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Journal of Accounting and Economics 37 (2004) 139165

An empirical analysis of auditor reporting and its

association with abnormal accruals$

Marty Butlera, Andrew J. Leonea,*, Michael Willenborgb

a

William E. Simon Graduate School of Business Administration, University of Rochester, Rochester,NY 14627, USAbSchool of Business Administration, University of Connecticut, Storrs, CT 06269, USA

Received 29 January 2002; received in revised form 9 June 2003; accepted 25 June 2003

Abstract

In this paper, we use a web-based sampling methodology to obtain and content analyze a

large sample of modified audit opinions. Based on this analysis, we re-examine whether certain

modified audit opinions are associated with abnormal accruals. We find that the documentedrelation between modified opinions and abnormal accruals rests with companies that have going-

concern opinions. These firms have large negativeaccruals that are likely due to severe financial

distress. Overall, we find no evidence to support inferences in previous research that firms

receiving modified audit opinions manage earnings more than those receiving clean opinions.

r2003 Elsevier B.V. All rights reserved.

JEL classification: M41; D21; C81

Keywords: Abnormal accruals; Audit firms; Audit opinions; Financial distress; Earnings management

ARTICLE IN PRESS

$We thank Mary Barth, Bill Beaver, Joe Carcello, Liz Demers, Bill Felix, Ed Kay, Bill Kinney, John

Hand, Paul Hribar (referee), Jagan Krishnan, Doug Skinner (editor), Richard Sloan, Christine Tan, Scott

Vandervelde, Charlie Wasley, Ross Watts, Joseph Weber, Tzachi Zach, Jerry Zimmerman, and workshop

participants at Dartmouth, Georgia State, Harvard, Iowa, Rochester, Stanford, Temple, the 2002 AAA

Audit Midyear Meeting, and the 2002 University of Illinois Symposium on Audit Research. We also thank

Paul Ames, Vinay Bassi, Natalya Bushneva, Rumen Efremov, Girts Freibergs, Junfeng Han, Treppy

Johnson, Winward Lewin, Ai Qin Liu, Trevor Lloyd, Chris Wang, and especially Kalina Berova for

excellent research assistance. Support was provided by the John M. Olin Foundation and the Bradley

Policy Research Center at the University of Rochester. Portions of this paper were completed while the

second and third authors were visiting the University of Michigan and the Universiteit Maastricht,respectively.

*Corresponding author. Tel.: +1-716-275-4714; fax: +1-716-442-6323.

E-mail address: [email protected] (A.J. Leone).

0165-4101/$ - see front matterr 2003 Elsevier B.V. All rights reserved.

doi:10.1016/j.jacceco.2003.06.004

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1. Introduction

The audit opinion, as the observable output from an otherwise unobservable

process, represents a crucial piece of information for financial statement users. Forexample, the presence of a going-concern (GC) opinion has been shown to be

informative with respect to stock returns (Dopuch et al., 1986;Choi and Jeter, 1992)

and bankruptcy events (Hopwood et al., 1989; Kennedy and Shaw, 1991). More

recently, several studies examine the relation between accounting accruals and the

presence of certain modified audit opinions (Francis and Krishnan, 1999; Bartov

et al., 2000;Bradshaw et al., 2001). In essence, these studies test the hypothesis that

earnings management increases the likelihood of receiving a modified audit opinion.1

The direction of causality is important because if auditor reporting conveys

information about earnings management, then a link can be made between audit

opinions and earnings quality. In this paper, we re-examine auditor reporting and its

association with abnormal accruals, assessing, in particular, the claim that modified

opinions are reliable signals of earnings management.

Although we expect auditing to limit earnings management, it is not obvious that

earnings management will typically lead to a modified audit opinion. Indeed, if an

auditor detects earnings management and firm managers refuse to adjust the

financial statements, the auditors reporting options under Generally Accepted

Auditing Standards (GAAS) are to issue an adverse, disclaimed, or qualified

opinion, the consequences of which can be severe (e.g., per Rule 2-02 of Regulation

S-X, the SEC will not accept the statements). Moreover, firms with certain modifiedopinions have unusual accruals for reasons other than earnings management. Due,

for example, to poor firm performance or liquidity-motivated survival tactics, the

presence of GC opinions is often contemporaneously associated with large negative

accruals. For these reasons, and consistent with the view that most earnings

management takes place within the boundaries of GAAP (Healy, 1985), we argue

that the opinion/accruals relation is not due to earnings management.

To examine the link between abnormal accruals and auditor opinion type, we

begin by providing descriptive information on Compustats auditor/auditors

opinion data item for the 20 years from 1980 to 1999, a period spanning a major

change in GAAS (i.e., SAS 58). Because auditors issue modified opinions fornumerous reasons that Compustat combines into just a few categories, we compare

Compustat opinion classifications for 19941999 to source documents on EDGAR.

We find that 1,385 (16%) of 8,478 opinions that Compustat classifies as modified are

actually clean opinions. For example, Compustat classifies 801 firm-year observa-

tions as modified simply because auditors mention that they reviewed a

supplementary schedule filed with the 10-K. Based on examining over 7,000

modified opinions from this period, we identify two factors that account for over

90% of modifications: consistency issues requiring no restatements (e.g., adoption of

ARTICLE IN PRESS

1We use the term modified opinions to refer to both qualified opinions (scope limitations or

departures from GAAP) and unqualified opinions with explanatory language (e.g., going concern and

consistency).

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new accounting standards) and GC opinions.2 In addition, we find that while

unqualified opinions with explanatory language are relatively common, qualified

opinions are rare. Further, the reasons provided for these qualified opinions appear

unrelated to earnings management and is thus inconsistent with the view thatearnings management typically causes modified audit opinions.3

Based on our analysis of the reasons auditors depart from standard unqualified

opinions, we identify the types of modified opinions that are associated with large

accruals. We find that companies with GC opinions drive the opinion/accruals

relation because such companies have extremely negative abnormal accruals.

However, we report no evidence of differences in abnormal accruals for GC firms

when compared to firms matched on a measure of financial distress. The evidence is

consistent with the view that firms in severe financial distress, independent of audit

opinion type, engage in liquidity-enhancing transactions (e.g., delaying payables or

factoring receivables) that result in large negative accruals. Because traditional

abnormal accrual models do not adequately control for distress-induced variation in

accruals, the large negative accruals characteristic of GC firms appear abnormal

(i.e., indicative of earnings management), but they are no different from similarly

distressed clean-opinion firms. Overall, we find no evidence that firms receiving

modified audit opinions manage earnings more than those receiving clean audit

opinions.

Our contribution is two-fold. First, we provide a large-sample descriptive analysis

of audit opinions by audit firm type. This shows the impact of SAS 58 on auditor

reporting, points out problems with Compustat audit opinion data, and provides acontent analysis of the reasons why companies receive modified opinions. Second, we

show that the modified opinions/abnormal accruals relation stems from companies

with GC opinions, because they have negative accruals. As such, our findings cast

some doubt on the conclusions of previous research that has attributed the opinion/

accruals relation to more aggressive earnings management. In particular, we point

out how theBartov et al. (2000)results appear to be due to severely distressed firms

(with GC opinions), rather than due to firms engaging in extreme earnings

management. Overall, we find no evidence to support the claim that firms receiving

modified audit opinions manage earnings more than those receiving clean audit

opinions.Our findings also have implications for research on the relation between audit

opinion modifications and earnings management, as well as earnings management

in general. In particular, because the auditors role is not to assess earnings

quality, researchers should be cautious when drawing inferences about the

relation between auditors opinions and traditional measures of abnormal accruals

as proxies for earnings management. As we discuss above, modifications due to

ARTICLE IN PRESS

2We use the term GC opinion to refer both to cases in which auditors explicitly use the term going

concern in the text of the audit report (2,910) and to cases in which auditors mention either bankruptcy

proceedings or a material business uncertainty, but do not explicitly use the term going concern (2 5 1).3Of course, the fact that a qualified audit opinion does not literally mention earnings management does

not mean that auditors fail to detect, or constrain, earnings management (see Section 2).

