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Accounting Research Journal

Emerald Article: Market reactions to qualified audit reports: research approaches Kim Ittonen

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To cite this document: Kim Ittonen, (2012),"Market reactions to qualified audit reports: research approaches", Accounting Research Journal, Vol. 25 Iss: 1 pp. 8 - 24 Permanent link to this document: http://dx.doi.org/10.1108/10309611211244483 Downloaded on: 26-09-2012 References: This document contains references to 55 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 22 times since 2012. *

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ARJ 25,1

Market reactions to qualied 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 qualied 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 qualied 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 signicant 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 qualied 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 identication, 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 Qualied audit reports, Market reactions, Event study, Literature review, Stock markets, Audit reports Paper type Literature review

Accounting Research Journal Vol. 25 No. 1, 2012 pp. 8-24 q Emerald Group Publishing Limited 1030-9616 DOI 10.1108/10309611211244483

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 conicting 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 on stock market reactions to qualied audit reports. In particular, the paper
The author gratefully acknowledges the helpful suggestions of Natalie Gallery (the Editor), two anonymous referees, Aasmund Eilifsen, Stefan Sundgren, and Sami Vahamaa.

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 rm and the users of its nancial statement. Theoretically, the relevance of the audit report in such cases where the auditor decides to issue a qualied 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 reect the auditors access to inside information such as forecast data and management plans, and, taking this into account, the auditors 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 insignicant value to nancial statement users. Additionally, Melumad and Ziv (1997) proposed in their theoretical model of market reactions to qualied audit reports that the reaction to avoidable and unavoidable qualied 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 qualied 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 qualied 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 review can be summarized as follows. The paper identies three different approaches used to examine the existence of abnormal stock returns to qualied 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 efcient market hypothesis, which implies stock prices reect all past public information and adjust instantaneously to new information. This is the most commonly used approach and in theory it should be a very powerful test if the event date can be identied, the predictability of the report can be estimated, and the concurrent disclosures can be controlled for. Second, the long event window approach has been

Qualied audit reports

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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 qualied 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. Specically, while audit reports are commonly disclosed as a part of the annual nancials, researchers have used related disclosures, such as bankruptcy lings and audit qualication 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 qualied 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 qualied audit reports, and availability of related disclosures, signicantly affect the measurement of stock market reactions and interpretation of the empirical ndings. 2. Market reactions to qualied audit reports The reaction of stock markets to qualied 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 qualied audit reports affects stock markets and thus provides evidence on the relevance of qualied 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 been challenging. Accordingly, researchers have developed approaches to overcome or at least control for those difculties. Third, because this stream of research utilizes qualied audit reports issued to publicly listed clients, the availability of such reports has directed the archival research to areas and markets where a sufcient number of qualied reports is available, and to those types of audit reports that public clients le. In this respect, research has beneted 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 qualied audit reports issued to clients; and requirements for auditors to report on the effectiveness of internal controls introduced a new type of qualied audit report). Finally, some of the differences in approaches are due to varying theoretical views. For example, approaches

Authors/year 1965-1968 1974-1975 1973-1974 1969-1975 1968-1975 1973-1978 1973-1980 1970-1982 1978-1987 1983-1986 1986-1988 1974-1988 1979-1986 1983-1988 1981-1988 42 (210, 10) days No 234 (0, 1) days No 153 (22, 2) days No 51 (22, 2) days No 143 (210, 1) days No 101 (21, 1) days No 52 (21, 0) days No 114 (21, 1) days No 604 (22, 2) days No No Yes Yes Yes No No 145 (245, 2 1) weeks Yes Yes 147 (210, 10) days Yes No 92 Yes 90 Yes 247 (220, 20) days Yes No 137 (25, 5) weeks Yes No

Journ.a Main test

Time period Obs. market examined Control group analysis Support for RQ

No. of Primary event MAO window-month/ obs. week/day (m/w/d)b

Baskin (1972) TAR

US

Firth (1978)

