The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence Student name: Carmen Necula Student number: 10622756 Supervisor: Dr. Alexandros Sikalidis MSc Accountancy and Control, Accountancy Track Faculty of Economics and Business Academic year: 2013-2014 June 22, 2014
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The influence of modified audit opinion on the
stock market and cost of debt: U.S. evidence
Student name: Carmen Necula
Student number: 10622756
Supervisor: Dr. Alexandros Sikalidis
MSc Accountancy and Control, Accountancy Track
Faculty of Economics and Business
Academic year: 2013-2014
June 22, 2014
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
2
Abstract
This study examines the impact of the announcement of a modified audit opinion on the market,
more specifically on the stock returns and on the cost of debt, and the way it is perceived by the
investors and creditors. The sample contains publicly held companies from U.S. with collected
data from 2012, that had a continuous auditing, excluding those from the financial and real estate
sector. The main focus was on the cumulative abnormal return and the interest rate for the
analysis of stock market and respectively the cost of debt. Contrary to the majority of previous
studies, the results suggest that there is no significant influence of a modified audit opinion over
the stock returns and the cost of debt, since the investors and creditors do not perceive this
information as value relevant for their decisions. However, the results may be biased by other
concurrent information, by the methodology approach or the sample might not be representative
1.2 Research question ................................................................................................................................ 6
2.1.3. Cost of debt ................................................................................................................................ 11
2.2 Literature review ............................................................................................................................... 12
2.3 Hypotheses development ................................................................................................................... 16
2.3.1 Hypothesis I ................................................................................................................................ 16
2.3.2 Hypothesis II ............................................................................................................................... 17
3. Research methodology ...................................................................................................................... 18
The unqualified opinion, also known as a clean opinion, states that the financial
statements are representing in a fair and accurate way the view of the business,
according to the accounting principles.
The modified unqualified opinion, also known as the standard auditor‟s report
with explanatory notes is used when the auditor wants to bring some specific
information into users‟ attention which may affect their decision making process.
A very known opinion in this case is the going concern report, which states that
the auditor has great doubts about the ability of the company to remain in
business.
A qualified opinion contains some misstatements detected by the auditor,
considered to be material but not pervasive.
For an adverse opinion, the auditor has found enough evidence to prove that the
misstatements are material and pervasive.
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
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The disclaimer opinion states that the auditor didn‟t find sufficient evidence over
the financial statements and is unable to complete the audit mission.
I chose to focus on two types, more precisely, on the unqualified opinion and the modified
unqualified opinion, because first of all, they are the most common among companies and
secondly, because I consider they bring different information that could matter in a way or
another for the constituencies. This means that it‟s expected to get different results with respect to
the effects of their disclosure on the stock returns and cost of debt.
2.1.2 Stock market
In order to better understand the relationship I want to analyze, I will provide an explanation for
stock market concept.
The stock market, also known as the equity market, is the market in which shares of
publicly held companies are issued and traded through exchanges, giving investors a part of
ownership and allowing them to participate in the achievements of the companies they own
shares, but they are also exposed to the risk of losing money if the company suffers losses. By
stock market reaction we can understand the changes that are happening in the market, through
the movement in the price, volume or returns of stocks.
There have been studies, as mentioned in the Background, that proved the stock market
underreacts following the going concern audit opinion disclosure. For instance, Taffler et al.
(2007) is one of the papers that brings into discussion this anomalous market behavior, consisting
in firms that are underperforming various return benchmarks. This is caused by “denying the bad
news conveyed by a going concern audit opinion and trading at prices inconsistent with
underlying value”3, which is explained by the existence of irrational or naïve investors. This fact
is inconsistent with the market efficiency concept, which states that prices fully reflect all the
publicly available information. The measurement procedure for this under-reaction of stock
market is represented by the difference between returns when the investors take into
consideration the going concern audit opinion and the returns when investors are ignoring this
disclosure.
3Taffler, R.J., Lu, J., Kausar, A., 2004. In denial? Stock market underreaction to going-concern audit report disclosures. Journal of Accounting
and Economics 38, 263–285
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The question that comes next is whether there are possible over-reactions of the stock
market and the answer could be affirmative as well. One representative study on this topic is
Schaub (2006), which explains this concept as the phenomenon through which investors initially
compound the true impact of new information on the firm, in this case the disclosure of going
concern opinion, determining stock prices go too low following bad news or too high, based on
good news. This concept of overreaction is also against the stock market efficiency, as long as the
investment is not profitable. The results show that greater initial price reactions are followed by
larger stock price adjustments, which is consistent with the over-reaction hypothesis.
