International Journal of Auditing Int. J. Audit. 7: 71–85 (2003)
Audit Qualification, Firm Litigation, and Financial Information: an Empirical Analysis in Greece Charalambos T. Spathis Aristotle’s University of Thessaloniki, Greece
In this study, we test the extent to which combinations of financial and non-financial information can be used to enhance the ability to discriminate between the choices of a qualified or unqualified (clean) audit report. We examined the financial statements, the opinions of the auditors, and the notes to financial statements for companies that received a qualified audit report and for those that received an unqualified audit report. The data are taken from a sample of 100 Greek companies. Logistic and OLS regression models were estimated to assess the effect of firm litigation and financial information on audit qualification opinion. The qualification decision is associated by financial information such as financial distress and by non-financial information such as firm litigation. The model developed is accurate in classifying the total sample correctly with rate 78%. This study has implications for internal and external auditors and company decision makers. Key words: audit opinion, audit report, audit qualification, firm litigation, financial statements, financial information, Greece.
SUMMARY In this study, we test the extent to which combinations of financial and non-financial information can be used to enhance the ability to discriminate between the choices of a qualified or unqualified (clean) audit report. Several models have been developed to explain qualifications in audit reports. The general consensus of these models has been that financial and non-financial factors dominate the audit opinion decision. In the USA, the Statement of Auditing Standards (SAS) Correspondence to: Aristotle’s University of Thessaloniki, Department of Economics, Division of Business Administration, 540 06 Thessaloniki, Greece. Email:
[email protected]
No. 59 provides guidance for auditors to provide more critical evaluations to identify the possibility of qualifications problems. It identifies the conditions that an auditor should consider in evaluating going-concern status. These conditions include financial problems and operating problems. The standards also provide guidance on two other types of information, negative trends (operating losses) and other indicators, including internal matters, e.g., losses, and external matters (legal proceedings). For the most part, prior studies have not used any other qualitative variable(s) as indicators when developing audit opinion models. These qualitative indicators of potential solvency problems indicate year’s losses and bad news characteristics, as firm litigation. The
ISSN 1090–6738 © Blackwell Publishing Ltd 2003. Published by Blackwell Publishing, 9600 Garsington Road, Received February 2002 Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. Accepted October 2002
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importance of these other qualitative indicators (firm litigation) in the auditor’s decision has not been tested. The objective of the study was to develop a model based on financial information and other indicators, such as firm litigation, to explain qualifications in audit reports of Greek companies. The model will provide information on the likelihood of a company’s receiving a qualification given its financial data and firm litigation data. This kind of model can serve as a decision aid for auditors when predicting what opinion other auditors would issue in similar circumstances, when evaluating potential clients, in determining the scope of an audit for existing clients, in peer reviews, to control quality within firms, and as a defence in lawsuits. Univariate tests (t-tests and chi-squared tests) and logistic and OLS regression methods are used to identify audit qualification opinion of Greek firms. The sample of a total of 100 manufacturing firms includes 50 with qualifications and 50 without qualifications. The results clearly indicate that firm litigation, financial distress and current year losses are the major indicators of audit qualification opinion. The two models of logistic regression are accurate in classifying the total sample correctly with accuracy rates of approximately 78% and 75%. These results suggest there is potential in detecting qualified audit reports through analysis of publicly available financial statements and firm litigation data. For the first time the variable of firm litigation has been examined using empirical evidence and has been found significant. This study tested whether, in the presence or absence of financial distress, non-financial data play an important role in auditors’ opinions. The proposed methodological framework could be of assistance to auditors, both internal and external, to taxation and other state authorities, individual and institutional investors, stock exchanges, law firms, financial analysts, credit scoring agencies and to the banking system.
1. INTRODUCTION References to audit qualification opinion are increasingly frequent over the last few years. The qualified audit report includes auditors’ opinions that are classified as having (a) a material but not fundamental effect upon the financial statements and (b) a fundamental effect upon the financial © Blackwell Publishing Ltd 2003
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statements. ‘Fundamental’ means that the matter is such as to seriously distort or undermine the view given by the financial statements to the extent that they could mislead user groups. Most qualifications of financial statements in Greece are of the ‘except for’ type of qualification that is given when the matter is a material but not fundamental uncertainty or disagreement. Some qualifications are of the ‘adverse’ type of opinion, indicating that the financial statements do not give a true and fair view. This type of opinion is given when the matter concerned gives rise to a fundamental disagreement. This paper intends to address this need in the existing literature. For this purpose (a) univariate tests and (b) logistic and OLS regression methods are used to identify audit qualification opinion of Greek firms. Factors used as possible indicators of audit opinion include firm litigation, financial distress, audit risk, and liquidity. The models were developed with a high probability of detecting qualifications in the sample and include the variables: firm litigation, financial distress and loss. This study has implications for auditors internal and external, company decision makers, investors, financial analysts and researchers. It helps company management understand how auditors evaluate their clients and the importance of the financial and non-financial factors used in their evaluation. It can also be used to predict the most probable outcome ahead of the external audit. The paper is organised as follows: the second section reviews research on qualified audit reports carried out up to now. The third section underlines the methodologies employed, the variables, the method and the data used in the present study. The fourth section describes the empirical results and discussion obtaining from the use of univariate tests and multivariate analyses. Finally, the fifth section presents conclusions and implications.