TAR

UK

US

Chow et al. AJPT (1982) Banks and JAR Kinney (1982) Davis (1982) AJPT

US

(2 2, 0) (2 11, 0) Yes months (212, 2 1) months Yes

US

Elliott (1982)

JAR

US

JAE

US

JAE

US

AJPT

US

AJPT

US

AJPT

US

JBFA

US

Market reaction to auditors consistency exception reports Market reaction to qualied audit reports, controlling for qualication type Stock price performance around qualied audit reports Do audit reports affect 12-month stock price performance of rms with loss contingencies? Market reaction to subject to audit reports, controlling for nancial distress Stock price performance around subject to audit reports Market reaction to disclosures of subject to audit reports Market reaction to media disclosures of subject to audit reports Market reaction to withdrawn subject to audit reports Market reaction to unexpected subject to audit reports Market reaction to auditors consistency exception reports Market reaction to audit qualications in OTC rms

Dodd et al. (1984) Dopuch et al. (1986) Fields et al. (1991) Loudder et al. (1992) Mittelstaedt et al. (1992) Ameen et al. (1994) Fleak and Wilson (1994) Frost (1994)

JAAF

US

AJPT

US

Chen and TAR Church (1996)

US

Market reaction to unexpected going concern audit Yes reports Market reaction to uncertainty-modied audit Yes reports, controlling for nancial distress Market reaction to bankruptcy lings, controlling for Yes going concern opinions (continued)

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11

Table I. Studies on the relevance of qualied audit reports to the stock markets

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Authors/year 1979-1988 1981-1988 1972-1992 1995-1997 1975-1996 1986-1995 1989-1996 1992-1995 1995-2000 (1, 12) months No No (25, 5) days (212, 2 1) month 2004-2005 330/ 383 (21, 1) days Yes (1, 12) months Yes (212, 12) days Yes 543 36 (25, 5) days (21, 1) days No No 107 (21, 1) days Yes 96 (21, 1) days Yes 110 (2200, 200) days No Yes 88 (22, 2) days Yes Yes 68 (22, 2) days Yes Yes

Jones (1996)

Carlson et al. (1998) Fargher and Wilkins (1998) Chen et al. (2000) Holder-Webb and Wilkins (2000) Soltani (2000) Schaub and Higheld (2003) Pucheta et al. (2004) Tafer et al. (2004) Ogneva et al. (2007) Market reaction to qualied audit reports, controlling Yes for concurrent announcements and qualication type Market reaction to bankruptcy lings, controlling for Yes going concern opinions Market reaction to qualied audit reports Yes Market reaction to going concern audit reports before and after the audit opinion name change Market reaction to qualied audit reports No Yes No 1999-2003 Stock price performance after going concern audit reports Stock price performance after going concern audit reports, controlling for choice of expected return and momentum Market reaction and stock price performance around going concern audit reports

Herbohn et al. AF (2007)

Beneish et al. (2008)

Table I. No. of Primary event MAO window-month/ obs. week/day (m/w/d)b Control group analysis Main test Support for RQ Market reaction to going concern audit reports, controlling for investors expectations Market reaction to going concern audit reports, controlling for concurrent disclosures Systematic and unsystematic risk changes around audit qualications and qualication withdrawals No (short) Yes (long) Market reaction to material internal control weakness No disclosures, controlling for auditor quality, weakness type and rm size (continued)

Journ.a

Time period Obs. market examined

JAPP

US

QJB E

US

JBFA

US

CAR

CHN

JAR

US

IJA JAM

FRA US

EAR

SPA

JAE

UK

JAE

UK/US 1993-2004 AUS

AUS

TAR

US

Authors/year 2003-2005 2003-2005 1993-2005 1999-2003 2005-2007 310 (21, 1) days No 386 (21, 1) days Yes No 1,293 (1, 12) months No Yes 787 (21, 1) days No Yes 358 (21, 1) days No Yes