The aspect I want to emphasize here, is that the stock market efficiency is only a theory
which can hardly be applied in an imperfect economic environment and that stakeholders should
expect anomalies to happen.
2.1.3. Cost of debt
Capital is a fundamental element of a company for its business survival and for a high turnover.
There are two major ways to raise money for a company: debt financing and equity financing, but
the predominant one among companies is the debt financing.
Jensen and Meckling (1976) provides an important theoretical background over the cost
of debt and its particular aspects, like the incentive effects associated with highly leveraged firms,
the monitoring costs and the bankruptcy and reorganization costs.
For the incentives, they explain that creditors would not borrow a company for an amount
much higher than the entrepreneur‟s investment, because the latter tends to engage in activities
with a high profitability but a low probability of success, since he will benefit of most of the
gains if the things turn out well, and if not, the creditors will bear the most of the costs.
In order to limit this managerial behaviour, the creditors could ask for covenants with
provisions that impose constraints on management‟s decisions, including limitations of the
riskiness of the investment project. All the costs associated with these type of covenants are the
monitoring costs.
In case of bankruptcy or litigation the cost of debt increases, because there is much more
risk involved for the lenders and they will pay for fixed claims for a price inversely related to the
probability of the incurrence of these costs to probability of bankruptcy.
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
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According to Sengupta (1998) there are two alternative measures of cost of debt:
- the yield to maturity on new debt issues, and
- the total interest cost of new debt issues
In my study, I will consider the cost of debt as the interest rate, determined as the interest
expense scaled by total liabilities.
2.2 Literature review
The subject of this paper is a difficult and controversial one, because there were different findings
that came out of related studies regarding the effect of audit opinion over the stock market, as I
have already mentioned in the Background. Regarding the connection with the cost of debt, this
is quite a new topic since there were few studies that focused on it, as far as I documented.
One important study that outlines the stock market reaction to a going concern opinion is
Herbohn et al. (2007), which focuses on the information content of the audit report, but also
investigates the stock market anomaly following the going concern opinion, using Australian
firms. The authors state that a going concern opinion of an audit report “is a significantly
unambiguous „badnews‟ event for stock market participants and an adverse stock market reaction
is expected.”4. But this expectation wasn‟t proved through their study, because they did find that
the stock market has a significant negative reaction in the pre-event period rather than the post-
event period. They explain this by Australian markets being well informed, so the announcement
of a going concern opinion is a culmination of multiple prior events, and disclosing it doesn‟t
actually give additional information to the market. I consider this study a interesting one, as long
as the results are not consistent with the ones expected at the beginning.
The going concern opinion has also been analyzed from another point of view,
specifically the ability to predict the bankruptcy, as stated in Chen and Church (1996). This can
show a significant level of information usefulness for investors, who didn‟t know about the real
situation of the company where they own shares. The authors found that, as opposed to receiving
unqualified opinions, firms that receive going concern opinions “experience less negative excess
returns in the period surrounding bankruptcy filings”5. They focused only on one financial
4Herbohn, K., V. Ragunathan& R. Garsden (2007). The horse has bolted: revisiting the market reaction to going concern modifications of audit
reports, Accounting and Finance, 47:3, 473–493 5 Chen, K.C., & Church B.K. (1996). Going concern opinions and the market’s reaction to bankruptcy filings. The Accounting Review, Vol. 71
(1), pp. 117-128.
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
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difficulty occurring after disclosing a going concern opinion, in order to prove the value
information, but there are others too, like quarterly losses, suspension of dividends, default on
debt etc.
Another view over information usefulness of the going concern opinions is given by
Dennis O‟Reilly (2010), which shows the importance of disclosure for valuing company‟s stocks
by investors. What makes this study more interesting is the fact of being the first one that uses an
experimental approach for reaching the findings. More precisely, U.S. financial analysts were
required to participate by email at two stock price estimates of a financial distressed company,
one before and one after including the auditor‟s opinion. The author found significant stock price
reductions, after receiving a going concern opinion, and the usefulness of the auditor‟s opinion is
proved to be “greater when it provides a signal that differs from that which the market is
expecting”6. It will be interesting to see whether a qualitative research like this one is consistent
with my conclusion, also based on the US sample.