2. PREVIOUS RESEARCH The information contained in audit reports has been subject to increasing academic and political interest in Greece, as in most Western countries. Auditing has a role in reducing agency problems stemming from the separation of management and control and the lender-borrower conflict. The theory suggests that as agency costs increase; there is a demand for higher quality audits either voluntarily undertaken by the managers or Int. J. Audit. 7: 71–85 (2003)
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externally imposed by stockholders or creditors (Watts & Zimmerman, 1986). In Greece, the public has been consistent in its demand for qualified opinions as warning signals of business failure. The 1992 liberalization made the Greek statutory audit market available to the Big Six and the second-tier international firms. The competition between the local Greek audit firms and foreign audit firms has been increased. For an extensive analysis of the Greek audit market see Citron and Manalis (2001) and Caramanis (1999). The debate has mainly dealt with the question as to whether audit reports give a fair and true view of the economic situation of the company for decision-making by various interest groups (Laitinen & Laitinen, 1998). In Greece, the qualification of financial statements has lately been brought more into the limelight in connection primarily with the increase in the number of companies listed on the Athens Stock Exchange and the raising of capital through public offering. The years 2000–01 have been very difficult for the Greek stock market, which has suffered from stagnation both in terms of share prices and liquidity. This fact, along with the recent pervasive record of qualified financial statements, raised the interest of the authorities, stock market, Ministry of the Economy, analysts and the banking sector in early-warning systems. The issue of False Financial Statements (FFS) was examined by Spathis et al. (2002) who suggest an innovative classification methodology that detects the firms, which issue FFS, and identifies the factors associated with FFS. In this context, the absence of a Greek study on the subject of audit opinion decision is striking. The general purpose of the present study is to analyse qualified audit reports of publicly listed Greek firms and to show the circumstances in the company’s economic situation which lead to the qualification. A model for audit qualification opinion is proposed. The prior studies on audit opinion information relevant to the present study are discussed.
2.1. Audit opinion as predictor Audit report information has been used to construct bankruptcy prediction models. Keasey and Watson (1987) showed through stepwise logistic models that marginally better predictions of small company failure might be obtained from non-financial audit information (prior years’ qualification, current year qualification) than from © Blackwell Publishing Ltd 2003
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using traditional financial ratios. Hopwood et al. (1989) investigated the usefulness of the audit opinion (consistency exception, i.e. opinion is related to voluntary and non-LIFO-related accounting change, subject to opinion and goingconcern opinion) in providing incremental explanatory power for bankruptcy. Their log-linear approach showed that the consistency exception and going-concern opinion had incremental explanatory power beyond financial ratios. Sundgren (1998) has shown that audit reports include only marginal additional information over financial ratios in bankruptcy prediction. Bankruptcy prediction models have been constructed to help in making audit qualifications. Koh and Killough (1990) constructed a failure prediction model using stepwise multiple discriminant analysis based on twenty-one financial ratios and demonstrated its use in making going-concern judgements. Koh (1991) compared the predictions of a probit bankruptcy prediction model based on six financial ratios and the assessment of auditors on the going-concern status. The statistical model outperformed auditors in making going-concern assessments and can thus be useful to auditors in assessments. The standard agency cost model portrays the role of the auditor as a monitoring mechanism to reduce agency costs. Agency costs include managers’ incentives to manage earnings. Kinney and Martin (1994) reviewed nine studies and concluded that auditing reduces positive bias in pre-audit net earnings and net assets. Hirst (1994) also demonstrated that auditors are sensitive to earnings manipulations through both income-increasing accruals and income-decreasing accruals, and that they are able to detect management incentives to manipulate earnings. The association between discretionary accruals and audit qualifications were examined to detect earnings management. Results from contingencytable tests suggest that the modified-Jones model, the cross-sectional Jones model and the crosssectional modified-Jones model are successful in identifying an association between audit qualifications and discretionary accruals (Bartov et al., 2001). Tests involving the association between audit qualifications and stock returns indicate that investors perceive qualified audit reports as informative. Dopuch et al. (1986), Choi and Jeter (1992), and Louder et al. (1992) all reported negative stock price reactions to audit qualifications. Frost (1997) examines discretionary Int. J. Audit. 7: 71–85 (2003)
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disclosures and stock price effects for firms that received first-time modified audit reports. The results indicate that these firms’ managers are forthcoming about adverse developments and appear to perceive the advantages of withholding negative news to be minimal. Managers of many of the stressed firms make disclosures about expected future performance that is overly optimistic relative to financial outcomes. As expected, stock market participants discount these firms’ positive tone disclosures.