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earnings management should be exceedingly rare. Further, because the negative

relation between certain modified audit opinions and abnormal accruals is

concentrated in firms in financial distressthat is, cases in which traditional

models of earnings management are especially misspecifiedusing modified-opinionfirms to compare competing abnormal accrual models is more likely to measure

the models relative misspecification than their power to detect earnings manage-

ment. More generally, because GC companies can substantially affect abnormal

accrual calculations, it is important to consider controlling for such opinions.

Finally, our findings highlight the importance of performance matching when the

companies of interest are experiencing extreme performance and demonstrate further

that the choice of performance control variable can be an important design

consideration.

The remainder of the paper is organized as follows. Section 2 discusses

institutional details and the opinion/accruals relation. Section 3 details our sampling

methodology. Section 4 provides a content analysis for those modified audit

opinions that we can find on EDGAR. Section 5 re-examines the opinion/accruals

relation. Section 6 summarizes our main findings and offers some implications and

suggestions for past and future earnings-management research.

2. Earnings-management and the audit opinions/accounting accruals relation

As a form of monitoring, auditing mitigates incentive problems between managersand outsiders. Following such an agency cost argument, several recent papers

(Francis and Krishnan, 1999; Bartov et al., 2000; Bradshaw et al., 2001) argue

that modified audit opinions are either influenced by, or provide evidence of,

more pervasive earnings management. In general, these papers posit that

modified audit opinions should be a function of accounting accruals.4 However,

given the nature of the audit process and federal securities laws governing accounting

reports, it is unlikely that earnings management will lead to a modified audit

opinion.

Consider a case where an auditor believes that certain accounts are misstated.

If the suspected earnings management involves no material misstatement orconforms to GAAP, then there is no basis for the auditor to qualify or otherwise

modify the opinion. For example, the auditor may believe that the allowance for

doubtful accounts is understated but deem the understatement to be either

immaterial or due to a difference in judgment within the confines of GAAP. In

either of these cases, the auditor will not issue a modified opinion even if the

ARTICLE IN PRESS

4While the empirical design of these papers differs somewhat, they all regress audit opinion type on

accounting accruals. Francis and Krishnan (1999) consider firms with audit opinions modified for asset

realization and GC uncertainties as a function of indicator variables that capture extreme levels or

components of total accruals.Bartov et al. (2000)consider firms with audit opinions modified for scope

limitations and GAAP departures as a function of the absolute value of different abnormal accrual

metrics.Bradshaw et al. (2001)consider firms with any type of modified (or unclean) audit opinion as a

function of signed working capital accruals.


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accounting seems aggressive. Auditors do not have latitude to comment or elaborate

on the overall quality of earnings as long as the financial statements materially

conform to GAAP.

If, on the other hand, the auditor determines that the financial statementsinclude a material misstatement or departure from GAAP, then GAAS oblige the

auditor to communicate the deficiencies to managementor directly to the audit

committee or SEC in cases of fraudand request that they adjust the financial

statements accordingly (OMalley et al., 2000, p. 82). If management makes

the necessary adjustments, then the monitoring role of the auditor is unobservable

and the audit opinion will contain no earnings-management-based modification.

However, should management refuse to adjust the financial statements, then

the auditors choice is either to resign or to issue an adverse, disclaimed, or qualified

audit opinion. The consequences of each option are severe. For example,

per Regulation S-X, the SEC will not accept a registrants financial statements

that have been qualified or disclaimed by their auditor. Moreover, because the

financial statements contain a material misstatement, the registrant [is] knowingly

... filing a false and misleading document, an act punishable under SEC Rule 10b-5

(Herz et al., 1997). The auditor and the company likely resolve earnings-

management-related issues before the audit report is issued because the costs

of not doing so are so high. As a result, given the nature of the audit process,

the auditors reporting choices under GAAS, and institutional features of the

audit environment, an audit opinion modification due to earnings management

should be rare.

5

Evidence inNelson et al. (2002)suggests that auditors and management virtually

always resolve earnings-management issues before opinions are issued. They report

the results of a survey of 253 audit partners and managers of a Big 5 firm, who

describe 515 specific incidences of potential earnings management detected during

the course of their audits. Of these instances of possible earnings management, 44%

of the time there was an adjustment, 21% of the time there was no adjustment

because the client was able to demonstrate compliance with GAAP, 17% of the time

there was no adjustment because the auditor was unable to convincingly show that

the clients position was incorrect, and 18% of the time there was no adjustment due

to immateriality (or some other reason). In only seven of the 515 instances did theputative earnings management attempt lead to an opinion modification.6 Moreover,

these seven modifications could be due to disagreements, between management and

the auditor, about the application of GAAP rather than earnings management. The

other 99% of cases were resolved prior to the issuance of the financial statements and

audit report.

ARTICLE IN PRESS

5We thank Ed Kay, Managing Partner at PricewaterhouseCoopers, Rochester, NY, for informative

discussions about the audit process and, in particular, the steps that auditors take when a material

misstatement is identified.6There was one instance of an adverse audit opinion and six instances of audit opinions qualified for

departure from GAAP. We thank Mark Nelson for providing this information, which is not reported in

Nelson et al. (2002).


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3. Web-based sample of modified audit opinions

3.1. Compustats audit data item, before and after SAS58

We begin with the merged Compustat database (i.e., full coverage, industrial

annual, and research) for the period from 1980 to 1999 and identify 147,926 firm-

year observations for which the auditor/auditors opinion data item (x149) is not

missing.7 Compustat uses this data item to designate a companys audit firm

companies with Big5 firms comprise 80.1% of the sampleand the type of audit

opinion the company receives: unaudited (0), unqualified (1), qualified (2),

disclaimer/no opinion (3), unqualified with explanatory language (4), or adverse

(5). The majority of the sample (77.3%) is unqualified opinions.

Several changes in auditing standards have influenced the format of audit reports

and, consequently, Compustats classification of audit opinions. Most importantly,

SAS 58, effective for reports issued after January 1,1989, changes the conditions

under which qualified opinions are issued. Prior to SAS 58, there were two broad

classes of qualified audit opinions: except for opinions were issued when there

were scope limitations, departures from GAAP, or a lack of consistency (e.g., a

change from one generally accepted accounting method to another); and subject

to opinions were issued in the presence of material uncertainties, such as asset

realization, contingent liabilities, or substantial doubt concerning an entitys ability

to continue as a going concern. Under SAS 58, changes from one acceptable

accounting method to another and every type of subject to opinion no longer giverise to qualified opinions. Instead, under present-day GAAS, there is now a

category for unqualified opinions with explanatory language that discusses either

the accounting change or material uncertainty. Consequently, only the format and

not the information contained in the audit opinion has changed.

As a result, prior to SAS 58, a Compustat qualified opinion (Compustat

opinion code 2) related to both except for as well as subject to audit opinions.

Under the SAS 58 regime, however, Compustat code 2 opinions include only

qualifications for scope limitations and departures from GAAP. Other modifica-

tions, such as changes from one generally accepted accounting method to another

and material uncertainties, should now be classified as unqualified opinions withexplanatory language (Compustat code 4).