Chen et al. (2000) focused on the differences between the qualified and unqualified
opinions, by analyzing the valuation effect of modified audit opinions (MAOs), in the Chinese
stock market. The environment here has some specific characteristics, which differ from the ones
in U.S.. Some of them are related to the Chinese investors, who are not experienced in using
financial information, others to Chinese auditors who usually disclose an unqualified opinion
with explanatory notes instead of a qualified opinion, and other characteristics are related to the
regulators, who are more strict and more offended in case of GAAP violations. By analyzing
different forms and contents of modified audit opinions, the authors want to emphasize the role of
the auditor in the market. They found that in an emerging market like the Chinese one, MAOs are
negatively associated with the returns but there is no difference observed between the qualified
opinion and the unqualified opinion with explanatory notes. Furthermore, investors don‟t react
negatively until the second year after disclosure.
Allen et al. (2011) focused on the auditor‟s going concern opinion as a communication of
risk investors are exposed to. This leads to a substantial shift in the structure of the market
valuation for firms financially distressed and more importantly, “the results hold even after
6 Dennis M. O'Reilly, (2010) Do investors perceive the going-concern opinion as useful for pricing stocks?, Managerial Auditing Journal, Vol. 25
Iss: 1, pp.4 - 16
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
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controlling for several other measures of financial distress”7. The analysis is conducted with
firms that are receiving for the first time the going concern opinion, which as opposed to the
other firms, have a greater valuation weight of the book value of equity. The authors succeed to
prove the value relevance of this type of opinion, as long as it brings up to investors the potential
risk of abandonment or adaption of firm assets.
As I noticed, there are many studies developed on one specific modifed report meaning
the going concern opinion, but less on the modified audit opinion as a whole, under all its
circumstances, as stated in Syou-Ching et al. (2009):
- going concern consideration
- change in the application of accounting principles for financial reporting as required under law
- change in the application of accounting principles for financial reporting on a voluntary basis
- uncertainty of events that may have significant impact on the future financial condition of the
firm
- the adoption of another auditor‟s audit report for the current year audit.
The reason for which the going concern opinion has got more attention from researchers
could be that the information provided is much more relvant for investors as opposed to the one
given by other issues, which may not influence in the same way the investment decisions. This
assumption is proved by Syou-Ching et al. (2009) which mentioned that “of the five
circumstances mentioned above, the one based on the going concern consideration had the
highest significant impact on stock prices”8. In their research, the authors have adopted Ohlson‟s
model for investigating the information content of MAO, in order to control for concurrent
information that could bring significant biases to the analysis, since they consider the event
approach a “validity trap”.
As Firth (1978) states, investors react differently to the various types of audit
qualification, meaning the type of audit opinion gives different information, and that the price
reactions occurred in the expected direction, immediately after releasing the audit reports. This is
an important study, that appears as reference for many recent articles, and that‟s one more reason
7Allen D. Blay, Marshall A. Geiger, David S. North (2011) The Auditor's Going-Concern Opinion as a Communication of Risk. A Journal of
Practice & Theory: May 2011, Vol. 30, No. 2, pp. 77-102. 8 Syou-Ching Lai, Cecilia Lin, Hung-Chih Li, Frederick H. Wu (2009). The Information Contents of Modified Unqualified Audit Opinions under
the Control of Concurrent Information: The Case of Taiwan, Journal of Accounting and Corporate Governance, Volume 6 Number 1, June 2009
pp.31-56
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
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to mention it, for proving the differences between the two types of audit opinions I chose to
analyze.
One of the main articles I have relied on in my research is Chen et al (2012), that came
with significant findings regarding the audit opinion influence on the debt costing. They have
focused only on the qualified audit opinion, which is associated with decreased use of
performance pricing provisions in debt contracts. They also bring into discussion the importance
of the quality accounting information, with an inverse relationship: the higher the quality is, the
lower the cost of monitoring the borrower, supported by lenders, which leads to a lower interest
rate demanded by them. Since the qualified audit opinion is giving outside investors a signal over
the financial statement quality as being lower than a clean opinion, this will determine lenders to
rely less on the financial statement numbers, and make use of other monitoring mechanisms, that
imply higher costs.
Another study I have considered in my research is Karjalainen (2011), which has
emphasized that both audit quality and the auditor‟s opinion is perceived as value relevant
sources of information in debt pricing. The author has also identified a mixed evidence in the
prior literature regarding the extent to which the auditor opinion can affect stock prices and cost
of debt. This can be explained by the methodological problems as “identifying the first day of
trade on the audit report information”9 and also the “difficulty of isolating the market reaction to
the information content of the auditor‟s opinion from the reaction to other concurrent
information”10
.