2.2. Audit qualification opinion Several models have been developed to explain qualifications in audit reports. The general consensus of these models has been that financial and non-financial factors dominate the audit opinion decision. In the USA, the Statement of Auditing Standards (SAS) No. 59 provides guidance for auditors to provide more critical evaluations to identify the possibility of qualifications problems. It identifies the conditions that an auditor should consider in evaluating going-concern status. These conditions include financial problems (specifically short-term liquidity, solvency and debt capacity) and operating problems (profitability and ability to generate cash from operations). The standards also provide guidance on two other types of information, negative trends (operating losses) and other indicators, including internal matters, e.g. losses, and external matters (legal proceedings). Dopuch et al. (1987) investigated the extent to which models based on financial and market variables predict auditors’ decisions to issue qualified audit reports. They developed a probit model with independent variables representing publicly available financial and market variables. The results showed that the most significant variables in qualification prediction are current year loss, industry return (per cent) and the change in the ratio of total liabilities to total assets. Of three qualification types, the going-concern opinion had the highest accuracy rate in prediction. Keasey et al. (1988) used the logistic analysis based on 12 financial and non-financial variables to explain qualification in small companies. Their results showed that the likelihood of a company receiving a qualified audit report was significantly greater if a large firm of accountants had audited the company, if the company had few directors, few non-director shareholders, a secured loan, and if © Blackwell Publishing Ltd 2003
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there was a long lag between the auditing year-end and the signing of audited accounts. Most of the studies that developed models to understand the auditor’s going-concern opinion used financial ratios as predictors. The rationale for this is that, as Asare (1990) noted, going-concern opinions can be predicted successfully using financial variables. Mutchler (1985), for example, was able to classify 83 per cent of her sample using financial variables. The ratios used in these models vary from a minimum of five (Kida, 1980) to a maximum of fourteen (Cormier et al., 1995). Most studies focused purely on financial variables as indicators, with only Chen and Church (1992), Goodman et al. (1995), and Mutchler et al. (1997) using non-financial variables. Chen and Church incorporated default status, a company defaulting on debt, as an additional indicator. They found that while financial variables were important, default status is also a significant variable that can explain the auditor’s choice. Chen and Church found that adding a default status variable to an opinion decision model containing only financial variables increased the predictive accuracy of their model from 38% to 93%, thus indicating the importance of this variable. Goodman et al. (1995) conducted a survey among auditors asking them to refer to their working papers. They incorporated 11 non-financial and seven financial variables in their study. The non-financial information comprised auditors’ responses to judgements that were measured on a five-point Likert-type scale. The purpose of these questions was to measure auditors’ perceptions of the quality of clients’ management in terms of their capability. They found that particular combinations of specific non-financial data could accurately discriminate between those firms receiving and not receiving going-concern modifications to the audit report. Mutchler (1985) concluded that qualitative variables that included good and bad news items had no incremental explanatory power relative to financial variables in a model of the auditor’s opinion decision for financially distressed companies. Mutchler et al. (1997) developed a list of 82 potential good news items, categorized these according to the ranking of these items with respect to their favorability to the companies’ prospects, and then collapsed the items into three categories of favorability. However, Mutchler et al. found different results in an extension of the 1985 study. They studied how qualitative information released in the Wall Street Journal Index, Int. J. Audit. 7: 71–85 (2003)
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specifically payment defaults and debt covenant violations, affected the probability of a company receiving a going-concern modified report. All the companies in their sample were in the category of ‘soon to be entering bankruptcy’. They found that the bad news items of payment default and covenant violation were significantly associated with issuance of the going-concern modified report by the auditor. They also found that the probability of bankruptcy was also significantly associated with the going-concern report. Auditors also consider certain characteristics as good news that may potentially mitigate the threat of insolvency. Krishnan and Krishnan (1996) extend the audit opinion models by incorporating economic tradeoffs that arise in the auditor’s litigation risk, the extent of outsider ownership, the relative importance of the client in the auditor’s portfolio, and future growth as important factors in the audit opinion decision. Laitinen and Laitinen (1998) used the multivariate logistic regression analysis based on 17 financial and non-financial variables to explain qualifications in large Finnish companies. Their results showed that the likelihood of receiving a qualified audit report is larger, the lower the growth of the firm, the lower the share of equity in the balance sheet and the smaller the number of employees. Kleinman and Anandarajan (1999) found empirical evidence that those nonfinancial variables such as the bad news, good news, reorganization proceedings, debt default and consecutive years losses, can be used to discriminate between the auditor’s decision to issue the going-concern qualified versus the clean report. Casterella et al. (2000) developed an opinion prediction model introducing a new bankruptcy resolution variable that proxies for the auditor’s prognosis of the ultimate disposition of the soonto-be-bankrupt company. They find that the auditors do not seem to be able to predict filings or resolution. The model suggests that auditors are less likely to issue a modified opinion when the financial prospects of the company are not clear and when auditors are faced with incentives to delay or avoid a modified opinion. Research study on auditor’s going-concern assessment focuses on the hybrid systems as a decision support model (Lenard et al., 2001). They find that the bankruptcy prediction is an important component of the going-concern decision. Other factors, such as the company’s plans or ability to obtain future financing, affect the auditor’s going-concern © Blackwell Publishing Ltd 2003
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assessment. Arnold et al. (2001) presents a theoretical framework of the audit decision process that consists of four broad-based components within the overall audit environment: (a) the auditor, (b) evidence gathering and analysis, (c) auditor/auditee contracting, and (d) social contracting. In addition they have examined the socio-political pressures surrounding the auditors’ decisions whether to issue an audit opinion that includes a going-concern exception. The effect of client size on auditor decision-making at the office of Big Five accounting firms has been analysed (Reynolds and Francis, 2001). They find that Big Five auditors do not treat large clients in their practice offices more favorably than smaller clients. Economic dependence does not lead to greater client discretion with respect to accounting accruals or fewer going-concern audit reports. These results are consistent with a white paper issued by the accounting profession (AICPA, 1997). Larger clients pose greater litigation risk, and Big Five auditors report more conservatively for larger clients, suggesting that reputation protection dominates auditor behavior (Reynolds and Francis, 2001). For the most part, prior studies have not used any other qualitative variable(s) as indicators when developing audit opinion models. These qualitative indicators of potential solvency problems indicate year’s losses and bad news characteristics as firm litigation. The importance of these other qualitative indicators (firm litigation) in the auditor’s decision has not been tested. Kida (1980), Mutchler (1986), and La Salle et al. (1996) argued that specific information cues, although not necessarily sufficient to trigger the qualified audit report, would cause the auditor to focus more extensively on whether the qualified report should be issued.