Table 1 presents Compustat opinion codings for the 19801999 period,

categorized by SAS 58 time frame and audit firm type. Because our sample includes

both pre-SAS 58 years (19801987), as well as years in which SAS 58 is effective

(19881999), we present annualized counts to aid comparability. As expected, the

most significant shift across the two time periods is the frequency of qualified

ARTICLE IN PRESS

7Compustat creates an observation for the entire 20-year period for each firm present in any of the years

covered. So, if Compustat began including a firm in 1990, Compustat adds records containing missing

values for the firm for each year from 1980 to 1989. To determine the number of valid firm-year

observations, we count only observations with non-missing values for both total assets and audit opinion

data items (x6 and x149, respectively).


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opinions (code 2) and unqualified opinions with explanatory language (code 4).Looking at Big5-audited companies, 11.1% had qualified opinions in the pre-SAS

regime versus only 0.2% in the SAS 58 regime. In contrast, there were virtually no

Big5-audited companies with Compustat code 4 (i.e., unqualified with explanatory

language) opinions in the pre-SAS 58 regime, but 25.6% of such companies received

these opinions in the SAS 58 regime. Notably, in the SAS 58 period, we detect no

meaningful distinction between Compustats code 2 and code 4 opinions. That is, we

identify companies with qualified opinions that have code 4 (i.e., unqualified opinion

with explanatory language) classifications, as well as companies with code 2 (i.e.,

qualified opinion) classifications that have unqualified opinions with explanatory

language. Overall patterns are similar for non-Big5 firms. The differences we reportin the pre-SAS 58 and SAS 58 periods likely have implications for the comparability

of our findings to past research, which we examine in Section 5.4.

3.2. Tracking Compustats audit data to EDGAR source documents via the Web

To independently verify and further refine Compustats audit opinion classifica-

tions, we construct a large database of modified opinions. To do this, we develop a

Web application that automates the process of collecting and classifying audit

opinions. The application searches EDGAR for the 10-K corresponding to a given

company name and fiscal year-end. Obtaining opinions from EDGAR reduces datacollection costs; however, it also limits the time period we cover from 19801999 to

19941999. Using keywords to identify the firms audit opinion, the program

ARTICLE IN PRESS

Table 1

Average annual Compustat audit opinion code types by SAS 58 regime and audit firm type (19801999)a

Opinion

code

Compustat

opinion type

Pre-SAS 58 (19801987) SAS 58 (19881999)

Big5 Non-Big5 Big5 Non-Big5

0 Unaudited 2 (0.05%) 1 (0.08%) 1 (0.01%) 2 (0.11%)

1 Unqualified 4,277 (88.22%) 1,271 (79.91%) 4,911 (73.98%) 912 (65.27%)

2 Qualified 540 (11.14%) 293 (18.44%) 12 (0.18%) 17 (1.24%)

3 Disclaimer/no opinion 27 (0.56%) 23 (1.47%) 16 (0.25%) 7 (0.51%)

4 Unqualified with

explanatory language

1 (0.03%) 2 (0.10%) 1,698 (25.58%) 459 (32.84%)

5 Adverse 0 (0.00%) 0 (0.00%) 0 (0.00%) 0 (0.03%)

Totals 4,847 (100.00%) 1,590 (100.00%) 6,638 (100.00%) 1,397 (100.00%)aThis table reports the frequency distribution of audit opinions by Compustat classification, auditor

type, and pre- and post-SAS 58 implementation. Under SAS 58, subject to and except for consistency

opinions are no longer considered qualified opinions. Instead, these situations give rise to unqualified

opinions with explanatory language. Audit firm/audit opinion data is from the merged Compustat

database (i.e., full coverage, industrial annual, and research) for the 20-year period from 1980 to 1999

(Compustat data item #149). Because the pre-SAS 58 regime contains 8 years of observations and the SAS

58 regime contains 12 years, we present annualized information to facilitate comparisons.


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extracts the opinion from the 10-K and copies it to a database. If the 10-K search

fails to find the opinion, the program searches other potentially relevant SEC filings

(e.g., S-l). In addition to facilitating collection of a large sample of audit opinions,

the application provides a systematic and efficient method (using keywordalgorithms) of categorizing opinions.8

Table 2summarizes sample construction. Using the Web application, we attempt

to collect and classify the 12,588 modified audit opinions of firms categorized by

Compustat from 1994 to 1999 as having either a qualified opinion (code 2) or an

unqualified opinion with explanatory language (code 4). Of the 12,588 audit

opinions, 900 relate to utilities and financial firms that we eliminate because of

inherent differences associated with accounting accruals for these firms. Approxi-

mately 73% (8,478) of the remaining 11,688 opinions are usable, as we discard 3,210

data records because we are unable to find either the filing or audit opinion on

EDGAR. Interestingly, given the criteria we use to select opinions of interest, we also

eliminate another 1,385 observations representing essentially clean opinions;9 that is,

approximately 16% (1,385C8,478) of the opinions classified by Compustat as

modified opinions (code-2 and code-4) from 1994 to 1999 are actually clean

opinions.10 It seems that Compustat simply flags all audit opinions as modified if

they deviate in any way from a standard boiler plate clean opinion. In summary,

using a Web-enabled, data collection routine, we collect and reliably classify 7,093

modified audit opinions for the 19941999 period (i.e., approximately 1,200 per year).

4. Content analysis of modified audit opinions

Table 3provides a content analysis, by audit firm type, of modified audit opinions.

Following GAAS, we broadly categorize opinions into two categories (qualified

opinions and unqualified opinions with explanatory language), which we then

partition into subcategories. The content analysis serves two purposes. First, it

provides a large-sample analysis of the reasons underlying auditors decisions to

depart from a standard, unqualified opinion. Second, it allows a detailed re-

examination of the audit opinion/accounting accruals relation.

4.1. Reasons for departures from a standard unqualified audit report

Table 3 provides several insights into auditor reporting. Audit opinion

qualifications occur much less frequently than unqualified opinions with explanatory

ARTICLE IN PRESS

8Specific keywords used for classification are available from the authors.9 Clean opinions either contain no qualifying or explanatory language or contain explanatory

language that is fundamentally different from that contained in other opinions. Explanatory language in

the latter opinion types was often trivial (e.g., 801 observations noted, without further qualification, that

ancillary schedules were audited in addition to financial statements; 33 observations noted the audited

company was a development stage enterprise).10We also review a large number of opinions classified as clean to verify that these are, in fact, clean

opinions.


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language. In addition, almost half of all modifications during our sample period are

GC opinions. Note that we classify some opinions that do not explicitly state going

concern as GC opinions if the opinions wording mentions severe business distress.

There were 251 (3,161 minus 2,910) cases where the auditors refer to eitherbankruptcy or the presence of material business uncertainties without explicit

reference to the term going concern. None of the results we report later, however,

are sensitive to the exclusion of opinions in which the auditor does not explicitly use

the term going concern. Consistent with claims that the largest audit firms are

shedding riskier clients (Berton, 1995), we document a lower frequency of GC

opinions for companies audited by Big 5 firms. In addition, material uncertainty

opinions are infrequent, probably because most of our sample is drawn from the

time period for which SAS 79 is effective.11 SAS 79 eliminates the requirement that,

ARTICLE IN PRESS

Table 2

Sample selection for content analysis and accruals analysis (19941999)

The sample is obtained by identifying all firm-year observations with Compustat audit opinion codes of

either 2 (i.e., qualified) or 4 (i.e., unqualified with explanatory language) for the 6-year period from 1994 to

1999. After eliminating 900 observations relating to utilities and financial services firms, we attempt to

identify the actual audit opinion on the SECs EDGAR database. Of the 11,688 firm-year observations

(i.e., 12,588 minus 900), we find 8,478 (i.e., 11,688 minus 3,210, or approximately 73%) on EDGAR. Of

these 8,478, we classified 1,385 firm-year observations (i.e., 801 plus 33 plus 551) as clean opinions

(Note: The opinions we characterize as clean either (a) contain no qualifying or explanatory language or

(b) contain trivial explanatory language fundamentally different from that contained in other collected

opinions. In other words, these opinions do not contain explanatory language that is consistent with

GAAS for designation as an unqualified opinion with explanatory language). We perform a content

analysis (seeTable 3) using the resulting 7,093 firm-year observations, by audit firm type, to identify the

specific reason the audit opinion was either qualified or unqualified with explanatory language. We thenperform an analysis of the association between modified audit opinions (per GAAS) and abnormal

accounting accruals using the 4,205 firm-year observations (of the 7,093) with adequate Compustat

information (seeTables 47).

