Why is it important for financial statements to receive an unqualified auditors opinion?

The US Public Company Accounting Oversight Board (PCAOB) describes the auditor’s report as utilizing “a pass/fail model because the auditor opines on whether the financial statements are fairly presented (pass) or not (fail)” (PCAOB, 2011, p. 3). However, the auditor technically has a third option beyond a strict “pass” or “fail” characterization of the financial statements, which is to qualify his or her opinion.1 A qualified opinion provides assurance that the overall financial statements are fairly presented in accordance with US Generally Accepted Accounting Principles (GAAP), with the exception of a particular, non-pervasive matter to which the qualification relates (AS 3101.20, PCAOB, 2015). Although the auditing standards give auditors the option to qualify their opinion, the Securities and Exchange Commission (SEC) takes the position that financial statements receiving a qualified opinion fail to comply with filing requirements for publicly listed companies (SEC Codification of Staff Accounting Bulletins, Topic 1E2). Given the SEC’s stance, it is not surprising that qualified audit opinions are rarely issued in the US. Despite the fact that nearly all companies receive unqualified audit reports, we still observe a significant number of financial statements that are restated each year due to GAAP violations. Thus, the question must be asked, is the current “pass/fail” system working?

Presumably, the SEC’s prohibitive stance on financial statements filed with a qualified report is intended to force companies to be GAAP compliant. This paper argues that the SEC’s stance may actually have the opposite effect. Building on the extant auditor-client negotiation literature (e.g., Gibbins, Salterio, & Webb, 2001; Gibbins, McCracken, & Salterio, 2007), we employ game theory (e.g., Dixit and Nalebuff, 1991, Fellingham and Newman, 1995) to contend that the severe repercussions associated with receiving a qualified audit report (e.g., suspension or delisting of securities), coupled with the fact that such reports are virtually non-existent in the US, have caused audit clients to perceive the qualified opinion as a non-credible threat. We further argue that the inability of auditors to use the threat of a qualification as leverage in auditor-client negotiations severely limits their ability to successfully negotiate audit adjustments, potentially impairing financial reporting quality. Such a result is consistent with the occurrence of financial statement restatements and may indicate that some percentage of the financial statements issued in the US that are subsequently restated likely should have received a qualified opinion when they were initially issued.

To develop this argument, we consider various streams of literature from both accounting and economics and provide data drawn from archival- and survey-based methods. In this way, our paper answers a call by Power and Gendron (2015) for audit research that integrates different research streams and methodological approaches to provide a variety of perspectives on an audit issue. First, we examine the number of qualified audit opinions issued to US publicly listed companies each year over a recent 16 year period and the severe consequences faced by these companies. Next, we apply a simple game theory – the Rotten Kid Game2 – to an auditor-client negotiation setting to illustrate how the severe consequences associated with receiving a qualified opinion may result in the issuance of financial statements that do not fully comply with GAAP. Specifically, the severe consequences could be causing audit clients to perceive the threat of a qualified opinion as being non-credible, leaving auditors with little leverage to negotiate GAAP compliance. Consistent with this idea, we note that the number of financial statement restatements each year are relatively high in comparison to the miniscule number of qualified audit opinions and argue that a qualified opinion technically should have been issued for at least some of these company filings. Finally, we look to enforcement agencies presiding over global securities market jurisdictions to provide possible guidance on how the SEC should consider changing its approach toward qualified audit opinions in the US.

Standards governing qualified audit opinions

The PCAOB specifies two conditions when an auditor should issue a qualified opinion (AS 3101.20, PCAOB, 2015)3:

There is a lack of sufficient appropriate audit evidence or there are restrictions on the scope of the audit that have led the auditor to conclude that he or she cannot express an unqualified opinion and

Auditor-client negotiation models

Gibbins et al. (2001) develop a descriptive model of auditor-client negotiations and describe the negotiation process as being influenced by three contextual features of the accounting environment: (1) the two parties’ capabilities, (2) the interpersonal relationship between the two parties, and (3) external conditions and constraints. Two of the “external conditions and constraints” said to influence auditor-client negotiations are existing securities regulations and the auditor’s power to

Strengthening the deterrent effect of the qualified audit opinion

Given the previous discussion of the qualified audit opinion being a threat of low credibility, considering how the credibility of the qualified audit opinion could be improved becomes of significant importance. Some economic theorists have proposed that to make a threat regarding a retaliatory action credible, the action must be the optimal choice (i.e., not costly) for the party levying the threat (e.g., Dixit, 1979, Spence, 1977). This idea was illustrated in the previous section using the

Discussion and conclusions

While the SEC’s response to qualified opinions likely has contributed to their near extinction within the US, it is not clear whether this result is optimal for financial statement users. In this paper, we argue that the overly severe penalties associated with receiving a qualified audit report have contributed to GAAP non-compliance, consistent with the Rotten Kid Game (Dixit & Nalebuff, 1991). While it is impossible to know the extent to which this is occurring, we do have evidence regarding

Data availability

Data used in this study are available from the authors upon request.

Acknowledgments

Special thanks to Luis Betancourt, Paul Copley, Audrey Gramling, Marlys Lipe, Bill Messier, James Whitworth, Michael Wilkins, and session participants at the 2013 AAA Annual Meeting for their helpful comments.

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