2.3. Firm litigation The effects of firm litigation on disclosure, stock price response, firm value and reputation have been examined, but the relation with audit opinion decision has not been examined. Skinner (1997) provides evidence on whether managers can reduce stockholder litigation costs by disclosing adverse earnings news early. He finds that voluntary disclosure occurs more frequently in quarters that result in litigation than in quarters that do not. Managers incentives to pre-disclose earnings news increase as the news becomes more Int. J. Audit. 7: 71–85 (2003)
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adverse, presumably because this reduces the cost of resolving litigation that inevitably follows in bad news quarters. Hughes and Sankar (1997) analyzed the impacts of expected litigation-related costs on a manager’s discretionary disclosure choice. The litigation has impact on future cash flow, on reputation cost and in the capital market. Share price falls and shareholder litigation are examined by Beck and Bhagat (1998). They find that sued firms are more likely to experience episodes of very poor performance, exhibit higher systematic risk, and issue more positive news in the misleading information period of the suit than the sample population of non-sued firms. Using data from lawsuits, Karpoff and Lott (1998) find that press coverage of punitive lawsuits corresponds to statistically significant decreases in the values of the defendant companies, indicating that punitive lawsuits are important to the defendants. Griffin et al. (2000) document a statistically significant negative short-term price response to the litigation announcement as well as a negative response that persists for several weeks subsequent to the litigation announcement. Johnson et al. (2001) provide direct evidence on the relation between legal environment and the voluntary disclosure of good news in high-technology industries. They find that the change in disclosure increases in firms’ ex ante risk of litigation. Bhagat and Romano (2001) review how event studies have been used to evaluate the wealth effects on corporate litigation. There is a significant wealth increase for defendant firms when they settle a suit with another firm, in contrast to other types of plaintiffs, and in contrast to the settling plaintiff firms. At minimum, lawsuits are not a value enhancing way for corporations to settle their disagreements with other corporations. The market appears to impose a higher sanction on firms than actual criminal sanctions, and reputational losses are of equal magnitude for civil fines as criminal ones.
2.4. Contribution of this study The objective of the present study is to develop a model based on financial information and other indicators, such as firm litigation, to explain qualifications in audit reports of publicly listed Greek companies. The model will provide information on the likelihood of a company’s receiving a qualification given its financial data and firm litigation data. This kind of model can © Blackwell Publishing Ltd 2003
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serve as a decision aid for auditors when predicting what opinion other auditors would issue in similar circumstances, when evaluating potential clients, in determining the scope of an audit for existing clients, in peer reviews, to control quality within firms, and as a defence in law suits (Laitinen & Laitinen, 1998). Bell and Tabor (1991) and Chen and Church (1992) note that auditors can use the output of these models to plan specific auditing procedures that can be applied to achieve an acceptable level of audit risk. These models can also be used as a quality control tool in the final or review stage of an engagement and for contingency analyses on how changes in specific variables could add or detract from the probability of obtaining a qualified opinion (Kleinman & Anandarajan, 1999). Researchers can use the model to assess the extent to which a qualification could be expected based on publicly available data (Dopuch et al., 1987). This study tests the extent to which variables other than financial ratios act as useful predictors of the audit opinion. Such variables included firm litigation and current year’s loss. The motivation of this study is to better understand the decisions made by auditors utilizing preliminary factors such as financial and non-financial data. The following section discusses the methodology proposed to identify audit qualification opinion.
3. METHODOLOGY 3.1. Data Financial statements with qualifications in Greece can be characterized on the basis of the quantity and content of the qualifications in the reports filed by the auditors on accounts for: depreciation, provision for bad debts, provision for redundancy payments, participation in other companies, and fiddling of accounts for tax liabilities and other qualifications. The classification of a financial statement as qualified was based on the inclusion in the auditors’ reports of opinions of serious doubt as to the correctness of accounts. The sample of a total of 100 publicly listed manufacturing firms includes 50 with qualifications and 50 without qualifications. The sample did not include financial companies. We restricted our analysis to manufacturing firms to ensure that the analysis would not be confounded by structural differences between manufacturing, Int. J. Audit. 7: 71–85 (2003)
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Table 1: Characteristics of firm’s means and t-tests
Total assets Equity Sales Net profit
Qualified
Nonqualified
t-test
Sig. (2-tailed)
10,344 4,622 6,617 -71
11,696 6,270 11,087 1,071
0.376 0.815 1.367 2.695
0.708 0.417 0.175 0.008
Notes: The amounts are reporting in million GRD.
service and merchandising firms. The sample period of the analysis is 1997–1999. Certified auditors check all the companies included in the sample. All public limited companies (sociétés anonymes) and limited liability companies are obliged to submit to a certified auditor’s control when they fulfil two of the three following criteria: (a) total revenues are over 1 billion Greek Drachmas (GRD) ($2,717 million) (1 Euro = 340.75 GRD), (b) total assets are over 500 million GRD ($1,359 million), and (c) the average number of employees is over 50 (Ballas, 1994; Caramanis, 1997). Some of the characteristics of the full sample of companies are presented in Table 1. There is a statistically significant difference between average profits of qualified firms, with losses averaging at 71 million GRD, and nonqualified firms, averaging a profit of 1,071 million GRD, (t = 2.695, p = 0.008). Mean equity also gives a non-statistically significant difference between qualified firms and non-qualified firms with 4,622 million GRD, and 6,270 million GRD respectively (t = 0.815, p = 0.417). With regard to total assets, although mean value for qualified firms is 10,344 million GRD, and 11,696 million GRD for nonqualified firms, the difference is not statistically significant (t = 0.376, p = 0.708).
