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ABSTRACT
We examine whether the type of audit opinion a company receives is associated with the debt characteristics of Chinese companies. Our analyses indicate that companies receiving modified audit opinions pay higher interest rates and have more short-term debt. When the auditor mentions going concern in the audit opinion, companies pay higher interest rates and have a lower percentage of long-term debt, but this result is weaker for state-owned enterprises. We also find that companies receiving qualified or adverse opinion pay higher interest rates and have a lower level of long-term debt as a percentage of total debt.
Acknowledgments
The authors gratefully acknowledge helpful comments received on this paper from participants at the American Accounting Association Annual meeting.
Disclosure statement
No potential conflict of interest was reported by the authors.
Notes
1. US Securities Regulations (Securities and Exchange Commission Citation2017) prohibit companies from filing annual reports (10-Ks) in which the auditor’s report on the financial statements contains a disclaimer of opinion (4220.1), a qualified opinion with scope limitation(s) (4220.3), a qualified opinion with material misstatement(s) (4220.4), or an adverse opinion on the financial statements.
2. Faccio (Citation2006) has shown that state-owned enterprises have greater access to debt financing than non-state-owned enterprises.
3. The SEC prohibition on filings containing qualified or adverse opinions refers to opinions on financial statements. A qualified or adverse opinion on financial statement would be preceded by an opportunity for management to correct the financial statements. Qualified or adverse opinions on financial statements thus indicate not only misstated financial statements, but also a refusal by management to correct the financial statements. The SEC does accept adverse opinions on companies’ internal control over financial reporting (ICFR) because a material weakness in internal control may be discovered after period end (the date as of which the auditor assesses the company’s ICFR). Unlike unissued financial statements, management cannot fix an ICFR material weaknesses which existed as of a previous date.
4. As discussed further below, our sample includes companies with going concern language added to unqualified opinions, qualified opinions and adverse opinions.
5. Other than going concern matters, common reasons for auditors to add explanatory/emphasis paragraphs are (a) when accounting principles have changed (consistency issues) (b) when an auditor’s responsibility for the financial statements is divided with another auditor (audit-related issues) and (c) any other matter the auditor wishes to emphasize.
6. Note that with both qualified and adverse audit opinions, the auditor provides management with an opportunity to correct the financial statements before the qualified or adverse opinion is issued. Thus, the issuance of a qualified or adverse audit opinion indicates that the financial statements are misstated (i.e., that the financial statements have reduced credibility) and that management has refused to fix the incorrect financial statements, thereby suggesting reduced management credibility.
7. A similar situation existed (prior to the financial crisis of 2008) in the United States with the Federal National Mortgage Association (Fannie Mae). While the US Government did not retain an ownership stake in Fannie Mae, the government did provide an implicit guarantee of the debts of Fannie Mae, allowing the company to borrow at lower interest rates (Jaffee Citation2003).
8. Bai et al. (Citation2006) and Zhou (Citation2009) suggest that non-SOEs can at least partially close the access-to-loans gap with SOEs by being more politically connected.
9. The Big 10 CPA firms are in China include the Big 4 International firms (i.e., PWC, Deloitte, EY, KPMG) plus BDO China Shu Lun Pan Certified Public Accountants, Pan-China Certified Public Accountants, Zhong Rui Yue Hua Certified Public Accountants, Shine Wing Pironti Consulting, Crowe Horwath China Certified Public Accountants, and Da Hua Certified Public Accountants.
10. There are an insufficient number of these types of adverse and disclaimer opinions to separate analyze adverse opinions relative to disclaimers.
11. In untabulated analyses, we developed six indicator variables as follows: (1) explanatory paragraph (no going concern mentioned), (2) explanatory paragraph (going concern mentioned), (3) qualified opinion (no going concern mentioned), (4) qualified opinion (going concern mentioned), (5) adverse/disclaimer (no going concern mentioned), and (6) adverse/disclaimer (going concern mentioned). The implications of the results using this categorization were materially consistent with the tabulated results. For clarity of exposition, consistency with the hypotheses, and because of very small numbers of observations in some categories, we present the results using the more parsimonious indicator variable structure.
12. The specific wording of an emphasis of matter paragraph unrelated to a going concern issue is as follows: ‘We remind the financial statement users: as the ‘Contingency’ in the report said, Nanshan Power Company and The Aron Private Company have not come to an agreement on the duties and compensation resulting from the termination of the option contract, so there is a possibility the two parties may achieve a final settlement through legal channels. The final result can therefore not be reliably estimated. Nanshan Power Company did not recognize estimated liabilities in the financial report. This paragraph does not affect the audit opinion which has been issued’ (translation from the Chinese original by the authors).
13. Note that all of the GCO observations were also coded as either UNQEXP, QUAL, or ADV/DIS. However, some observations coded as UNQEXP, QUAL, or ADV/DIS were not GCOs. We chose this approach to more clearly isolate the different effects of financial distress (GCO) from the effects of financial reporting credibility.
14. As an alternative approach, we estimated the regression models on the whole sample using interactions between the modified audit opinion variables and Big 10 status. The results (untabulated) are consistent with the results presented in this section.
15. For example, we are not aware of any database in China providing detailed loan terms, like the US Dealscan database used by P. Chen et al. (Citation2016).