Journal of Accounting and Economics 37 (2004) 139165

An empirical analysis of auditor reporting and its

association with abnormal accruals
$
Marty Butler
a
, Andrew J. Leone
a,
*, Michael Willenborg
b
a
William E. Simon Graduate School of Business Administration, University of Rochester, Rochester,
NY 14627, USA
b
School of Business Administration, University of Connecticut, Storrs, CT 06269, USA
Received 29 January 2002; received in revised form 9 June 2003; accepted 25 June 2003
Abstract
In this paper, we use a web-based sampling methodology to obtain and content analyze a
large sample of modied audit opinions. Based on this analysis, we re-examine whether certain
modied audit opinions are associated with abnormal accruals. We nd that the documented
relation between modied opinions and abnormal accruals rests with companies that have going-
concern opinions. These rms have large negative accruals that are likely due to severe nancial
distress. Overall, we nd no evidence to support inferences in previous research that rms
receiving modied audit opinions manage earnings more than those receiving clean opinions.
r 2003 Elsevier B.V. All rights reserved.
JEL classication: M41; D21; C81
Keywords: Abnormal accruals; Audit rms; Audit opinions; Financial distress; Earnings management
ARTICLE IN PRESS
$
We thank Mary Barth, Bill Beaver, Joe Carcello, Liz Demers, Bill Felix, Ed Kay, Bill Kinney, John
Hand, Paul Hribar (referee), Jagan Krishnan, Doug Skinner (editor), Richard Sloan, Christine Tan, Scott
Vandervelde, Charlie Wasley, Ross Watts, Joseph Weber, Tzachi Zach, Jerry Zimmerman, and workshop
participants at Dartmouth, Georgia State, Harvard, Iowa, Rochester, Stanford, Temple, the 2002 AAA
Audit Midyear Meeting, and the 2002 University of Illinois Symposium on Audit Research. We also thank
Paul Ames, Vinay Bassi, Natalya Bushneva, Rumen Efremov, Girts Freibergs, Junfeng Han, Treppy
Johnson, Winward Lewin, Ai Qin Liu, Trevor Lloyd, Chris Wang, and especially Kalina Berova for
excellent research assistance. Support was provided by the John M. Olin Foundation and the Bradley
Policy Research Center at the University of Rochester. Portions of this paper were completed while the
second and third authors were visiting the University of Michigan and the Universiteit Maastricht,
respectively.
*Corresponding author. Tel.: +1-716-275-4714; fax: +1-716-442-6323.
E-mail address: leone@ssb.rochester.edu (A.J. Leone).
0165-4101/$ - see front matter r 2003 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2003.06.004
1. Introduction
The audit opinion, as the observable output from an otherwise unobservable
process, represents a crucial piece of information for nancial statement users. For
example, the presence of a going-concern (GC) opinion has been shown to be
informative with respect to stock returns (Dopuch et al., 1986; Choi and Jeter, 1992)
and bankruptcy events (Hopwood et al., 1989; Kennedy and Shaw, 1991). More
recently, several studies examine the relation between accounting accruals and the
presence of certain modied audit opinions (Francis and Krishnan, 1999; Bartov
et al., 2000; Bradshaw et al., 2001). In essence, these studies test the hypothesis that
earnings management increases the likelihood of receiving a modied audit opinion.
1
The direction of causality is important because if auditor reporting conveys
information about earnings management, then a link can be made between audit
opinions and earnings quality. In this paper, we re-examine auditor reporting and its
association with abnormal accruals, assessing, in particular, the claim that modied
opinions are reliable signals of earnings management.
Although we expect auditing to limit earnings management, it is not obvious that
earnings management will typically lead to a modied audit opinion. Indeed, if an
auditor detects earnings management and rm managers refuse to adjust the
nancial statements, the auditors reporting options under Generally Accepted
Auditing Standards (GAAS) are to issue an adverse, disclaimed, or qualied
opinion, the consequences of which can be severe (e.g., per Rule 2-02 of Regulation
S-X, the SEC will not accept the statements). Moreover, rms with certain modied
opinions have unusual accruals for reasons other than earnings management. Due,
for example, to poor rm performance or liquidity-motivated survival tactics, the
presence of GC opinions is often contemporaneously associated with large negative
accruals. For these reasons, and consistent with the view that most earnings
management takes place within the boundaries of GAAP (Healy, 1985), we argue
that the opinion/accruals relation is not due to earnings management.
To examine the link between abnormal accruals and auditor opinion type, we
begin by providing descriptive information on Compustats auditor/auditors
opinion data item for the 20 years from 1980 to 1999, a period spanning a major
change in GAAS (i.e., SAS 58). Because auditors issue modied opinions for
numerous reasons that Compustat combines into just a few categories, we compare
Compustat opinion classications for 19941999 to source documents on EDGAR.
We nd that 1,385 (16%) of 8,478 opinions that Compustat classies as modied are
actually clean opinions. For example, Compustat classies 801 rm-year observa-
tions as modied simply because auditors mention that they reviewed a
supplementary schedule led with the 10-K. Based on examining over 7,000
modied opinions from this period, we identify two factors that account for over
90% of modications: consistency issues requiring no restatements (e.g., adoption of
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1
We use the term modied opinions to refer to both qualied opinions (scope limitations or
departures from GAAP) and unqualied opinions with explanatory language (e.g., going concern and
consistency).
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 140
new accounting standards) and GC opinions.
2
In addition, we nd that while
unqualied opinions with explanatory language are relatively common, qualied
opinions are rare. Further, the reasons provided for these qualied opinions appear
unrelated to earnings management and is thus inconsistent with the view that
earnings management typically causes modied audit opinions.
3
Based on our analysis of the reasons auditors depart from standard unqualied
opinions, we identify the types of modied opinions that are associated with large
accruals. We nd that companies with GC opinions drive the opinion/accruals
relation because such companies have extremely negative abnormal accruals.
However, we report no evidence of differences in abnormal accruals for GC rms
when compared to rms matched on a measure of nancial distress. The evidence is
consistent with the view that rms in severe nancial distress, independent of audit
opinion type, engage in liquidity-enhancing transactions (e.g., delaying payables or
factoring receivables) that result in large negative accruals. Because traditional
abnormal accrual models do not adequately control for distress-induced variation in
accruals, the large negative accruals characteristic of GC rms appear abnormal
(i.e., indicative of earnings management), but they are no different from similarly
distressed clean-opinion rms. Overall, we nd no evidence that rms receiving
modied audit opinions manage earnings more than those receiving clean audit
opinions.
Our contribution is two-fold. First, we provide a large-sample descriptive analysis
of audit opinions by audit rm type. This shows the impact of SAS 58 on auditor
reporting, points out problems with Compustat audit opinion data, and provides a
content analysis of the reasons why companies receive modied opinions. Second, we
show that the modied opinions/abnormal accruals relation stems from companies
with GC opinions, because they have negative accruals. As such, our ndings cast
some doubt on the conclusions of previous research that has attributed the opinion/
accruals relation to more aggressive earnings management. In particular, we point
out how the Bartov et al. (2000) results appear to be due to severely distressed rms
(with GC opinions), rather than due to rms engaging in extreme earnings
management. Overall, we nd no evidence to support the claim that rms receiving
modied audit opinions manage earnings more than those receiving clean audit
opinions.
Our ndings also have implications for research on the relation between audit
opinion modications and earnings management, as well as earnings management
in general. In particular, because the auditors role is not to assess earnings
quality, researchers should be cautious when drawing inferences about the
relation between auditors opinions and traditional measures of abnormal accruals
as proxies for earnings management. As we discuss above, modications due to
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2
We use the term GC opinion to refer both to cases in which auditors explicitly use the term going
concern in the text of the audit report (2,910) and to cases in which auditors mention either bankruptcy
proceedings or a material business uncertainty, but do not explicitly use the term going concern (2 5 1).
3
Of course, the fact that a qualied audit opinion does not literally mention earnings management does
not mean that auditors fail to detect, or constrain, earnings management (see Section 2).
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 141
earnings management should be exceedingly rare. Further, because the negative
relation between certain modied audit opinions and abnormal accruals is
concentrated in rms in nancial distressthat is, cases in which traditional
models of earnings management are especially misspeciedusing modied-opinion
rms to compare competing abnormal accrual models is more likely to measure
the models relative misspecication than their power to detect earnings manage-
ment. More generally, because GC companies can substantially affect abnormal
accrual calculations, it is important to consider controlling for such opinions.
Finally, our ndings highlight the importance of performance matching when the
companies of interest are experiencing extreme performance and demonstrate further
that the choice of performance control variable can be an important design
consideration.
The remainder of the paper is organized as follows. Section 2 discusses
institutional details and the opinion/accruals relation. Section 3 details our sampling
methodology. Section 4 provides a content analysis for those modied audit
