m
a
r
k
e
t
T
i
m
e
p
e
r
i
o
d
e
x
a
m
i
n
e
d
N
o
.
o
f
M
A
O
o
b
s
.
P
r
i
m
a
r
y
e
v
e
n
t
w
i
n
d
o
w
-
m
o
n
t
h
/
w
e
e
k
/
d
a
y
(
m
/
w
/
d
)
b
C
o
n
t
r
o
l
g
r
o
u
p
a
n
a
l
y
s
i
s
M
a
i
n
t
e
s
t
S
u
p
p
o
r
t
f
o
r
R
Q
H
a
m
m
e
r
s
l
e
y
e
t
a
l
.
(
2
0
0
8
)
R
A
S
T
U
S
2
0
0
3
-
2
0
0
5
3
5
8
(
2
1
,
þ
1
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
S
O
X
3
0
2
d
i
s
c
l
o
s
u
r
e
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
h
a
r
a
c
t
e
r
i
s
t
i
c
s
o
f
t
h
e
w
e
a
k
n
e
s
s
Y
e
s
A
s
h
b
a
u
g
h
-
S
k
a
i
f
e
e
t
a
l
.
(
2
0
0
9
)
J
A
R
U
S
2
0
0
3
-
2
0
0
5
7
8
7
(
2
1
,
þ
1
)
d
a
y
s
N
o
S
y
s
t
e
m
a
t
i
c
a
n
d
u
n
s
y
s
t
e
m
a
t
i
c
r
i
s
k
c
h
a
n
g
e
s
a
r
o
u
n
d
i
n
t
e
r
n
a
l
c
o
n
t
r
o
l
w
e
a
k
n
e
s
s
d
i
s
c
l
o
s
u
r
e
s
a
n
d
r
e
m
e
d
i
a
t
i
o
n
s
Y
e
s
K
a
u
s
a
r
e
t
a
l
.
(
2
0
0
9
)
J
A
R
U
S
1
9
9
3
-
2
0
0
5
1
,
2
9
3
(
þ
1
,
þ
1
2
)
m
o
n
t
h
s
N
o
S
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
f
t
e
r
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
a
n
d
t
h
e
i
r
s
u
b
s
e
q
u
e
n
t
w
i
t
h
d
r
a
w
a
l
Y
e
s
C
z
e
r
n
k
o
w
s
k
i
e
t
a
l
.
(
2
0
1
0
)
M
A
J
C
H
N
1
9
9
9
-
2
0
0
3
3
8
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Table I.
Quali?ed audit
reports
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S
I
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t
2
1
:
1
4
2
4
J
a
n
u
a
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y
2
0
1
6
(
P
T
)
differ in their views of the effectiveness of stock markets; some assume ef?cient markets
where stock prices adjust instantly to newinformation, while others recognize that stock
prices may only react fully to the disclosed information within a longer time frame.
This paper divides the research into three main approaches as shown in Figure 1.
The strengths, weaknesses and key ?ndings of the short event window approach, the
long event window approach and the indirect approach are discussed next.
3. Short-window event studies examining market reactions to quali?ed
audit reports
The underlying assumption in the short event window studies is that the stock
markets are ef?cient, in that all new information will be incorporated into the stock
prices immediately after its announcement. Consequently, when the content of the
audit report is disclosed the investors will immediately re-estimate the value of the ?rm
and the stock prices adjust to a new equilibrium.
The method used to estimate short event window abnormal returns around the
audit report disclosure has not changed much over the years. Kothari and Warner
(2006) point out that while event studies in general are still signi?cantly based on
Fama et al. (1969), there are two major changes:
(1) studies mostly examine daily return data as data availability has improved; and
(2) the methods of estimating abnormal returns and testing their statistical
signi?cance have improved over time.
These advances are also observable from the audit report event studies.
3.1 Strengths and weaknesses
The short event window approach is a powerful method for examining the relevance of
audit reports. An event study is perceived to be a reliable measure of the abnormal
performance of a stock at the time of an unanticipated event (Kothari and Warner, 2006).
Figure 1.
Approaches used to study
stock market reactions to
audit report
announcements
Notes: * Denotes papers reporting significant value relevance of audit reports in stock markets
THREE APPROACHES TO STUDYING STOCK MARKET
REACTIONS TO AUDIT REPORT ANNOUNCEMENT
(1)
ABNORMAL STOCK REACTION –
SHORT EVENT WINDOW REACTION
(1 to 30 days)
Baskin (1972, TAR) Jones (1996, JAPP)*
Firth (1978, TAR) Carlson et al. (1998, QJBE)*
Davis (1982, AJPT) Chen et al. (2000, CAR)*
Elliott (1982, JAR) Soltani (2000, IJA)*
Dodd et al. (1984, JAE) Schaub et al. (2003, JAM)*
Dopuch et al. (1986, JAE)* Pucheta et al. (2004, EAR)
Loudder et al.(1992, AJPT)* Beneish et al. (2008, TAR)
Mittelstaedt et al. (1992, AJPT) Hammersley et al. (2008, RAST)*
Ameen et al. (1994, JBFA) Ashbaugh-Skaife et al. (2009, JAR)*
Fleak et al. (1994, JAAF)* Czernkowski et al. (2010, MAJ)
Frost (1994, AJPT)* Ittonen (2010, MAJ)*
(2)
ABNORMAL STOCK
REACTION –
LONG EVENT
WINDOW
REACTION
(2 to 12 months)
Banks et al. (1982, JAR)*
Chow et al. (1982, AJPT)*
Taffler et al. (2004, JAE)*
Herbohn et al. (2007, AF)*
Ogneva et al. (2007, JAE)
Kausar et al. (2009, JAR)*
(3)
INDIRECT MARKET
REACTION –
SHORT WINDOW
REACTION TO A
RELATED
ANNOUNCEMENT
Fields et al. (1991, AJPT)*
Chen et al. (1996, TAR)*
Fargher et al. (1998, JBFA)*
Holder-Webb et al. (2000, JAR)*
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A market reaction should be observable if the audit report contains new information
affecting the estimation of the magnitude or the riskiness of future cash ?ows, or the
viability of the ?rm.
This approach presents two signi?cant challenges because a market reaction
is expected only if the disclosed information is relevant and if it is new. As illustrated
in Table I, most papers have focused on going concern (or “subject to”) audit reports. In
addition, the market reactions to reports on the effectiveness of internal controls
mandated by SOX Section 404 have received attention more recently. The information
contained in these two report types is considered relevant to investors. While studying
the market reaction to the disclosure of these audit report types, researchers have been
occupied with controlling for the surprise and novelty of the information disclosed in
the audit report. To control for novelty and surprise two issues should be considered:
(1) the point at which the audit report is publicly disclosed, which involves de?ning
the event date; and
(2) controlling for how surprising the information in the audit report is.
3.1.1 Event date selection. In a short-window event study, the identi?cation of the event
date is one of the most fundamental issues. Since, assuming ef?cient markets, the stock
market will quickly digest any new and relevant information and the stock price will
be instantly re-estimated. In theory, the correct event date is the date when the audit
report information reaches investors. In the audit report literature several alternative
event dates have been used. Figure 2 shows a timeline illustration of them.
The most frequently used event date is the date of ?ling of the annual report. The
problem with this date is that the audit report accompanies the annual report, which
also contains the annual ?nancial information and the management’s discussion, and
in an event study simultaneous disclosures, or confounding information releases, may
lead to Type I or Type II errors. For example, if the audit report and the annual
earnings information are disclosed together then the observed market reaction could be
a result of either the audit report, the earnings information, management’s discussion,
Figure 2.
Timeline illustration of
different event dates used
in the literature
Auditor
issues/ client
receives the
audit report
Soltani
(2000, IJA)
Ittonen
(2010, MAJ)*
SEC filing date of annual report/10-K report
Baskin (1972, TAR) Chen et al. (2000, CAR)*
Firth (1978, TAR) Pucheta et al. (2004, EAR)
Chow et al. (1982, AJPT)* Taffler et al. (2004, JAE)*
Banks et al. (1982, JAR)* Ogneva et al. (2007, JAE)
Davis (1982,AJPT) Herbohn et al. (2007, AF)*
Dodd et al. (1984, JAE) Beneish et al. (2008, TAR)
Mittelstaedt et al.
