Financial-Statement and Audit-Report Messages Author(s): William T. Bailey
Source: The Accounting Review, Vol. 56, No. 4 (Oct., 1981), pp. 882-896 Published by: American Accounting Association
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October 1981
The Efects of Audit Reports on
Chartered Financial Analysts'
Perceptions of the Sources of
Financial-Statement and Audit-Report Messages
William T. Bailey
ABSTRACT: The paper reports the results of a study of the information that four types of audit reports convey to Chartered Financial Analysts about the sources of both financial - statement and audit-report messages. Four hypotheses are tested, two of which concern the perceived identity of the source of specific financial-statement messages. Two others concern the effect of the audit reports on analysts' perceptions of the credibility of the source of financial-statement messages and of the auditor. The study indicates that audi- tors are perceived to be much more involved in the communication of financial-statement messages than many people realize. This perceived involvement and the information that audit reports convey about the auditor's credibility combine to produce some unsuspected credibility effects.
T
HIS study seeks to enhance our un- derstanding of the process through which audit reports influence users' perceptions of the credibility of financial- statement data. According to communi- cation theory, the extent to which a message is believed depends on people's perceptions of the message's source.Reported herein are results of an experi- mental investigation of the information content of four types of audit reports regarding the sources of financial-state- ment and audit-report messages. Infor- mation conveyed to Chartered Financial Analysts (CFAs) about the identity of the source of particular financial-statement messages is the subject of two hypothe- ses.1 Two others address the audit reports' effects on CFAs' perceptions of
the credibility of the auditor and manage- ment.
The ensuing discussion has five parts.
Research dealing with the measurement and effects of source credibility is re- viewed in Part I. Part II develops the
I In this study, the term financial-statement message refers to a line item and the associated dollar amount that are reported in a financial statement. For example,
"Net Sales. . . $xxxx" would be one such message.
The author wishes to thank Glenn A. Welsch, Lawrence A. Tomassini, and Earl Jennings for their constructive suggestions regarding this project. Its shortcomings remain the author's sole responsibility.
William T. Bailey resides in Houston, Texas.
Manuscript received January 1980.
Revisions received June and October 1980.
Accepted January 1981.
882
hypotheses, and Parts III and IV describe the experiment and report the results, respectively. The study's conclusions are summarized in Part V.
I. SOURCE CREDIBILITY
The relationship between source credi- bility and the acceptance of information has been researched extensively. After reviewing such efforts, Andersen and Clevenger [1963, p. 77] conclude: "The finding is almost universal that the ethos of the source is related . . . to the impact of the message." Berlo et al. [1969-1970, p. 563] state:
We know an individual's acceptance of in- formation and ideas is based in part on "who said it." This variable, the source's role in communication effectiveness, has been given many names: ethos, prestige, charisma, im- age, or, most frequently, source credibility.
Whichever label is used, research consistently has indicated that the more of "it" the com- municator is perceived to have, the more likely the receiver is to accept the transmitted in- formation.
In early research, source credibility appeared as an independent variable, and, if it was measured at all, the measure- ments were ordinal. Efforts to develop interval-scale measurements of source credibility began in the 1930s. In the 1940s, source credibility was recognized to be multidimensional, but identification of the various dimensions became feasi- ble only with the advent of factor analy- sis. Numerous factor-analytic studies have produced instruments specially de- signed to measure source credibility. The instruments vary somewhat, but much of the variance is due to differences in factor-analytic methods and their appli- cation rather than to differences in the underlying structures. For example, both Andersen and Berlo developed instru- ments to measure ethos, and the instru- ments differ somewhat. Andersen and Clevenger [1963, p. 77] state: "Inspec-
tion suggests that the two structures were not essentially dissimilar if allowance is made for the difference in factor rotation methods." To measure source credibility, this study used an instrument developed by Berlo et al. [1969-1970]. The instru- ment and the reasons for its selection appear below in Part III.
II. DEVELOPMENT OF HYPOTHESES Communication processes usually are described in terms of channels carrying messages from sources to receivers. When analyzing a set of financial statements and the audit report, one receives mes- sages via two different channels and from potentially different sources.
In most communication situations, the receiver of a message knows its source.