opinions that we can nd on EDGAR. Section 5 re-examines the opinion/accruals
relation. Section 6 summarizes our main ndings and offers some implications and
suggestions for past and future earnings-management research.
2. Earnings-management and the audit opinions/accounting accruals relation
As a form of monitoring, auditing mitigates incentive problems between managers
and outsiders. Following such an agency cost argument, several recent papers
(Francis and Krishnan, 1999; Bartov et al., 2000; Bradshaw et al., 2001) argue
that modied audit opinions are either inuenced by, or provide evidence of,
more pervasive earnings management. In general, these papers posit that
modied audit opinions should be a function of accounting accruals.
4
However,
given the nature of the audit process and federal securities laws governing accounting
reports, it is unlikely that earnings management will lead to a modied audit
opinion.
Consider a case where an auditor believes that certain accounts are misstated.
If the suspected earnings management involves no material misstatement or
conforms to GAAP, then there is no basis for the auditor to qualify or otherwise
modify the opinion. For example, the auditor may believe that the allowance for
doubtful accounts is understated but deem the understatement to be either
immaterial or due to a difference in judgment within the connes of GAAP. In
either of these cases, the auditor will not issue a modied opinion even if the
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4
While the empirical design of these papers differs somewhat, they all regress audit opinion type on
accounting accruals. Francis and Krishnan (1999) consider rms with audit opinions modied for asset
realization and GC uncertainties as a function of indicator variables that capture extreme levels or
components of total accruals. Bartov et al. (2000) consider rms with audit opinions modied for scope
limitations and GAAP departures as a function of the absolute value of different abnormal accrual
metrics. Bradshaw et al. (2001) consider rms with any type of modied (or unclean) audit opinion as a
function of signed working capital accruals.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 142
accounting seems aggressive. Auditors do not have latitude to comment or elaborate
on the overall quality of earnings as long as the nancial statements materially
conform to GAAP.
If, on the other hand, the auditor determines that the nancial statements
include a material misstatement or departure from GAAP, then GAAS oblige the
auditor to communicate the deciencies to managementor directly to the audit
committee or SEC in cases of fraudand request that they adjust the nancial
statements accordingly (OMalley et al., 2000, p. 82). If management makes
the necessary adjustments, then the monitoring role of the auditor is unobservable
and the audit opinion will contain no earnings-management-based modication.
However, should management refuse to adjust the nancial statements, then
the auditors choice is either to resign or to issue an adverse, disclaimed, or qualied
audit opinion. The consequences of each option are severe. For example,
per Regulation S-X, the SEC will not accept a registrants nancial statements
that have been qualied or disclaimed by their auditor. Moreover, because the
nancial statements contain a material misstatement, the registrant [is] knowingly
... ling a false and misleading document, an act punishable under SEC Rule 10b-5
(Herz et al., 1997). The auditor and the company likely resolve earnings-
management-related issues before the audit report is issued because the costs
of not doing so are so high. As a result, given the nature of the audit process,
the auditors reporting choices under GAAS, and institutional features of the
audit environment, an audit opinion modication due to earnings management
should be rare.
5
Evidence in Nelson et al. (2002) suggests that auditors and management virtually
always resolve earnings-management issues before opinions are issued. They report
the results of a survey of 253 audit partners and managers of a Big 5 rm, who
describe 515 specic incidences of potential earnings management detected during
the course of their audits. Of these instances of possible earnings management, 44%
of the time there was an adjustment, 21% of the time there was no adjustment
because the client was able to demonstrate compliance with GAAP, 17% of the time
there was no adjustment because the auditor was unable to convincingly show that
the clients position was incorrect, and 18% of the time there was no adjustment due
to immateriality (or some other reason). In only seven of the 515 instances did the
putative earnings management attempt lead to an opinion modication.
6
Moreover,
these seven modications could be due to disagreements, between management and
the auditor, about the application of GAAP rather than earnings management. The
other 99% of cases were resolved prior to the issuance of the nancial statements and
audit report.
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5
We thank Ed Kay, Managing Partner at PricewaterhouseCoopers, Rochester, NY, for informative
discussions about the audit process and, in particular, the steps that auditors take when a material
misstatement is identied.
6
There was one instance of an adverse audit opinion and six instances of audit opinions qualied for
departure from GAAP. We thank Mark Nelson for providing this information, which is not reported in
Nelson et al. (2002).
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 143
3. Web-based sample of modied audit opinions
3.1. Compustats audit data item, before and after SAS58
We begin with the merged Compustat database (i.e., full coverage, industrial
annual, and research) for the period from 1980 to 1999 and identify 147,926 rm-
year observations for which the auditor/auditors opinion data item (x149) is not
missing.
7
Compustat uses this data item to designate a companys audit rm
companies with Big5 rms comprise 80.1% of the sampleand the type of audit
opinion the company receives: unaudited (0), unqualied (1), qualied (2),
disclaimer/no opinion (3), unqualied with explanatory language (4), or adverse
(5). The majority of the sample (77.3%) is unqualied opinions.
Several changes in auditing standards have inuenced the format of audit reports
and, consequently, Compustats classication of audit opinions. Most importantly,
SAS 58, effective for reports issued after January 1,1989, changes the conditions
under which qualied opinions are issued. Prior to SAS 58, there were two broad
classes of qualied audit opinions: except for opinions were issued when there
were scope limitations, departures from GAAP, or a lack of consistency (e.g., a
change from one generally accepted accounting method to another); and subject
to opinions were issued in the presence of material uncertainties, such as asset
realization, contingent liabilities, or substantial doubt concerning an entitys ability
to continue as a going concern. Under SAS 58, changes from one acceptable
accounting method to another and every type of subject to opinion no longer give
rise to qualied opinions. Instead, under present-day GAAS, there is now a
category for unqualied opinions with explanatory language that discusses either
the accounting change or material uncertainty. Consequently, only the format and
not the information contained in the audit opinion has changed.
As a result, prior to SAS 58, a Compustat qualied opinion (Compustat
opinion code 2) related to both except for as well as subject to audit opinions.
Under the SAS 58 regime, however, Compustat code 2 opinions include only
qualications for scope limitations and departures from GAAP. Other modica-
tions, such as changes from one generally accepted accounting method to another
and material uncertainties, should now be classied as unqualied opinions with
explanatory language (Compustat code 4).
Table 1 presents Compustat opinion codings for the 19801999 period,
categorized by SAS 58 time frame and audit rm type. Because our sample includes
both pre-SAS 58 years (19801987), as well as years in which SAS 58 is effective
(19881999), we present annualized counts to aid comparability. As expected, the
most signicant shift across the two time periods is the frequency of qualied
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7
Compustat creates an observation for the entire 20-year period for each rm present in any of the years
covered. So, if Compustat began including a rm in 1990, Compustat adds records containing missing
values for the rm for each year from 1980 to 1989. To determine the number of valid rm-year
observations, we count only observations with non-missing values for both total assets and audit opinion
data items (x6 and x149, respectively).
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 144
opinions (code 2) and unqualied opinions with explanatory language (code 4).
Looking at Big5-audited companies, 11.1% had qualied opinions in the pre-SAS
regime versus only 0.2% in the SAS 58 regime. In contrast, there were virtually no
Big5-audited companies with Compustat code 4 (i.e., unqualied with explanatory
language) opinions in the pre-SAS 58 regime, but 25.6% of such companies received
these opinions in the SAS 58 regime. Notably, in the SAS 58 period, we detect no
meaningful distinction between Compustats code 2 and code 4 opinions. That is, we
identify companies with qualied opinions that have code 4 (i.e., unqualied opinion
with explanatory language) classications, as well as companies with code 2 (i.e.,
qualied opinion) classications that have unqualied opinions with explanatory
language. Overall patterns are similar for non-Big5 rms. The differences we report
in the pre-SAS 58 and SAS 58 periods likely have implications for the comparability
of our ndings to past research, which we examine in Section 5.4.
3.2. Tracking Compustats audit data to EDGAR source documents via the Web
To independently verify and further rene Compustats audit opinion classica-
tions, we construct a large database of modied opinions. To do this, we develop a
Web application that automates the process of collecting and classifying audit
opinions. The application searches EDGAR for the 10-K corresponding to a given
company name and scal year-end. Obtaining opinions from EDGAR reduces data
collection costs; however, it also limits the time period we cover from 19801999 to