11SAS 79 is effective for reports issued on or after February 29, 1996, but earlier application was

encouraged.


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ARTICLE IN PRESS

Table 3

Content analysis of modified audit opinions by audit firm type (19941999)

Observations are the 7,093 firm years inTable 2that, guided by GAAS, we categorize as either qualifiedopinions or unqualified opinions with explanatory language. We then partition these two categories

into subcategories based on the underlying reason for the opinion modification.


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when certain criteria are met relating to uncertainties, the auditors report must

include an explanatory paragraph. Under SAS 79, auditors may add an emphasis of

matterparagraph to highlight an uncertainty that is already appropriately disclosed,

but evidently few opinions contain such paragraphs. Lastly, and due largely tochanges in GAAP (e.g., deferred taxes, OPEB), we document a high percentage of

opinions that refer to accounting changes not involving restatements. Approximately

48% of our sample firms with modified opinions report an accounting change;

however, most of these opinions refer to the adoption of a new standard rather than

to a change from one generally accepted method to another.

4.2. A simple test of the relation between certain audit opinions and accruals

While auditors likely play an important role in monitoring and controllingmanagers accrual choices, the content analysis provides little support for the

rationale that audit opinions commonly convey the presence of earnings manage-

ment. Bartov et al. (2000) assert that qualifications for scope limitations or GAAP

departures proxy for extreme earnings management.12 However, our content

analysis identifies only 19 and 14 instances of opinion qualifications for scope

limitation and GAAP departures, respectively, from 1994 to 1999.13 We also

identify 147 unqualified opinions with explanatory language referencing a

permissible departure from GAAP, meaning that the SEC will accept the

financial statements. Of these opinions, 69 refer to the use of international

accounting standards, 75 pertain to trusts using a modified cash basis of accounting,and three refer to the auditing of supplemental schedules that do not conform to

GAAP.14

Thus, the majority of opinions qualified for either scope or departure from GAAP

bear no discernible connection to extreme earnings management by the client.

Moreover, we identify no modified opinions that refer to the future consequences of

ARTICLE IN PRESS

12Bartov et al. (2000)include all firms receiving qualified opinions (code 2 on Compustat). However, the

time period they study spans the pre-SAS 58 period. At that time, a qualified opinion could be issued due

to scope limitations, departures from GAAP, lack of consistency, going concern, asset realization and

contingent liabilities. Therefore, while they correctly used code 2 to identify qualified opinions, the

definition of a qualified opinion during much of their study-period is different from the definition in the

SAS 58 period. Because the code 2 opinion code is used infrequently after 1988 (see our Table 1), it is likely

that most of their sample came from the pre-SAS 58 time period. In addition, Bartov et al. describe in their

paper that Compustat Code 3 is assigned when a company receives a going concern opinion. However,

code 3 is assigned when the auditor chooses not to issue an opinion. This can happen if going concern

issues are extremely severe, but in most cases the auditor modifies the opinion for going concern opinions

(code 2 in the pre-SAS 58 regime and code 4 in the SAS 58 regime).13The 14 qualified opinions mentioning GAAP departures involve three companies. One company elects

not to consolidate certain subsidiaries; the other two do not recognize deferred taxes in accordance with

US GAAP. Of these 33 qualified opinion observations, 17 have adequate Compustat information to

compute cross-sectional Jones (1991) model abnormal accruals. Of these 17, 10 (7) observations have

positive (negative) abnormal accruals as per Eq. (1) (see footnote 16). The mean for these 17 observations

is positive, though not significantly different from zero.14Financial statements prepared in accordance with foreign GAAP are acceptable only if reconciled to

US GAAP. A modified cash basis of accounting is permissible for trusts.


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high positive accruals (Bradshaw et al., 2001). As such, our findings do not support

the underlying rationale for the opinion/accruals relation put forth by Bartov et al.

(2000). They are, however, consistent with one explanation given by Bradshaw et al.

(2001) for the unexpected negative relation they find between modified opinionsand working capital accruals, that reporting on the quality of earnings is beyond the

scope of the audit report. Nevertheless, even though earnings management does not

explain the abnormally large negative accruals of modified-opinion firms, the

underlying cause of the opinion/accruals relation remains unidentified. In the

following section we investigate the source of this relation.

5. Accruals analysis of modified audit opinions

5.1. Descriptive statistics by audit opinion type

Table 4 reports mean and median statistics for firm-year observations from

1994 to 1999 with adequate Compustat information to compute the variables

of interest. We divide the observations into five audit opinion categories: un-

qualified, going concern, material uncertainty, accounting change (without restate-

ments), and other.15 We provide information regarding total and abnormal accruals

per Jones (1991).16 Following Hribar and Collins (2002), we use the statement of

cash flows approach in our tables, although our findings are robust to using the

balance sheet approach to obtain total accruals (see also Section 5.4). Table 4alsoprovides information for several of the independent variables in our accruals

regressions.

Firms in the GC category differ on almost every dimension from those in other

categories. For example, firms with GC opinions tend to be smaller, less profitable,

less liquid, and to have more negative accruals. Highlighting the poor performance

of GC companies (e.g., mean and median lagged ROA is 0.60 and 0.32,

respectively) is the fact that over 85% of these observations report a loss in the year

prior to the GC. The peculiarities of companies with GC opinions reported inTable

4are borne out in the multivariate analysis that follows.

ARTICLE IN PRESS

15The sum of observations in modified-opinion categories inTable 4(5,122) exceeds the total number of

modified opinions inTable 2(4,205) because some firms have modifications for multiple reasons (e.g., an

opinion referencing GC status and an accounting change would be classified as both GoingConcern and

OtherModified).16Following DeFond and Jiambalvo (1994), we estimate a cross-sectional version of theJones (1991)

model for each (two-digit SIC) industry and year. After winsorizing at the 1st and 99th percentiles, we take

the residuals from the following regressions as our measures of abnormal accruals, which we denote as

AbnormalAccruals:

TotalAccrualsi;t a0 a1 DSalesi;t a2PPEi;t ei;t; 1

where TotalAccruals=earnings before extraordinary items and discontinued operations minus operating

cash flows from continuing operations (Compustat 123(308124)Ctotal assets (beginning of year), per

Hribar and Collins (2002)); D Sales=change in sales from year t1 to year tCtotal assets (beginning of

year); PPE=net property, plant and equipment as of year tCtotal assets (beginning of year).