(1992, AJPT)
Hammersley et al. (2008, RAST)*
Ashbaugh-Skaife et al. (2009, JAR)*
Frost (1994, AJPT)* Kausar et al. (2009, JAR)
Carlson et al. (1998, QJBE) Czernkowski et al. (2010, MAJ)
Media
coverage
Dopuch et al.
(1986, JAE)*
Fargher et al.
(1998, JBFA)
Schaub et al.
(2003)*
Annual
general
meeting
Soltani
(2000, IJA)*
Pucheta et al.
(2004, EAR)
Financial
year end
Filing of
related event
Fields et al.
(1991, AJPT)*
Chen et al.
(1996, TAR)*
Fargher et al.
(1998, JBFA)*
Holder-Webb et al.
(2000, JAR)*
Earliest of conceivable
disclosure dates
Loudder et al. (1992, AJPT)*
Earnings
announce -
ment date
Davis
(1982, AJPT)
Elliot
(1982, JAR)*
Notes: * Denotes papers reporting significant value relevance of audit reports in stock markets
Jones (1996, JAPP)
Fleak et al. (1994, JAAF)*
Ameen et al. (1994, JBFA)
Quali?ed audit
reports
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or any combination of those. In such a case, the researcher must single out the market
reaction caused by the audit report.
In the Australian setting, Herbohn et al. (2007) study the market reactions on the
date of the “?nal annual report”. Australian ?rms are required ?rst to release a
preliminary annual report with only the earnings information and later the ?rms
publish the ?nal annual report. The requirement allows Herbohn et al. (2007) to restrict
the in?uence of the earnings information from the abnormal returns on the day of the
?nal annual report. However, as they note, the ?nal annual reports may still contain
amendments to the earnings or other relevant non-earnings information.
Although the annual report date is most frequently used, a review of the papers
reveals that the issue is far from straightforward. The ?rst observation is that some
studies have used several dates. This is illustrated by Loudder et al. (1992) in their
description of sample selection:
The quali?cation disclosure date was de?ned as the earliest of (1) the publication date of a
media story, if one was found, (2) the annual report date, or (3) the 10-K stamp date.
Multiple event dates have also been used by several other studies and this is clearly an
indication of the dif?culty of identifying or determining the ?rst day of trading on the
information contained in the audit opinion.
Studies have attempted to solve the problem of the simultaneous annual report or
other information disclosures in different ways. First, studies have concentrated on
audit reports attracting media attention (Dopuch et al., 1986; Fargher and Wilkins, 1998;
Schaub and High?eld, 2003). Media disclosure dates are considered to be relatively free
fromnoise incurred by simultaneous disclosures and so the use of this date is debatable.
In addition, the media is likely to focus on quali?ed audit reports that are surprises or
issued to widely followed ?rms. Second, Soltani (2000) in his French study and
Pucheta et al. (2004) in their Spanish study use an estimation of the date when the audit
report is publicly announced. They both use the 15th day before the annual general
meeting as an alternative event date, indicating that in their setting the audit report
(and the annual report) has to be presented to the shareholders no later than 15 days
before the annual general meeting. Both papers recognize, however, that ?rms may
choose to present the audit report earlier and therefore both studies use longer event
windows. Finally, Soltani (2000) and Ittonen (2010) use the date of the auditor’s signature
on the audit report. Their choice is supported by Carter and Soo (1999) and Knechel et al.
(2007) showing that the stock market reacts as early as the date of the actual event (e.g.
auditor change), instead of the public disclosure of the event, that is the ?ling of the 8-K
report. It is not clear, however, how the information about auditor switching or a
quali?ed audit report reaches investors’ attention before it is publicly disclosed, but one
explanation could be that some investors are using inside information.
3.1.2 Controlling for expectation. The second issue, besides the event date, that
needs to be controlled for when applying the short-window event study method, is the
market participants’ knowledge and expectations of the matters disclosed in the audit
report. The issue arises because a quali?ed audit report is less informative and
valuable when disclosed if the circumstances that it refers to are already well known to
outside investors, or they have been anticipated based on more timely data in the
public realm. If the market price already re?ects the audit report information, then the
reaction around the disclosure time is weaker or possibly non-existent.
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In the standard short-window setting, the degree to which disclosed information is
expected has been controlled for with different proxies. The most common method
applied is controlling for audit report type in the preceding year. For example, Chow
and Rice (1982) examined the abnormal returns associated with various types of audit
reports and their sample included ?rms receiving a quali?ed audit report in year t and
an unquali?ed report in t 2 1. They conclude that a short-window event study will
capture the stock price effect only if the market cannot predict the occurrence of the
quali?cation. Similar approach has been applied in most papers since then.
In addition to the previous year’s audit report, Davis (1982) advocated the need to
control for the market knowledge about the economic circumstances underlying the
issue of the quali?ed audit report. Subsequently, studies focusing on going concern
audit reports typically control for the ?nancial distress of the client prior to the audit
report, because ?nancial distress increases the likelihood of going concern audit
reports. Similarly, investors’ knowledge about the number of segments, foreign sales,
mergers and acquisitions, and restructurings for example may affect the information
content of, or the degree of surprise in, a material internal control weakness report.
Summary of the key ?ndings. No general conclusion can be drawn from the studies
examining short event window abnormal returns to quali?ed audit reports. The results
remain inconsistent even when analyzed separately for different time periods, event
dates, report types or controls for expectations. However, except for Chow and Rice
(1982) and Soltani (2000) all studies ?nding a signi?cant short-window market reaction
have examined going concern or material internal control weakness reports. This
suggests that those two types of reports are the most relevant that can be examined in an
archival short event windowstudy. Furthermore, the evidence regarding short-window
abnormal returns around media disclosures seems slightly more consistent, proposing
that media disclosures of quali?ed audit reports may contain relevant information.
Media disclosures may contain additional relevant information or they may simply
bring the circumstances to the attention of a broader audience and consequently result in
a negative market reaction.
4. Long-window event studies
This approach draws on the evidence that investors need time to interpret and digest
bad news, in contrast to reacting promptly to good news (Ball and Brown, 1968; Bernard
and Thomas, 1989, 1990; Womak, 1996; Dichev and Piotroski, 2001). Accordingly, share
prices may not adjust to the “correct” level during a short event window, but rather,
a longer event window (e.g. 12 months) is necessary to measure the full impact. In other
words, the investors either do not instantly reach agreement on the correct stock price or
there may then be market frictions delaying the price adjustment (e.g. illiquid stocks).
Strengths and weaknesses
This approach overcomes one major problem of the short-window approach. Because
the market reaction is typically estimated from monthly returns, the identi?cation of
the exact event day is not as essential as in the short event window studies. Finding the
appropriate event month is easier and more reliable than ?nding the event day.
The major weakness of the long event window method is the lack of reliability.
More speci?cally, long-window methods may suffer from speci?cation problems, low
ability to detect abnormal performance, high sensitivity to assumptions about the
Quali?ed audit
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return generating process, and misspeci?cation risk when the variance of a stock
increases (Kothari and Warner, 2006). These weaknesses of long-window event studies
may be highlighted in the analysis of quali?ed audit reports, because sample sizes are
typically small (due to the low proportion of quali?ed audit reports), and furthermore,
because ?rms receiving certain types of audit reports may have nonrandom
characteristics (e.g. size, industry, pro?tability, or growth).
Summary of the key ?ndings
This review has identi?ed six papers applying the long-window event study method.
These papers document ?ndings that are to some extent inconsistent. To begin with,
Taf?er et al. (2004) and Kausar et al. (2009) ?nd signi?cant negative abnormal returns to
going concern disclosures in the UK and the USA, respectively. On the contrary,
Herbohn et al. (2007) and Ogneva and Subramanyam (2007) ?nd no evidence of
abnormal returns in the USAor Australia. Moreover, Herbohn et al. (2007) ?nd a market
reaction only in the 12-months prior to the going concern report, which is broadly in line
with the early studies of Banks and Kinney (1982) and Chow and Rice (1982).
5. The indirect approach
The relevance of audit reports has also been studied using an indirect approach.
The indirect approach focuses on the short-window abnormal returns around a
disclosure related to a quali?ed audit report. Two types of disclosures have so far been
examined: bankruptcy ?lings and withdrawals of quali?ed audit reports. The studies
concentrating on bankruptcy ?lings hypothesize that the market reaction to bankruptcy
?lings is associated with the type of the latest audit report. Chen and Church (1996) and
Holder-Webb and Wilkins (2000) suggest that going concern audit reports may be useful
in predicting bankruptcies and consequently reducing the surprise associated with
bankruptcy ?lings. Following this reasonable assumption, Chen and Church (1996)
examine whether the negative market reaction to bankruptcy ?lings is smaller for ?rms
that receive a going concern audit report, than for ?rms that receive an unquali?ed audit
report.