3.2. Method We used four statistical analyses to discern whether there was an association between our variables and the auditor opinion decision. First, we used t-tests and chi-squared tests to examine the relation between each variable and the incidence of qualification by comparing the means of the unqualified sample. Second, we used logistic regression analysis to test the ability of various combinations of the variables to correctly predict the audit opinion. Third, we used OLS regression analysis to find when there is a relationship between the independent variables and the number of qualifications in audit reports. © Blackwell Publishing Ltd 2003
The probability of a qualified opinion conditioned on independent variables using a logistic regression approach on our full sample of 100 firms (50 with qualified and 50 with unqualified opinions) is estimated. The models we estimated are: Prob(QUALi ) = b0 + b1LITIGi + b2 FDISTRi + b3 INVRECi + b4 LOSSi + b5 CA CLi + b6 WC TAi + ei
(1)
Prob(QUALi ) = b0 + b1LITIGi + b2 INVRECi + b3 LOSSi + b4 CA CL i + b5 WC TAi + ei
(2)
where Prob (QUALi) takes on the value of 1 if firm i receives a qualified audit opinion (of any type), zero otherwise. b0, b1 . . . bi are parameters to be estimated, and ei is a disturbance term. We expect the coefficients on dummy variables LITIGi and LOSSi to be positive, and the coefficients on FDISTRi, INVRECi, CA/CLi, and WC/TAi we expect to be negative. For model (2) the variable FDISTRi was excluded. We also use an OLS regression approach to explain the magnitude of the number of qualifications (QUALNUMi) as a function of independent variables; this may help to audit opinion decision. The average number of qualifications (QUALNUMi) is 2.8 with minimum zero and maximum 24, for the full sample. For the sample with qualified audit reports the average number of qualifications is 5.7. The models (1a) and (2a) are estimated suggesting that the number of qualifications (QUALNUMi) was associated with some of the independent variables from models (1) and (2). Both models (1a) and (2a) use the same independent variables as follows: LITIGi is 1 if the firm has litigation in the current year, 0 otherwise; FDISTRi is financial distress (z-score of Altman) Int. J. Audit. 7: 71–85 (2003)
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for model 1; INVRECi the ratio of inventories plus receivable to total assets; LOSSi is 1 if the firm has loss in the current year, 0 otherwise; CA/CLi is the ratio of current assets to ccurrent lliabilities; and WC/TAi is the ratio of working capital to total assets.
3.3. Variables This section describes the variables used in our models and the justification for them. The variables in this study come from many sources. To find variables, prior work on the topic of audit opinion was carefully considered. Relevant work by DeAngelo (1981); Mutchler (1985, 1986); Keasey and Watson (1987); Keasey et al. (1988); Hopwood et al. (1989); Koh and Killough (1990); Hirst (1994); Krishnan and Krishnan (1996); Laitinen and Laitinen (1998); Sundgren (1998); Kleinman and Anandarajan (1999); Casterella et al. (2000); and Reynolds and Francis (2001) all contained suggested indicators of qualified audit reports. Initially, a set of 10 mainly financial ratios was formed. However, to avoid ratios providing the same information due to high correlations, it was decided to exclude highly correlated ratios, while retaining ratios describing all aspects of financial performance, including solvency/liquidity and managerial performance. Apart from correlation analysis, the statistical significance of the financial ratios was also considered through t-tests. This combination of correlation analysis and t-tests led to the selection of a limited set of six variables – four financial ratios and two dummy variables – which provide meaningful and non-overlapping information (as far as possible). Given the data available, the arguments reviewed earlier and the particular nature of audit qualification, the general model used to determine which factors influence the receipt of a company audit qualification is as follows: Y= f (litigation, financial distress, financial information) where Y is the dependent variable, coded 1 if a company audit qualification has been received and 0 otherwise. The independent variables included in the model are described below.
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Litigation A dummy variable coded as 1 if a company had litigation in the year preceding the audit opinion and coded 0 otherwise. The lawsuit filings are obtained from specific newsletter, magazines and Greek financial press. We apply the following selection criteria for litigated companies (Skinner, 1997): (a) the suit is filed in a Greek court; (b) a corporate defendant; (c) alleged common stock price fraud (for availability of underlying price data, since this is an important lawsuit case); (d) alleged stock exchange violation under Greek law, i.e. when the suit alleges some misstatement or omission of material information. This procedure provides a sample of 21 lawsuit filings. For the non-lawsuit sample, we search the same newsletters, magazines and Greek financial press for the same period.
