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- 1. Review of Accounting and FinanceEmerald Article: Apparent audit failures and value relevance of earningsand book valueLi Dang, Kevin F. Brown, B.D. McCulloughArticle information:To cite this document:Li Dang, Kevin F. Brown, B.D. McCullough, (2011),"Apparent audit failures and value relevance of earnings and book value", Reviewof Accounting and Finance, Vol. 10 Iss: 2 pp. 134 - 154Permanent link to this document:http://dx.doi.org/10.1108/14757701111129616Downloaded on: 29-06-2012References: This document contains references to 36 other documentsTo copy this document: firstname.lastname@example.orgThis document has been downloaded 973 times since 2011. *Users who downloaded this Article also downloaded: *Imen Khanchel El Mehdi, Souad Seboui, (2011),"Corporate diversification and earnings management", Review of Accounting andFinance, Vol. 10 Iss: 2 pp. 176 - 196http://dx.doi.org/10.1108/14757701111129634Haidan Li, Yiming Qian, (2011),"Outside CEO directors on compensation committees: whose side are they on?", Review of Accountingand Finance, Vol. 10 Iss: 2 pp. 110 - 133http://dx.doi.org/10.1108/14757701111129607Edward M. Werner, (2011),"The value relevance of pension accounting information: evidence from Fortune 200 firms",Review of Accounting and Finance, Vol. 10 Iss: 4 pp. 427 - 458http://dx.doi.org/10.1108/14757701111185362Access to this document was granted through an Emerald subscription provided by Universidad Nacional de CordobaFor Authors:If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service.Information about how to choose which publication to write for and submission guidelines are available for all. Please visitwww.emeraldinsight.com/authors for more information.About Emerald www.emeraldinsight.comWith over forty years experience, Emerald Group Publishing is a leading independent publisher of global research with impact inbusiness, society, public policy and education. In total, Emerald publishes over 275 journals and more than 130 book series, aswell as an extensive range of online products and services. Emerald is both COUNTER 3 and TRANSFER compliant. The organization isa partner of the Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archivepreservation.*Related content and download information correct at time of download.
2. The current issue and full text archive of this journal is available atwww.emeraldinsight.com/1475-7702.htmRAF10,2Apparent audit failures and value relevance ofearnings and book value134Li DangOrfalea College of Business, California Polytechnic State University, San Luis Obispo, California, USA Kevin F. BrownDepartment of Accountancy, Raj Soin College of Business, Wright State University, Dayton, Ohio, USA, andB.D. McCulloughDepartment of Decision Sciences, LeBow College of Business,Drexel University, Philadelphia, Pennsylvania, USA Abstract Purpose The purpose of this paper is to examine the value relevance of accounting information in cases of apparent audit failures. Design/methodology/approach The authors adopt the bootstrapping technique and compare the value relevance of key accounting information across samples of rms experiencing apparent audit failures with matched non-audit failure rms. Findings Accounting information is found to be less value relevant for rms experiencing apparent audit failures, regardless of auditor reputation. Research limitations/implications This study has limitations due to the ex ante research approach adopted. Future research could address this issue by possibly incorporating an intervening factor into the model to indicate how the market can differentiate audit failure rms from other rms. Originality/value The paper gives support to the assertion that the market appears to rely less on accounting numbers when audit failures occur, even though formal allegations of audit failure may not appear until years after their occurrence. In addition to contributing to value-relevance research by providing empirical evidence for the market phenomenon around the time of material misstatements, the paper demonstrates an innovative application of bootstrapping to test for differences in R 2. Keywords Auditing, Accounting information, Earnings Paper type Research paper I. Introduction DeAngelo (1981, p. 186) denes audit quality as the market-assessed joint probability that a given auditor will both (a) discover a breach in the clients accounting system, and (b) report the breach. However, assessment of quality for particular audit engagements remains somewhat murky, due to the nature of the audit process, the reporting of audit outcomes, and users response to the auditors reputation (i.e. a BigReview of Accounting and Finance vs non-Big dichotomous audit quality measurement). Previous studies have examinedVol. 