The relationship between the auditor choice and debt pricing, was analysed in Pittman and
Fortin (2004), and later in 2007, the authors extended their research from publicly to private
traded companies. In the first paper, they have defined the cost of debt as the interest rate on the
debt of the firm, calculated as the interest expense for the year divided by the average short and
long term debt during the year. But in the second one, they used as a dependent variable the yield
spread as “the difference in basis points between the at-issue yield to maturity on the corporate
bond and that of a U.S. treasury bond issued on the same date with comparable maturity”11
.
9 Karjalainen, J. (2011), Audit Quality and Cost of Debt Capital for Private Firms: Evidence from Finland. International Journal of Auditing, 15: 88–108 10 Manuel Cano-Rodríguez (2010). Big Auditors, Private Firms and Accounting Conservatism: Spanish Evidence, European Accounting Review,
19:1, 131-159 11 Fortin, S. and Pittman, J. A. (2007), The Role of Auditor Choice in Debt Pricing in Private Firms. Contemporary Accounting Research, 24:
859–896
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
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As opposed to their first research, they were unable to support the value relevance of
BIG4 audits in pricing bond issues. They concluded that the auditor characteristics are irrelevant
to the debt-contracting process for the private firms: “neither the presence of BIG4 auditor nor
auditor tenure explains debt pricing12
”.
One recent article that got my attention is Armitage and Marston (2014) which focuses on
the views of finance directors about the link between disclosure and the cost of capital, using a
qualitative methodology, through conducting 16 semi-structured confidential interviews. The
main question was whether greater disclosure to a rating agency or bank would affect the cost of
a bond issue or a bank loan. In most of the cases the answer was affirmative: nine of the
interviewees said that providing more information would increase the availability of debt or
reduce the cost of debt, one said it would have no effect and the rest of six were not sure.
Considering these views, I assume that providing an external audit, would have the same effect,
since this could be one way of increasing the corporate disclosure, especially when the auditor is
from Big4.
2.3 Hypotheses development
In order to provide a clear answer for each of the two research questions of my study, I will
develop two separate hypotheses that will be explained later in this section. The link between
them is the modified audit opinion, which remains the aim of the research along the whole study,
since I want to emphasize the differences from a clean opinion.
2.3.1 Hypothesis I
The first effect of a modified audit opinion I want to measure is the one on the stock
market, by analysing the daily returns based on stock prices.
As I noticed in previous studies, Chen and Church (1996) and Allen et al. (2011), the
going concern opinion is seen as a bad news because it announces financial difficulties of the
company, but the question is whether the unqualified opinion is considered by investors a good
news, which could encourage them to buy the specific stocks.
12 Fortin, S. and Pittman, J. A. (2007), The Role of Auditor Choice in Debt Pricing in Private Firms. Contemporary Accounting Research, 24:
859–896
The influence of modified audit opinion on the stock market and cost of debt: U.S. evidence
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The Chen et al. (2000) paper has a similar purpose, more precisely, analyzing if this type
of information provided through disclosing a modified audit opinion can be evaluated by
investors in a proper and timely way. According to Chen et al. (2000) there are differences
between the qualified opinion and unqualified opinion but these may not be observed by the
investors. The authors refer to one article from news to emphasize the “difference between the
two types of opinions as lawful but unreasonable (unqualified with explanations) versus unlawful
(qualified opinions)”13
. One problem here would be that some of the auditors are choosing an
unqualified opinion with explanatory notes – referred to as the modified audit opinion – instead
of a qualified opinion in order to keep their clients and in the same time conforming with auditing
standards. This assertions is made for the Chinese environment, which has an emerging market.
Based on this, the first hypothesis is as it follows:
H1: Ceteris paribus, the announcement of modified audit opinions is negatively
associated with market returns.
2.3.2 Hypothesis II
Another important effect of the auditor‟s opinion over the market that worths to be analysed is
the change in the cost of debt. This relationship between auditing and cost of debt has not been
studied by too many researchers, as most of the papers are focusing on the connection with the
accounting quality given by the way of disclosing the information to the market, as already
mentioned in the Literature review.
The qualified audit opinion has been proved to have a negative reaction among creditors,
which implicitly lead to a higher cost of debt, according to Chen et al (2012). Pittman and Fortin
(2004) examines the impact of auditor choice on debt pricing and concludes that the services
provided by Big 4 Auditors leads to enhancing the credibility of financial statements, which
reduces the debt monitoring costs.
Another factor besides the auditor choice is the auditor opinion, as the main subject of this
study. So I found it interesting to research on this relationship. The interest rate is the variable
that need to be analysed in order to figure out the direction towards it moves, when the auditor‟s
13 CHEN, C. J. P., SU, X. and ZHAO, R. (2000), An Emerging Market's Reaction to Initial Modified Audit Opinions: Evidence from the Shanghai