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5.2. Regression analysisfull sample

We begin by regressing absolute abnormal accruals on control variables and audit

opinion type. This is essentially the reverse of theBartov et al. (2000)specification in

which audit opinion type (qualified or unqualified) is the dependent variable andabsolute abnormal accruals is an independent variable (along with control

variables). We estimate the model this way because institutional characteristics of

ARTICLE IN PRESS

Table 4

Descriptive statistics by audit opinion category (19941999)

Variable Unqualified

opinions

Going

concern

opinions

Material

uncertainty

opinions

Accounting

change

opinions

Other

modified

opinions

TotalAccrualst Mean 0.06 0.27 0.10 0.06 0.15

Median 0.05 0.20 0.04 0.05 0.10

AbnormalAccrualst Mean 0.01 0.14 0.03 0.02 0.06

Median 0.02 0.10 0.03 0.03 0.01

MktCapt Mean 2.06 1.10 1.84 2.30 1.65

Median 2.01 1.12 1.78 2.25 1.54

Book/Mktt Mean 0.57 0.31 0.49 0.61 0.46

Median 0.44 0.20 0.40 0.52 0.38

ROAt1 Mean 0.03 0.60 0.08 0.01 0.27

Median 0.04 0.32 0.03 0.04 0.03Debt/Assetst Mean 0.17 0.19 0.17 0.21 0.18

Median 0.11 0.07 0.12 0.18 0.11

CurrRatiot Mean 2.89 1.37 2.29 2.33 1.84

Median 2.03 0.79 1.76 1.74 1.29

Assetst Mean 920.75 91.02 530.16 1,579.02 561.54

Median 86.99 9.90 49.30 249.87 40.81

Big5t Mean 0.85 0.55 0.70 0.93 0.69

Observations 22,653 1,823 105 2,509 685

Observations are those firm-years from 1994 to 1999 for which adequate Compustat information is

available. For the modified audit opinion categories, observations are the 4,205 in Table 2; although,

instances of multiple classifications are now reflected in the above columns. These modified audit opinioncategories correspond to the categories in Table 3, with the following exceptions: Accounting Change

Opinion observations relate to the Consistencynon-restatement category in Table 3, and the other

opinion observations come from the qualified, consistencyrestatements, reliance on another auditor, and

related party transaction categories inTable 3.

Variables are defined as follows:

TotalAccruals=earnings before extraordinary items and discontinued operations minus operating cash

flows from continuing operations (Compustat 123(308124)Ctotal assets (beginning of year), perHribar

and Collins (2002)).

AbnormalAccruals=cross-sectional Jones (1991)abnormal accruals (Eq. (1)).

MktCap =Log(Market value of equity).

Book/Mkt=book value of equityCmarket value of equity.

ROA=income before extraordinary itemsCtotal assets (beginning of year).

Debt/Assets=long-term debtCtotal assets (beginning of year).

CurrRatio=current assetsCcurrent liabilities.

Assets=total assets (beginning of year).

Big5=one if a Big5 audit firm and zero otherwise.


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the audit process and our content analysis do not support a causal relation in which

earnings management leads to an audit opinion modification.17 Consistent with

Bartov et al., we control for market capitalization, book-to-market, profitability,

and leverage. Due to the characteristics of companies with GC opinions (seeTable 4), we also control for liquidity (CurrRatio). In addition, to consider the non-

linear relation between performance and abnormal accruals, as described byKothari

et al. (2003), we include ROA2t1 in addition to ROAt1: 18 To lessen the effect of

outliers, we winsorize extreme observations for all variables by setting the values in

the bottom and top 1% of observations of each measure to the values of the 1st and

99th percentiles of their respective distributions.19

jAbnormalAccrualsji;t b0 b1 MktCapi;tb2 Book=Mkti;t b3 ROAi;t1

b4 ROA

2

i;t1 b5 Debt=Assetsi;t b6 CurrRatioi;tb7 Big5i;t b8 Modifiedi;t ei;t; 2a

where

AbnormalAccruals =cross-sectionalJones (1991)abnormal accruals (Eq. (1)).

MktCap =Log10 (Market value of equity).

Book/Mkt =book value of equityCmarket value of equity.

ROA =lagged income before extraordinary itemsCtotal assets (begin-

ning of year).

ROA2 =square ofROA.Debt/Assets =long-term debtCtotal assets (beginning of year).

CurrRatio =current assetsCcurrent liabilities.

Big5 =one if a Big5 audit firm and zero otherwise.

Modified =one if opinion is qualified or unqualified with explanatory

language and zero otherwise.

To consider the effects of the specific type of audit opinion modification, we

augment Eq. (2a) by replacing the Modifiedvariable with variables corresponding to

the audit opinion categories inTable 4:

jAbnormalAccrualsji;t b0 b1 MktCapi;tb2 Book=Mkti;t b3 ROAi;t1

b4 ROA2i;t1 b5 Debt=Assetsi;t b6 CurrRatioi;t

b7 Big5i;t b8 GoingConcerni;t

b9 MatUncerti;t b10 AcctChangei;t

b11 OtherModifiedi;t ei;t; 2b

ARTICLE IN PRESS

17Following Bartov et al. (2000) we also estimate logit models. Inferences are unchanged (see

Section 5.4).18The inclusion of this variable, the squared of lagged ROA, has no effect on the papers inferences.19As an additional sensitivity test, we exclude outliers per Belsley et al. (1980). This data trimming

increases the regressions explanatory power but, again, has no effect on inferences.


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where

GoingConcern =one if opinion is unqualified with explanatory language pertain-

ing to going concern status, bankruptcy, or material businessuncertainty, and zero otherwise.

MatUncert =one if opinion is unqualified with explanatory language pertain-

ing to a material uncertainty (e.g., asset realization or contingent

liability), and zero otherwise.

AcctChange =one if opinion is unqualified with explanatory language pertain-

ing to lack of consistency not requiring restatement, and zero

otherwise.

OtherModified =one if opinion is qualified (scope limitations or GAAP departure)

or unqualified with explanatory language pertaining to lack of

consistency requiring restatement or reliance on another auditor or

related party transactions and zero otherwise.

The first two columns ofTable 5present the results of these regressions. Results in

the first column, where the coefficient onModifiedis positive and significant, support

Bartov et al.s (2000) contention that modified audit opinions are positively

associated with the magnitude of abnormal accounting accruals. However, results in

column two demonstrate that the positive coefficient on Modified stems primarily

from companies with GC opinions. Companies with material uncertainty opinions

also have larger absolute abnormal accruals. However, as Table 3 shows, mostmaterial-uncertainty opinions arise from litigation risk, suggesting that income-

increasing earnings management is unlikely.

Next, given the findings of Bradshaw et al. (2001) that firms with modified

(unclean) opinions have more negative working capital accruals, we change the

dependent variable in Eqs. (2a) and (2b) from absolute abnormal accruals to signed

abnormal accruals:

AbnormalAccuralsi;t b0 b1 MktCapi;tb2 Book=Mkti;t b3 ROAi;t1


b7 Big5i;t b8 Modifiedi;t ei;t; 3a

AbnormalAccrualsi;t b0 b1 MktCapi;tb2 Book=Mkti;t b3 ROAi;t1


b7 Big5i;t b8 GoingConcerni;tb9 MatUncerti;t

b10 AcctChangei;t b11 OtherModifiedi;tei;t: 3b

The last two columns ofTable 5present the results of these regressions. As column

three shows, companies with modified opinions have significantly more negative

abnormal accruals than companies with unqualified opinions. Column four showsthat the negative coefficient on Modified stems from firms with GoingConcern

opinions. Therefore, even after controlling for other factors, the association between

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modified opinions and abnormal accruals is due to the large negative (i.e., income-

decreasing) accruals of companies with GC opinions. We also find that MatUncert

(AcctChange) firms have more negative (positive) abnormal accruals than firms with

