Does Audit Reporting Matter in Pricing Securities? Evidence from an Emerging Market

Abstract

Previous research on whether the market responds to auditors’ opinions has provided mixed results. We revisit this issue in China, where the stock market is dominated by individual investors who are less sophisticated in assimilating value-relevant information such as modified audit opinions (MAOs). In addition, China permits audit modifications triggered by violations of the generally accepted accounting principles (GAAP) or disclosure rules (GAAP/DISC MAOs), which are subtler than going concern opinions (GCOs) in their value implications and thus are more likely to be mispriced. The Chinese stock market thus gives us the best chance of detecting MAO mispricing. We find that MAOs predict firms’ future financial performance, and that the market reaction during the short window around MAO disclosure is also consistent with such predictive power of MAOs. Importantly, MAO disclosure is not followed by negative long-term stock returns, suggesting that stock price adjustments to MAOs are speedy and unbiased. These findings hold for both GCOs and GAAP/DISC MAOs. Together, our findings support the informativeness of audit opinions and cast doubt on the argument that investors inefficiently use this important information in pricing securities due to information processing bias.