Financial distress Clients with a high probability of bankruptcy are more likely to receive qualified opinions because their ability to continue as a going concern is in greater doubt (McKeown et al., 1991; Reynolds and Francis, 2001). A surrogate for probability of bankruptcy is the Altman z-score (Altman, 1983) as a control variable to investigate the association of audit opinion and financial distress. The use of the z-score is accompanied by some limitations, as was its use 30 years ago to develop a corporate failure prediction model for the US manufacturing sector. It is nevertheless still used today in many studies. With regard to Greek companies, despite the fact that a number of researchers have looked at bankruptcy, a generally accepted model has not been established (Theodosiou, 1991; Negakis, 1995; Dimitras et al., 1995). We measure this variable through the difference in the z-score in the model (1) outlined below as a control variable for differences in financial condition between qualified and non-qualified firms.
Financial information Auditors give ‘subject to’ qualifications when there are uncertainties about material events which management will not or cannot explicitly provide for in the financial statements. The material uncertainties will usually be reflected in one or more components representing the financial position and performance of the company. Since the financial well being of a company is Int. J. Audit. 7: 71–85 (2003)
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represented by its financial statement variables, they are appropriate independent variables for the audit opinion expectations model. Financial variables have been used by many researchers in the last 20 years (Kida, 1980; Mutchler, 1985; Dopuch et al., 1987; Krishnan, 1994; Francis & Krishnan, 1996; Krishnan & Krishnan, 1996; Mutchler et al., 1997; Laitinen & Laitinen, 1998; Sudgren, 1998; Reynolds & Francis, 2001). Financial information includes the following variables. (a) The ratio of inventory and receivables to total assets is used. This ratio is believed to capture risky or hand-to-audit assets that involve audit time and effort beyond that of other assets (Houghton & Jubb, 1999). Jubb et al. (1996) argue that this measure proxies for client ‘business risk’ and that it is necessary to also capture ‘audit risk’ by incorporating a second measure of risk. This asset composition measure is an important variable in the audit opinion expectations process because receivables and inventories are unmanageably large in comparison to total assets. (b) Loss is an indicator variable whose value is 1 if an auditee experienced a loss in the year of audit opinion and 0 otherwise. It is used as a measure of risk. Liquidity is represented by the two ratios: (a) current assets to current liability and (b) working capital to total assets. The liquidity measures are direct measures of financial health. The possibility of a qualified audit report is higher when the financial health of a company deteriorates.
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The above explanatory variables capture most of the aspects that seem relevant to explaining the receipt of a company audit qualification. However, due to the limitations of publicly available information, we were not able to include some other variables that might be relevant. This is not a function of the limits of the data.
4. RESULTS 4.1. Univariate tests Panel A of Table 2 reports the mean values, standard deviation and t-tests of ratios for qualified and non-qualified firms and indicates the magnitude of the differences in the variables between the two types of reports. The univariate tests suggest several variables may be helpful in audit opinion qualification. The large differences in average values of ratios between qualified and non-qualified firms and the high statistical significance (p < 0.05) indicate that the above ratios may indeed be related to audit opinion decisions. The companies with qualified audit reports show lower z-scores (high financial distress) and lower liquidity. The differences of ratios INVREC and CA/CL are not statistically significant at the 0.10 level. The ratios FDISTR and WC/TA are statistically significant. The very low values for FDISTR and WC/TA for the qualified firms compared to the corresponding ones for the nonqualified firms indicate the former companies are
Table 2: Descriptive statistics t-tests and chi-squared tests in the means of variables for qualified and non-qualified audit opinions Panel A: Continuous variables
Qualified
FDISTR INVREC CA/CL WC/TA Panel B: Categorical variables LITIG LOSS
(Yes) (No) (Yes) (No)
Non-qualified
Mean
Std. Dev.
Mean
Std. Dev.
0.905 0.531 1.434 0.105
0.948 0.191 0.809 0.226
1.935 0.595 2.751 0.217
0.798 0.209 5.567 0.235
t-test
Sig. (2-tailed)
5.879 1.579 1.656 2.437
0.000 0.118 0.101 0.017
Qualified No.
Non-qualified No.
Chisquare
Sig.
19 31 20 30
2 48 3 47
17.420
0.000
16.318
0.000
Notes: FDISTR: Financial Distress (z-score), INVREC: (Inventories + Receivable)/Total Assets, CA/CL: Current Assets/Current Liabilities, WC/TA: Working Capital/Total Assets, LITIG: Litigation, LOSS: Current Year Losses. © Blackwell Publishing Ltd 2003
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facing difficulties of low z-score, and low working capital. The ratio WC/TA shows that qualified firms have a very low WC and present liquidity problems such that they cannot meet their obligations. Low WC is associated with financial distress according to the literature. Examination of Section B of Table 2 shows that 19 of the 21 instances with firm litigations received a qualified audit report (chi-square = 17.420, p < 0.000). The chi-square statistics indicate that there is significant difference between qualified and nonqualified audit reports in relation to firm litigation. The same result also holds for current year losses. 20 out of 23 firms with losses in the current year received a qualified audit report. The difference between the two groups of firms reported is significant (chi-square = 16.318, p < 0.000). These differences are evidence that the qualified firms related significantly with litigation or losses.
