The relation between accounting earnings and stock returns: A study of firms receiving a modified audit report

This study investigates whether the receipt of a modified audit report is associated with a reduction in the perceived (by investors) quality of the firm's earnings as reflected in its earnings response coefficient (ERC). The accounting numbers of a firm receiving a modification to its audit report are likely to contain relatively higher measurement error and, hence, be more noisy. Furthermore, there is likely to be greater uncertainty regarding the production, investment, and financing (PIF) activities of these firms. Both of these factors--noise in accounting earnings and uncertainty in PIF activities--are expected to be negatively related to the market's responsiveness to earnings. Therefore, firms receiving modified audit reports are expected to exhibit reduced ERCs. Furthermore, firms receiving a going concern modified audit report are expected to have more noisy accounting numbers and higher uncertainty regarding future PIF activities than firms receiving a material uncertainty modified audit report without a going concern uncertainty. Accordingly, firms in the former category are expected to exhibit a greater decline in their ERCs than firms in the latter group. For similar reasons, the firms facing a material uncertainty modified audit report will exhibit a sharper decline in their ERCs than firms receiving a consistency modified audit report.;A sample of 677 firms receiving first-time modifications is examined over a six year period, the three years prior to a first-time modification through the two years following this modification. Descriptive evidence is provided that examines market performance, accounting performance, leverage position, and accrual management. This evidence suggests that firms receiving modifications are performing more poorly, are more leveraged than similar firms. Moreover, these firms appear to be engaging in earnings management at the time of the modification. The regression results indicate that following a modification, a firm's ERC is lower, implying increased noise in accounting information. Modifications for going concern uncertainties are associated with the largest decline in ERC, followed by material uncertainty modifications. No significant decline in ERC was observed for consistency modifications.