19941999. Using keywords to identify the rms audit opinion, the program
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Table 1
Average annual Compustat audit opinion code types by SAS 58 regime and audit rm type (19801999)
a
Opinion
code
Compustat
opinion type
Pre-SAS 58 (19801987) SAS 58 (19881999)
Big5 Non-Big5 Big5 Non-Big5
0 Unaudited 2 (0.05%) 1 (0.08%) 1 (0.01%) 2 (0.11%)
1 Unqualied 4,277 (88.22%) 1,271 (79.91%) 4,911 (73.98%) 912 (65.27%)
2 Qualied 540 (11.14%) 293 (18.44%) 12 (0.18%) 17 (1.24%)
3 Disclaimer/no opinion 27 (0.56%) 23 (1.47%) 16 (0.25%) 7 (0.51%)
4 Unqualied with
explanatory language
1 (0.03%) 2 (0.10%) 1,698 (25.58%) 459 (32.84%)
5 Adverse 0 (0.00%) 0 (0.00%) 0 (0.00%) 0 (0.03%)
Totals 4,847 (100.00%) 1,590 (100.00%) 6,638 (100.00%) 1,397 (100.00%)
a
This table reports the frequency distribution of audit opinions by Compustat classication, auditor
type, and pre- and post-SAS 58 implementation. Under SAS 58, subject to and except for consistency
opinions are no longer considered qualied opinions. Instead, these situations give rise to unqualied
opinions with explanatory language. Audit rm/audit opinion data is from the merged Compustat
database (i.e., full coverage, industrial annual, and research) for the 20-year period from 1980 to 1999
(Compustat data item #149). Because the pre-SAS 58 regime contains 8 years of observations and the SAS
58 regime contains 12 years, we present annualized information to facilitate comparisons.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 145
extracts the opinion from the 10-K and copies it to a database. If the 10-K search
fails to nd the opinion, the program searches other potentially relevant SEC lings
(e.g., S-l). In addition to facilitating collection of a large sample of audit opinions,
the application provides a systematic and efcient method (using keyword
algorithms) of categorizing opinions.
8
Table 2 summarizes sample construction. Using the Web application, we attempt
to collect and classify the 12,588 modied audit opinions of rms categorized by
Compustat from 1994 to 1999 as having either a qualied opinion (code 2) or an
unqualied opinion with explanatory language (code 4). Of the 12,588 audit
opinions, 900 relate to utilities and nancial rms that we eliminate because of
inherent differences associated with accounting accruals for these rms. Approxi-
mately 73% (8,478) of the remaining 11,688 opinions are usable, as we discard 3,210
data records because we are unable to nd either the ling or audit opinion on
EDGAR. Interestingly, given the criteria we use to select opinions of interest, we also
eliminate another 1,385 observations representing essentially clean opinions;
9
that is,
approximately 16% (1,385C8,478) of the opinions classied by Compustat as
modied opinions (code-2 and code-4) from 1994 to 1999 are actually clean
opinions.
10
It seems that Compustat simply ags all audit opinions as modied if
they deviate in any way from a standard boiler plate clean opinion. In summary,
using a Web-enabled, data collection routine, we collect and reliably classify 7,093
modied audit opinions for the 19941999 period (i.e., approximately 1,200 per year).
4. Content analysis of modied audit opinions
Table 3 provides a content analysis, by audit rm type, of modied audit opinions.
Following GAAS, we broadly categorize opinions into two categories (qualied
opinions and unqualied opinions with explanatory language), which we then
partition into subcategories. The content analysis serves two purposes. First, it
provides a large-sample analysis of the reasons underlying auditors decisions to
depart from a standard, unqualied opinion. Second, it allows a detailed re-
examination of the audit opinion/accounting accruals relation.
4.1. Reasons for departures from a standard unqualied audit report
Table 3 provides several insights into auditor reporting. Audit opinion
qualications occur much less frequently than unqualied opinions with explanatory
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8
Specic keywords used for classication are available from the authors.
9
Clean opinions either contain no qualifying or explanatory language or contain explanatory
language that is fundamentally different from that contained in other opinions. Explanatory language in
the latter opinion types was often trivial (e.g., 801 observations noted, without further qualication, that
ancillary schedules were audited in addition to nancial statements; 33 observations noted the audited
company was a development stage enterprise).
10
We also review a large number of opinions classied as clean to verify that these are, in fact, clean
opinions.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 146
language. In addition, almost half of all modications during our sample period are
GC opinions. Note that we classify some opinions that do not explicitly state going
concern as GC opinions if the opinions wording mentions severe business distress.
There were 251 (3,161 minus 2,910) cases where the auditors refer to either
bankruptcy or the presence of material business uncertainties without explicit
reference to the term going concern. None of the results we report later, however,
are sensitive to the exclusion of opinions in which the auditor does not explicitly use
the term going concern. Consistent with claims that the largest audit rms are
shedding riskier clients (Berton, 1995), we document a lower frequency of GC
opinions for companies audited by Big 5 rms. In addition, material uncertainty
opinions are infrequent, probably because most of our sample is drawn from the
time period for which SAS 79 is effective.
11
SAS 79 eliminates the requirement that,
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Table 2
Sample selection for content analysis and accruals analysis (19941999)
The sample is obtained by identifying all rm-year observations with Compustat audit opinion codes of
either 2 (i.e., qualied) or 4 (i.e., unqualied with explanatory language) for the 6-year period from 1994 to
1999. After eliminating 900 observations relating to utilities and nancial services rms, we attempt to
identify the actual audit opinion on the SECs EDGAR database. Of the 11,688 rm-year observations
(i.e., 12,588 minus 900), we nd 8,478 (i.e., 11,688 minus 3,210, or approximately 73%) on EDGAR. Of
these 8,478, we classied 1,385 rm-year observations (i.e., 801 plus 33 plus 551) as clean opinions
(Note: The opinions we characterize as clean either (a) contain no qualifying or explanatory language or
(b) contain trivial explanatory language fundamentally different from that contained in other collected
opinions. In other words, these opinions do not contain explanatory language that is consistent with
GAAS for designation as an unqualied opinion with explanatory language). We perform a content
analysis (see Table 3) using the resulting 7,093 rm-year observations, by audit rm type, to identify the
specic reason the audit opinion was either qualied or unqualied with explanatory language. We then
perform an analysis of the association between modied audit opinions (per GAAS) and abnormal
accounting accruals using the 4,205 rm-year observations (of the 7,093) with adequate Compustat
information (see Tables 47).
11
SAS 79 is effective for reports issued on or after February 29, 1996, but earlier application was
encouraged.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 147
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Table 3
Content analysis of modied audit opinions by audit rm type (19941999)
Observations are the 7,093 rm years in Table 2 that, guided by GAAS, we categorize as either qualied
opinions or unqualied opinions with explanatory language. We then partition these two categories
into subcategories based on the underlying reason for the opinion modication.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 148
when certain criteria are met relating to uncertainties, the auditors report must
include an explanatory paragraph. Under SAS 79, auditors may add an emphasis of
matter paragraph to highlight an uncertainty that is already appropriately disclosed,
but evidently few opinions contain such paragraphs. Lastly, and due largely to
changes in GAAP (e.g., deferred taxes, OPEB), we document a high percentage of
opinions that refer to accounting changes not involving restatements. Approximately
48% of our sample rms with modied opinions report an accounting change;
however, most of these opinions refer to the adoption of a new standard rather than
to a change from one generally accepted method to another.
4.2. A simple test of the relation between certain audit opinions and accruals
While auditors likely play an important role in monitoring and controlling
managers accrual choices, the content analysis provides little support for the
rationale that audit opinions commonly convey the presence of earnings manage-
ment. Bartov et al. (2000) assert that qualications for scope limitations or GAAP
departures proxy for extreme earnings management.
12
However, our content
analysis identies only 19 and 14 instances of opinion qualications for scope
limitation and GAAP departures, respectively, from 1994 to 1999.
13
We also
identify 147 unqualied opinions with explanatory language referencing a
permissible departure from GAAP, meaning that the SEC will accept the
nancial statements. Of these opinions, 69 refer to the use of international
accounting standards, 75 pertain to trusts using a modied cash basis of accounting,
and three refer to the auditing of supplemental schedules that do not conform to
GAAP.
14
Thus, the majority of opinions qualied for either scope or departure from GAAP
bear no discernible connection to extreme earnings management by the client.
Moreover, we identify no modied opinions that refer to the future consequences of
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12
Bartov et al. (2000) include all rms receiving qualied opinions (code 2 on Compustat). However, the
time period they study spans the pre-SAS 58 period. At that time, a qualied opinion could be issued due
to scope limitations, departures from GAAP, lack of consistency, going concern, asset realization and
contingent liabilities. Therefore, while they correctly used code 2 to identify qualied opinions, the
denition of a qualied opinion during much of their study-period is different from the denition in the
SAS 58 period. Because the code 2 opinion code is used infrequently after 1988 (see our Table 1), it is likely
