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The relevance of quantifiable audit qualifications in the valuation of IPOs

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Abstract

How useful are audit qualifications to financial statement users? We analyze a sample of 204 firms that went public at the Athens Stock Exchange over the period 1987–2002. For 149 of these firms, auditors report quantitative estimates of the amount by which assets are overstated and/or liabilities are understated in reported financial statements. We find that underwriters and their affiliated analysts do not incorporate the negative information provided by these qualifications into offer prices and earnings forecasts. Investors, however, appear to efficiently impound the negative implications of the audit qualifications into stock market prices within the first day of trading. The results suggest that underwriters tend to align their interests with the interests of their clients, the old stockholders, at the expense of the new stockholders. They also suggest that the practice of reporting quantifiable qualifications in audit reports is valuable to investors given that they are disclosed by an expert.

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Notes

  1. Before 1987 firms were free to use any reporting system. Until then, the main concern of the state was reporting for tax purposes.

  2. In terms of timing of events, first the auditing of the financial statements takes place and then the IPO prospectus is issued that contains the financial statements, the analysts’ earnings forecasts, and the offer price (among other information).

  3. This framework (explained in Sect. 4 below) has been proposed by Penman (1992) and has been applied in numerous prior studies such as Abarbanell and Bushee (1997) and Amir and Sougiannis (1999).

  4. See Craswell (1985) for a discussion of methodological issues that arise in this area of research.

  5. A recent study by Martinez et al. (2004) analyzes a sample of Spanish publicly traded firms and also concludes that “qualified audit reports do not have information value for investors.”

  6. A number of research studies examines whether audit opinions are informative in predicting bankruptcy, e.g., Hopwood et al. (1989), Lennox (1999). The results in this line of research are also mixed.

  7. Carter and Manaster (1990) also report lower underpricing when the issuing firm hires a reputable underwriter.

  8. Our study also relates to the recognition versus disclosure literature, e.g., Holthausen and Watts (2001). In our setting amounts not recognized by the management are disclosed by the auditor. We are not aware of any prior “recognition versus disclosure” studies relating to IPOs.

  9. See Presidential Decree 350/1985.

  10. Some of these banks are Alpha Bank, National Bank of Greece and Eurobank.

  11. The prospectus of FORTHnet Inc., a telecommunications company, presents in great detail and in a very prominent position the audit qualifications and financial analysis based on accounting information that has been restated for the effects of the following qualifications: (1) Doubtful Accounts Receivable of 87,750 Euros for which the provision is inadequate by 23,000 Euros. (2) Research-in-Progress of 294,000 Euros for which no amortization has been recognized. Local GAAP requires that all intangible assets be amortized over 5 years. (3) Taxes Payable of 50,000 Euros that have not been recognized. This analysis of the qualifications is made in the prospectus although the same information is contained in the audit opinion, which accompanies the financial statements. The financial statements with the audit opinion are also included in the prospectus.

  12. See, for example, section 324 of the Hellenic Auditing Standards (1999).

  13. Not only firms going public but also seasoned firms already listed in the ASE had quantifiable audit qualifications during the period of the study. In general, the issuance of qualifications was an acceptable and widespread audit practice. We did not include seasoned firms in our analysis because it is much more difficult to test our hypotheses with these firms given that it is virtually impossible to identify the issue date of the audit report (event date). The IPO setting avoids this problem because the event date for stock market investors is without doubt the first day of trading. In addition, the IPO setting is richer by involving many parties (old and new stockholders, underwriters and their affiliated analysts) with conflicting interests and thus the economic consequences of audit qualifications can be easier to detect. We think that the valuation implications of quantifiable audit qualifications for seasoned firms should be similar to those for IPOs because both sets of firms are valued in the same market (by the same investors). Perhaps a future study would verify this argument.

  14. The Greek stock market is an emerging market. The extent of its informational efficiency has been the subject of various studies. Using data over the period 1981–1990, Barkoulas et al. (2000) reject weak-form efficiency as does Siourounis (2002) using data from 1988 to 1998. However, using data from 1985 to 2001, Laopodis (2004) cannot reject weak-form efficiency. Only one study, Ghicas et al. (2000), provides evidence (within the construction industry) suggesting that the Greek stock market is not semi-strong-form efficient. Our study provides further evidence on this issue, although for only one information variable—quantitative audit qualifications—and thus it also contributes to the literature on Greek stock market efficiency.

