The Value of Audited Financial Reports
Recently I wrote a short piece concluding that audit opinions still matter. I drafted this essay within the judicial context of a class action lawsuit, which asserted that BDO had committed fraud, or at least negligence, in its audit of the now-defunct AmTrust. BDO’s defense was that the audit […]
Recently I wrote a short piece concluding that audit opinions still matter. I drafted this essay within the judicial context of a class action lawsuit, which asserted that BDO had committed fraud, or at least negligence, in its audit of the now-defunct AmTrust. BDO’s defense was that the audit opinion has no significance to investors (https://tinyurl.com/bdtur53).
I disagree. Much is squeezed into an audit opinion. An unqualified opinion states that the auditor has followed generally accepted auditing standards (GAAS) and that, taken together, its tests supply reasonable assurance to investors and creditors that the financial reports follow generally accepted accounting principles (GAAP)—and that these financial statements and their notes contain no material misstatements and no omissions of material facts.
Congress felt that audits are important when it mandated independent, external audits in the 1934 Securities and Exchange Act. The SEC clearly thinks it so, as it said in 2003, “Few matters could be more important to investors than that of whether an issuer’s financial statements, contained in its filings with the Commission, had, in fact, been subjected to an annual audit conducted in accordance with GAAS in all material respects” (https://tinyurl.com/56ywearh).
Feeling so does not make it so. Consider the following empirical research that backs up the proposition that audited financial reports matter.
Earnings Numbers Matter
Auditing meaningless numbers would be in vain, however well done. More basic than auditing, then, are the constructs that are being audited. The most important of these variables is net income. The question is whether this popularity is deserved.
Amid the criticism of accounting numbers by investors and academics alike during the 1960s, Ball and Brown (“An Empirical Evaluation of Accounting Income Numbers,” Journal of Accounting Research, vol. 6, no. 2, 1968, pp. 159–178, https://www.jstor.org/stable/2490232) conducted the seminal study on whether the earnings numbers matter. The essence of the study depended on the notion that market participants have expectations regarding earnings and firm returns. The researchers then filter out those expectations and examine whether there is a relationship between unexpected earnings and unexpected returns. Think of it this way—why might a company have a 20% increase in earnings but drop 3% in value? Because the market anticipated a greater increase in earnings. The market does not react to what it already has anticipated; it reacts to the unforeseen.
Ball and Brown had a simple expectations model for earnings—that next year’s earnings would equal last year’s net income. They developed two portfolios based only on whether the firms achieved greater earnings or not. The researchers then graphed the portfolio returns starting one year before the earnings announcement to six months after the announcement. The portfolio that obtained greater earnings obtained excess stock returns (defined as the amount of return above a market-adjusted return) from the beginning and continued to grow. At the announcement date, this portfolio achieved excess returns of 6–8%, while the portfolio of stocks with less than expected earnings had market declines of approximately 9–11%. These results show that knowing only whether earnings forecasts would be met or not had substantial information content.
This study has been replicated and extended many times; every time indicating the worth of the earnings construct. Indeed, the original authors replicated their work 50 years after the initial publication. The Ball and Brown [Ray Ball and Philip Brown, “Ball and Brown (1968) after Fifty Years,” Pacific-Basin Finance Journal, vol. 53, February 2019, pp. 410–431] replication essentially did the same study for each year from 1972 through 2017 and found the same result. Ball and Brown also replicated the study for 16 countries in addition to the United States, and the results were the same. The earnings number has information value to market participants.
Beaver (1968) attacked the question from a different angle—he investigated the price variability and the changes in volume around earnings announcements (“The Information Content of Annual Earnings Announcements,” Journal of Accounting Research, vol. 6, Empirical Research in Accounting: Selected Studies, 1968, pp. 67–92, https://www.jstor.org/stable/2490070). The idea is that if earnings supply information, then one should observe price variability and more trades around earnings announcements, and that is what he found. An interesting replication was carried out by Landsman and Maydew (2002) who posited that, because there were more sources of information about companies and these were more timely than earnings, one could expect the decline in the usefulness of net income (“Has the Information Content of Quarterly Earnings Announcements Declined in the Past Three Decades?” Journal of Accounting Research, vol. 40, no. 3, June 2002, pp. 797–808, https://www.jstor.org/ stable/3542273). They found the exact opposite. Despite the additional information, earnings were even more valuable than in earlier time periods as quantified in the price variability and volume changes. Beaver, McNichols, and Wang (2020) replicated the original Beaver study and found comparable results (“Increased market response to earnings announcements in the 21st century: An Empirical Investigation,” Journal of Accounting and Economics, vol. 69, no. 1, February 2020, https://tinyurl.com/3rypuur3). In addition, they found that management guidance, analyst forecasts, and line-item disclosures are often packaged with earnings announcements.