that most of their sample came from the pre-SAS 58 time period. In addition, Bartov et al. describe in their
paper that Compustat Code 3 is assigned when a company receives a going concern opinion. However,
code 3 is assigned when the auditor chooses not to issue an opinion. This can happen if going concern
issues are extremely severe, but in most cases the auditor modies the opinion for going concern opinions
(code 2 in the pre-SAS 58 regime and code 4 in the SAS 58 regime).
13
The 14 qualied opinions mentioning GAAP departures involve three companies. One company elects
not to consolidate certain subsidiaries; the other two do not recognize deferred taxes in accordance with
US GAAP. Of these 33 qualied opinion observations, 17 have adequate Compustat information to
compute cross-sectional Jones (1991) model abnormal accruals. Of these 17, 10 (7) observations have
positive (negative) abnormal accruals as per Eq. (1) (see footnote 16). The mean for these 17 observations
is positive, though not signicantly different from zero.
14
Financial statements prepared in accordance with foreign GAAP are acceptable only if reconciled to
US GAAP. A modied cash basis of accounting is permissible for trusts.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 149
high positive accruals (Bradshaw et al., 2001). As such, our ndings do not support
the underlying rationale for the opinion/accruals relation put forth by Bartov et al.
(2000). They are, however, consistent with one explanation given by Bradshaw et al.
(2001) for the unexpected negative relation they nd between modied opinions
and working capital accruals, that reporting on the quality of earnings is beyond the
scope of the audit report. Nevertheless, even though earnings management does not
explain the abnormally large negative accruals of modied-opinion rms, the
underlying cause of the opinion/accruals relation remains unidentied. In the
following section we investigate the source of this relation.
5. Accruals analysis of modied audit opinions
5.1. Descriptive statistics by audit opinion type
Table 4 reports mean and median statistics for rm-year observations from
1994 to 1999 with adequate Compustat information to compute the variables
of interest. We divide the observations into ve audit opinion categories: un-
qualied, going concern, material uncertainty, accounting change (without restate-
ments), and other.
15
We provide information regarding total and abnormal accruals
per Jones (1991).
16
Following Hribar and Collins (2002), we use the statement of
cash ows approach in our tables, although our ndings are robust to using the
balance sheet approach to obtain total accruals (see also Section 5.4). Table 4 also
provides information for several of the independent variables in our accruals
regressions.
Firms in the GC category differ on almost every dimension from those in other
categories. For example, rms with GC opinions tend to be smaller, less protable,
less liquid, and to have more negative accruals. Highlighting the poor performance
of GC companies (e.g., mean and median lagged ROA is 0.60 and 0.32,
respectively) is the fact that over 85% of these observations report a loss in the year
prior to the GC. The peculiarities of companies with GC opinions reported in Table
4 are borne out in the multivariate analysis that follows.
ARTICLE IN PRESS
15
The sum of observations in modied-opinion categories in Table 4 (5,122) exceeds the total number of
modied opinions in Table 2 (4,205) because some rms have modications for multiple reasons (e.g., an
opinion referencing GC status and an accounting change would be classied as both GoingConcern and
OtherModied).
16
Following DeFond and Jiambalvo (1994), we estimate a cross-sectional version of the Jones (1991)
model for each (two-digit SIC) industry and year. After winsorizing at the 1st and 99th percentiles, we take
the residuals from the following regressions as our measures of abnormal accruals, which we denote as
AbnormalAccruals:
TotalAccruals
i;t
a
0
a
1
DSales
i;t
a
2
PPE
i;t
e
i;t;
1
where TotalAccruals=earnings before extraordinary items and discontinued operations minus operating
cash ows from continuing operations (Compustat 123(308124)Ctotal assets (beginning of year), per
Hribar and Collins (2002)); D Sales=change in sales from year t1 to year tCtotal assets (beginning of
year); PPE=net property, plant and equipment as of year tCtotal assets (beginning of year).
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 150
5.2. Regression analysisfull sample
We begin by regressing absolute abnormal accruals on control variables and audit
opinion type. This is essentially the reverse of the Bartov et al. (2000) specication in
which audit opinion type (qualied or unqualied) is the dependent variable and
absolute abnormal accruals is an independent variable (along with control
variables). We estimate the model this way because institutional characteristics of
ARTICLE IN PRESS
Table 4
Descriptive statistics by audit opinion category (19941999)
Variable Unqualied
opinions
Going
concern
opinions
Material
uncertainty
opinions
Accounting
change
opinions
Other
modied
opinions
TotalAccruals
t
Mean 0.06 0.27 0.10 0.06 0.15
Median 0.05 0.20 0.04 0.05 0.10
AbnormalAccruals
t
Mean 0.01 0.14 0.03 0.02 0.06
Median 0.02 0.10 0.03 0.03 0.01
MktCap
t
Mean 2.06 1.10 1.84 2.30 1.65
Median 2.01 1.12 1.78 2.25 1.54
Book/Mkt
t
Mean 0.57 0.31 0.49 0.61 0.46
Median 0.44 0.20 0.40 0.52 0.38
ROA
t1
Mean 0.03 0.60 0.08 0.01 0.27
Median 0.04 0.32 0.03 0.04 0.03
Debt/Assets
t
Mean 0.17 0.19 0.17 0.21 0.18
Median 0.11 0.07 0.12 0.18 0.11
CurrRatio
t
Mean 2.89 1.37 2.29 2.33 1.84
Median 2.03 0.79 1.76 1.74 1.29
Assets
t
Mean 920.75 91.02 530.16 1,579.02 561.54
Median 86.99 9.90 49.30 249.87 40.81
Big5
t
Mean 0.85 0.55 0.70 0.93 0.69
Observations 22,653 1,823 105 2,509 685
Observations are those rm-years from 1994 to 1999 for which adequate Compustat information is
available. For the modied audit opinion categories, observations are the 4,205 in Table 2; although,
instances of multiple classications are now reected in the above columns. These modied audit opinion
categories correspond to the categories in Table 3, with the following exceptions: Accounting Change
Opinion observations relate to the Consistencynon-restatement category in Table 3, and the other
opinion observations come from the qualied, consistencyrestatements, reliance on another auditor, and
related party transaction categories in Table 3.
Variables are dened as follows:
TotalAccruals=earnings before extraordinary items and discontinued operations minus operating cash
ows from continuing operations (Compustat 123(308124)Ctotal assets (beginning of year), per Hribar
and Collins (2002)).
AbnormalAccruals=cross-sectional Jones (1991) abnormal accruals (Eq. (1)).
MktCap =Log(Market value of equity).
Book/Mkt=book value of equityCmarket value of equity.
ROA=income before extraordinary itemsCtotal assets (beginning of year).
Debt/Assets=long-term debtCtotal assets (beginning of year).
CurrRatio=current assetsCcurrent liabilities.
Assets=total assets (beginning of year).
Big5=one if a Big5 audit rm and zero otherwise.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 151
the audit process and our content analysis do not support a causal relation in which
earnings management leads to an audit opinion modication.
17
Consistent with
Bartov et al., we control for market capitalization, book-to-market, protability,
and leverage. Due to the characteristics of companies with GC opinions (see
Table 4), we also control for liquidity (CurrRatio). In addition, to consider the non-
linear relation between performance and abnormal accruals, as described by Kothari
et al. (2003), we include ROA
2
t1
in addition to ROA
t1
:
18
To lessen the effect of
outliers, we winsorize extreme observations for all variables by setting the values in
the bottom and top 1% of observations of each measure to the values of the 1st and
99th percentiles of their respective distributions.
19
jAbnormalAccrualsj
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
Modified
i;t
e
i;t
; 2a
where
AbnormalAccruals =cross-sectional Jones (1991) abnormal accruals (Eq. (1)).
MktCap =Log
10
(Market value of equity).
Book/Mkt =book value of equityCmarket value of equity.
ROA =lagged income before extraordinary itemsCtotal assets (begin-
ning of year).
ROA
2
=square of ROA.
Debt/Assets =long-term debtCtotal assets (beginning of year).
CurrRatio =current assetsCcurrent liabilities.
Big5 =one if a Big5 audit rm and zero otherwise.
Modied =one if opinion is qualied or unqualied with explanatory
language and zero otherwise.
To consider the effects of the specic type of audit opinion modication, we
augment Eq. (2a) by replacing the Modied variable with variables corresponding to
the audit opinion categories in Table 4:
jAbnormalAccrualsj
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
GoingConcern
i;t
b
9
MatUncert
i;t
b
10
AcctChange
i;t
b
11
OtherModified
i;t
e
i;t
; 2b
ARTICLE IN PRESS
17
Following Bartov et al. (2000) we also estimate logit models. Inferences are unchanged (see
Section 5.4).
18
The inclusion of this variable, the squared of lagged ROA, has no effect on the papers inferences.
19
As an additional sensitivity test, we exclude outliers per Belsley et al. (1980). This data trimming
increases the regressions explanatory power but, again, has no effect on inferences.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 152
where
GoingConcern =one if opinion is unqualied with explanatory language pertain-
ing to going concern status, bankruptcy, or material business
uncertainty, and zero otherwise.
MatUncert =one if opinion is unqualied with explanatory language pertain-
ing to a material uncertainty (e.g., asset realization or contingent
liability), and zero otherwise.
AcctChange =one if opinion is unqualied with explanatory language pertain-
ing to lack of consistency not requiring restatement, and zero
otherwise.
OtherModied =one if opinion is qualied (scope limitations or GAAP departure)
or unqualied with explanatory language pertaining to lack of
consistency requiring restatement or reliance on another auditor or
related party transactions and zero otherwise.
The rst two columns of Table 5 present the results of these regressions. Results in
the rst column, where the coefcient on Modied is positive and signicant, support
Bartov et al.s (2000) contention that modied audit opinions are positively
associated with the magnitude of abnormal accounting accruals. However, results in