Journ.a Main test

Time period Obs. market examined Control group analysis Support for RQ

No. of Primary event MAO window-month/ obs. week/day (m/w/d)b

RAST US

JAR

US

JA R

US

Hammersley et al. (2008) AshbaughSkaife et al. (2009) Kausar et al. (2009) Czernkowski et al. (2010) Ittonen (2010) Yes Systematic risk, volatility and market reactions to SOX 404 disclosures, controlling for preceding SOX 302 disclosures

MAJ

CHN

Market reaction to SOX 302 disclosures, controlling for characteristics of the weakness Systematic and unsystematic risk changes around internal control weakness disclosures and remediations Stock price performance after going concern audit reports and their subsequent withdrawal Market reaction to qualied audit reports

MAJ

US

Notes: aAF Accounting and Finance, AJPT Auditing: A Journal of Practice and Theory, CAR Contemporary Accounting Research, EAR European Accounting Review, IJA International Journal of Auditing, JAAF Journal of Accounting, Auditing and Finance, JAE Journal of Accounting and Economics, JAM Journal of Asset Management, JAPP Journal of Accounting and Public Policy, JAR Journal of Accounting Research, JBFA Journal of Business Finance & Accounting, MAJ Managerial Auditing Journal, QJBE Quarterly Journal of Business and Economics, RAST Review in Accounting Studies, TAR The Accounting Review;bseveral papers test multiple event windows, in these cases the main window, as indicated in the paper, is tabulated here

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13

Table I.

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differ in their views of the effectiveness of stock markets; some assume efcient markets where stock prices adjust instantly to new information, 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 qualied audit reports The underlying assumption in the short event window studies is that the stock markets are efcient, 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 signicantly 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 signicance 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).
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) Firth (1978, TAR) Davis (1982, AJPT) Elliott (1982, JAR) Dodd et al. (1984, JAE) Dopuch et al. (1986, JAE)* Loudder et al.(1992, AJPT)* Jones (1996, JAPP)* Carlson et al. (1998, QJBE)* Chen et al. (2000, CAR)* Soltani (2000, IJA)* Schaub et al. (2003, JAM)* Pucheta et al. (2004, EAR) Beneish et al. (2008, TAR) Hammersley et al. (2008, RAST)*
Ashbaugh-Skaife et al. (2009, JAR)*

14

(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)*

Figure 1. Approaches used to study stock market reactions to audit report announcements

Mittelstaedt et al. (1992, AJPT) Ameen et al. (1994, JBFA) Fleak et al. (1994, JAAF)* Frost (1994, AJPT)*

Czernkowski et al. (2010, MAJ) Ittonen (2010, MAJ)*

Notes: * Denotes papers reporting significant value relevance of audit reports in stock markets

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 signicant 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 dening 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 identication of the event date is one of the most fundamental issues. Since, assuming efcient 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 managements 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, managements discussion,
Earliest of conceivable disclosure dates Loudder et al. (1992, AJPT)* Ameen et al. (1994, JBFA) Fleak et al. (1994, JAAF)* Jones (1996, JAPP) Financial year end

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15

Auditor issues/ client receives the audit report Soltani (2000, IJA) Ittonen (2010, MAJ)*

Earnings announce ment date Davis (1982, AJPT) Elliot (1982, JAR)*

SEC filing date of annual report/10-K report Baskin (1972, TAR) Firth (1978, TAR) Chow et al. (1982, AJPT)* Banks et al. (1982, JAR)* Davis (1982,AJPT) Dodd et al. (1984, JAE) Mittelstaedt et al. (1992, AJPT) Frost (1994, AJPT)* Chen et al. (2000, CAR)* Pucheta et al. (2004, EAR) Taffler et al. (2004, JAE)* Ogneva et al. (2007, JAE) Herbohn et al. (2007, AF)* Beneish et al. (2008, TAR) Hammersley et al. (2008, RAST)* Ashbaugh-Skaife et al. (2009, JAR)* Kausar et al. (2009, JAR)