  15. The detailed and thorough analysis and disclosure in the prospectus was also the result of participation by large non-Greek institutional investors who owned about 40% of market value in 2003, as the 2003 annual report of the ASE indicates. Some of these institutional investors are Fidelity, BNP Paribas, Citigroup, Dresdner, Goldman Sacks, JP Morgan, Lehman Brothers, Merril Lynch, Societe General and UBS.

  16. The information regarding market share of audit firms was provided to us by the Greek Institute of Certified Auditors and Accountants and is based on revenues from audit services for the year 2001.

  17. It is possible that the management thinks that the audit qualifications are relevant in the valuation of the IPO but also believes that disclosure, through the audit report, is sufficient at this point and recognition can take place later. The refusal to recognize the qualifications can also be part of the earnings management exercised by the firm before the IPO. Strong evidence of earnings management by IPO firms has been detected by prior studies, e.g., Teoh et al. (1998) and DuCharme et al. (2001). Evidence consistent with managers of Greek firms reporting aggressively high earnings when audit effort is low is reported by Caramanis and Lennox (2007).

  18. Greek law appears to place a cap (upper bound) on auditor’s liability. Specifically, article 19 of Presidential Decree 229/92 indicates that the cap is the maximum of the following two amounts: (1) five times the salary of the chief judge of the Supreme Court of Greece and (2) the total audit fees the auditor earned in the prior period. At first glance, the potential penalty does not seem to be a material amount. However, the law is open to interpretation. A litigation lawyer who specializes in litigation involving auditors explained to us that the law does not indicate how many parties can sue the auditor at the same time for the same case. That is, each party could request the same amount and if thousands of stockholders who lost money sue the same auditor for the same case, the total penalty becomes a very large amount. Therefore, although there is a cap, the court makes the final decision about the amount of liability. In general, Greek society has become in recent years very litigious, and auditors have been sued frequently as investors think that they played some role in the 1999–2000 Greek stock market bubble. Moreover, a number of auditors have been investigated by the office of the District Attorney for possible criminal charges. Recently, auditors have expressed their fear that they may be found liable for false certification, a criminal charge that entails jail terms. A litigation lawyer confirmed that it is very likely for auditors to face criminal charges.

  19. Securities regulators most likely allow firms to go public with qualified opinions based on the expectation that full disclosure of relevant information will take place on the IPO prospectus by pooling the information of all parties involved, i.e., management, auditors, analysts, and underwriters.

  20. We develop one hypothesis for both financial analysts and underwriters because the analysts are not independent but are affiliated with the underwriters.

  21. Both the management and the underwriter are legally responsible for the information included in the prospectus, which also contains the earnings forecasts.

  22. The derivation of Eq. (1) is provided in the appendix.

  23. We thank an anonymous reviewer for suggesting the use of this framework for both the earnings prediction and valuation models.

  24. The derivation of Eq. (2) is provided in the appendix.

  25. We also used an offer values model that was based on valuation models that have been estimated in prior empirical IPO studies such as Downes and Heinkel (1982), Ritter (1984), and Clarkson et al. (1991, 1992). These models draw from the CAPM-based IPO valuation theory of Leland and Pyle (1977). We derive similar conclusions from the estimation of that model (results are available upon request).

  26. We found 0, 10, 30, and 77 firms having declared dividends during windows 5, 22, 66, and 126, respectively.

  27. Our initial sample consisted of 206 firms 150 with audit qualifications and 56 without them. However, we eliminated one firm (ELFICO Inc.) that did not have lagged book value of equity. We then estimated our models using 205 observations. Testing for outliers using the COOK’s_D test, we identified one firm (ATHENS MEDICAL Inc.) to be an outlier because of its very small lagged book value of equity. The outlier did not affect our inferences with respect to audit qualifications. It only affected the coefficient of lagged book value. Our results using 205 observations are available upon request.

  28. Two companies—SPIDER Inc. and MINOAN LINES Inc.—are cases with representative qualifications. The qualifications of SPIDER Inc., a metallurgical company, which are presented in the auditor’s opinion, refer to: (1) doubtful accounts receivable of 227,439 euros for which the company has recognized a provision of only 38,151 euros, (2) inventories that have not been sold over a long period of 180,484 euros, and (3) the nonrecognition of provisions for severance payments of 170,212 euros. The qualifications for MINOAN LINES Inc. refer to: (1) higher depreciation by 903,888 euros, (2) inadequate contingent liabilities for pending litigation with other shipping companies of 293,470 euros, (3) nonrecognition of sales taxes while the ships were taking trips to other countries of 645,634 euros, (4) recognition of 4,352,437 euros profit on an exchange of assets with related parties, (5) lower provision for severance payments by 161,408 euros, and (6) pending litigation regarding additional income taxes of prior periods of 1,523,110 euros.

