The Relevance of Quantifiable Audit Qualifications in the Valuation of IPOs

Abstract

How useful are audit qualifications to financial statement users? Prior studies provide mixed evidence on this fundamental issue. In this study we analyze a sample of 206 firms that went public at the Athens Stock Exchange over the period 1987-2002. This is a unique sample because for 150 firms auditors report quantitative estimates of the amount by which assets are overstated and/or liabilities are understated in reported financial statements. We find evidence that financial analysts and underwriters do not incorporate the negative information provided by these qualifications into earnings forecasts and offer prices. Investors, however, appear to efficiently impound the negative implications of the audit qualifications into stock market prices within the first day of trading. We also detect a strong negative market reaction on and around June 10, 2004, when regulators disallowed IPOs with audit qualifications in compliance with European Union Directives. Sample firms with and without qualifications were equally penalized. This negative market sentiment confirms the wider market skepticism reflected in very low IPO activity in Greece in recent years. Overall, our results suggest that underwriters tend to align their interests with the interests of their clients, the old stockholders, at the expense of the new stockholders. They also suggest that the practice of reporting quantifiable qualifications in audit reports is valuable to investors. Although the management may choose not to recognize qualified amounts, investors price these amounts given that they are disclosed by an expert.