Fields and Wilkins (1991) and Fargher and Wilkins (1998) examine market reactions
around audit quali?cation withdrawal announcements. They expect that if quali?ed
audit reports accurately identify and effectively communicate ?rms’ uncertainties,
a negative stock price reaction should follow around the time of the announcement.
Similarly, withdrawals of such reports should reduce or remove these uncertainties
and, as a result, a positive stock price reaction should follow.
Strengths and weaknesses
The indirect approach has strengths that address the weaknesses of the short event
window approach. The main strength is the identi?cation of the event day. The
quali?cation withdrawals are usually announced on an additional opinion at the time
when the quali?cation issues are resolved. Similarly, in the sample used by Chen and
Church (1996) bankruptcy ?lings were considered separately from the ?nancial
statements, and in their sample they occurred between 11 and 281 trading days after the
last set of ?nancial statements. The indirect approach also provides an opportunity to
study the relevance of quali?ed audit reports and for example how useful the quali?ed
audit report is for bankruptcyprediction. Evenif the audit report does not cause a market
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reaction around the time of its disclosure, it may, alone or jointly with some other
information, become relevant at a later stage.
The ?rst major weakness of this approach is common to all event studies, namely
controlling for concurrent information disclosed and for the surprise of the disclosure.
Bankruptcy ?lings’ and quali?cation withdrawals’ information content may vary
depending on the case and the differences in market reactions may be a result of the
information disclosed, rather than underlying information about the audit report.
Furthermore, it is likely that there are also disclosures other than, for example, going
concern audit reports that affect the surprise element of bankruptcy ?lings. For instance,
the severityof the ?rm’s ?nancial distress signaledinthe last set of ?nancial statements will
probably be associated with the market reaction to bankruptcy ?lings. Accordingly, Chen
and Church (1996) address these issues by calculating the probability of bankruptcy from
the last set of ?nancial statements and, additionally, they control for media disclosures
occurring subsequent to the issuance of ?nancial statements but prior to bankruptcy.
Summary of the key ?ndings
The indirect approach has consistently documented that quali?ed audit reports contain
information relevant to investors. Withdrawn audit quali?cations result in positive
abnormal returns and lower levels of risk, suggesting that audit reports contain
important information for investors. Bankruptcy ?lings result in a more negative
market reaction when the last audit report was unquali?ed. This ?nding proposes that
going concern audit reports contain relevant information and signi?cantly reduce the
surprise of a bankruptcy ?ling.
6. Areas of future research
Since 1972 there has been a substantial body of research on market reactions to
quali?ed audit reports. As Kothari and Warner (2006) have pointed out, the basic
statistical format has not changed much over time and the limitations of event studies
are well known. The following section makes important suggestions on how future
research could contribute to our knowledge.
New settings for a traditional approach
Analyzing the abnormal returns to quali?ed audit reports around annual report ?ling
dates (the traditional set-up) has provided important information about factors affecting
the relevance of audit reports. An interesting area of development, as in Herbohn et al.
(2007), is to ?nd institutional settings were the audit report information can be separated
fromthe annual ?nancials or where the audit report is disclosed alone. For example, the
receipt of a quali?ed audit report could be considered a material current event which
must be disclosed to the investors after the event is revealed, and without delay. The
current practice in the major stock markets is, however, that the audit report can be
disclosed later, together with the annual ?lings, not when the report is received.
Examining markets that demand immediate disclosure of an audit quali?cation would
signi?cantly address the current problems of identifying the correct and timely event
date, and separating the impact that the accompanying annual ?nancial information has
on the abnormal returns.
In a similar vein, another opportunity would be to ?nd new settings in which to
apply the indirect approach or extend the analysis of Fields and Wilkins (1991) and
Quali?ed audit
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Chen and Church (1996). For example, it could be interesting to examine market
reactions to fraud announcements from ?rms that have reported material internal
control weaknesses and those that have not.
New approaches to measuring relevance to investors
The vast majority of reviewed papers have examined abnormal stock returns to
determine whether quali?ed audit report information is relevant to investors or not.
Capital markets research has also provided evidence that other measures may be
apposite in studying the relevance of ?nancial information in the stock markets. Several
studies since Beaver (1968) have examined changes in volatility, volume, or bid-ask
spread around public announcements to measure the ?ow and relevance of disclosed
information.
Accordingly, Choi and Jeter (1992) examine the market’s responsiveness to earnings
announcements after the issuance of a quali?ed audit report and show that
quali?cations add noise to or reduce the persistence of earnings. Similarly, Fargher
and Wilkins (1998) and Ittonen (2010) use systematic risk and change in volatility to
measure whether quali?ed audit reports affect the risk of future cash ?ows and add
uncertainty to the stock market. Although these alternative measures are not completely
unfamiliar in the audit quali?cations literature, they could be applied more frequently,
because they re?ect different perspectives on investors’ reactions to information
announcements.
7. Conclusion
This paper reviews the literature on the stock market reactions to quali?ed audit reports.
There is considerable empirical evidence reporting a stock market reaction both to
management produced ?nancial information, as well as information produced by others.
From a theoretical perspective, quali?ed audit reports may change the market
responsiveness to earnings by adding noise or reducing the persistence of reported
earnings, and thus a market reaction could be expected (Choi and Jeter, 1992). In other
words, audit report information, quali?ed or unquali?ed, is expected to affect investors
by conveying information that affects either the estimations about the amount of future
cash ?ows or the riskiness of future cash ?ows. A stock market reaction, however,
depends heavily on whether the audit report contains new information that is not
already available or expected.
This paper identi?es three different approaches to studying market reactions to
quali?ed audit reports. First, some reviewed papers use short event window abnormal
stock returns to determine whether there is an immediate market reaction to the audit
report announcement, as might be expected assuming ef?cient stock markets. Second,
some studies apply the long event window approach to monitor under-reaction in the
market, that is, the abnormal performance of stockprices over a six-12-monthperiodafter
the audit report has been announced. Third, the study reviews the alternative indirect
approaches to document the relevance of audit reports, including analyzing stock returns
around bankruptcy announcements or audit report quali?cation withdrawals.
Examining the strengths and weaknesses of the approaches reveals that
researchers should carefully consider the opportunities the institutional setting offers.
For example, the short event window approach seems highly advisable in settings
where:
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.
the event date can be precisely identi?ed; and
.
the audit report is either disclosed separately or the market impact of concurrent
disclosures can be separated.
On the other hand, the indirect approach appears powerful if related disclosures can be
identi?ed and the information content of the related disclosure can be measured.
Moreover, if the trading volume of the sample ?rms is low or other market frictions are
expected to affect investors trading behavior, applying the long event window
approach seems warranted.
The empirical ?ndings on stock market reactions to announcements of quali?ed
audit reports are mixed. The contradictory results seemto be driven, to some extent, by
different methodological choices and approaches. The review suggests that only with
the indirect approach do the ?ndings consistently support the hypothesis that quali?ed
audit reports are relevant to investors. In addition, reviewing the methodological
choices and arguments in the prior literature, it seems that a the most relevant types of
quali?ed audit reports are:
.
unexpected;
.
?rst-time quali?cations; related to
.
going concern doubts or material internal control weaknesses.
Two recommendations for future research can be made. First, for short event date
studies it is important to ?nd and take advantage of institutional settings where:
.
the audit report event date can be identi?ed unambiguously; and
.
the effect of concurrent disclosures can be controlled.
For research purposes the optimal setting would be where the audit report is disclosed
immediately upon the auditor’s signature. Second, in addition to the widely-used
abnormal stock returns, researchers should acknowledge other, in some cases more
accurate, measures of market reaction. For instance, changes in volatility, volume, bid-ask
spread, or systematic risk around quali?ed audit report disclosures are suggested as
measures that mayalso contribute tothe literature andincrease our knowledge concerning
the relevance of quali?ed audit reports.
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Accounting and Economics, Vol. 30 No. 3, pp. 279-313.
Corresponding author
Kim Ittonen can be contacted at: kit@uwasa.?
