Quarterly earnings announcements reaction: The role of audit report

Published:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Many studies have suggested that there are different market reactions to earnings announcement where the market reaction towards 4th quarter earnings announcement is associated with the negative unexpected earnings and a smaller negative adjustment in stock returns as compared to all other quarters (Jones & Bublitz, 2010; 1). This paper, therefore, investigates (i) the market reaction toward quarterly earning announcement, (ii) the value relevance of auditing and (iii) the relation between audit quality and firm size. Research results indicate that there is significantly stronger market reaction to the 4th quarter earnings announcements relative to the 1st, 2nd and 3rd earnings announcement. There is also evidence showing that auditing affect investors future decisions therefore value relevant to investors. And after examining the market reactions to big 4 audits vs. non big 4 audits, evidence shows that there is no different reactions toward earnings announcements of firms audited by the big 4 auditors and for those not audited by the big 4.

Introduction:

This research paper examines the market response to 1st 2nd 3rd quarter earnings announcements vs. the 4th quarter earnings announcement by identifying several factors one of which is the auditing added value. Note that what is meant by earning announcement is the release of the earning report. Several previous studies have addressed the issue of the market response toward earnings announcements. One of several studies is by Beaver 1968 showing that the volume and prices of stocks changes in the weeks surrounding earnings announcements thus supports the argument that earnings reports possess information content, therefore has value.

But is there a market response to the 1st, 2nd and 3rd quarter earning announcement? To answer this question several issues should be addressed which will be explained later on.

This paper also examines whether auditing reports are value relevant to investors. Various studies focused on the value relevance of auditing reports and their effects on stock prices but all of these studies have concluded with different results. The last issue examined in this paper is whether the market reaction to earning announcement of firms audited by one of the big 4 auditors will differ than the market reaction to earnings announcement of firms audited by non big 4 auditors as whether the audit quality of big 4 firms is better than the audit quality of non big 4 auditing firms (small auditing firms). This empirical study examines whether there is a mandatory need for auditing the quarter earning reports if auditing adds value.

The next section examines the market reaction to quarterly earning announcements; section 3 addresses the role of audit report in enhancing the quality of earnings. section 4 investigates the relation between audit quality and firm size, followed by section 5 containing previous literature, empirical testing and sample selection. The last section provides suggestions for future researches.

2. 1st, 2nd and 3rd quarter earning announcement vs. 4th quarter earning announcement.

Why focus on earnings as a measure of a firm's performance? As mentioned in Statement of Financial Accounting Concepts (FASB 1983): "The primary focus of financial reporting is information about an enterprise's performance provided by measures of earnings and it components" for that the quality of earning is an important factor for the investor to evaluate management's performance, predict future earnings and asses the risk associated with investments.

Many previous studies were interested in examining the information content of earning announcement and how the market reacts to their release. Ball and Brown (1968) suggested that a significant portion of the information of earning announcement is reflected in security prices. Also a study by Beaver (1968) examining the investor reaction to earning announcement, which is reflected in the volume and price movements to common stocks in weeks surround the announcement date. Both found that the market reacts to earning announcement either through changes in stock price or changes in the trading volume or both thus I conclude that the 4th quarter earning announcement is value relevant to investors. But the issue is whether the market reacts to the 1st, 2nd and 3rd quarter earning announcement as whether those quarter announcements have information content. Evidence has shown that the market reaction toward the 4th quarter earning announcement is stronger than that for the 1st, 2nd and 3rd quarter earning announcement. Matching and timing problems are predicted to become less acute when performance is measured over long intervals this is because the longer the length of the measurement interval the less probability that revenue and expenses items are recognized in the wrong period (Dechow; 1993). The 4th quarter measures the performance of a full fiscal year therefore 4th quarter earnings have less matching and timing problems thus better earning quality than other quarter earning announcement therefore its more informative. If earnings have less timing and matching problems it will reflect the firm's position more accurately resulting in less estimation errors hence lower risk.

Another important fact that should be mentioned is that the 4th quarter earning announcement is the closest to the release of annual reports this implies that it has the shortest time lag between the announcement and the formal release of financial statements.

According to the efficient market hypothesis, since the 4th quarter earnings reduces estimation risk resulting in low cost of capital leading to high returns thus high stock prices.