This certainly is true of face-to-face communication, and it is true of most written messages. Unlike personal letters, financial statements bear no signature, and the owners of a company often are far removed from the production and transmission of the company's financial statements. Furthermore, a company's management and its outside auditor sometimes disagree over the proper ac- counting for an item, and what finally appears in financial statements is a joint product of the auditor and management.
Under these conditions, users may con- strue financial-statement messages to emanate from any of several possible sources, including the auditor.
For one who is interested in under- standing the means by which audit reports influence users, the perceived identity of the source of each financial- statement message is an important issue.
It is important because one source may be more less credible than another, and source credibility is an important deter- minant of message acceptance.
Audit reports potentially transmit sig- nals regarding the identity of the source
of each financial-statement message. For example, one would expect users to be less inclined to regard the outside auditor as the source of an exception-related financial-statement message than of one not so related. This is especially true as the severity of the exception increases. In the most extreme case, viz., that of an adverse opinion, to regard the auditor as the source of an exception-related finan- cial-statement message seemingly would place him in the position of voicing through the audit report severe reserva- tions about his own messages (i.e., about that exception-related financial-state- ment message of which the auditor is the perceived source). To determine whether audit reports indeed do transmit source- identification signals, the following null hypothesis is tested:
H1: Unqualified opinions, consistency exceptions, GAAP qualifications, and adverse opinions convey the same information about the iden- tity of the source of financial- statement messages.
Two messages may be perceived to emanate from different sources, but the difference in perceptions need not be the result of audit reports. That is, the per- ceived source of one message may differ from that of another message, but the difference in perceptions may be constant across audit reports. To learn whether different financial-statement messages are perceived to emanate from different sources, the following null hypothesis is tested:
H2: All income-statement messages are perceived to come from the same source.
Theoretically, audit reports influence the credibility, and thereby the accep- tance, of financial-statement messages [Commission on Auditors' Responsi- bilities, 1978, p. 1; Committee on Basic
Auditing Concepts, 1972, p. 68 ]. As stated in Part I, the acceptance of a message depends partly on the receiver's percep- tions of the message's source. One way then for an audit report to influence users is for it to affect their perceptions of the credibility of the source of financial- statement messages. Carmichael [1972, p. 126] suggests that audit reports convey credibility cues about management, but little research has been conducted on this aspect of the information content of audit reports. It is investigated in this study by testing the following null hy- pothesis:
H3: Unqualified opinions, consistency exceptions, GAAP qualifications, and adverse opinions convey the same information about the credi- bility of management.
Because an auditor signs his report, the identity of the source of audit-report messages is known. Unknown, though, is the effect that audit reports have on the auditor's own credibility as a source of information. Accordingly, the following null hypothesis is tested:
H4: The perceived credibility of an outside auditor as a source of in- formation is not a function of his opinion.
III. METHOD
CFAs' reactions to specially designed information sets were solicited and com- pared in such a way as to isolate the effects of information conveyed by the audit-report components of the sets.
Data from 14 groups of analysts were analyzed in a posttest-only control group design. Pretreatment equality of groups was achieved by randomization.
Samples
From the population of all CFAs residing in the United States and Canada, a systematic random sample of 1,778
FIGURE 1 EXPERIMENTAL DESIGN
UUNQ LTCON UGAAP AUNQ ACON AGAAP AADV
Net Earnings 22(17?() 25(20%) 32(25%) 32(25%)I 24(l90%) 20(16%) 18(14%) Net Sales 36(28%) 14(11/) 25(19%) 23(18%) 31(24%) 21(170) 35(28%)
v~~~~ v-
Control Groups Experimental Groups
Sb1hol Meaning
LUNQ Unaudited Set-I statements UCON Unaudited Set-2 statements
L/GAAP Unaudited Set-3 statements
AUNQ Unqualified opinion (Audited Set-I statements)
ACON Consistency exception (Audited Set-2 statements)
AGAAP GA AP qualification (Audited Set-3 statements)
AADV Adverse opinion (Audited Set-3 statements)
CFAs was drawn. This sample was di- vided into 14 subsamples of 127 each to which the experimental and control treat- ments randomly were assigned. A total of 358 CFAs responded, which is a response of 20 percent. Illustration I discloses the composition of the overall response. The number of responses from each group is shown nonparenthetically. Each number is expressed parenthetically as a percent- age of the 127 questionnaires mailed to the group.