4.2. Multivariate analyses The univariate tests provide valuable information regarding a large number of variables over a sample. The univariate results were informative but there was the question of whether the association was a direct association or whether there was a joint correlation with a third variable. A univariate test does not allow detection of interaction effects, which multivariate tests may find. While some of the suggested variables were not statistically significant in this study, the results should be viewed cautiously. This study examined these variables at the aggregate level on one sample and generalizations to specific cases should be made with care. Every instance of audit opinion of financial statements is an individual case and variables that are not significant in the aggregate may still be useful indicators for a particular case. The aim was to develop a model with variables which auditors can find useful. While several of these variables were good predictors in this study, they lacked the ability to transfer to other samples. Ratios and categorical variables allow better generalization and are easily derived from published financial statements, and they have been used in the model development. There were six possible variables in this study using the results of the univariate tests. The next step, in securing two models was the application of multivariate testing with logistic regression. This study used model (1) with six variables (FDISTRS included) and model (2) with five variables (FDISTR excluded). © Blackwell Publishing Ltd 2003
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Table 3 reports the results for the logistic regression. According to the results for model (1), the overall percent of correct classification, by means of the proposed model, is 78%. This implies that 42 (84%) out of the 50 non-qualified firms and 36 (72%) out of the 50 qualified firms were classified correctly. The relationship between the dependent – non-qualified and qualified firms – and the independent variables is significant (chisquare = 46.210, p < 0.000). The association strength between the dependent and independent variables is R2L = 0.333 (pseudo r2) indicating a mediumefficient strong relationship. The results indicate that only two variables with significant coefficients were included in the model: LITIG and FDISTR. Litigation has an increased probability of being classified with qualified firms (b = 2.257, p = 0.048) and this ratio has a positive effect. This implies that firms with litigation have an increased probability of being classified with qualified firms. Financial distress has an increased probability of being classified into qualified firms (b = -1.324, p = 0.014) and this ratio has a significant negative effect. That means that firms with a high z-score have an increased probability of being classified into the non-qualified firms. For model (2) (without FDISTR), the overall percent of correct classification is 75% with chi-square = 38.913, p < 0.000 and R2L = 0.281. Only two variables with significant coefficients were included in the model: LITIG and LOSS. Litigation and current year loss have an increased probability of being classified with qualified firms (LITIG: b = 3.092, p = 0.006; LOSS: b = 2.090, p = 0.016) and these ratios have a positive effect. In both models, LITIG is indicated as the important variable. The results clearly indicate that firm litigation and financial distress for model (1) and firm litigation and loss for model (2) are the major factors distinguishing the two groups of firms. The evidence of remaining variables is mixed. The table shows that there is an insignificant negative relation between the firm’s INVREC and CA/ CL and the likelihood of a qualified opinion. These results are contrary to the conjecture that inventories and receivables are risky accounts (Dopuch et al., 1987; Sundgren, 1998). Francis and Krishnan (1996) found a positive but insignificant coefficient of inventories to assets and a negative and significant coefficient of receivables to assets. Sundgren (1998) found a positive and significant coefficient of losses. Mutchler (1985), examining empirical evidence of auditor’s opinion decision, Int. J. Audit. 7: 71–85 (2003)
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Table 3: Logistic analysis of qualified and non-qualified audit opinions (standard errors in parentheses) Independent variables LITIG FDISTR INVREC LOSS CA/CL WC/TA Constant Model Chi-square RL2 Classification accuracy (%) Non-qualified Qualified Overall
Model 1
Model 2
Coefficients
Sig.
Coefficients
Sig.
2.257 (1.141) -1.324 (0.539) -1.381 (1.631) 1.196 (0.981) -0.768 (0.735) 5.059 (3.428) 2.711 (1.456) 46.210 0.333
0.048
3.092 (1.114) –
0.006
-2.352 (1.502) 2.090 (0.865) -0.920 (0.695) 3.305 (3.151) 1.561 (1.285) 38.913 0.281
0.117
84.00 72.00 78.00
0.014 0.398 0.223 0.296 0.140 0.063 0.000
–
0.016 0.186 0.294 0.224 0.000
92.00 58.00 75.00
Variables definitions: QUAL 1 if the auditor has issued to the auditee firm a qualified audit opinion (of any type), 0 otherwise LITIG 1 if firm has litigation in the current year, 0 otherwise FDISTR Financial Distress (z-score of Altman) INVREC (Inventories + Receivable)/Total Assets LOSS 1 if firm has loss in the current year, 0 otherwise CA/CL Current Assets/Current Liabilities WC/TA Working Capital/Total Assets
found that companies that had received goingconcern opinions displayed a low degree of financial distress (as evidenced by high discriminant scores). Her conclusion was that in these situations ‘contrary information’ (bad news) was the driving factor in the auditor’s decision. Dopuch et al. (1987) showed that the most significant variables in qualification prediction are current year loss, industry return and the change in the ratio of total liabilities to total assets. A study by Keasey et al. (1988) found that companies audited by large audit practices, companies with a prior year qualification, a secured loan, declining earnings, large audit lags and few non-director shareholders were more likely to receive an audit qualification that other companies. The analysis of Laitinen and Laitinen (1998) showed that the qualification of an audit report is mainly associated with the growth of the firm (percentage change in © Blackwell Publishing Ltd 2003
net sales), the share of equity (equity to liabilities ratio) and the number of employees. Kleinman and Anandarajan (1999) found that the consecutive year losses could be used to discriminate between the auditor’s decisions to issue the going-concern qualification versus the clean report.
Additional analysis The magnitude of the impact of firm litigation and financial data on the number of qualifications (QUALNUM) can be found in Table 4. Results for the OLS regression analysis for models (1a) and (2a) are reported for the full sample. The model (1a) is significant (F = 11.679, p < 0.000) and explains 39.3% of the variation in number of qualifications by the adjusted R-square. The variables with significant coefficients are four. These are LITIG, FDISTR, CA/CL and WC/TA. Int. J. Audit. 7: 71–85 (2003)
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Table 4: Coefficient estimates from regression of number of qualifications (QUALNUM) (t-statistics in parentheses) Independent variables LITIG FDISTR INVREC LOSS CA/CL WC/TA Constant Adjusted R F statistic
2
Model 1a Coefficients
Sig.