One may argue that earning management is greater in the 4th quarter than other quarter since manger's bonuses and performances are tied to 4th quarter earnings. If that is so earning quality in the 4th quarter is less than the earning quality of other quarters. Here comes the role of auditors in curbing earning management in the 4th quarter earnings since it is audited unlike the other quarters. To eliminate the earning management factor I will measure earnings management using Jones model (1991) and test whether auditing eliminates or reduces earning management in the 4th quarter.

While the most significant fact is that the 4th quarter earnings are audited while the 1st, 2nd and 3rd earnings are not. The reason why 1st, 2nd and 3rd earnings quarters announcement are not likely to have stronger market response is due to their characteristics such as lower earnings quality, firms do not disclose all required information and these earnings announcements are not audited by external auditors (Healy & Palepu, 2001). This leads to another hypothesis is that whether audits enhance the quality of earnings?

3. Role of audit report in enhancing the quality of earnings.

This paper argues that audits increases earning's quality thus it is value relevant to investors. What do investors expect from auditors? Investors expect auditors to provide useful information about the company's position and detect and report any material misstatements through unbiased reports to help them through their decision making process, if this is the case auditing will decrease information asymmetry between the company and the investors.

Several theories have explained the importance of auditing: the policeman theory where the auditor is responsible for searching discovering and preventing fraud hence provide assurance to investors and verify the fairness of financial statements. Lending credibility theory states that audited financial statements are used by management to enhance the stakeholders' faith in management actions. Also according to the signaling theory management signals to the market through audits that their financial statements perceive quality and fairly reflects the actual position of the firm therefore reduces information asymmetry leading to better decision making and less estimation risk.

According to agency theory a principal (investor) hires an agent (management) to provide some tasks on its behalf. This relationship may result in conflict of interest since they have different attitudes toward risk where the manger wants to reveal the least information about the company to the investors or wants to take advantage of insider information to maximize his wealth. For that auditors reduce the agency problem once they provide accurate and credible information about the company to investors. Why an auditor will not act in the interest of mangers that hire them? Auditors are concern with their reputation in the market because it affects future employment opportunities and they are also concern with litigations that might occur.

Auditors are also concerned with their legal liability so they have to provide accurate information about the company (Healy & Palepu 2001), for those reasons auditors focused profoundly on the quality of their work after the Arthur Andersen's failure.

As mentioned by Leftwich (1983) banks require firms to present audited financial statements this implies that capital providers regard auditors as enhancing credibility mechanism.

As a conclusion 1st, 2nd, and 3rd quarter earnings which are usually performed by internal auditors are not considered reliable as opinion expressed by a company's auditors has little impact on the market stock prices (Soltani, 2000).

Hypothesis 1: 4th quarter (annual) earnings have a stronger market reaction (Price) than 1st, 2nd and 3rd quarter earnings. Thus, auditing is value relevant to investors.

4. Audit quality and firm size.

I have hypothesized earlier that auditors enhance the quality of earnings thus it is value relevant but will the quality of earnings differ according to the audit firm size (Big 4 vs. non big 4)? The quality of earnings depends on the audit quality which is measured by the level of assurance that an audit provides. Several studies were interested in the relation between audit quality and firm size. DeAngelo (1981) demonstrates that auditor firm size is positively related to audit quality. In her study, auditor size is measured by number of clients. She argues that auditors with more clients have more to lose by failing to report discovered misstatements in financial statements. Another study by Davidson and Neu (1993) assumes that management have incentives to minimize the difference between forecasted and reported earnings thus the more auditors quality the larger the forecasted error, after testing their hypothesis on Toronto listed companies they have concluded that auditing firms provide higher-quality audits than do small auditing firms. Also Blokdijk, Drieenhuizen, Simunic and Stein (2003) examined determinates of the number of audit hours performed by a sample of 113 audits of Dutch companies in years 1998-1999. They found that the details of audits production by big 5 are more reasonable and predictable than audits by non big 5 firms.