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doc_968710083.pdf
The purpose of this paper is to review the archival literature on market reactions to
qualified audit reports and to seek to identify the different approaches used in those studies. In
addition, the paper discusses the strengths and weaknesses of different approaches, summarizes key
findings, and provides suggestions for future research.
Accounting Research Journal
Market reactions to qualified audit reports: research approaches
Kim Ittonen
Article information:
To cite this document:
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Research J ournal, Vol. 25 Iss 1 pp. 8 - 24
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Market reactions to quali?ed
audit reports: research
approaches
Kim Ittonen
Department of Accounting and Finance, University of Vaasa, Vaasa, Finland
Abstract
Purpose – The purpose of this paper is to review the archival literature on market reactions to
quali?ed audit reports and to seek to identify the different approaches used in those studies. In
addition, the paper discusses the strengths and weaknesses of different approaches, summarizes key
?ndings, and provides suggestions for future research.
Design/methodology/approach – The paper reviews articles examining the relevance of quali?ed
audit reports published between 1972 and 2010.
Findings – First, the review suggests that there are three main approaches used in the literature: the
short-window approach, the long-window approach, and the indirect approach. Each approach has
both strengths and signi?cant weaknesses that should be acknowledged. Second, as a whole the
empirical ?ndings in this area are mixed. A more detailed analysis reveals that only the indirect
approach has consistently found support for the relevance of quali?ed audit reports.
Research limitations/implications – This paper shows that in future, researchers in this area
should strive to identify the correct information release date, because it is the most critical step in
conducting event studies. In addition to the event date identi?cation, the effect of simultaneous
information releases during the event period must be considered. Last, it is suggested that researchers
include other stock market measures besides abnormal returns in their analysis, because measures like
change in volatility, volume, bid-ask spread, and systematic risk could provide information that
abnormal returns do not offer.
Originality/value – This paper provides a review of the current state of knowledge on whether
audit reports convey new information to the stock markets.
Keywords Quali?ed audit reports, Market reactions, Event study, Literature review, Stock markets,
Audit reports
Paper type Literature review
1. Introduction
Does the audit report announcement provide new information that is important for
?nancial statement users’ decision-making and does this information have an effect on
stock markets? The general public opinion and the empirical evidence from prior
research provide con?icting answers. The question of the relevance of audit reports to
?nancial statement users has been studied in archival and experimental studies. The
experimental literature mostly examines the relevance of audit opinions in the
decision-making process of ?nancial statement users, while archival studies focus on
stock market reactions around the announcement of the audit report. This paper reviews
the literature onstock market reactions to quali?ed audit reports. In particular, the paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The author gratefully acknowledges the helpful suggestions of Natalie Gallery (the Editor), two
anonymous referees, Aasmund Eilifsen, Stefan Sundgren, and Sami Va¨ha¨maa.
ARJ
25,1
8
Accounting Research Journal
Vol. 25 No. 1, 2012
pp. 8-24
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309611211244483
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aims to identify and discuss the main approaches the literature has adopted to study
whether the content of the audit report affects stock prices.
Auditing plays a key role in the communication process between a ?rmand the users
of its ?nancial statement. Theoretically, the relevance of the audit report in such cases
where the auditor decides to issue a quali?ed audit report is obvious. This is because
considerable evidence supports the simultaneous or delayed correlation between
earnings announcements and stock price changes (Ball and Brown, 1968; Bernard and
Thomas, 1989; Jegadeesh and Livnat, 2006). Furthermore, Lev (1989) documents that
earnings explain only a fraction of the change in returns on the earnings announcement
date, and consequently, accounting research has also focused on explaining the
relationship between stock markets and other ?nancial information (Ou and Penman,
1989; Livnat and Zarovin, 1990; Sloan, 1996). One other source of ?nancial information is
the audit report, since audit reports have the potential to change the market
responsiveness to earnings by adding noise or reducing the persistence of reported
earnings (Choi and Jeter, 1992).
There are two primary reasons why an audit report might affect stock prices. First,
the audit report may contain information that affects either the estimation of the
magnitude of future cash ?ows and/or the riskiness of future cash ?ows. Any
information that affects these components is relevant to the investors. Second, the audit
report can contain substantial information about the viability of the ?rm, in the form of
the going concern audit report. The audit report should at all times re?ect the auditor’s
access to inside information such as forecast data and management plans, and, taking
this into account, the auditor’s reporting decision also reveals some private information
(Mutchler, 1984).
An alternative view is expressed by Mutchler (1985) and Dopuch et al. (1987) who
suggest that the going concern audit report is a function of publicly available
information, and therefore its contents can be predicted. Predictable ?nancial
information is likely to be of low or insigni?cant value to ?nancial statement users.
Additionally, Melumad and Ziv (1997) proposed in their theoretical model of market
reactions to quali?ed audit reports that the reaction to avoidable and unavoidable
quali?ed audit reports is different. An avoidable audit report, which the management
could have avoided by making a change in reporting, could result in either a positive or a
negative reaction. Whereas an unavoidable quali?ed audit report, which the
management could not have avoided, is expected to result in a negative reaction.
The purpose of this paper is to review the archival literature on market reactions to
quali?ed audit reports and to identify the different approaches used in these studies. In
addition, the paper discusses the strengths and weaknesses of different approaches,
summarizes key ?ndings, and provides suggestions for future research.
The main ?ndings of this reviewcan be summarized as follows. The paper identi?es
three different approaches used to examine the existence of abnormal stock returns to
quali?ed audit report disclosures. First, traditional short-window event studies analyze
the instant market reaction after the audit report disclosure. An instant reaction is
expected based on the ef?cient market hypothesis, which implies stock prices re?ect all
past public information and adjust instantaneously to newinformation. This is the most
commonly used approach and in theory it should be a very powerful test if the event date
can be identi?ed, the predictability of the report can be estimated, and the concurrent
disclosures can be controlled for. Second, the long event window approach has been
Quali?ed audit
reports
9
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applied to investigate the market under-reaction to announcements of audit reports over
a 12-month period. For example, it has been suggested that market frictions create
limits-to-arbitrage conditions that slow down the market response to new information
(Zhang, 2006) or expectations of the market regarding a quali?ed audit report have, to an
extent, already been conditioned before the disclosure of the audit report and therefore a
short event window reaction is not observable (Herbohn et al., 2007). Third, indirect
approaches have been used to study the relevance of audit reports by examining market
reactions to related disclosures while controlling for the content of the audit report.
Speci?cally, while audit reports are commonly disclosed as a part of the annual
?nancials, researchers have used related disclosures, such as bankruptcy ?lings and
audit quali?cation withdrawals, to overcome the problem of disentangling the effect of
the audit report from other annual ?nancial information disclosures.
The empirical ?ndings in the literature are mixed. A more detailed analysis of the
approaches and event dates used in the papers reveals that only the indirect approach
has consistently found support for the hypothesis that quali?ed audit reports are
relevant to investors. Researchers conducting and analyzing research in this ?eld
should acknowledge that certain environmental and institutional factors, such as
clarity of the event date, concurrent disclosures, predictability of the report, trading
volume and availability of daily quotes of the underlying stocks, frequency, recurrence
and type of quali?ed audit reports, and availability of related disclosures, signi?cantly
affect the measurement of stock market reactions and interpretation of the empirical
?ndings.
2. Market reactions to quali?ed audit reports
The reaction of stock markets to quali?ed audit report announcements has been
studied extensively in the literature. Table I summarizes the key features of the papers
published in this area between 1972 and 2010. The main research question addressed
in these studies is whether the information contained in quali?ed audit reports affects
stock markets and thus provides evidence on the relevance of quali?ed audit reports.
Market reaction studies have used a number of methods and approaches in the
empirical examinations. There are several reasons for the variability of approaches.
First, due to advances in the research methods used and the wider availability of stock
market data over the years, the empirical approaches have changed. Second,
research approaches have also improved due to observed weaknesses in previous
studies. For example, the literature clearly indicates that determining the relevant event
date, controlling for coinciding ?nancial information disclosures and controlling for
investors’ expectations have beenchallenging. Accordingly, researchers have developed
approaches to overcome or at least control for those dif?culties. Third, because this
stream of research utilizes quali?ed audit reports issued to publicly listed clients, the
availability of such reports has directed the archival research to areas and markets
where a suf?cient number of quali?ed reports is available, and to those types of audit
reports that public clients ?le. In this respect, research has bene?ted from recessions
(resulting in more going concern audit reports) and regulatory changes (e.g. the
enactment of SOX and the requirements of the PCAOB resulted in more quali?ed audit
reports issued to clients; and requirements for auditors to report on the effectiveness of
internal controls introduced a new type of quali?ed audit report). Finally, some of the
differences in approaches are due to varying theoretical views. For example, approaches
ARJ
25,1
10
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Table I.