  29. Similar findings for the Greek IPO market have also been reported by Ghicas et al. (2000), Nounis (2004) and Tsangarakis (2004).

  30. It seems that the primary concern of the auditors is conservative financial reporting.

  31. The high R-squared is most likely due to the very high correlation of 97% between predicted earnings, FEt/BVt−2, and reported earnings at t−1, ERt−1/BVt−2, as panel D of Table 1 indicates. Multicollinearity statistics did not show the presence of this econometric issue in the estimation of regression (1).

  32. An issue relating to the estimation of equation (1) needs to be pointed out. We use the IPO proceeds to construct the net dividends independent variable (INVt−DIVt−1). The IPO proceeds are defined as offer price times the new shares issued in the offer. Thus, our net dividends variable is a linear function of the offer price [(Offer price times*New shares issued)t−DIVt−1]. In other words, the offer price is in our independent variables set. If underwriters have incorporated the implications of audit qualifications into offer prices, then the net dividends variable may subsume the impact of qualifications on analysts’ earnings forecasts. In such a case, the presence of the IPO proceeds as a component of an independent variable may render the qualifications variable insignificant in regression (1). However, this is not the case because, as the results below indicate, underwriters do not incorporate the qualifications into offer prices either.

  33. An issue in Eq. (2) is the presence of the offer price in both the right and left sides. Thus, in the left side of (2) OV = offer price*(New Shares + Old Shares), while in the right side of (2) INV = offer price*New Shares. We examined whether this issue affected our results by using the theoretical insight that capital contributions, INV, are valued euro-for-euro and moved INV to the left hand side of (2). That is, we estimated the following Eq. (2a):

    $$\begin{aligned} [{\hbox{OV}_{\rm{it}}}-{\hbox{INV}_{\rm{it}}}]/{\hbox{BV}_{\rm{it-2}}} &={\hbox{b}_{0}}({\hbox{1/BV}_{\rm{it-2}}})+{\hbox{b}_{1}}+{\hbox{b}_{2}}({\hbox{DIV}_{\rm{it-1}}}/{\hbox{BV}_{\rm{it-2}}})+{\hbox{b}_{3}}({\hbox{ER}_{\rm{it-1}}}/{\hbox{BV}_{\rm{it-2}}})\\ &+{\hbox{b}_{\rm{4}}}({\hbox{AQ}_{\rm{it-1}}}/{\hbox{BV}_{\rm{it-2}}})+{\hbox{b}_{5}}{\hbox{AQD}_{\rm{i}}}+{\hbox{b}_{6}}{\hbox{UND}_{\rm{i}}} +{\hbox{b}_{7}}{\hbox{UND}_{\rm{i}}}*({\hbox{AQ}_{\rm{it-1}}}/{\hbox{BV}_{\rm{it-2}}})+{{u}_{\rm{it}}} \end{aligned}$$
    (2a)

    In (2a) the dependent variable is effectively equal to Offer Price*the shares outstanding before the IPO (Old Shares). The estimation of (2a) yields results (available on request) that do not affect our inferences from the estimation of Eq. (2). That is, the audit qualifications variable is still not significant in explaining offer values. The R-squared in regression (2a) is 50% which is much lower than 94% in regression (2).

  34. Michaely and Shaw (1994) report a positive coefficient on the investment variable for their sample firms and argue that large issues require more underwriting and distribution efforts leading to greater underpricing.

  35. The market-adjusted returns for firms with and without qualifications are statistically different from zero only in year 1, .4047, and .4568, respectively.

  36. Decision number 1/304/06.10.2004 of the Capital Markets Commission that was published in the Government Gazette (ΦEK) 900B/06.16. 2004.

  37. Out of 149 firms with qualifications, 131 survived to 2004. From the 18 that dropped out of the sample, 10 merged or were acquired, four went bankrupt, and four permanently delisted. Out of 55 firms without qualifications, 44 survived to 2004. From the 11 that dropped out of the sample, eight merged or were acquired, and three were temporarily delisted.

  38. Failure of analysts to incorporate into their earnings forecasts information reported in financial statements has also been documented by prior studies such as Abarbanell and Bushee (1997) and Amir and Sougiannis (1999).