Media coverage

Annual general meeting Soltani (2000, IJA)* Pucheta et al. (2004, EAR)

Filing of related event

Dopuch et al. (1986, JAE)* Fargher et al. (1998, JBFA) Schaub et al. (2003)*

Fields et al. (1991, AJPT)* Chen et al. (1996, TAR)* Fargher et al. (1998, JBFA)* Holder-Webb et al. (2000, JAR)*

Carlson et al. (1998, QJBE) Czernkowski et al. (2010, MAJ)

Notes: * Denotes papers reporting significant value relevance of audit reports in stock markets

Figure 2. Timeline illustration of different event dates used in the literature

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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 inuence 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 qualication disclosure date was dened 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 difculty 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 Higheld, 2003). Media disclosure dates are considered to be relatively free from noise incurred by simultaneous disclosures and so the use of this date is debatable. In addition, the media is likely to focus on qualied 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 auditors 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 qualied 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 qualied 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 reects the audit report information, then the reaction around the disclosure time is weaker or possibly non-existent.

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 qualied audit report in year t and an unqualied 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 qualication. Similar approach has been applied in most papers since then. In addition to the previous years audit report, Davis (1982) advocated the need to control for the market knowledge about the economic circumstances underlying the issue of the qualied 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 qualied 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 signicant 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 window study. Furthermore, the evidence regarding short-window abnormal returns around media disclosures seems slightly more consistent, proposing that media disclosures of qualied 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 identication 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 specically, long-window methods may suffer from specication problems, low ability to detect abnormal performance, high sensitivity to assumptions about the

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return generating process, and misspecication 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 qualied audit reports, because sample sizes are typically small (due to the low proportion of qualied audit reports), and furthermore, because rms receiving certain types of audit reports may have nonrandom characteristics (e.g. size, industry, protability, or growth). Summary of the key ndings This review has identied six papers applying the long-window event study method. These papers document ndings that are to some extent inconsistent. To begin with, Tafer et al. (2004) and Kausar et al. (2009) nd signicant 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 USA or 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 qualied audit report. Two types of disclosures have so far been examined: bankruptcy lings and withdrawals of qualied 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 unqualied audit report. Fields and Wilkins (1991) and Fargher and Wilkins (1998) examine market reactions around audit qualication withdrawal announcements. They expect that if qualied 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 identication of the event day. The qualication withdrawals are usually announced on an additional opinion at the time when the qualication 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 qualied audit reports and for example how useful the qualied audit report is for bankruptcy prediction. Even if the audit report does not cause a market

18

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 qualication 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 severity of the rms nancial distress signaled in the 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 qualied audit reports contain information relevant to investors. Withdrawn audit qualications 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 unqualied. This nding proposes that going concern audit reports contain relevant information and signicantly 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 qualied 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 qualied 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 from the annual nancials or where the audit report is disclosed alone. For example, the receipt of a qualied 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 qualication would signicantly 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

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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 qualied 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 markets responsiveness to earnings announcements after the issuance of a qualied audit report and show that qualications 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 qualied 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 qualications literature, they could be applied more frequently, because they reect different perspectives on investors reactions to information announcements. 7. Conclusion This paper reviews the literature on the stock market reactions to qualied 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, qualied 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, qualied or unqualied, 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 identies three different approaches to studying market reactions to qualied 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 efcient stock markets. Second, some studies apply the long event window approach to monitor under-reaction in the market, that is, the abnormal performance of stock prices over a six-12-month period after 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 qualication 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 identied; and the audit report is either disclosed separately or the market impact of concurrent disclosures can be separated.

Qualied audit reports

On the other hand, the indirect approach appears powerful if related disclosures can be identied 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 qualied audit reports are mixed. The contradictory results seem to 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 qualied 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 qualied audit reports are: . unexpected; . rst-time qualications; 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 identied 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 auditors 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 qualied audit report disclosures are suggested as measures that may also contribute to the literature and increase our knowledge concerning the relevance of qualied audit reports.
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