column two demonstrate that the positive coefcient on Modied stems primarily
from companies with GC opinions. Companies with material uncertainty opinions
also have larger absolute abnormal accruals. However, as Table 3 shows, most
material-uncertainty opinions arise from litigation risk, suggesting that income-
increasing earnings management is unlikely.
Next, given the ndings of Bradshaw et al. (2001) that rms with modied
(unclean) opinions have more negative working capital accruals, we change the
dependent variable in Eqs. (2a) and (2b) from absolute abnormal accruals to signed
abnormal accruals:
AbnormalAccurals
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
Modified
i;t
e
i;t
; 3a
AbnormalAccruals
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
GoingConcern
i;t
b
9
MatUncert
i;t
b
10
AcctChange
i;t
b
11
OtherModified
i;t
e
i;t
: 3b
The last two columns of Table 5 present the results of these regressions. As column
three shows, companies with modied opinions have signicantly more negative
abnormal accruals than companies with unqualied opinions. Column four shows
that the negative coefcient on Modied stems from rms with GoingConcern
opinions. Therefore, even after controlling for other factors, the association between
ARTICLE IN PRESS
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 153
modied opinions and abnormal accruals is due to the large negative (i.e., income-
decreasing) accruals of companies with GC opinions. We also nd that MatUncert
(AcctChange) rms have more negative (positive) abnormal accruals than rms with
ARTICLE IN PRESS
Table 5
OLS on absolute value and signed abnormal accruals (full sample)
jAbnormalAccruals
i;t
j b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
Modified
i;t
e
i;t
; 2a
jAbnormalAccruals
i;t
j b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
GoingConcern
i;t
b
9
MatUncert
i;t
b
10
AcctChange
i;t
b
11
OtherModified
i;t
e
i;t
; 2b
AbnormalAccruals
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
Modified
i;t
e
i;t
; 3a
AbnormalAccruals
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Big5
i;t
b
8
GoingConcern
i;t
b
9
MatUncert
i;t
b
10
AcctChange
i;t
b
11
OtherModified
i;t
e
i;t
: 3b
Variables Eq. (2a) Eq. (2b) Eq. (3a) Eq. (3b)
Constant 0.204 0.191 0.024 0.046
(73.98)
a
(67.12)
a
(6.72)
a
(12.29)
a
MktCap 0.025 0.022 0.003 0.008
(26.58)
a
(23.09)
a
(2.25)
b
(6.22)
a
Book/Mkt 0.033 0.030 0.007 0.013
(25.17)
a
(22.50)
a
(4.10)
a
(7.29)
a
ROA 0.074 0.061 0.129 0.108
(21.12)
a
(17.26)
a
(28.01)
a
(23.32)
a
ROA
2
0.011 0.009 0.025 0.022
(9.12)
a
(7.24)
a
(15.87)
a
(13.59)
a
Debt/Assets 0.054 0.051 0.012 0.008
(13.89)
a
(13.24)
a
(2.39)
b
(1.53)
CurrRatio 0.033 0.030 0.006 0.005
(25.17)
a
(22.50)
a
(16.66)
a
(14.53)
a
Big5 0.003 0.002 0.006 0.012
(11.46)
a
(9.66)
a
(1.91)
c
(4.19)
a
Modied 0.014 0.039
(7.03)
a
(14.48)
a
GoingConcern 0.060 0.113
(18.07)
a
(25.79)
a
MatUncert 0.024 0.041
(2.05)
a
(2.64)
a
AcctChange 0.014 0.008
(5.49)
a
(2.36)
a
OtherModied 0.005 0.007
(1.13) (1.16)
Observations 27,219 27,219 27,219 27,219
Adjusted R
2
12.2% 13.2% 6.5% 8.2%
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 154
clean opinions, although the association between abnormal accruals and these
opinion types is not nearly as economically nor statistically signicant as the GC-
accrual association.
Overall, these ndings suggest that Bartov et al.s (2000) results stem from
rms with GC opinions. That is, the positive relation between modied opinions
and the magnitude of accruals relates primarily to companies receiving GC
opinions, which have large negative accruals. These ndings are also inconsistent
with the explanation for the opinion/accruals relation in Francis and Krishnan
(1999). Francis and Krishnan argue that larger, higher-quality auditors assess high-
accrual rms as inherently more riskybecause managers of such rms are more
likely to have exercised discretionand, as a result, adjust opinion materiality
thresholds downward. However, this implies that the signed abnormal accruals
regressions for rms with modied opinions should be positive, not negative as our
results show.
These ndings highlight the importance of testing both signed and absolute
abnormal accruals. If, as in this setting, absolute abnormal accruals are dominated
by one side of the distribution (i.e., negative or positive abnormal accruals),
inferences likely differ from the case in which absolute abnormal accruals are larger
but symmetric.
ARTICLE IN PRESS
t-Statistics are in parentheses. Observations are all rm-year observations from 1994 to 1999 with
adequate Compustat information.
Variables are dened as follows:
AbnormalAccruals=cross-sectional Jones (1991) abnormal accruals (Eq. (1)).
MktCap=Log
10
(Market value of equity).
Book/Mkt=book value of equityCmarket value of equity.
ROA=income before extraordinary itemsCtotal assets (beginning of year).
ROA
2
=square of ROA.
Debt/Assets=long-term debtCtotal assets (beginning of year).
CurrRatio=current assetsCcurrent liabilities.
Big5=one if a Big5 audit rm and zero otherwise.
Modied=one if opinion is qualied or unqualied with explanatory language and zero otherwise.
GoingConcern=one if opinion is unqualied with explanatory language pertaining to going-concern
status, bankruptcy, or material business uncertainty and zero otherwise.
MatUncert=one if opinion is unqualied with explanatory language pertaining to a material uncertainty
(e.g., asset realization or contingent liability) and zero otherwise.
AcctChange=one if opinion is unqualied with explanatory language pertaining to lack of consistency not
requiring restatement and zero otherwise.
OtherModied=one if opinion is qualied (scope limitation or GAAP departure) or unqualied with
explanatory language pertaining to lack of consistency requiring restatement or reliance on another
auditor or related party transactions and zero otherwise.
a
Signicant beyond the 1% level (two-sided tests).
b
Signicant beyond the 5% level (two-sided tests).
c
Signicant beyond the 10% level (two-sided tests).
Table 5 (Continued)
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 155
5.3. Why do GC rms have extremely negative abnormal accruals?
Several studies show that abnormal accruals are non-zero for rms with extreme
performance (e.g., Dechow et al., 1995; Kothari et al., 2003). In particular, abnormal
accruals are more negative (positive) for rms with extreme poor (good)
performance. These studies show that accrual models tend to overreject the null of
zero abnormal accruals. Given that nancial distress is essentially a necessary
condition for observing a GC opinion (Hopwood et al., 1994) and that certain
nancially troubled rms have large negative accruals (DeAngelo et al., 1994),
companies with GC opinions are likely to have more extreme negative accruals. That
is, GC companies likely have negative accruals due to poor performance.
For example, nancially distressed rms often face liquidity constraints that force
them to reduce non-cash net working capital to survive. It is also likely that these
rms have non-performing assets that they are required to write off under GAAP.
To the extent that conventional accrual models do not account for the accrual
consequences of distress due to liquidity-related transactions, these accruals will be
misclassied as discretionary. This misspecication is likely a signicant source of
the association between modied opinions and conventional estimates of abnormal
accruals.
As Table 4 shows, there are marked differences between companies with GC
opinions and other rms, whether they receive other types of modied opinions or
standard, unqualied opinions. In particular, GC rms are experiencing extremely
poor performance. To determine whether the abnormal accruals of GC rms are
reliably negative we follow Kothari et al.s (2003) performance-matching
approach.
20
In a study of the statistical properties of discretionary accrual models,
Kothari et al. advocate matching to control for the impact of rm performance on
accruals. They demonstrate that performance matching leads to accrual-based tests
of earnings management that are well specied and powerful.
Given our unique sample, we consider two alternative measures of performance
for identifying a matched sample. First, as suggested by Kothari et al. (2003),
we use ROA
t1
(i.e., lagged return on assets, or the ratio of prior-year income
before extraordinary items to total assets). Second, we use the probability of
bankruptcy constructed from Shumway (2001), which we label Distress. As
mentioned, GC rms tend to have more severe liquidity problems than other
rms. To survive, the GC rms are likely to engage in liquidity-enhancing
transactions which lead to large negative accruals but which do not necessarily
affect ROA (e.g., delaying payments to suppliers or factoring receivables).
21
It is
therefore important to control for differences in liquidity as well as protability.
ARTICLE IN PRESS
20
Conditioning empirical analysis on nancial distress is common in research on GC opinions (e.g.,
McKeown et al., 1991; Hopwood et al., 1994; Mutchler et al., 1997; Louwers, 1998).
21
Factoring receivables will likely have some impact on income but most of the related accrual will not.
For example, suppose a rm factors receivables with a book value of $100 at a price of $90. The rm will
record a negative accrual of $100 but only $10 of it will be reected on the income statement.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 156
Consistent with this reasoning, Distress is more effective than ROA
t1
for matching
in our sample.
22
Our matching procedure is as follows. We construct a dataset from the merged
Compustat database that contains rms with unqualied opinions (without
explanatory language) and sufcient data to compute our performance measures,
abnormal accruals, and the regression covariates. Then, for each newly initiated GC
opinion observation (e.g., a GC opinion in year t, but not in t1), we identify that
observation in the matched group with the closest performance (i.e., either ROA
t1
or Distress). In other words, control rms are matched on year, industry, auditor
type, and a measure of performance. This procedure yields a sample size of 1,052:
526 rms with rst-time GC opinions and 526 control rms with standard,
unqualied opinions. Using this matched sample, we estimate the following
regression:
AbnormalAccruals
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Distress
i;t
b
8
Big5
i;t
b
9
GoingConcern
i;t
b
10
Big5