Information Sets
Each group in Figure 1 is characterized by an information set and a financial- statement message. Eight experimental groups responded to information sets containing (1) a description of the test company including a five-year sales and earnings summary, (2) the test company's two-year comparative financial state- ments, and (3) an audit report covering both years. Six other groups, which served as controls in testing H3, reacted to information sets composed of the company description and unaudited statements. No auditor's name was as- sociated with the unaudited statements.
The information sets were assembled
into booklets, each containing a cover page listing the contents and instructing the analyst to examine them in the follow- ing order: company description, balance sheet, income statement, statement of changes in financial position, and notes to the statements.2 If the statements were audited, then an audit report followed the notes. Immediately preceding each set of unaudited statements was a page stating:
"The following financial statements have not been audited."3
All financial statements used in the study were of the same real company, the identity of which was disguised. The name appearing on each audit report as that of the auditor was the same, but the name was fictional. The auditor was de- scribed as representing one of the large international CPA firms. Analysts were told that the names of the company and the auditor had been changed.
2 This also is the order in which the items appeared in the booklet.
3 This statement is needed to assure that those who are exposed to unaudited statements do, in fact, respond to unaudited statements. In the pilot study, the statement was omitted, and most analysts assumed that the state- ments had been audited and that the auditor's report was unqualified. Those who make such an assumption effec- tively respond to audited rather than to unaudited statements.
FIGURE 2
MATERIALITY SPACE AND AUDIT OPINIONS
1 Adverse
(
Opinion
Material Threshold 2
Qualified Opinion
- Threshold I Immaterial Unqualified
Opinion
The accounts to which exception was taken were held constant by having inven- tory as the subject of both consistency and GAAP exceptions. Inventory com- prised approximately 26 percent of the test company's total assets. In the state- ments on which an unqualified opinion was expressed, inventory was valued at the lower of FIFO absorption cost or market. To produce a consistency quali- fication, financial-statement numbers were altered to reflect a change from FIFO to LIFO. To produce an exception for the failure to follow GAAP, inventory was valued on a FIFO direct-cost basis.
The first note to the statements disclosed the inventory-valuation method.
An exception is to be expressed in an audit report only when the items to which exception is taken are material. To ap- preciate the design of this study, two materiality thresholds need to be dis- tinguished. One threshold separates the material from the immaterial. Within the material region, an amount may become
"so material that in the independent auditor's judgment a qualified opinion is not justified" [AICPA, 1973, paragraph 513.02]. At this point, an adverse opinion is issued. Figure 2 portrays the situation.
The materiality problem in designing this study was the location of threshold 2.
This threshold needed to be approxi- mated because it is the one at which an amount can warrant either a qualified or
an adverse opinion, and both were inves- tigated in this study. If different dollar amounts were embedded in different audit reports, then the different amounts would rival the different opinions as explanations of a criterion difference.
The location of threshold 2 is un- known. Carmichael [1972, p. 146] tried to locate it but was forced to conclude, 'll . sufficient evidence is not available to establish quantitative guidelines at the professional level." An FASB publica- tion [1975, p. 83] suggests that materiality decisions concerning the income state- ment are based largely on the percentage effect on current net income. Some prac- ticing CPAs suggested that a 25-percent to 30-percent effect on the test company's net income would approximate thresh- old 2.
An unqualified opinion had been issued on the real company's two-year comparative statements. In Figure 1, these are the Set-1 statements. To pro- duce a set of statements that would accommodate both the GAAP qualifi- cation and the adverse opinion, the Set-i statements were modified so as to reduce net earnings by 28 percent in one year and by 25 percent in the other. The first note to the statements was modified to disclose the fact that the inventory cost excluded fixed factory overhead. The resulting statements and notes are de- noted in Figure 1 as Set-3 statements.
Neither these nor the Set-1 statements and notes would accommodate the con- sistency exception; so a third set of statements and notes was created. In this set, the data pertaining to the earlier of the two years were not modified, and they were labeled "As Previously Reported."