Studies on the relevance
of quali?ed audit reports
to the stock markets
Quali?ed audit
reports
11
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e
e
k
/
d
a
y
(
m
/
w
/
d
)
b
C
o
n
t
r
o
l
g
r
o
u
p
a
n
a
l
y
s
i
s
M
a
i
n
t
e
s
t
S
u
p
p
o
r
t
f
o
r
R
Q
J
o
n
e
s
(
1
9
9
6
)
J
A
P
P
U
S
1
9
7
9
-
1
9
8
8
6
8
(
2
2
,
þ
2
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
i
n
v
e
s
t
o
r
s
’
e
x
p
e
c
t
a
t
i
o
n
s
Y
e
s
C
a
r
l
s
o
n
e
t
a
l
.
(
1
9
9
8
)
Q
J
B
E
U
S
1
9
8
1
-
1
9
8
8
8
8
(
2
2
,
þ
2
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
o
n
c
u
r
r
e
n
t
d
i
s
c
l
o
s
u
r
e
s
Y
e
s
F
a
r
g
h
e
r
a
n
d
W
i
l
k
i
n
s
(
1
9
9
8
)
J
B
F
A
U
S
1
9
7
2
-
1
9
9
2
1
1
0
(
2
2
0
0
,
þ
2
0
0
)
d
a
y
s
N
o
S
y
s
t
e
m
a
t
i
c
a
n
d
u
n
s
y
s
t
e
m
a
t
i
c
r
i
s
k
c
h
a
n
g
e
s
a
r
o
u
n
d
a
u
d
i
t
q
u
a
l
i
?
c
a
t
i
o
n
s
a
n
d
q
u
a
l
i
?
c
a
t
i
o
n
w
i
t
h
d
r
a
w
a
l
s
Y
e
s
C
h
e
n
e
t
a
l
.
(
2
0
0
0
)
C
A
R
C
H
N
1
9
9
5
-
1
9
9
7
9
6
(
2
1
,
þ
1
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
q
u
a
l
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
o
n
c
u
r
r
e
n
t
a
n
n
o
u
n
c
e
m
e
n
t
s
a
n
d
q
u
a
l
i
?
c
a
t
i
o
n
t
y
p
e
Y
e
s
H
o
l
d
e
r
-
W
e
b
b
a
n
d
W
i
l
k
i
n
s
(
2
0
0
0
)
J
A
R
U
S
1
9
7
5
-
1
9
9
6
1
0
7
(
2
1
,
þ
1
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
b
a
n
k
r
u
p
t
c
y
?
l
i
n
g
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
g
o
i
n
g
c
o
n
c
e
r
n
o
p
i
n
i
o
n
s
Y
e
s
S
o
l
t
a
n
i
(
2
0
0
0
)
I
J
A
F
R
A
1
9
8
6
-
1
9
9
5
5
4
3
(
2
5
,
þ
5
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
q
u
a
l
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
Y
e
s
S
c
h
a
u
b
a
n
d
H
i
g
h
?
e
l
d
(
2
0
0
3
)
J
A
M
U
S
1
9
8
9
-
1
9
9
6
3
6
(
2
1
,
þ
1
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
b
e
f
o
r
e
a
n
d
a
f
t
e
r
t
h
e
a
u
d
i
t
o
p
i
n
i
o
n
n
a
m
e
c
h
a
n
g
e
P
u
c
h
e
t
a
e
t
a
l
.
(
2
0
0
4
)
E
A
R
S
P
A
1
9
9
2
-
1
9
9
5
(
2
1
2
,
þ
1
2
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
q
u
a
l
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
N
o
T
a
f
?
e
r
e
t
a
l
.
(
2
0
0
4
)
J
A
E
U
K
1
9
9
5
-
2
0
0
0
(
þ
1
,
þ
1
2
)
m
o
n
t
h
s
Y
e
s
S
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
f
t
e
r
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
Y
e
s
O
g
n
e
v
a
e
t
a
l
.
(
2
0
0
7
)
J
A
E
U
K
/
U
S
A
U
S
1
9
9
3
-
2
0
0
4
(
þ
1
,
þ
1
2
)
m
o
n
t
h
s
N
o
S
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
f
t
e
r
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
h
o
i
c
e
o
f
e
x
p
e
c
t
e
d
r
e
t
u
r
n
a
n
d
m
o
m
e
n
t
u
m
N
o
H
e
r
b
o
h
n
e
t
a
l
.
(
2
0
0
7
)
A
F
A
U
S
1
9
9
9
-
2
0
0
3
(
2
5
,
þ
5
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
a
n
d
s
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
r
o
u
n
d
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
N
o
(
s
h
o
r
t
)
(
2
1
2
,
2
1
)
m
o
n
t
h
Y
e
s
(
l
o
n
g
)
B
e
n
e
i
s
h
e
t
a
l
.
(
2
0
0
8
)
T
A
R
U
S
2
0
0
4
-
2
0
0
5
3
3
0
/
3
8
3
(
2
1
,
þ
1
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
m
a
t
e
r
i
a
l
i
n
t
e
r
n
a
l
c
o
n
t
r
o
l
w
e
a
k
n
e
s
s
d
i
s
c
l
o
s
u
r
e
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
a
u
d
i
t
o
r
q
u
a
l
i
t
y
,
w
e
a
k
n
e
s
s
t
y
p
e
a
n
d
?
r
m
s
i
z
e
N
o
(
c
o
n
t
i
n
u
e
d
)
Table I.
ARJ
25,1
12
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
4
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
u
t
h
o
r
s
/
y
e
a
r
J
o
u
r
n
.
a
O
b
s
.
m
a
r
k
e
t
T
i
m
e
p
e
r
i
o
d
e
x
a
m
i
n
e
d
N
o
.
o
f
M
A
O
o
b
s
.
P
r
i
m
a
r
y
e
v
e
n
t
w
i
n
d
o
w
-
m
o
n
t
h
/
w
e
e
k
/
d
a
y
(
m
/
w
/
d
)
b
C
o
n
t
r
o
l
g
r
o
u
p
a
n
a
l
y
s
i
s
M
a
i
n
t
e
s
t
S
u
p
p
o
r
t
f
o
r
R
Q
H
a
m
m
e
r
s
l
e
y
e
t
a
l
.
(
2
0
0
8
)
R
A
S
T
U
S
2
0
0
3
-
2
0
0
5
3
5
8
(
2
1
,
þ
1
)
d
a
y
s
N
o
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
S
O
X
3
0
2
d
i
s
c
l
o
s
u
r
e
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
c
h
a
r
a
c
t
e
r
i
s
t
i
c
s
o
f
t
h
e
w
e
a
k
n
e
s
s
Y
e
s
A
s
h
b
a
u
g
h
-
S
k
a
i
f
e
e
t
a
l
.
(
2
0
0
9
)
J
A
R
U
S
2
0
0
3
-
2
0
0
5
7
8
7
(
2
1
,
þ
1
)
d
a
y
s
N
o
S
y
s
t
e
m
a
t
i
c
a
n
d
u
n
s
y
s
t
e
m
a
t
i
c
r
i
s
k
c
h
a
n
g
e
s
a
r
o
u
n
d
i
n
t
e
r
n
a
l
c
o
n
t
r
o
l
w
e
a
k
n
e
s
s
d
i
s
c
l
o
s
u
r
e
s
a
n
d
r
e
m
e
d
i
a
t
i
o
n
s
Y
e
s
K
a
u
s
a
r
e
t
a
l
.
(
2
0
0
9
)
J
A
R
U
S
1
9
9
3
-
2
0
0
5
1
,
2
9
3
(
þ
1
,
þ
1
2
)
m
o
n
t
h
s
N
o
S
t
o
c
k
p
r
i
c
e
p
e
r
f
o
r
m
a
n
c
e
a
f
t
e
r
g
o
i
n
g
c
o
n
c
e
r
n
a
u
d
i
t
r
e
p
o
r
t
s
a
n
d
t
h
e
i
r
s
u
b
s
e
q
u
e
n
t
w
i
t
h
d
r
a
w
a
l
Y
e
s
C
z
e
r
n
k
o
w
s
k
i
e
t
a
l
.
