Predictive Ability of Audit Qualifications for Loss Contingencies*

Abstract

. Adequate disclosure of risks and uncertainties is an issue of interest to the accounting profession and regulators both in Canada and in the United States. Previously, auditors were required to modify their audit reports in the presence of material uncertainties. However, following suggestions that such disclosure is redundant and not useful, the CICA removed this requirement in 1980. Auditors in the United States are still required to disclose material uncertainties in the audit report. The criterion of predictive ability is used in this research to evaluate the potential usefulness of this report modification requirement. Specifically, the study examines the ability of report modifications to predict the materially adverse resolutions of pending litigation. The subsequent resolution patterns for a sample of litigation loss contingencies (with an audit report modification) and a control sample of litigation loss contingencies (without an audit report modification) were compared. The results indicate that a larger proportion of contingencies with an audit report modification were resolved materially against the client. Also noteworthy, audit report modifications had incremental predictive ability over other types of disclosures such as footnotes to the financial statements and prior media disclosure of the contingency. Résumé. La présentation adéquate des risques et des incertitudes est une question d'intérêt pour la profession comptable et les responsables de la réglementation, tant au Canada qu'aux États‐Unis. Les vérificateurs étaient auparavant tenus de modifier leur rapport en cas d'incertitudes importantes. Toutefois, à la suite de suggestions selon lesquelles cette information était redondante et sans véritable utilité, l'I.C.C.A. a supprimé cette exigence en 1980. Aux États‐Unis, les vérificateurs sont encore tenus de prvérificateurssenter les incertitudes importantes dans leurs rapports. L'auteur utilise le critère de la capacité de prédiction pour évaluer l'utilité potentielle de cette demande de modification du rapport des vérificateurs. Il examine plus précisément dans quelle mesure les modifications apportées au rapport permettent de pédire si les litiges en instance auront un dénouement défavorable dont les conséquences seront importantes. Les modèles de dénouement ultérieur d'un échantillon de pertes éentuelles attribuantes à des litiges, avec modification du rapport des vérificateurs, et d'un échantillon de contrôle de pertes éventuelles attribuables à des litiges, sans modification du rapport des vérificateurs, ont été comparés. Les résultats de cette comparaison indiquent qu'une plus grande proportion de pertes éventuelles attribuables à des litiges avec modification du rapport des vérificateurs se sont soldées par un résultat défavorable important pour le client. Autre fait digne de mention: les modifications apportées au rapport des vérificateurs présentaient une capacité de prédiction marginale par rapport aux autres types d'information tels que les notes afférentes aux états fina...

Accounting Accruals and Auditor Reporting Conservatism*

“…Our evidence indicates that they did, suggesting that it may have been unwise to eliminate this reporting option since doing so curtails the ability of auditors to manage audit risk through the audit report choice. * In addition to being a vehicle for auditors to manage audit risk, there is also evidence that audit report modifications for material uncertainties convey new information to JKnancial statement users in the sense of having predictive ability (over and above required footnote disclosures) with respect to the future resolution of the uncertainties (Raghunandan 1993). In related research, Bamber and Stratton (1997) report an experiment in which modified reports for material uncertainties affected bank loan officers risk assessment, interest rate premium, and loan decisions.…”

The relevance of quantifiable audit qualifications in the valuation of IPOs

“…5 However, subsequent studies reported the presence of such an association for audit qualifications that received media attention (Dopuch et al 1986), audit qualifications that were subsequently withdrawn (Fields and Wilkins 1991), audit qualifications that were unexpected (Loudder et al 1992), and audit qualifications for over-the-counter firms (Ameen et al 1994). As a result, Raghunandan (1993), and Bamber and Stratton (1997) have argued that since such audit qualifications have information content, the elimination of modified audit opinions in both Canada and the U.S. is not justified. We add to this literature by investigating whether auditor-disclosed qualifications in the form of quantifiable asset overstatements and/or liability nonrecognition or nondisclosure convey information to capital market participants.…”

The Effect of Deadline Pressure on Pre‐Negotiation Positions: A Comparison of Auditors and Client Management

“…Additionally, creditors may consider qualified opinions when making lending decisions (e.g., Guiral‐Contreras, Gonzalo‐Angulo, and Rodgers ), possibly because modified opinions often signal a decline in future earnings (Frost ). Raghunandan () even found that companies with modified opinions are more likely to receive an adverse resolution of pending litigation than similar companies that receive unqualified (“clean”) opinions. In summary, modified opinions can affect clients' cost of capital, market capitalization, and in some cases their ability to continue as a going concern (Wilkins ).…”