  39. Theory has focused more on the underwriter-investor relationship, e.g., Benveniste and Spindt (1989).

  40. We assume a constant cost of equity capital to simplify the exposition but a time-varying r can also be assumed.

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Acknowledgments

We thank the editor, Charles M.C. Lee, an anonymous reviewer, A. Rashad Abdel-khalik, Apostolos Ballas, William Beaver, Andreas Charitou, Rajib Doogar, Kostas Karamanis, Mark Peecher, Ira Solomon, Efthimios Tsionas, Nikolaos Travlos, and seminar participants at the University of Cyprus, and at the 2003 European Accounting Association meetings for their comments and suggestions. Funding for this project was received from the European Social Fund and Greek National Resources (Ministry of Education) Pythagoras II – EPEAEK.

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Authors and Affiliations

  1. Athens University of Economics and Business, Athens, 10434, Greece

    Dimitrios C. Ghicas, Afroditi Papadaki & Georgia Siougle

  2. Department of Accountancy, University of Illinois-Champaign, 209 Wohlers Hall, 1206 South Sixth Street, Champaign, IL, 61820, USA

    Theodore Sougiannis

  3. Athens Laboratory of Business Administration (ALBA), Vouliagmeni, 16671, Greece

    Theodore Sougiannis

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  1. Dimitrios C. Ghicas
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  2. Afroditi Papadaki
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  3. Georgia Siougle
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  4. Theodore Sougiannis
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Correspondence to Theodore Sougiannis.

Appendix

Appendix

1.1 Derivation of the forecasted earnings and offer value models

A. We derive the forecasted earnings model from the framework developed in Ohlson (1995) and Feltham and Ohlson (1995). In that framework, future abnormal earnings, \(\tilde{X}_{t+1}^a,\) are predicted by current abnormal earnings, X at , and information other than abnormal earnings, V t :

$$\tilde {X}_{t+1}^a =\omega X_t^a +\lambda V_t +\tilde {\varepsilon}_{t+1}$$
(1a)

where ω and λ are parameters and \(\tilde {\varepsilon }_{t+1}\) is an unpredictable error term.

Abnormal earnings at t + 1 and t are defined as:

$$\tilde {X}_{t+1}^a =\tilde {X}_{t+1} -rY_t$$
(2a)

and

$$ X_t^a =X_t -rY_{\rm t-1}$$
(3a)

where \(\tilde {X}_{t+1}\) is predicted earnings at t + 1, X t is actual earnings at t, r is the firm’s cost of equity capital, and Y t and Y t−1 is the book value of equity at t and t−1, respectively. Footnote 40

Substituting (2a) and (3a) into (1a) yields:

$$\tilde{X}_{t+1}=\omega X_t -\omega rY_{t-1} +rY_t +\lambda V_t+\tilde {\varepsilon }_{t+1}$$
(4a)

Using the clean surplus equation, Y t  = Y t−1 + X t −D t , where D t is net dividends, (4a) gives:

$$\tilde {X}_{t+1} =(r-\omega r)Y_{\rm t-1} -rD_t +(\omega +r)X_t+ \lambda V_t +\tilde {\varepsilon }_{t+1}$$
(5a)

Equation (5a) indicates that earnings at t + 1 are predicted by equity book values at t−1, net dividends at t, earnings at t, and other information at t. In our setting (a) net dividends at t is the difference between the new investment (IPO proceeds) and any dividends declared or distributed and (b) other information is the auditors’ qualifications. Equation (5a) is the basis of our earnings forecasting model, Eq. (1) in the text, with a difference in timing given that analysts provide forecasts for year t, the year of the IPO.

B. We derive the offer value model from the contemporaneous equity valuation model developed in Ohlson (1995) and Feltham and Ohlson (1995). That is:

$$P_t =Y_t +\alpha X_t^a +\beta V_t$$
(1b)

where P t is the value of common equity, α and β are valuation parameters, and the remaining variables defined as in part A above. Using the clean surplus equation for Y t and the definition of X a t from (3a) above, (1b) yields:

$$P_t =(1-\alpha r)Y_{t-1} -D_t +(1+\alpha)X_t +\beta V_t$$
(2b)

Equation (2b) indicates that the current value of common equity is determined by the book value of equity at t−1, net dividends at t, earnings at t, and other information at t. Equation (2b) is the basis of our offer value model, Eq. (2) in the text, but again with a difference in timing given that the year of the IPO is the current year t. Clearly, in (5a) and (2b) the right hand side variables are the same. This is consistent with the theoretical framework: variables relevant in predicting future earnings must also be relevant in determining equity values.

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Ghicas, D.C., Papadaki, A., Siougle, G. et al. The relevance of quantifiable audit qualifications in the valuation of IPOs. Rev Account Stud 13, 512–550 (2008). https://doi.org/10.1007/s11142-007-9051-2

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