(
2
0
1
0
)
M
A
J
C
H
N
1
9
9
9
-
2
0
0
3
3
8
6
(
2
1
,
þ
1
)
d
a
y
s
Y
e
s
M
a
r
k
e
t
r
e
a
c
t
i
o
n
t
o
q
u
a
l
i
?
e
d
a
u
d
i
t
r
e
p
o
r
t
s
N
o
I
t
t
o
n
e
n
(
2
0
1
0
)
M
A
J
U
S
2
0
0
5
-
2
0
0
7
3
1
0
(
2
1
,
þ
1
)
d
a
y
s
N
o
S
y
s
t
e
m
a
t
i
c
r
i
s
k
,
v
o
l
a
t
i
l
i
t
y
a
n
d
m
a
r
k
e
t
r
e
a
c
t
i
o
n
s
t
o
S
O
X
4
0
4
d
i
s
c
l
o
s
u
r
e
s
,
c
o
n
t
r
o
l
l
i
n
g
f
o
r
p
r
e
c
e
d
i
n
g
S
O
X
3
0
2
d
i
s
c
l
o
s
u
r
e
s
Y
e
s
N
o
t
e
s
:
a
A
F
–
A
c
c
o
u
n
t
i
n
g
a
n
d
F
i
n
a
n
c
e
,
A
J
P
T
–
A
u
d
i
t
i
n
g
:
A
J
o
u
r
n
a
l
o
f
P
r
a
c
t
i
c
e
a
n
d
T
h
e
o
r
y
,
C
A
R
–
C
o
n
t
e
m
p
o
r
a
r
y
A
c
c
o
u
n
t
i
n
g
R
e
s
e
a
r
c
h
,
E
A
R
–
E
u
r
o
p
e
a
n
A
c
c
o
u
n
t
i
n
g
R
e
v
i
e
w
,
I
J
A
–
I
n
t
e
r
n
a
t
i
o
n
a
l
J
o
u
r
n
a
l
o
f
A
u
d
i
t
i
n
g
,
J
A
A
F
–
J
o
u
r
n
a
l
o
f
A
c
c
o
u
n
t
i
n
g
,
A
u
d
i
t
i
n
g
a
n
d
F
i
n
a
n
c
e
,
J
A
E
–
J
o
u
r
n
a
l
o
f
A
c
c
o
u
n
t
i
n
g
a
n
d
E
c
o
n
o
m
i
c
s
,
J
A
M
–
J
o
u
r
n
a
l
o
f
A
s
s
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Table I.
Quali?ed audit
reports
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differ in their views of the effectiveness of stock markets; some assume ef?cient markets
where stock prices adjust instantly to newinformation, while others recognize that stock
prices may only react fully to the disclosed information within a longer time frame.
This paper divides the research into three main approaches as shown in Figure 1.
The strengths, weaknesses and key ?ndings of the short event window approach, the
long event window approach and the indirect approach are discussed next.
3. Short-window event studies examining market reactions to quali?ed
audit reports
The underlying assumption in the short event window studies is that the stock
markets are ef?cient, in that all new information will be incorporated into the stock
prices immediately after its announcement. Consequently, when the content of the
audit report is disclosed the investors will immediately re-estimate the value of the ?rm
and the stock prices adjust to a new equilibrium.
The method used to estimate short event window abnormal returns around the
audit report disclosure has not changed much over the years. Kothari and Warner
(2006) point out that while event studies in general are still signi?cantly based on
Fama et al. (1969), there are two major changes:
(1) studies mostly examine daily return data as data availability has improved; and
(2) the methods of estimating abnormal returns and testing their statistical
signi?cance have improved over time.
These advances are also observable from the audit report event studies.
3.1 Strengths and weaknesses
The short event window approach is a powerful method for examining the relevance of
audit reports. An event study is perceived to be a reliable measure of the abnormal
performance of a stock at the time of an unanticipated event (Kothari and Warner, 2006).
Figure 1.
Approaches used to study
stock market reactions to
audit report
announcements
Notes: * Denotes papers reporting significant value relevance of audit reports in stock markets
THREE APPROACHES TO STUDYING STOCK MARKET
REACTIONS TO AUDIT REPORT ANNOUNCEMENT
(1)
ABNORMAL STOCK REACTION –
SHORT EVENT WINDOW REACTION
(1 to 30 days)
Baskin (1972, TAR) Jones (1996, JAPP)*
Firth (1978, TAR) Carlson et al. (1998, QJBE)*
Davis (1982, AJPT) Chen et al. (2000, CAR)*
Elliott (1982, JAR) Soltani (2000, IJA)*
Dodd et al. (1984, JAE) Schaub et al. (2003, JAM)*
Dopuch et al. (1986, JAE)* Pucheta et al. (2004, EAR)
Loudder et al.(1992, AJPT)* Beneish et al. (2008, TAR)
Mittelstaedt et al. (1992, AJPT) Hammersley et al. (2008, RAST)*
Ameen et al. (1994, JBFA) Ashbaugh-Skaife et al. (2009, JAR)*
Fleak et al. (1994, JAAF)* Czernkowski et al. (2010, MAJ)
Frost (1994, AJPT)* Ittonen (2010, MAJ)*
(2)
ABNORMAL STOCK
REACTION –
LONG EVENT
WINDOW
REACTION
(2 to 12 months)
Banks et al. (1982, JAR)*
Chow et al. (1982, AJPT)*
Taffler et al. (2004, JAE)*
Herbohn et al. (2007, AF)*
Ogneva et al. (2007, JAE)
Kausar et al. (2009, JAR)*
(3)
INDIRECT MARKET
REACTION –
SHORT WINDOW
REACTION TO A
RELATED
ANNOUNCEMENT
Fields et al. (1991, AJPT)*
Chen et al. (1996, TAR)*
Fargher et al. (1998, JBFA)*
Holder-Webb et al. (2000, JAR)*
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A market reaction should be observable if the audit report contains new information
affecting the estimation of the magnitude or the riskiness of future cash ?ows, or the
viability of the ?rm.
This approach presents two signi?cant challenges because a market reaction
is expected only if the disclosed information is relevant and if it is new. As illustrated
in Table I, most papers have focused on going concern (or “subject to”) audit reports. In
addition, the market reactions to reports on the effectiveness of internal controls
mandated by SOX Section 404 have received attention more recently. The information
contained in these two report types is considered relevant to investors. While studying
the market reaction to the disclosure of these audit report types, researchers have been
occupied with controlling for the surprise and novelty of the information disclosed in
the audit report. To control for novelty and surprise two issues should be considered:
(1) the point at which the audit report is publicly disclosed, which involves de?ning
the event date; and
(2) controlling for how surprising the information in the audit report is.
3.1.1 Event date selection. In a short-window event study, the identi?cation of the event
date is one of the most fundamental issues. Since, assuming ef?cient markets, the stock
market will quickly digest any new and relevant information and the stock price will
be instantly re-estimated. In theory, the correct event date is the date when the audit
report information reaches investors. In the audit report literature several alternative
event dates have been used. Figure 2 shows a timeline illustration of them.
The most frequently used event date is the date of ?ling of the annual report. The
problem with this date is that the audit report accompanies the annual report, which
also contains the annual ?nancial information and the management’s discussion, and
in an event study simultaneous disclosures, or confounding information releases, may
lead to Type I or Type II errors. For example, if the audit report and the annual
earnings information are disclosed together then the observed market reaction could be
a result of either the audit report, the earnings information, management’s discussion,
Figure 2.
Timeline illustration of
different event dates used
in the literature
Auditor
issues/ client
receives the
audit report
Soltani
(2000, IJA)
Ittonen
(2010, MAJ)*
SEC filing date of annual report/10-K report
Baskin (1972, TAR) Chen et al. (2000, CAR)*
Firth (1978, TAR) Pucheta et al. (2004, EAR)
Chow et al. (1982, AJPT)* Taffler et al. (2004, JAE)*
Banks et al. (1982, JAR)* Ogneva et al. (2007, JAE)
Davis (1982,AJPT) Herbohn et al. (2007, AF)*
Dodd et al. (1984, JAE) Beneish et al. (2008, TAR)
Mittelstaedt et al.