ARTICLE IN PRESS

Table 5

OLS on absolute value and signed abnormal accruals (full sample)

jAbnormalAccruals i;t j b0 b1 MktCapi;t b2 Book=Mkti;t b3 ROAi;t1b4 ROA2i;t1 b5 Debt=Assetsi;t

b6 CurrRatioi;t b7 Big5i;t b8 Modifiedi;t ei;t; 2a

jAbnormalAccruals i;t j b0 b1 MktCapi;t b2 Book=Mkti;t b3 ROAi;t1b4 ROA2i;t1 b5 Debt=Assetsi;t

b6 CurrRatioi;t b7 Big5i;t b8 GoingConcerni;t b9 MatUncerti;t

b10 AcctChangei;t b11 OtherModifiedi;t ei;t; 2b

AbnormalAccruals i;t b0b1 MktCapi;t b2 Book=Mkti;t b3 ROA i;t1 b4 ROA2i;t1b5 Debt=Assetsi;t

b6 CurrRatioi;t b7 Big5i;t b8 Modifiedi;t ei;t; 3a

AbnormalAccruals i;t b0b1 MktCapi;t b2 Book=Mkti;t b3 ROA i;t1 b4 ROA2i;t1b5 Debt=Assetsi;t

b6 CurrRatioi;t b7 Big5i;t b8 GoingConcerni;t b9 MatUncerti;t

b10 AcctChangei;t b11 OtherModifiedi;t ei;t: 3b

Variables Eq. (2a) Eq. (2b) Eq. (3a) Eq. (3b)

Constant 0.204 0.191 0.024 0.046

(73.98)a (67.12)a (6.72)a (12.29)a

MktCap 0.025 0.022 0.003 0.008(26.58)a (23.09)a (2.25)b (6.22)a

Book/Mkt 0.033 0.030 0.007 0.013

(25.17)a (22.50)a (4.10)a (7.29)a

ROA 0.074 0.061 0.129 0.108

(21.12)a (17.26)a (28.01)a (23.32)a

ROA2 0.011 0.009 0.025 0.022

(9.12)a (7.24)a (15.87)a (13.59)a

Debt/Assets 0.054 0.051 0.012 0.008

(13.89)a (13.24)a (2.39)b (1.53)

CurrRatio 0.033 0.030 0.006 0.005

(25.17)a (22.50)a (16.66)a (14.53)a

Big5 0.003 0.002 0.006 0.012

(11.46)a (9.66)a (1.91)c (4.19)a

Modified 0.014 0.039

(7.03)a (14.48)a

GoingConcern 0.060 0.113

(18.07)a (25.79)a

MatUncert 0.024 0.041

(2.05)a (2.64)a

AcctChange 0.014 0.008

(5.49)a (2.36)a

OtherModified 0.005 0.007

(1.13) (1.16)Observations 27,219 27,219 27,219 27,219

Adjusted R2 12.2% 13.2% 6.5% 8.2%


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clean opinions, although the association between abnormal accruals and these

opinion types is not nearly as economically nor statistically significant as the GC-

accrual association.

Overall, these findings suggest that Bartov et al.s (2000) results stem from

firms with GC opinions. That is, the positive relation between modified opinions

and the magnitude of accruals relates primarily to companies receiving GC

opinions, which have large negative accruals. These findings are also inconsistentwith the explanation for the opinion/accruals relation in Francis and Krishnan

(1999). Francis and Krishnan argue that larger, higher-quality auditors assess high-

accrual firms as inherently more riskybecause managers of such firms are more

likely to have exercised discretionand, as a result, adjust opinion materiality

thresholds downward. However, this implies that the signed abnormal accruals

regressions for firms with modified opinions should be positive, not negative as our

results show.

These findings highlight the importance of testing both signed and absolute

abnormal accruals. If, as in this setting, absolute abnormal accruals are dominated

by one side of the distribution (i.e., negative or positive abnormal accruals),inferences likely differ from the case in which absolute abnormal accruals are larger

but symmetric.

ARTICLE IN PRESS

t-Statistics are in parentheses. Observations are all firm-year observations from 1994 to 1999 with

adequate Compustat information.Variables are defined as follows:


MktCap=Log10(Market value of equity).



ROA2=square of ROA.




Modified=one if opinion is qualified or unqualified with explanatory language and zero otherwise.

GoingConcern=one if opinion is unqualified with explanatory language pertaining to going-concern

status, bankruptcy, or material business uncertainty and zero otherwise.MatUncert=one if opinion is unqualified with explanatory language pertaining to a material uncertainty

(e.g., asset realization or contingent liability) and zero otherwise.

AcctChange=one if opinion is unqualified with explanatory language pertaining to lack of consistency not

requiring restatement and zero otherwise.

OtherModified=one if opinion is qualified (scope limitation or GAAP departure) or unqualified with

explanatory language pertaining to lack of consistency requiring restatement or reliance on another

auditor or related party transactions and zero otherwise.aSignificant beyond the 1% level (two-sided tests).bSignificant beyond the 5% level (two-sided tests).cSignificant beyond the 10% level (two-sided tests).

Table 5 (Continued)


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5.3. Why do GC firms have extremely negative abnormal accruals?

Several studies show that abnormal accruals are non-zero for firms with extreme

performance (e.g.,Dechow et al., 1995;Kothari et al., 2003). In particular, abnormalaccruals are more negative (positive) for firms with extreme poor (good)

performance. These studies show that accrual models tend to overreject the null of

zero abnormal accruals. Given that financial distress is essentially a necessary

condition for observing a GC opinion (Hopwood et al., 1994) and that certain

financially troubled firms have large negative accruals (DeAngelo et al., 1994),

companies with GC opinions are likely to have more extreme negative accruals. That

is, GC companies likely have negative accruals due to poor performance.

For example, financially distressed firms often face liquidity constraints that force

them to reduce non-cash net working capital to survive. It is also likely that these

firms have non-performing assets that they are required to write off under GAAP.

To the extent that conventional accrual models do not account for the accrual

consequences of distress due to liquidity-related transactions, these accruals will be

misclassified as discretionary. This misspecification is likely a significant source of

the association between modified opinions and conventional estimates of abnormal

accruals.

As Table 4 shows, there are marked differences between companies with GC

opinions and other firms, whether they receive other types of modified opinions or

standard, unqualified opinions. In particular, GC firms are experiencing extremely

poor performance. To determine whether the abnormal accruals of GC firms arereliably negative we follow Kothari et al.s (2003) performance-matching

approach.20 In a study of the statistical properties of discretionary accrual models,

Kothari et al. advocate matching to control for the impact of firm performance on

accruals. They demonstrate that performance matching leads to accrual-based tests

of earnings management that are well specified and powerful.

Given our unique sample, we consider two alternative measures of performance

for identifying a matched sample. First, as suggested by Kothari et al. (2003),

we use ROAt1 (i.e., lagged return on assets, or the ratio of prior-year income

before extraordinary items to total assets). Second, we use the probability of

bankruptcy constructed from Shumway (2001), which we label Distress. Asmentioned, GC firms tend to have more severe liquidity problems than other

firms. To survive, the GC firms are likely to engage in liquidity-enhancing

transactions which lead to large negative accruals but which do not necessarily

affect ROA (e.g., delaying payments to suppliers or factoring receivables).21 It is

therefore important to control for differences in liquidity as well as profitability.

ARTICLE IN PRESS

20Conditioning empirical analysis on financial distress is common in research on GC opinions (e.g.,

McKeown et al., 1991;Hopwood et al., 1994;Mutchler et al., 1997;Louwers, 1998).21Factoring receivables will likely have some impact on income but most of the related accrual will not.

For example, suppose a firm factors receivables with a book value of $100 at a price of $90. The firm will

record a negative accrual of $100 but only $10 of it will be reflected on the income statement.