GoingConcern
i;t
e
i;t
; 4
where
Distress =bankruptcy probability per Shumways (2001) Table 4b hazard
model (1(1/exp(7.8116.307

Net Income/Total As-

sets+4.068

Total Liabilities/Total Assets0.158

Current Assets/
Current Liabilities+0.307

Ln (Company Age))).
Big5

Going Concern
=one if a Big5 audit rm issued the GoingConcern opinion and
zero otherwise.
We add the term interacting Big5 and GoingConcern opinions to consider an
alternative explanation to performance. An alternative explanation for companies
with GC opinions having large negative accruals is that auditors, in response to
heightened litigation risk, impose a higher level of conservatism on companies to
which they render GC opinions (DeFond and Subramanyam, 1999). Given that
larger audit rms are perceived to provide increased coverage (i.e., deeper pockets) in
the event of securities litigation (Arthur Andersen et al., 1992), one test of this
explanation is to examine whether income-decreasing accruals vary by audit rm
type. Evidence that abnormal accruals are more negative for GC companies audited
by the Big5 than for those audited by the non-Big5 would support the auditor
conservatism explanation. If accruals are not different for Big5 versus non-Big5
audited GC companies or if accruals are more negative for GC companies audited by
ARTICLE IN PRESS
22
The mean and median values of ROA, current ratio, book-to-market and size of the sample matched
on distress are much closer to the GC sample than the sample matched on lagged ROA.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 157
the non-Big5, then the relation between accruals and troubled rms is less likely due
to auditor conservatism.
Column one of Table 6 provides the results of estimating Eq. (4) for this sample of
companies with rst-time GC opinions and a control sample matched on year,
auditor, industry, and ROA
t1
: As in column four of Table 5, the coefcient for
GoingConcern is negative and statistically signicant (beyond 0.001).
23
That is, rms
with GC opinions have negative abnormal accruals compared to a matched sample
of rms with similar prior-year ROA, even after controlling for other factors
associated with abnormal accruals and GC opinions. The coefcient for
Big5