Coefficients
Sig.
4.198 (4.661) -1.557 (-3.163) -0.290 (-0.179) -0.434 (-0.477) -0.184 (-1.880) 3.286 (1.673) 4.307 (4.324) 0.393 11.679
0.000
5.158 (5.812) –
0.000
-1.949 (-1.214) 0.707 (0.808) -0.186 (-1.812) 0.140 (0.079) 3.079 (3.207) 0.335 10.963
0.228
Firms receiving high numbers of qualifications relate with litigation (b = 4.198, p < 0.000), low zscore (b = -1.557, p = 0.002), low current assets to current liabilities (b = -0.184, p = 0.063) and high working capital to total assets (b = 3.286, p = 0.098). The variables INVREC and LOSS related not significantly with the number of qualifications (p > 0.10). These results suggest that the number of qualifications is dependent on litigation, financial distress and liquidity. Model (2a) is significant (F = 10.963, p < 0.000) and explains 33.5% of the variation in number of qualifications by the adjusted R-square. The variables with significant coefficients are two. These are LITIG (b = 5.158, p < 0.000) and CA/CL (b = -0.186, p = 0.073). This additional test suggests for model (1a) that the variables LITIG and FDISTR are important and significant and for model (2a) that the variables LITIG and WC/TA are significant for the receipt of a qualification by a firm and related directly with the number of qualifications in the audit report. The liquidity of firms, represented by the variables CA/CL and WC/TA, are related to the number of qualifications. Firms with low CA/CL and high WC/TA relate to the receipt of high numbers of qualifications.
5. CONCLUSIONS AND IMPLICATIONS The primary objective of this study has been the development of a reliable model based on financial © Blackwell Publishing Ltd 2003
Model 2a
0.002 0.858 0.634 0.063 0.098 0.000 0.000
–
0.421 0.073 0.937 0.002 0.000
statement information and non-financial information such as firm litigation, to identify audit qualification opinion for Greek firms. In order to achieve this goal we used a sample of qualified and non-qualified firms. We used univariate and multivatiate statistical techniques such as logistic and OLS regression analysis to develop a model that identifies factors associated with qualified audit reports. Six variables (four financial ratios and two dummy variables) are selected for examination as potential predictors of qualified audit reports. These variables appeared to be important in prior research and constitute ratios derived from published financial statements. The variables selected by the above techniques as possible indicators are firm litigation, financial distress (z-score) and current year losses. The models of logistic regression are accurate in classifying the total sample correctly with accuracy rates of approximately 78% and 75%. The results of this model suggest there is potential in detecting qualified audit reports through analysis of publicly available financial statements and firm litigation data. Alternative methods for identification of audit opinion decision can be used, such as adaptive logit networks, discriminate analysis, multicriteria analysis, and neural networks. This proposed audit opinion decision examines auditee’s financial data and the case of firm litigation as possible factors for qualification. Auditor’s skills and abilities, the Int. J. Audit. 7: 71–85 (2003)
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social contract (trust, self-regulation, litigation threats), and the auditor/auditee contact have not been examined. There were several variables, available publicly, that remain for future study. These variables include standing within industries and long-term trends. Industry standing probably would provide additional valuable information with respect to the growth and financial distress variables. A further possibility would be to examine variables other than those in financial statements, such as the number of members of the board of directors, the number of employees, the rate of turnover of the financial manager, the type of auditor used and the frequency with which they are changed, the size of the company, the existence of company branches, market variables and time lag between the end of the accounting period and the date of audit report. The results are encouraging in that we have developed a reliable model for assessing the likelihood of qualified audit reports for businesses in Greece. For the first time the variable of firm litigation has been examined using empirical evidence and has been found significant. This study tested whether, in the presence or absence of financial distress, non-financial data play an important role in auditors’ opinion. The proposed methodological framework could be of assistance to auditors, both internal and external, to taxation and other state authorities, individual and institutional investors, stock exchanges, law firms, financial analysts, credit scoring agencies and to the banking system. For the auditing profession, moving to address its responsibility to identify qualified audit reports, the results of this study should be beneficial. The present study contributes to auditing and accounting research by examining the suggested variables to identify those that can best discriminate cases of audit opinion. This study suggests certain variables taken from information publicly available to which auditors should be allocating additional audit time. With improved new statistical techniques and a greater number of variables it would be possible to develop a more powerful analytical tool. A decision support system for auditing purposes could be developed.
ACKNOWLEDGEMENTS An earlier version of this paper was presented at the European Auditing Research Network Symposium held in Wuppertal, Germany on © Blackwell Publishing Ltd 2003
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October 26–27, 2001. I wish to thank the discussant Stuart Turley and the participants for their constructive comments that resulted in significant improvements in the present version. I thank the two anonymous reviewers of the International Journal of Auditing for their valuable comments.
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AUTHOR PROFILE Charalambos T. Spathis (BSc, MBA, PhD) is Assistant Professor of Accounting and Auditing at the Division of Business Administration, Department of Economics, Aristotle’s University of Thessaloniki in Greece.
Int. J. Audit. 7: 71–85 (2003)