(1992, AJPT)
Hammersley et al. (2008, RAST)*
Ashbaugh-Skaife et al. (2009, JAR)*
Frost (1994, AJPT)* Kausar et al. (2009, JAR)
Carlson et al. (1998, QJBE) Czernkowski et al. (2010, MAJ)
Media
coverage
Dopuch et al.
(1986, JAE)*
Fargher et al.
(1998, JBFA)
Schaub et al.
(2003)*
Annual
general
meeting
Soltani
(2000, IJA)*
Pucheta et al.
(2004, EAR)
Financial
year end
Filing of
related event
Fields et al.
(1991, AJPT)*
Chen et al.
(1996, TAR)*
Fargher et al.
(1998, JBFA)*
Holder-Webb et al.
(2000, JAR)*
Earliest of conceivable
disclosure dates
Loudder et al. (1992, AJPT)*
Earnings
announce -
ment date
Davis
(1982, AJPT)
Elliot
(1982, JAR)*
Notes: * Denotes papers reporting significant value relevance of audit reports in stock markets
Jones (1996, JAPP)
Fleak et al. (1994, JAAF)*
Ameen et al. (1994, JBFA)
Quali?ed audit
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or any combination of those. In such a case, the researcher must single out the market
reaction caused by the audit report.
In the Australian setting, Herbohn et al. (2007) study the market reactions on the
date of the “?nal annual report”. Australian ?rms are required ?rst to release a
preliminary annual report with only the earnings information and later the ?rms
publish the ?nal annual report. The requirement allows Herbohn et al. (2007) to restrict
the in?uence of the earnings information from the abnormal returns on the day of the
?nal annual report. However, as they note, the ?nal annual reports may still contain
amendments to the earnings or other relevant non-earnings information.
Although the annual report date is most frequently used, a review of the papers
reveals that the issue is far from straightforward. The ?rst observation is that some
studies have used several dates. This is illustrated by Loudder et al. (1992) in their
description of sample selection:
The quali?cation disclosure date was de?ned as the earliest of (1) the publication date of a
media story, if one was found, (2) the annual report date, or (3) the 10-K stamp date.
Multiple event dates have also been used by several other studies and this is clearly an
indication of the dif?culty of identifying or determining the ?rst day of trading on the
information contained in the audit opinion.
Studies have attempted to solve the problem of the simultaneous annual report or
other information disclosures in different ways. First, studies have concentrated on
audit reports attracting media attention (Dopuch et al., 1986; Fargher and Wilkins, 1998;
Schaub and High?eld, 2003). Media disclosure dates are considered to be relatively free
fromnoise incurred by simultaneous disclosures and so the use of this date is debatable.
In addition, the media is likely to focus on quali?ed audit reports that are surprises or
issued to widely followed ?rms. Second, Soltani (2000) in his French study and
Pucheta et al. (2004) in their Spanish study use an estimation of the date when the audit
report is publicly announced. They both use the 15th day before the annual general
meeting as an alternative event date, indicating that in their setting the audit report
(and the annual report) has to be presented to the shareholders no later than 15 days
before the annual general meeting. Both papers recognize, however, that ?rms may
choose to present the audit report earlier and therefore both studies use longer event
windows. Finally, Soltani (2000) and Ittonen (2010) use the date of the auditor’s signature
on the audit report. Their choice is supported by Carter and Soo (1999) and Knechel et al.
(2007) showing that the stock market reacts as early as the date of the actual event (e.g.
auditor change), instead of the public disclosure of the event, that is the ?ling of the 8-K
report. It is not clear, however, how the information about auditor switching or a
quali?ed audit report reaches investors’ attention before it is publicly disclosed, but one
explanation could be that some investors are using inside information.
3.1.2 Controlling for expectation. The second issue, besides the event date, that
needs to be controlled for when applying the short-window event study method, is the
market participants’ knowledge and expectations of the matters disclosed in the audit
report. The issue arises because a quali?ed audit report is less informative and
valuable when disclosed if the circumstances that it refers to are already well known to
outside investors, or they have been anticipated based on more timely data in the
public realm. If the market price already re?ects the audit report information, then the
reaction around the disclosure time is weaker or possibly non-existent.
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In the standard short-window setting, the degree to which disclosed information is
expected has been controlled for with different proxies. The most common method
applied is controlling for audit report type in the preceding year. For example, Chow
and Rice (1982) examined the abnormal returns associated with various types of audit
reports and their sample included ?rms receiving a quali?ed audit report in year t and
an unquali?ed report in t 2 1. They conclude that a short-window event study will
capture the stock price effect only if the market cannot predict the occurrence of the
quali?cation. Similar approach has been applied in most papers since then.
In addition to the previous year’s audit report, Davis (1982) advocated the need to
control for the market knowledge about the economic circumstances underlying the
issue of the quali?ed audit report. Subsequently, studies focusing on going concern
audit reports typically control for the ?nancial distress of the client prior to the audit
report, because ?nancial distress increases the likelihood of going concern audit
reports. Similarly, investors’ knowledge about the number of segments, foreign sales,
mergers and acquisitions, and restructurings for example may affect the information
content of, or the degree of surprise in, a material internal control weakness report.
Summary of the key ?ndings. No general conclusion can be drawn from the studies
examining short event window abnormal returns to quali?ed audit reports. The results
remain inconsistent even when analyzed separately for different time periods, event
dates, report types or controls for expectations. However, except for Chow and Rice
(1982) and Soltani (2000) all studies ?nding a signi?cant short-window market reaction
have examined going concern or material internal control weakness reports. This
suggests that those two types of reports are the most relevant that can be examined in an
archival short event windowstudy. Furthermore, the evidence regarding short-window
abnormal returns around media disclosures seems slightly more consistent, proposing
that media disclosures of quali?ed audit reports may contain relevant information.
Media disclosures may contain additional relevant information or they may simply
bring the circumstances to the attention of a broader audience and consequently result in
a negative market reaction.
4. Long-window event studies
This approach draws on the evidence that investors need time to interpret and digest
bad news, in contrast to reacting promptly to good news (Ball and Brown, 1968; Bernard
and Thomas, 1989, 1990; Womak, 1996; Dichev and Piotroski, 2001). Accordingly, share
prices may not adjust to the “correct” level during a short event window, but rather,
a longer event window (e.g. 12 months) is necessary to measure the full impact. In other
words, the investors either do not instantly reach agreement on the correct stock price or
there may then be market frictions delaying the price adjustment (e.g. illiquid stocks).
Strengths and weaknesses
This approach overcomes one major problem of the short-window approach. Because
the market reaction is typically estimated from monthly returns, the identi?cation of
the exact event day is not as essential as in the short event window studies. Finding the
appropriate event month is easier and more reliable than ?nding the event day.
The major weakness of the long event window method is the lack of reliability.
More speci?cally, long-window methods may suffer from speci?cation problems, low
ability to detect abnormal performance, high sensitivity to assumptions about the
Quali?ed audit
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return generating process, and misspeci?cation risk when the variance of a stock
increases (Kothari and Warner, 2006). These weaknesses of long-window event studies
may be highlighted in the analysis of quali?ed audit reports, because sample sizes are
typically small (due to the low proportion of quali?ed audit reports), and furthermore,
because ?rms receiving certain types of audit reports may have nonrandom
characteristics (e.g. size, industry, pro?tability, or growth).
Summary of the key ?ndings
This review has identi?ed six papers applying the long-window event study method.
These papers document ?ndings that are to some extent inconsistent. To begin with,
Taf?er et al. (2004) and Kausar et al. (2009) ?nd signi?cant negative abnormal returns to
going concern disclosures in the UK and the USA, respectively. On the contrary,
Herbohn et al. (2007) and Ogneva and Subramanyam (2007) ?nd no evidence of
abnormal returns in the USAor Australia. Moreover, Herbohn et al. (2007) ?nd a market
reaction only in the 12-months prior to the going concern report, which is broadly in line
with the early studies of Banks and Kinney (1982) and Chow and Rice (1982).
5. The indirect approach
The relevance of audit reports has also been studied using an indirect approach.