GoingConcern is positive and thus does not support a differential auditor

conservatism explanation. Of course, it is possible that auditor conservatism is
important, but equally so across audit rm types. As with the Table 5 regression,
inferences are robust to considering the effects of inuential observations per Belsley
et al. (1980).
24
Column two of Table 6 reports the results of estimating Eq. (4) using the
alternative control sample matched on Distress (Shumway, 2001). For this
regression, the coefcient on GoingConcern is not signicantly different from zero,
suggesting that the GC opinion itself is neither the cause nor the result of abnormal
accruals. Instead, rms in nancial distress likely have more negative accruals due to
poor performance and transactions arising to meet liquidity needs (e.g., delaying
payables and factoring receivables). Again, the coefcient on Big5

GoingConcern is
positive. This is further evidence that auditor conservatism does not explain the
relation between abnormal accruals and GC opinions.
5.4. Adopting Bartov et al.s (2000) empirical design
Based on our analysis of a large sample of rms receiving modied opinions
between 1994 and 1999, we conclude that the relation between accruals and modied
opinions is not due to earnings management but is instead driven by rms receiving
ARTICLE IN PRESS
23
We adopt an alternative form of Kothari et al.s (2001) method. Following their specic technique, the
sample size is halved and the variable of interest is the intercept. In our context, the intercept captures the
change in abnormal accruals for a rm with a rst-time GC opinion compared to a rm in the same
industry, audited by the same type of auditor with the closest lagged ROA (or distress). This method yields
results similar to those reported.
24
We conduct additional robustness checks. First, following Hribar and Collins (2002), we exclude 359
rms with assets below $10 million to assess whether the inverse relation between GC opinions and
abnormal accruals stems from extremely small rms. However, when we rerun the Eq. (4) regression, the
GoingConcern coefcient remains signicantly negative. Second, we estimate total accruals using a balance
sheet approach in which total accruals are the change in non-cash current assets minus change in non-debt
current liabilities minus depreciation expense. We also estimate abnormal accruals using the modied
Jones model (Dechow et al., 1995). In both cases, the GoingConcern coefcient remains signicantly
negative. Finally, we transform AbnormalAccruals into unscaled levels, add assets (i.e., the former deator)
as an independent variable, and adjust standard errors per White (1980) (see Barth and Kallapur, 1995).
The coefcient on GoingConcern is again signicantly negative.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 158
GC opinions. As DeAngelo et al. (1994) nd in their study of loss rms that cut
dividends, we nd that troubled rms with GC opinions have large negative,
performance-related accruals. Thus, the results of past research, in particular Bartov
et al. (2000), seem to be explained by poor performance rather than, as they imply,
aggressive accounting. However, there are several important differences between our
empirical design and that of Bartov et al.: (1) matching procedures used to obtain
control samples differ; (2) right-hand-side control variables differ; and (3) regression
specications of the association between abnormal accruals and audit opinions differ
(Bartov et al. use a logit specication with the presence of a qualied opinion as the
dependent variable). In this section, we assess the sensitivity of our results to these
differences.
Following Bartov et al., we identify those rms in our sample with a newly
initiated modied opinion (i.e., a modied opinion in year t, but not t1) that we
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Table 6
OLS on signed abnormal accruals (rst-time GC opinion and performance-matched samples)
AbnormalAccruals
i;t
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
ROA
i;t1
b
4
ROA
2
i;t1
b
5
Debt=Assets
i;t
b
6
CurrRatio
i;t
b
7
Distress
i;t
b
8
Big5
i;t
b
9
GoingConcern
i;t
b
10
Big5

GoingConcern
i;t
e
i;t
; 4
.
Variable Eq. (3c) with match
on lagged ROA
Eq. (3c) with match
on distress
Constant 0.058 0.070
(2.43)
b
(2.32)
b
MktCap 0.032 0.019
(2.82)
a
(1.33)
Book/Mkt 0.020 0.003
(2.25)
b
(0.24)
ROA 0.007 0.010
(0.32) (0.51)
ROA
2
0.005 0.002
(1.18) (0.62)
Debt/Assets 0.054 0.028
(1.74)
c
(0.71)
CurrRatio 0.009 0.014
(3.50)
a
(4.54)
a
Distress 0.003 0.003
(12.41)
a
(12.29)
a
Big5 0.002 0.031
(0.07) (1.14)
GoingConcern 0.115 0.021
(4.70)
a
(0.73)
Big5GoingConcern 0.040 0.061
(1.35) (1.71)
c
Observations 1,052 1,052
Adjusted R
2
22.6% 15.8%
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 159
match on year, industry, auditor type, and assets (i.e., size-matching on assets, not
performance-matching on ROA
t1
or Distress) to construct our control sample. This
approach yields a sample size of 2,236: 1,118 rms with newly initiated modied
opinions (of which 523 are GCs) and 1,118 control rms with standard, unqualied
opinions. We then add a new regressor, Perform, that Bartov et al. specify to
capture extreme earnings performance and estimate the following logistic
regression:
1 if Modified
i;t
0 Otherwise
)
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
Debt=Assets
i;t
b
4
Perform
i;t
b
5
jAbnormalAccrualsj
i;t
e
i;t
; 5
where
Perform =absolute value of the change in income from continuing operations
Ctotal assets (beginning of year).
Table 7 reports the results of estimating Eq. (5) with various sub-samples. Column
one, which includes the entire sample of 2,236 observations, is consistent with
column one of Table 5 and Bartov et al. (2000). Abnormal accruals are greater for
rms that receive a modied audit opinion. However, columns two and three of
Table 7 show that this association stems from companies with GC opinions. Column
two replicates the logistic regression only for companies with GC opinions (and their
ARTICLE IN PRESS
t-Statistics are in parentheses. Observations are all companies with newly-initiated GoingConcern opinions
(e.g., a GC in year t, but not t1) from 1994 to 1999 matched with a clean-opinion company on year,
industry, auditor type and either closest lagged ROA (Kothari et al., 2001) or closest contemporaneous
Distress (Shumway, 2001). All observations must have adequate Compustat information.
Variables are dened as follows:
AbnormalAccruals=cross-sectional Jones (1991) abnormal accruals (Eq. (1)).
MktCap=Log
10
(Market value of equity).
Book/Mkt=book value of equityCmarket value of equity.
ROA=income before extraordinary itemsCtotal assets (beginning of year).
ROA
2
=square of ROA.
Debt/Assets=long-term debtCtotal assets (beginning of year).
CurrRatio=current assetsCcurrent liabilities.
Distress=bankruptcy probability per Shumways (2001) Table 4b hazard model (1
(1/exp(7.8116.307