All of these studies show that the audit quality of the big 4 or 5 firms is greater than for those non big 4- 5. But the fact that DeAngelo 1981 used only the firm size as a measure of the audit quality is questionable, an audit firm of a big size may not necessary be one of the big 4! DeAngelo in her study also assumes infinite horizon as the auditors never change but in reality companies change their auditors constantly, in the state of Kuwait it is mandatory to change the company's auditor this is what is called rotation.

An important issue should be noted is that all of the previous mentioned studies were conducted prior to the Arthur Andersen's failure in 2001. So are these results still valid after the failure of one of the big 5?

Big 4 audit firms charge higher fees than non big 4 audit firms (LI, SONG and WONG; 2005) this does not necessarily indicate that they provide better quality relative to non big audit firm, when a manger contract with one of the big 4 audit firms he might be paying extra for the brand name rather than quality.

In the 70's and 80's studies showed that big 8 or 6 audit quality is higher than the non big 8 or 6 audit quality however this might not be the case now, we can not expect a constant audit quality for an audit firm.

As mentioned before Blokdijk, Drieenhuizen, Simunic and Stein (2003) have found that the audit quality by big 5 is greater than non big 5 in Netherland. Also LI, SONG and WONG (2005) have concluded that there is a positive relation between audit firm size and audit quality in China. While Elfouzi (2010) found that there is no difference between the information content of the audit report of big 4 and non big 4 in Tunisia thus, if the audit quality of the big 4 is greater than the audit quality of non big 4 in some countries it is not the case in some others. So this fact is not universal. Further investigation needs to be done in this matter.

Hypothesis 2: Big 4 audit firms and non big 4 have the same audit quality.

5.1 Previous literature

Several studies were interested in whether auditing adds value or not. To Chen et al, (2007), auditing adds value to financial statement information and improves the reliability. Auditors, by issuing their qualified opinion to firm with unreliable financial statements, are able to screen out financial performance of firms. Kim ITTONEN (2009) examined the relationship between the relevance of the audit report information and the information asymmetry between owners and management she has preformed her testing on 3000 largest, most liquid US Firms. She confirms that the audit reports contain some relevant information to the investors. Another study by Tahinakis, Mylonakis and Mylonakis (2010) examined the audit reports of companies that are listed on Athens Stock Exchange during the periods from 2005 - 2007. Their results showed that audit report have limited information content and do not affect investor's decision making process. They have explained their reasoning behind their result is that investors may not understand the content or the importance of these reports. Chen, Srinidhi and Su (2007) have examined the Effects of Auditing on Variability of Returns and Trading Volume on Chinese listed companies for the periods from 1997 to 2000; they have found that auditing reduces perceived information risk in audited financial statements as well as reduces information asymmetry. Lin, Liu and Wang (2007) studied auditor switches in China they concluded that audit information is valued by the market in China.

Researches were also interested in the effect of firm size on audit quality, that is do big 4 provide better audit quality than the non big 4?

Francis and Yu (2007) examined the effect of big 4 audits on audit quality defining audit quality as auditor's likelihood of issuing a going concern audit report and the auditor's willingness to restrain clients from aggressive earnings management behavior. They provided evidence that the big 4 perform higher quality audits. DeAnglo (1981) have studied the relation between firm size and audit quality. She have measured the firm size by number of clients, she argues the bigger the firm the more clients it will have the more it will lose if it doesn't discover material misstatements thus, firm size is positively related with audit quality. Blokdijk, Drieenhuizen, Simunic and Stein (2003) examined determinates of the number of audit hours performed by a sample of 113 audits of Dutch companies in years 1998-1999. They found that the details of audits production by big 5 are more reasonable and predictable than audits by non big 5 firms. LI, SONG and WONG; 2005 gathered data about audit firms and Chinese public listed companies in periods 2001 to 2003 to examine the relationship between audit firm size and audit quality. Their findings show that there is a positive relationship between firm size and audit quality. On the other hand Elfouzi (2010) test the relationship between audit reports by Big 4 and non Big 4 external auditors and stock prices in the Tunisian financial capital market in periods 2002 to 2007. the result support the notion that there is no difference in audit quality by bi4 vs. non big 4. Davidson and Neu (1993) examined the relation between audit firm size and audit quality in Toronto by testing the size of the forecasting error, hypothesizing that the higher the forecasted error the better the audit quality. They found that larger auditing firms provide higher-quality audits than do small auditing firms. It is clear that the firm size and audit quality was the interest of many researchers but there was conflicting results. So this area needs further investigation and if it was proven that the audit quality of big 4 is better than the non big 4 is this fact universal?