The later year's data were modified so as
to reflect the same cumulative two-year
effect on net earnings as was reflected in
the Set-3 statements. The first note dis-
closed the change to LIFO, manage-
ment's justification for the change, the effect of the change on the current year's earnings, etc. The resulting statements and notes, which, in Figure 1, are the Set-2 statements, accommodated the con- sistency exception.
Experimental Tasks
The first task was to forecast the test company's upcoming year's inventory, net sales, and net earnings. The forecasts were to be based on the information set accompanying the questionnaire. As the various information sets were analyzed, the experimental and control treatments were administered. Having the analysts forecast the data got them to process the information sets. It also gave them a definite problem to solve, without which they would have had no reason to observe any particular element of the information set.
The second task was to evaluate either the more recent Net Earnings or Net Sales message that was reported in the test company's comparative income statement. Although analysts were asked to forecast inventory, they were not asked
Tasks Perjormed by Recipients of Unaudited Statements I, Forecast data.
2. Evaluate financial-statement message.
3. Rate management's credibility.
to evaluate the inventory message re- ported in the balance sheet. Inventory and Net Earnings were two of several messages related to the exception ex- pressed in the audit report. The Net Earnings message was selected nonran- domly to represent these messages. The Net Sales message was selected non- randomly to represent the nonexception- related group of messages.
The third task depended upon whether the analyst received audited or unaudited statements. As their third task, recipients of audited statements answered a ques- tion designed to identify the party they perceived as the source of the message that was evaluated as the second task.
The question appears below in the dis- cussion of the measuring instruments.
After identifying the source, their fourth task was to rate the source's credibility.
If the source whose credibility was rated was the auditor, then the fourth task was the last. If the source rated in step four was not the auditor, then the analysts' fifth and final task was to rate the audi- tor's credibility.
Recipients of unaudited statements were not asked a source-identification question. No outside auditor was associ- ated with these statements; so it is reasonable to regard management as the source of the financial-statement mes- sages. Management was so regarded, and the third and final task for recipients of unaudited statements was to rate management's credibility.
The following lists summarize the aforementioned tasks:
Tasks Performed by Recipients of Audited Statements I .Forecast data.
2. Evaluate financial-statement message, 3. Identify message's source.
4. Rate source's credibility.
5. Rate credibility of auditor if not done in step 4.
Measuring Instruments
To identify the source of the Net Sales message, the following question was asked:
In face-to-face communication, people trans- mit messages to one another by talking. If the people are not face to face, the talking may be by telephone, letter, telegram, or financial statement. Who do you think was "talking"
to you when you read in Vista's income state-
ment that its Net Sales for fiscal 1978 were
$4,935,693? Answer by circling one of the four letters below that you deem most appropriate.
a. The outside auditor.
b. Vista's management.
c. The outside auditor and Vista's manage- ment jointly.
d. Other; please specify
A similar question was used to identify the source of the Net Earnings message.
The question differs in some important respects from those other researchers have asked. It attempts to identify the source in a purely descriptive sense.
Others [e.g., Smith, 1972] have asked about "the responsibility for financial statements." Responsibility is a moral or a legal issue-not a communication issue.
A solution to a legal or a moral problem may require a solution to a communica- tion problem, but the reverse is not the case. The question also asks about the source of a specific message rather than about the source of an indefinite set of messages referred to in the aggregate as
"financial statements." It is quite possible for different messages transmitted through the same financial statement to be perceived as coming from different
source credibility to be multidimensional, The instrument used in this study tc measure source credibility taps three independent dimensions: (1) safety, (2, qualification, and (3) dynamism. This instrument was chosen because the steps that Berlo et al. [1969-1970] took ir developing it were more extensive than those others have taken, and they werc more carefully executed. For example.
whereas Whitehead [1968] analyzed the ratings of only two sources, Berlo et al analyzed the ratings of 18 sources ol considerable variety. While Berlo et al selected the raters randomly from a residential population, others, including Whitehead, used only students as raters Furthermore, the safety, qualification, and dynamism dimensions have emerge in other studies (among them White head's) that have explored the factor structure of source credibility.