10 No. 2, 2011pp. 134-154the association between audit quality and earnings response coefcients (Teoh andq Emerald Group Publishing Limited1475-7702 Wong, 1993). The empirical results appear to support that the market respondsDOI 10.1108/14757701111129616positively to reputable auditors. 3. However, whether auditor reputation could serve as a reliable proxy for audit Apparentquality may be unknown due to the high-prole audit failures which occurred during the audit failuresdownturn in the nancial markets a decade ago. Many notorious rms, for instance,Enron, WorldCom, and Tyco, were audited by Big ve auditors with reputations similaror even superior to those of the non-Big ve. Thus, one might conclude that an auditorsreputation may actually hinder the markets ability to assess the reliability of accountinginformation.135The purpose of this paper is to explore whether auditor reputation affects the valuerelevance of accounting information in cases of apparent audit failures. For the purposeof this study, apparent audit failures are dened as instances that an auditor issuesan unqualied opinion on materially misstated nancial statements. Since apparentaudit failures indicate poor audit quality, they offer an opportunity to explore theassociation between stock prices and accounting information given low audit quality.Therefore, this study compares ex ante value relevance of accounting information ofpublicly held US rms experiencing apparent audit failures with a matched groupof rms not experiencing such failures. Ex ante value relevance refers to value relevanceof accounting information prior to the discovery of audit failures. Matching auditfailure rms with non-audit failure rms allows audit quality to be evaluated on aservice-by-service basis, consistent with the suggestion of Lam and Chang (1994).This study differs from previous studies on market reactions to news of auditfailures, accounting scandals, or earnings restatements (Chaney and Philipich, 2002;Dechow et al., 1996; Feroz et al., 1991). Instead of examining stock market reactions to thenews of audit failures, we focus on examining value relevance of accounting informationin the alleged periods of misstatement. Those alleged periods are the reporting periodswhen audited nancial statements contain material misstatements. We comparerms experiencing apparent audit failures with matched rms without audit failures inthe same periods in order to nd whether there is a difference in value relevance ofaccounting information prior to audit failures becoming public. Therefore, this is anexploratory study that aims to examine market reactions around the time when nancialstatements contain misstatements. In addition, we divided our sample into sub-samplesclassied by auditor types (i.e. Big 8/6/5/4 auditors vs non-Big 8/6/5/4 auditors) andconduct the same comparisons to investigate whether such a difference is conditioned onauditor reputation.Several sources are used to identify apparent audit failures (in these cases, an auditorissues an unqualied opinion on materially misstated nancial statements). Thesesources include the US Securities and Exchange Commissions (SECs) Accounting andAuditing Enforcement Releases (AAERs), nancial statements restatements because ofpast misstatements, and litigation against auditors due to audit failures.Consistent with prior research (Collins et al., 1997, 1999; Rees, 1999; Rajgopal et al.,2002), value relevance is measured by the explanatory power of contemporaneousearnings and book values for stock prices (i.e. the regression of stock price on earningsand book values). We apply a bootstrapping analysis to test data collected. The results ofthis analysis indicate that the accounting information of rms experiencing apparentaudit failures is generally less value relevant than that of a matched group of rms notexperiencing such failures. Results of sub-sample comparisons further indicate that theaudit reputation may not be essential because the market appears to discount lessreliable accounting information. The remainder of this paper is organized as follows. 4. RAFSection II describes prior research pertaining to market perceptions of audit quality.10,2 Section III contains the development of the research hypothesis. Section IV discusses data collection and the research methodology. Section V presents statistical analysis and empirical results. Section VI provides concluding remarks.136II. Prior research Previous studies of audit failures have focused on market reactions to the announcements of earnings restatements, fraud class actions, and SEC enforcement actions (Liu et al., 2009; Akhigbe et al., 2005; Chaney and Philipich, 2002; Dechow et al., 1996; Bhagat et al., 1994; Francis et al., 1994; Kellogg, 1984). Overall, these studies have documented a negative market reaction to such announcements. For example, Francis et al. (1994) nd a negative market response to the corrective disclosure of rms experiencing class action litigation. Feroz et al. (1991) document a 10 percent decline in stock prices at announcements of