The indirect approach focuses on the short-window abnormal returns around a
disclosure related to a quali?ed audit report. Two types of disclosures have so far been
examined: bankruptcy ?lings and withdrawals of quali?ed audit reports. The studies
concentrating on bankruptcy ?lings hypothesize that the market reaction to bankruptcy
?lings is associated with the type of the latest audit report. Chen and Church (1996) and
Holder-Webb and Wilkins (2000) suggest that going concern audit reports may be useful
in predicting bankruptcies and consequently reducing the surprise associated with
bankruptcy ?lings. Following this reasonable assumption, Chen and Church (1996)
examine whether the negative market reaction to bankruptcy ?lings is smaller for ?rms
that receive a going concern audit report, than for ?rms that receive an unquali?ed audit
report.
Fields and Wilkins (1991) and Fargher and Wilkins (1998) examine market reactions
around audit quali?cation withdrawal announcements. They expect that if quali?ed
audit reports accurately identify and effectively communicate ?rms’ uncertainties,
a negative stock price reaction should follow around the time of the announcement.
Similarly, withdrawals of such reports should reduce or remove these uncertainties
and, as a result, a positive stock price reaction should follow.
Strengths and weaknesses
The indirect approach has strengths that address the weaknesses of the short event
window approach. The main strength is the identi?cation of the event day. The
quali?cation withdrawals are usually announced on an additional opinion at the time
when the quali?cation issues are resolved. Similarly, in the sample used by Chen and
Church (1996) bankruptcy ?lings were considered separately from the ?nancial
statements, and in their sample they occurred between 11 and 281 trading days after the
last set of ?nancial statements. The indirect approach also provides an opportunity to
study the relevance of quali?ed audit reports and for example how useful the quali?ed
audit report is for bankruptcyprediction. Evenif the audit report does not cause a market
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reaction around the time of its disclosure, it may, alone or jointly with some other
information, become relevant at a later stage.
The ?rst major weakness of this approach is common to all event studies, namely
controlling for concurrent information disclosed and for the surprise of the disclosure.
Bankruptcy ?lings’ and quali?cation withdrawals’ information content may vary
depending on the case and the differences in market reactions may be a result of the
information disclosed, rather than underlying information about the audit report.
Furthermore, it is likely that there are also disclosures other than, for example, going
concern audit reports that affect the surprise element of bankruptcy ?lings. For instance,
the severityof the ?rm’s ?nancial distress signaledinthe last set of ?nancial statements will
probably be associated with the market reaction to bankruptcy ?lings. Accordingly, Chen
and Church (1996) address these issues by calculating the probability of bankruptcy from
the last set of ?nancial statements and, additionally, they control for media disclosures
occurring subsequent to the issuance of ?nancial statements but prior to bankruptcy.
Summary of the key ?ndings
The indirect approach has consistently documented that quali?ed audit reports contain
information relevant to investors. Withdrawn audit quali?cations result in positive
abnormal returns and lower levels of risk, suggesting that audit reports contain
important information for investors. Bankruptcy ?lings result in a more negative
market reaction when the last audit report was unquali?ed. This ?nding proposes that
going concern audit reports contain relevant information and signi?cantly reduce the
surprise of a bankruptcy ?ling.
6. Areas of future research
Since 1972 there has been a substantial body of research on market reactions to
quali?ed audit reports. As Kothari and Warner (2006) have pointed out, the basic
statistical format has not changed much over time and the limitations of event studies
are well known. The following section makes important suggestions on how future
research could contribute to our knowledge.
New settings for a traditional approach
Analyzing the abnormal returns to quali?ed audit reports around annual report ?ling
dates (the traditional set-up) has provided important information about factors affecting
the relevance of audit reports. An interesting area of development, as in Herbohn et al.
(2007), is to ?nd institutional settings were the audit report information can be separated
fromthe annual ?nancials or where the audit report is disclosed alone. For example, the
receipt of a quali?ed audit report could be considered a material current event which
must be disclosed to the investors after the event is revealed, and without delay. The
current practice in the major stock markets is, however, that the audit report can be
disclosed later, together with the annual ?lings, not when the report is received.
Examining markets that demand immediate disclosure of an audit quali?cation would
signi?cantly address the current problems of identifying the correct and timely event
date, and separating the impact that the accompanying annual ?nancial information has
on the abnormal returns.
In a similar vein, another opportunity would be to ?nd new settings in which to
apply the indirect approach or extend the analysis of Fields and Wilkins (1991) and
Quali?ed audit
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Chen and Church (1996). For example, it could be interesting to examine market
reactions to fraud announcements from ?rms that have reported material internal
control weaknesses and those that have not.
New approaches to measuring relevance to investors
The vast majority of reviewed papers have examined abnormal stock returns to
determine whether quali?ed audit report information is relevant to investors or not.
Capital markets research has also provided evidence that other measures may be
apposite in studying the relevance of ?nancial information in the stock markets. Several
studies since Beaver (1968) have examined changes in volatility, volume, or bid-ask
spread around public announcements to measure the ?ow and relevance of disclosed
information.
Accordingly, Choi and Jeter (1992) examine the market’s responsiveness to earnings
announcements after the issuance of a quali?ed audit report and show that
quali?cations add noise to or reduce the persistence of earnings. Similarly, Fargher
and Wilkins (1998) and Ittonen (2010) use systematic risk and change in volatility to
measure whether quali?ed audit reports affect the risk of future cash ?ows and add
uncertainty to the stock market. Although these alternative measures are not completely
unfamiliar in the audit quali?cations literature, they could be applied more frequently,
because they re?ect different perspectives on investors’ reactions to information
announcements.
7. Conclusion
This paper reviews the literature on the stock market reactions to quali?ed audit reports.
There is considerable empirical evidence reporting a stock market reaction both to
management produced ?nancial information, as well as information produced by others.
From a theoretical perspective, quali?ed audit reports may change the market
responsiveness to earnings by adding noise or reducing the persistence of reported
earnings, and thus a market reaction could be expected (Choi and Jeter, 1992). In other
words, audit report information, quali?ed or unquali?ed, is expected to affect investors
by conveying information that affects either the estimations about the amount of future
cash ?ows or the riskiness of future cash ?ows. A stock market reaction, however,
depends heavily on whether the audit report contains new information that is not
already available or expected.
This paper identi?es three different approaches to studying market reactions to
quali?ed audit reports. First, some reviewed papers use short event window abnormal
stock returns to determine whether there is an immediate market reaction to the audit
report announcement, as might be expected assuming ef?cient stock markets. Second,
some studies apply the long event window approach to monitor under-reaction in the
market, that is, the abnormal performance of stockprices over a six-12-monthperiodafter
the audit report has been announced. Third, the study reviews the alternative indirect
approaches to document the relevance of audit reports, including analyzing stock returns
around bankruptcy announcements or audit report quali?cation withdrawals.
Examining the strengths and weaknesses of the approaches reveals that
researchers should carefully consider the opportunities the institutional setting offers.
For example, the short event window approach seems highly advisable in settings
where:
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the event date can be precisely identi?ed; and
.
the audit report is either disclosed separately or the market impact of concurrent
disclosures can be separated.
On the other hand, the indirect approach appears powerful if related disclosures can be
identi?ed and the information content of the related disclosure can be measured.
Moreover, if the trading volume of the sample ?rms is low or other market frictions are
expected to affect investors trading behavior, applying the long event window
approach seems warranted.
The empirical ?ndings on stock market reactions to announcements of quali?ed
audit reports are mixed. The contradictory results seemto be driven, to some extent, by
different methodological choices and approaches. The review suggests that only with
the indirect approach do the ?ndings consistently support the hypothesis that quali?ed
audit reports are relevant to investors. In addition, reviewing the methodological
choices and arguments in the prior literature, it seems that a the most relevant types of
quali?ed audit reports are:
.
unexpected;
.
?rst-time quali?cations; related to
.
going concern doubts or material internal control weaknesses.
Two recommendations for future research can be made. First, for short event date
studies it is important to ?nd and take advantage of institutional settings where:
.
the audit report event date can be identi?ed unambiguously; and
.
the effect of concurrent disclosures can be controlled.
For research purposes the optimal setting would be where the audit report is disclosed
immediately upon the auditor’s signature. Second, in addition to the widely-used
abnormal stock returns, researchers should acknowledge other, in some cases more
accurate, measures of market reaction. For instance, changes in volatility, volume, bid-ask
spread, or systematic risk around quali?ed audit report disclosures are suggested as
measures that mayalso contribute tothe literature andincrease our knowledge concerning
the relevance of quali?ed audit reports.
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Corresponding author
Kim Ittonen can be contacted at: kit@uwasa.?
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