5.2 Empirical testing.

I will first use Jones model (1991) to measure earning management in firms to divide them into two categories: high earning management and low earning management.

First: using the OLS to obtain the coefficients estimates of the model in non prediction period.

Where:

Tait = total accruals in year t for firm i.

REVit = revenues in year t less revenues in year t-1 for firm i.

PPEit = gross property, plant and equipment in year t for firm i.

Ait-1= total assets in yea t-1 for firm i.

Eit = error term in year t for firm i.

Second: calculate the prediction error for prediction periods (Discretionary accruals).

Third: Calculate standardized prediction error.

After dividing the firms to high and low earning management (high: firms with high earnings management) I will test the market reaction (prices) to earnings using Ohlson model (1995).

Pt = β0 + β1Xt + β2BVt-1 + et

Where:

Pt= (closing price + dividends at time t) \ opening price

Note: opening price 1\1\ t-1 and closing price 31\3\ t

Xt is current period earning per share

BVt-1 is book value of equity per share at the end of fiscal year t-1 (Lagged BV)

Big 4 Auditor

Big 4 Auditor

High Earning Management

Low Earning Management

1st Q

1st Q

2nd Q

2nd Q

4th Q

4th Q

After performing a regression I compare the R² for each of the following elements:

By holding the audit quality constant (big 4) I compare the R² of the 1st quarter in firms with high earning management with the R² of the 1st quarter for firms with low earning management and so on for the other quarters to see whether the earning management affects our results and whether the auditing in the 4th quarter curbs earning management. After that I compare the R² of the 4th quarter relative to the other quarters in both scenarios (high or low earning management) to assess whether the market reaction to the 4th quarter earnings was stronger than for the other quarters.

If the R² were relatively the same for all quarters or close to each other then an F-test should be performed to test the significance level.

To test whether the audit quality depends on firm size (big 4 vs. non big 4) I will compare the R² for the following elements.

Big 4 Auditor

Non Big 4 Auditor

Low Earning Management (high)

Low Earning Management (high)

4th Quarter

4th Quarter

Now I hold the level of earning management constant and change the type of auditor and compare the R² for the 4th quarter to assess whether the big 4 auditors have higher audit quality then the non big 4.

5.3 Sample selection.

The study will be based on 111 company listed in Kuwait Stock Exchange from different sectors excluding the banking sector for periods from 2005 to 2007. All the data is gathered from the company's quarter and annual reports and the Kuwait stock exchange web site.

6. Questions for further studies.

Does earning management affect only the 4th quarter earnings quality? And did the audit failure in 2001 affect the market response to audited financial statements in preceding years? Is the audit quality of the big4 higher than the audit quality of the non big 4 universal?

Writing Services

Essay Writing
Service

Find out how the very best essay writing service can help you accomplish more and achieve higher marks today.

Assignment Writing Service

From complicated assignments to tricky tasks, our experts can tackle virtually any question thrown at them.

Dissertation Writing Service

A dissertation (also known as a thesis or research project) is probably the most important piece of work for any student! From full dissertations to individual chapters, we’re on hand to support you.

Coursework Writing Service

Our expert qualified writers can help you get your coursework right first time, every time.

Dissertation Proposal Service

The first step to completing a dissertation is to create a proposal that talks about what you wish to do. Our experts can design suitable methodologies - perfect to help you get started with a dissertation.

Report Writing
Service

Reports for any audience. Perfectly structured, professionally written, and tailored to suit your exact requirements.

Essay Skeleton Answer Service

If you’re just looking for some help to get started on an essay, our outline service provides you with a perfect essay plan.

Marking & Proofreading Service

Not sure if your work is hitting the mark? Struggling to get feedback from your lecturer? Our premium marking service was created just for you - get the feedback you deserve now.

Exam Revision
Service

Exams can be one of the most stressful experiences you’ll ever have! Revision is key, and we’re here to help. With custom created revision notes and exam answers, you’ll never feel underprepared again.