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Consistent with this reasoning, Distressis more effective than ROAt1 for matching

in our sample.22

Our matching procedure is as follows. We construct a dataset from the merged

Compustat database that contains firms with unqualified opinions (withoutexplanatory language) and sufficient data to compute our performance measures,

abnormal accruals, and the regression covariates. Then, for each newly initiatedGC

opinion observation (e.g., a GC opinion in year t, but not in t1), we identify that

observation in the matched group with the closest performance (i.e., either ROAt1or Distress). In other words, control firms are matched on year, industry, auditor

type, and a measure of performance. This procedure yields a sample size of 1,052:

526 firms with first-time GC opinions and 526 control firms with standard,

unqualified opinions. Using this matched sample, we estimate the following

regression:

AbnormalAccrualsi;t b0 b1 MktCapi;tb2 Book=Mkti;t

b3 ROAi;t1 b4 ROA2i;t1

b5 Debt=Assetsi;t b6 CurrRatioi;t

b7 Distressi;t b8 Big5i;t b9 GoingConcerni;t

b10 Big5GoingConcerni;t ei;t; 4

where

Distress =bankruptcy probability perShumways (2001) Table 4b hazard

model (1(1/exp(7.8116.307Net Income/Total As-

sets+4.068Total Liabilities/Total Assets0.158Current Assets/

Current Liabilities+0.307Ln (Company Age))).

Big5

Going Concern

=one if a Big5 audit firm issued the GoingConcern opinion and

zero otherwise.

We add the term interacting Big5 and GoingConcern opinions to consider an

alternative explanation to performance. An alternative explanation for companies

with GC opinions having large negative accruals is that auditors, in response toheightened litigation risk, impose a higher level of conservatism on companies to

which they render GC opinions (DeFond and Subramanyam, 1999). Given that

larger audit firms are perceived to provide increased coverage (i.e., deeper pockets) in

the event of securities litigation (Arthur Andersen et al., 1992), one test of this

explanation is to examine whether income-decreasing accruals vary by audit firm

type. Evidence that abnormal accruals are more negative for GC companies audited

by the Big5 than for those audited by the non-Big5 would support the auditor

conservatism explanation. If accruals are not different for Big5 versus non-Big5

audited GC companies or if accruals are more negative for GC companies audited by

ARTICLE IN PRESS

22The mean and median values of ROA, current ratio, book-to-market and size of the sample matched

on distress are much closer to the GC sample than the sample matched on lagged ROA.


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the non-Big5, then the relation between accruals and troubled firms is less likely due

to auditor conservatism.

Column one ofTable 6provides the results of estimating Eq. (4) for this sample of

companies with first-time GC opinions and a control sample matched on year,auditor, industry, and ROAt1: As in column four of Table 5, the coefficient forGoingConcernis negative and statistically significant (beyond 0.001).23 That is, firms

with GC opinions have negative abnormal accruals compared to a matched sample

of firms with similar prior-year ROA, even after controlling for other factors

associated with abnormal accruals and GC opinions. The coefficient for

Big5GoingConcern is positive and thus does not support a differential auditor

conservatism explanation. Of course, it is possible that auditor conservatism is

important, but equally so across audit firm types. As with the Table 5 regression,

inferences are robust to considering the effects of influential observations perBelsley

et al. (1980).24

Column two of Table 6 reports the results of estimating Eq. (4) using the

alternative control sample matched on Distress (Shumway, 2001). For this

regression, the coefficient on GoingConcern is not significantly different from zero,

suggesting that the GC opinion itself is neither the cause nor the result of abnormal

accruals. Instead, firms in financial distress likely have more negative accruals due to

poor performance and transactions arising to meet liquidity needs (e.g., delaying

payables and factoring receivables). Again, the coefficient on Big5GoingConcern is

positive. This is further evidence that auditor conservatism does not explain the

relation between abnormal accruals and GC opinions.

5.4. Adopting Bartov et al.s (2000) empirical design

Based on our analysis of a large sample of firms receiving modified opinions

between 1994 and 1999, we conclude that the relation between accruals and modified

opinions is not due to earnings management but is instead driven by firms receiving

ARTICLE IN PRESS

23We adopt an alternative form of Kothari et al.s (2001) method. Following their specific technique, the

sample size is halved and the variable of interest is the intercept. In our context, the intercept captures the

change in abnormal accruals for a firm with a first-time GC opinion compared to a firm in the same

industry, audited by the same type of auditor with the closest lagged ROA (or distress). This method yields

results similar to those reported.24We conduct additional robustness checks. First, following Hribar and Collins (2002),we exclude 359

firms with assets below $10 million to assess whether the inverse relation between GC opinions and

abnormal accruals stems from extremely small firms. However, when we rerun the Eq. (4) regression, the

GoingConcern coefficient remains significantly negative. Second, we estimate total accruals using a balance

sheet approach in which total accruals are the change in non-cash current assets minus change in non-debt

current liabilities minus depreciation expense. We also estimate abnormal accruals using the modified

Jones model (Dechow et al., 1995). In both cases, the GoingConcern coefficient remains significantly

negative. Finally, we transform AbnormalAccrualsinto unscaled levels, add assets (i.e., the former deflator)

as an independent variable, and adjust standard errors perWhite (1980)(seeBarth and Kallapur, 1995).

The coefficient on GoingConcern is again significantly negative.


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GC opinions. As DeAngelo et al. (1994) find in their study of loss firms that cut

dividends, we find that troubled firms with GC opinions have large negative,

performance-related accruals. Thus, the results of past research, in particularBartov

et al. (2000), seem to be explained by poor performance rather than, as they imply,aggressive accounting. However, there are several important differences between our

empirical design and that of Bartov et al.: (1) matching procedures used to obtain

control samples differ; (2) right-hand-side control variables differ; and (3) regression

specifications of the association between abnormal accruals and audit opinions differ

(Bartov et al. use a logit specification with the presence of a qualified opinion as the

dependent variable). In this section, we assess the sensitivity of our results to these

differences.

Following Bartov et al., we identify those firms in our sample with a newly

initiated modified opinion (i.e., a modified opinion in year t, but not t1) that we

ARTICLE IN PRESS

Table 6

OLS on signed abnormal accruals (first-time GC opinion and performance-matched samples)

AbnormalAccruals i;t b0 b1 MktCapi;t b2 Book=Mkti;t b3 ROA i;t1 b4 ROA2i;t1 b5 Debt=Assetsi;t b6 CurrRatioi;t

b7 Distressi;t b8 Big5i;t b9 GoingConcerni;t b10 Big5GoingConcerni;t ei;t; 4

.

Variable Eq. (3c) with match

on lagged ROA

Eq. (3c) with match

ondistress

Constant 0.058 0.070

(2.43)b (2.32)b

MktCap 0.032 0.019

(2.82)a (1.33)

Book/Mkt 0.020 0.003

(2.25)b (0.24)

ROA 0.007 0.010

(0.32) (0.51)

ROA2 0.005 0.002

(1.18) (0.62)

Debt/Assets 0.054 0.028

(1.74)c (0.71)

CurrRatio 0.009 0.014

(3.50)a (4.54)a

Distress 0.003 0.003

(12.41)a (12.29)a

Big5 0.002 0.031

(0.07) (1.14)

GoingConcern 0.115 0.021

(4.70)a (0.73)

Big5GoingConcern 0.040 0.061

(1.35) (1.71)c

Observations 1,052 1,052

Adjusted R2 22.6% 15.8%


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match on year, industry, auditor type, and assets (i.e., size-matching on assets, notperformance-matching onROAt1 or Distress) to construct our control sample. This

approach yields a sample size of 2,236: 1,118 firms with newly initiated modified

opinions (of which 523 are GCs) and 1,118 control firms with standard, unqualified

opinions. We then add a new regressor, Perform, that Bartov et al. specify to

capture extreme earnings performance and estimate the following logistic

regression:

1 if Modifiedi;t

0 Otherwise

) b0 b1 MktCapi;t b2 Book=Mkti;t b3 Debt=Assetsi;t

b4 Performi;t b5 jAbnormalAccrualsji;t ei;t; 5

where

Perform =absolute value of the change in income from continuing operations

Ctotal assets (beginning of year).