Net Income/Total Assets+4.068

Total Liabilities/Total Assets0.158

Current
Assets/Current Liabilities+0.307

Ln(Company Age))).
Big5=one if a Big5 audit rm and zero otherwise.
GoingConcern=one if opinion is unqualied with explanatory language pertaining to going-concern
status, bankruptcy or material business uncertainty and zero otherwise.
Big5GoingConcern=one if a Big5 audit rm issued the GoingConcern opinion and zero otherwise.
a
Signicant beyond the 1% level (two-sided tests).
b
Signicant beyond the 5% level (two-sided tests).
c
Signicant beyond the 10% level (two-sided tests).
Table 6 (Continued)
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 160
matched rms), and column three includes all other modications (and their
matched rms). The coefcient on the absolute value of abnormal accruals is
signicant for the GC opinion regression but not for the other opinion modications
regression. From these results, we conclude that our main results are robust to
considering a different matching procedure, alternative control variables, and an
alternative econometric specication. As an additional check, we replicate the tests
ARTICLE IN PRESS
Table 7
Logit regressions on audit opinion type (rst-time modied opinion and size-matched sample)
1 if Modified
i;t
0 Otherwise
)
b
0
b
1
MktCap
i;t
b
2
Book=Mkt
i;t
b
3
Debt=Assets
i;t
b
4
Perform
i;t
b
5
jAbnormalAccruals
i;t
j e
i;t
; 5
Variable All observations GC rms Non-GC rms
Constant 0.310 0.325 0.157
(6.86)
a
(3.80)
c
(0.72)
MktCap 0.043 0.178 0.032
(0.73) (3,57)
c
(0.22)
Book/Mkt 0.020 0.017 0.042
(0.91) (0.41) (0.77)
Debt/Assets 1.133 1.435 0.774
(26.91)
a
(22.71)
a
(5.76)
b
Perform 0.098 0.140 0.024
(5.17)
b
(6.62)
b
(0.09)
1.172 1.524 0.611
|AbnormalAccruals| (14.61)
a
(16.52)
a
(1.12)
Observations 2,236 1,046 1,190
Log likelihood 50.47
a
53.89
a
7.33
Chi-square statistics are in parentheses. Observations are all companies with newly initiated Modied audit
opinions (i.e., a modied audit opinion in year t, but not t1) from 1994 to 1999 matched with a clean-
opinion company on year, industry, auditor type and total assets (Bartov et al. 2000). All observations
must have adequate Compustat information. In the case of the GC sample regression (column 2), there are
3 pairs of observations for which we are unable to compute Perform; and, as such, this regression has a
sample size of 1,046 as opposed to a sample size of 1,052 per Table 6. In the case of the Non-GC sample
regression (column 3), the 595 newly initiated Modied audit opinions are a subset of the 3,299 (i.e., 105
Material Uncertainty, 2,509 Accounting Change and 685 Other Modied) opinions per Table 4.
Variables are dened as follows:
Modied=one if opinion is qualied or unqualied with explanatory language and zero otherwise.
MktCap=Log
10
(Market value of equity).
Book/Mkt=book value of equityCmarket value of equity.
Debt/Assets=long-term debtCtotal assets (beginning of year).
Perform=absolute value of the change in operating income (Compustat \#18) divided by beginning of the
year assets.
AbnormalAccruals=cross-sectional Jones (1991) abnormal accruals (Eq. (1)).
a
Signicant beyond the 1% level (two-sided tests).
b
Signicant beyond the 5% level (two-sided tests).
c
Signicant beyond the 10% level (two-sided tests).
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 161
reported in Table 7 using a balance sheet measure of total accruals (as in Bartov
et al.) and results are qualitatively similar.
25
6. Conclusion and implications
6.1. Conclusion
We conduct a large-sample study of the relation between audit opinions and
abnormal accruals, after taking into account the variation in the types of
modied-opinions auditors render. Our particular interest is assessing whether
such opinions are a function of earnings management (i.e., whether observable
auditing judgments proxy for the exercise of managerial discretion). In other
words, does it seem that managers of companies receiving modied opinions are
more likely to have managed earnings than managers of companies receiving clean
opinions?
Consistent with our understanding of audit procedures and standards, we nd no
evidence that auditors use their opinions to alert nancial statement users of either
excessive earnings management or the consequences of high positive accruals. In
particular, based on our content analysis of modied audit opinions, we demonstrate
that few rms receive opinion qualications for scope limitations or departures from
GAAP and that the opinions of those who do bear no literal or discernible relation
to income-increasing earnings management.
We nd that the modied opinion/abnormal accruals relation stems from
companies with going-concern opinions, because such companies have negative
abnormal accruals. Our ndings are inconsistent with earnings-management and
auditor-conservatism explanations for the audit opinion/abnormal accruals relation.
Importantly, we demonstrate that the negative accruals of companies with GC
opinions are no different from a matched sample of companies experiencing similar
severe nancial distress.
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25
In addition to these differences, our EDGAR-based sample period is from 1994 to 1999, whereas
Bartov et al. study the period from 1980 to 1997. To assess whether our main results are robust to
considering these different time periods, we randomly sample 1,000 rm-year observations from a pre-SAS
58 period (19801987) where Compustat ags the rm as having a qualied audit opinion (i.e., code 2).
Based on Bartov et al.s description of their sample selection procedure, the majority of their observations
are likely from this time period. As Table 2 shows, qualied audit opinions were far more common
during the pre-SAS 58 regime; however, during this time period, a qualied opinion was appropriate for
scope limitations, GAAP departures, lack of consistency, and material uncertainties (e.g., asset realization,
going concern, and contingent liabilities). We obtain 743 of these 1,000 rm-year observations from either
the NAARS database or the microche collection at the University of Rochester library. We eliminate 38
(5.1%) observations because they are unqualied opinions, resulting in a sample size of 705. Of these 705,
104 are newly initiated qualications of which 54 are GC qualications and 50 are non-GC qualications.
We then rerun the Eq. (5) regressions for these observations (and their matched counterparts) and obtain
results consistent with those in Table 7.
M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 162
6.2. Implications for earnings-management research relating to audit opinions
Our ndings have implications for research that attributes the audit opinions/
accounting accruals relation to more-pervasive earnings management. Because
auditing is thought to reduce agency costs, several papers assert that certain
types of modied audit opinions are (or should be) a function of accounting
accruals. Francis and Krishnan (1999) provide evidence suggesting that
larger, higher-quality auditors assess high-accrual rms as inherently more risky
because managers of such rms are more likely to have exercised discretionand,
as a result, adjust their asset realization and GC opinion materiality
thresholds downward. We show that the audit opinions/accounting accruals
association is reliably negative, yet that it dissipates upon matching on distress
and controlling for other factors associated with accruals. This suggests that the
conditions that lead to a GC opinion are contemporaneously associated with
the conditions that lead to income-decreasing accruals (i.e., both the opinion and the
accruals are consequences of the rm being nancially distressed) and that no
causality should be inferred.
Bartov et al. (2000) compare the power of various accrual models in detecting
earnings management under the assumption that rms receive certain modied
opinions because they engage in extreme earnings management. Our ndings
suggest that the relation between opinion type and abnormal accruals is due
not to earnings management, but instead to model misspecication. This implies
that the models that Bartov et al. (2000) recommend as having the most
powercross-sectional Jones and cross-sectional Modied Jonesare the
models that suffer most from misspecication because they are most prone to
picking up distress-related accruals and hence are more confounded by
nancial distress than other accruals models. As such, differences in the power
of models they report are likely to be measures of relative misspecication,
not power.
With respect to Bradshaw et al. (2001), we help to distinguish between certain
explanations they offer for the surprisingly (p. 68) negative relation
between working capital accruals and unclean audit opinions. They are unable
to distinguish their explanations because they do not have details on the
underlying cause of the modied (unclean) opinion. One explanation they offer is
that auditors ... lack the necessary sophistication to understand the future
implications of high levels of accruals (p. 46) or that ... auditors interpret
the higher earnings associated with higher accruals as a positive sign, and are
less likely to issue modied opinions in such cases (p. 68). Our ndings are
consistent with another of their explanations: that the role of auditors is
not to modify their opinions based on an assessment about the quality of earnings
as measured by accruals (i.e., they may understand the implications of inated
accruals, ... but are not to communicate this information to investors through their
audit opinions (p. 46)). As our description of the audit process and our content
analysis imply, auditors are unlikely to issue modied opinions for earnings-
management reasons.
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M. Butler et al. / Journal of Accounting and Economics 37 (2004) 139165 163
6.3. Implications for earnings-management research in general
Our ndings also have broader implications for earnings-management research.
For one, as noted, GC companies can substantially impact abnormal accrual
calculations. For another, studies often use absolute abnormal accruals as a measure
of earnings management. Our results suggest that using absolute value may mask the
source of abnormal accruals. If absolute abnormal accruals are large because
accruals are especially positive or negative, inferences likely differ from the case in
which absolute abnormal accruals are large but accruals are more symmetric.
Finally, our ndings lend some support to the importance of performance matching
when the companies of interest are experiencing extreme performance. In our case of
extreme poor performance, matching on contemporaneous distress more effectively
captures accrual-sensitive differences in performance than matching on lagged ROA.
This is likely because matching on distress captures the negative accruals associated
with poor operating performance as well as the negative accruals arising from
liquidity-motivated transactions (e.g., delaying payables and factoring receivables).
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