Auditing Matters
The question remains whether auditing adds value to the financial reporting institution. This issue can be addressed via two avenues: voluntary audits and the effects of modified opinions.
Normally, researchers have difficulty assessing the impact of an audit because all publicly traded corporations are required to have such opinions. Occasionally, something happens to allow one to investigate this question. Minnis (2011) obtained access to a data set of privately held companies that wished to borrow funds (“The Value of Financial Statement Verification in Debt Financing: Evidence from Private U.S. Firms,” Journal of Accounting Research, vol. 49, no. 2, May 2011, pp. 457–506; https://tinyurl.com/ypurtyxf). Minnis discovered that those entities with audited statements had lower interest rates than those without audited reports. Having the audit opinion served as a signal that they were safer than companies without such verification.
Another instance involved an institutional change in the United Kingdom. Private companies in the United Kingdom had to have external audits if they had sales over £1 million pounds or assets over £1.4 million. In 2004 the government dropped this requirement, but some enterprises continued to have audits. This setup allowed researchers to examine why some companies volunteered to have external audits while others did not. Lennox and Pittman (2011) observed credit ratings to rise for those entities which chose to have audits in the latter period (“Voluntary Audits versus Mandatory Audits,” The Accounting Review, vol. 86, no. 5, September 2011, pp. 1655–1678, https://www.jstor.org/stable/23045583). They also noticed that during the period prior to 2004, companies that were later voluntarily audited had better credit ratings than those companies which discontinued; even so, these entities received a boost in their credit ratings in the latter period, but those that dropped the audits had lower credit ratings.
The second avenue for assessing the empirical value of audits is to consider what happens when the auditor issues an opinion other than “unqualified.” Gutierrez et al. (2020) looked at the usefulness of going concern opinions in predicting corporate failure (“Do going concern opinions provide incremental information to predict corporate defaults?” Review of Accounting Studies, June 2020, vol. 25, pp. 1344–1381, https://tinyurl.com/2zjs6pne). Several models already do this, so the research question was whether going concern opinions provide any incremental predictive power beyond that supplied by these models. Gutierrez et al. found that these modified opinions do provide additional predictive power. Munoz-Izquierdo (2019) replicated this finding in a Spanish setting (“Does audit report information improve financial distress prediction over Altman’s traditional Z-Score model?” Journal of International Financial Management & Accounting, vol. 31, no. 1, February 2020, pp. 65–97, https://tinyurl.com/yc6ufjvr).
Chen et al. (2016) broadened their focus by looking at a variety of modified opinions in a debt contracting setting (“The Information Role of Audit Opinions in Debt Contracting,” Journal of Accounting and Economics, 2016, vol. 61, pp. 121–144, https://tinyurl.com/3ajwtp4s). For material uncertainties and going concern qualifications, they found such entities had higher interest spreads, more general covenants, smaller loan sizes, and higher chances of collateral being required. In other words, entities that receive these modifications were viewed as having greater risk, and creditors protected themselves against this additional risk.
Quality Matters
These and many more research projects demonstrate that earnings numbers and audit opinions have value. Audit opinions have value because they allow users to trust the accounting numbers.
One might ask about small investors. Do they gain any benefit from audited financial statements? The answer is found in the vast research on stock market efficiency. Small investors do not buy or sell enough shares of stock to impact the markets; essentially, they are price takers. Large investors, however, do buy and sell enough shares to impact prices. They search for information to assist them in earning profits, and this information includes audited financial statements. Audited financial reports assist them, and therein lies the chief value of audit opinions. Small investors gain a derivative benefit by relying on the efforts of large investors.
This article must end with a caveat: Audit opinions have value as long as the audits are performed well. Their value erodes if professional values decline; this fact underlies the importance of the SEC, the PCAOB, and tort law. Quality matters.
J. Edward Ketz, PhD, is an associate professor at the Smeal College of Business, Pennsylvania State University. This essay reflects the opinion of the author and not necessarily the opinion of Pennsylvania State University.
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