Table 7reports the results of estimating Eq. (5) with various sub-samples. Column

one, which includes the entire sample of 2,236 observations, is consistent with

column one ofTable 5andBartov et al. (2000). Abnormal accruals are greater for

firms that receive a modified audit opinion. However, columns two and three ofTable 7show that this association stems from companies with GC opinions. Column

two replicates the logistic regression only for companies with GC opinions (and their

ARTICLE IN PRESS

t-Statistics are in parentheses. Observations are all companies with newly-initiated GoingConcernopinions

(e.g., a GC in year t, but not t1) from 1994 to 1999 matched with a clean-opinion company on year,

industry, auditor type and either closest lagged ROA (Kothari et al., 2001) or closest contemporaneous

Distress(Shumway, 2001). All observations must have adequate Compustat information.

Variables are defined as follows:


MktCap=Log10(Market value of equity).



ROA2=square of ROA.



Distress=bankruptcy probability per Shumways (2001) Table 4b hazard model (1

(1/exp(7.8116.307

Net Income/Total Assets+4.068

Total Liabilities/Total Assets0.158

CurrentAssets/Current Liabilities+0.307Ln(Company Age))).


GoingConcern=one if opinion is unqualified with explanatory language pertaining to going-concern

status, bankruptcy or material business uncertainty and zero otherwise.

Big5GoingConcern=one if a Big5 audit firm issued the GoingConcern opinion and zero otherwise.aSignificant beyond the 1% level (two-sided tests).bSignificant beyond the 5% level (two-sided tests).cSignificant beyond the 10% level (two-sided tests).

Table 6 (Continued)


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reported in Table 7 using a balance sheet measure of total accruals (as in Bartov

et al.) and results are qualitatively similar.25

6. Conclusion and implications

6.1. Conclusion

We conduct a large-sample study of the relation between audit opinions and

abnormal accruals, after taking into account the variation in the types of

modified-opinions auditors render. Our particular interest is assessing whether

such opinions are a function of earnings management (i.e., whether observable

auditing judgments proxy for the exercise of managerial discretion). In other

words, does it seem that managers of companies receiving modified opinions are

more likely to have managed earnings than managers of companies receiving clean

opinions?

Consistent with our understanding of audit procedures and standards, we find no

evidence that auditors use their opinions to alert financial statement users of either

excessive earnings management or the consequences of high positive accruals. In

particular, based on our content analysis of modified audit opinions, we demonstrate

that few firms receive opinion qualifications for scope limitations or departures from

GAAP and that the opinions of those who do bear no literal or discernible relation

to income-increasing earnings management.We find that the modified opinion/abnormal accruals relation stems from

companies with going-concern opinions, because such companies have negative

abnormal accruals. Our findings are inconsistent with earnings-management and

auditor-conservatism explanations for the audit opinion/abnormal accruals relation.

Importantly, we demonstrate that the negative accruals of companies with GC

opinions are no different from a matched sample of companies experiencing similar

severe financial distress.

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25 In addition to these differences, our EDGAR-based sample period is from 1994 to 1999, whereas

Bartov et al. study the period from 1980 to 1997. To assess whether our main results are robust to

considering these different time periods, we randomly sample 1,000 firm-year observations from a pre-SAS

58 period (19801987) where Compustat flags the firm as having a qualified audit opinion (i.e., code 2).

Based on Bartov et al.s description of their sample selection procedure, the majority of their observations

are likely from this time period. As Table 2 shows, qualified audit opinions were far more common

during the pre-SAS 58 regime; however, during this time period, a qualified opinion was appropriate for

scope limitations, GAAP departures, lack of consistency, and material uncertainties (e.g., asset realization,

going concern, and contingent liabilities). We obtain 743 of these 1,000 firm-year observations from either

the NAARS database or the microfiche collection at the University of Rochester library. We eliminate 38

(5.1%) observations because they are unqualified opinions, resulting in a sample size of 705. Of these 705,

104 are newly initiated qualifications of which 54 are GC qualifications and 50 are non-GC qualifications.

We then rerun the Eq. (5) regressions for these observations (and their matched counterparts) and obtain

results consistent with those inTable 7.


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6.2. Implications for earnings-management research relating to audit opinions

Our findings have implications for research that attributes the audit opinions/

accounting accruals relation to more-pervasive earnings management. Becauseauditing is thought to reduce agency costs, several papers assert that certain

types of modified audit opinions are (or should be) a function of accounting

accruals. Francis and Krishnan (1999) provide evidence suggesting that

larger, higher-quality auditors assess high-accrual firms as inherently more risky

because managers of such firms are more likely to have exercised discretionand,

as a result, adjust their asset realization and GC opinion materiality

thresholds downward. We show that the audit opinions/accounting accruals

association is reliably negative, yet that it dissipates upon matching on distress

and controlling for other factors associated with accruals. This suggests that the

conditions that lead to a GC opinion are contemporaneously associated with

the conditions that lead to income-decreasing accruals (i.e., both the opinion and the

accruals are consequences of the firm being financially distressed) and that no

causality should be inferred.

Bartov et al. (2000) compare the power of various accrual models in detecting

earnings management under the assumption that firms receive certain modified

opinions because they engage in extreme earnings management. Our findings

suggest that the relation between opinion type and abnormal accruals is due

not to earnings management, but instead to model misspecification. This implies

that the models that Bartov et al. (2000) recommend as having the mostpowercross-sectional Jones and cross-sectional Modified Jonesare the

models that suffer most from misspecification because they are most prone to

picking up distress-related accruals and hence are more confounded by

financial distress than other accruals models. As such, differences in the power

of models they report are likely to be measures of relative misspecification,

not power.

With respect to Bradshaw et al. (2001), we help to distinguish between certain

explanations they offer for the surprisingly (p. 68) negative relation

between working capital accruals and unclean audit opinions. They are unable

to distinguish their explanations because they do not have details on theunderlying cause of the modified (unclean) opinion. One explanation they offer is

that auditors ... lack the necessary sophistication to understand the future

implications of high levels of accruals (p. 46) or that ... auditors interpret

the higher earnings associated with higher accruals as a positive sign, and are

less likely to issue modified opinions in such cases (p. 68). Our findings are

consistent with another of their explanations: that the role of auditors is

not to modify their opinions based on an assessment about the quality of earnings

as measured by accruals (i.e., they may understand the implications of inflated

accruals, ... but are not to communicate this information to investors through their

audit opinions (p. 46)). As our description of the audit process and our contentanalysis imply, auditors are unlikely to issue modified opinions for earnings-

management reasons.

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6.3. Implications for earnings-management research in general

Our findings also have broader implications for earnings-management research.

For one, as noted, GC companies can substantially impact abnormal accrualcalculations. For another, studies often use absolute abnormal accruals as a measure

of earnings management. Our results suggest that using absolute value may mask the

source of abnormal accruals. If absolute abnormal accruals are large because

accruals are especially positive or negative, inferences likely differ from the case in

which absolute abnormal accruals are large but accruals are more symmetric.

Finally, our findings lend some support to the importance of performance matching

when the companies of interest are experiencing extreme performance. In our case of

extreme poor performance, matching on contemporaneous distress more effectively

captures accrual-sensitive differences in performance than matching on lagged ROA.

This is likely because matching on distress captures the negative accruals associated

with poor operating performance as well as the negative accruals arising from

liquidity-motivated transactions (e.g., delaying payables and factoring receivables).

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