The dimensions can be analyzed indi vidually or they can be combined into E
composite measure of source credibility To extract the most information, this study separately analyzed each dimen sion. The scales used to tap each dimen sion and the numerical coding scheme appear below:
Safety dimension:
Safe ) ( Unsafe
Honest Dishonest
Fair J 1 2 3 4 5 6 7 (Unfair
Qualification dimension:
Qualified) : : :Unqualified
Skilled -a _ _ by Unskilled
Informed J 1 2 3 4 5 6 7 (Uninformed Dynamism dimension:
Bold : : :Timid
Aggressive ---- i - Meek
Active 1 2 3 4 5 6 7 (Passive
sources. Should they be, the source- identification questions asked in this study permit its detection.
Factor analyses repeatedly have shown
A simple arithmetic average of the scales used to tap each factor formed the factor scores.
FIGURE 3
NUMBER OF ANALYSTS RATING MANAGEMENT (AND THE AUDITOR)
UUNQ L(CON UGAAP AUNQ ACON AGAAP A ADV
Net Eamings 22 25 32 20(32) 11(24) 16(20) 14(18)
Net Sales 36 14 25 6(23) 12(31) 8(21) 18(35)
Nonresponse Bias
Oppenheim [1966, p. 34] indicates that those who are late in returning question- naires resemble nonrespondents. If they do, then nonresponse bias can be de- tected by comparing early and late re- sponses. This study compared them by linearly regressing the credibility data over time. Each respondent who received unaudited statements rated the credibility of management. Some respondents from each of the eight groups that received audited statements identified manage- ment as the source of the message they evaluated. These respondents also rated management's credibility. Hence, ratings of management were secured from all 14 groups. Only the eight groups that re- ceived audited statements rated the audi- tor. Figure 3 reports nonparenthetically the number of analysts from each group that rated management and parentheti- cally the number that rated the auditor.
In each group, separate regressions were run on each dimension of source credibility. Of the 14 groups, only one contained evidence that the ratings of management varied over time; in only one of the eight groups was there evidence that the ratings of the auditor varied over time.4 In both cases, the evidence was confined to the qualification dimension;
it was not buttressed by similar results on the other dimensions of source credi- bility. Furthermore, in comparing the responses, 66 separate regression coeffi- cients were tested for statistical signifi- cance. At a .05 probability level per test,
approximately three significant results should occur simply by chance. Hence, the two statistically significant coeffi- cients are consistent with the hypothesis that the analysts' responses do not vary with time.
IV. RESULTS
Replies to the source-identification question are summarized in Table 1, where "NE" and "NS" denote Net Earnings and Net Sales, respectively.
Test of H1
H1 was tested by analyzing separately the responses to the Net Earnings and Net Sales messages.5 From these an- alyses, it cannot be concluded that the four types of opinions convey different information about the identity of the source of either the Net Sales message (x2==3.80, df=3, p=.29) or the Net Earnings message (X = 7.21, df= 3, p
=.07). Since the data are consistent with the notion that the four types of audit
4 The evidence was a statistically significant (p < .05) regression coefficient.
5 In both analyses, the Management and Auditor, Auditor, and Other categories were combined so that no fewer than 20 percent of the cells would have an expected frequency of less than five [Siegel, 1956, p. 178]. In the case of the Net Sales message, the aggregation produced the following data to which the chi-square test was applied:
A UNO ACON AGAAP AADV
Management as Sole
Source 6 12 8 18
Management Not as
Sole Source 1 7 19 13 17
Responses to the Net Earnings message were treated similarly.
TABLE I
SUMMARY OF SOURCE-IDENTIFICATION RESPONSES
A CON AGAAP AADV Tola/s
NE NS NE NS NE NS NE NS NE NS
Management 20 6 11 12 16 8 14 18 61 44
ManagementandAuditor 11 15 11 17 4 11 3 14 29 57
Auditor 0 2 2 2 0 2 0 2 2 8
Other 1 0 0 0 0 0 1 1 2 1
reports convey the same information about the identity of the source of finan- cial-statement messages, H, is not re- jected.
Test of H2
H2 is refuted if CFAs perceive any two messages to emanate from different sources. The hypothesis was tested by comparing analysts' responses to the Net Earnings and Net Sales messages. Re- sponses were summed over the audit- report categories producing Table l's
"Totals" columns. Analysis of these totals leads to the rejection of H2 and to the conclusion that CFAs do not perceive all income-statement messages to come from the same source (x2 = 12.61, df=2, p <.O 1).6 They view the outside auditor as being more involved in transmitting the Net Sales message than in sending the Net Earnings message.
Some may be inclined to attribute this difference in perceptions to the difference in the exception-related status of the two messages. Such an attribution should not occur. The responses produced by just the unqualified opinion showed the same tendency for the auditor to be viewed as more involved in sending the Net Sales message than in transmitting the Net Earnings message (X2- 5.73, df= 1, p < .02). With an unqualified opinion, no exception-related messages exist; so something about the two messages other
than their relationship to an audit-report exception causes them to be perceived as emanating from different sources. The following explanation is offered.
This author conjectures that CFAs are predisposed to regard the auditor as the source of audited financial-statement messages, but that as the complexity of a message increases, analysts shift away from the auditor and toward manage- ment. Net Sales is only one component of Net Earnings. The magnitude of other components is within management's dis- cretion. Management elects to incur or not to incur certain costs, it selects amortization periods, it estimates many expenses, and it is free to change its estimates. There is a sense, then, in which management is more involved in the production of the Net Earnings message than in that of the Net Sales message, and that may be what the responses to the source-identification question indi- cate.
Test of H3
A two-step procedure, the logic of which is explained in the Appendix, was used in testing H3. The first step was to perform what amounts to an interaction test. The purpose of this test was to decide whether the comparative effects of the four audit reports on CFAs' percep-
t The chi-square test was applied with the Auditor and Other categories combined.
TABLE 2
ESTIMATED MEAN CREDIPILITY RATINGS OF MANAGEMFNT
U!UNQ UCON UJ0A4P A UNsQ ACoN AGAAP AADV
Ad---251 - -32 20 --I 1 1 6 1
}4
Net Earnings -. 4.08 4. 12 3 4.09 4.25 4.21 14.48 4 5.14 Safety yNet Sales Ket14l 66 4.0 8 4.10 -4.01 4.22 12 383 81. 3 88 8 4.17~
Net Earnings 2.92 3.04 | 3.081 2.92 2.97 3.00 3.19
Net Sales 3.06 3.00 | 3.19 | 3.67 3.03 2.83 2.3?5
Net Earnings 2.55 2.53 2.58 2.35 2.70 2.73 2.29
Neynamtsm 2 26 3 2 2 2 -
Net Sales 2.68 2.24 2.61 3.22 2.67 2.67 2.33
tions of management's credibility depend on the message of which management is the perceived source.
The following matrix numerically identifies the study's 14 populations:
UUNQ UCON UGAAP AUNQ ACON AGAAP AADV
Net Eamings 1 2 3 4 5 6 7
Net Sales 8 9 10 I 1 12 13 14
In terms of the preceding matrix, step one tested the following relationships among expected values (EV):
(EV4 -EV5 )-(EV1-EV2 )= C1 (1) (EV1 1-EV12)- (EV8- EV9 )=C1 (2)
(EV4 -EV6 )-(EVI-EV3 )= C2 (3) (EV1 1-EV13)-(EV8-EV1o)= C2 (4) (EV4 -EV7 )-(EVI-EV3 )=C3 (5) (EV1 1-EVI4)-(EV8-EV1o) = C3 (6) Equations (1) and (2) test for interaction between the messages and the effects of unqualified opinions and consistency exceptions. Equations (3) and (4) test for interaction involving unqualified opin- ions and GAAP qualifications. Equa- tions (5) and (6) express the absence of interaction between the messages and the
comparative effects of unqualified and adverse opinions. There are only three such independent tests involving four types of opinions.
The relationships expressed in Equa- tions (1) through (6) were tested simul- taneously by using a 14-parameter neces- sarily-true starting model.7 Empirical estimates of the mean safety, qualifica- tion, and dynamism ratings of manage- ment produced by the starting models appear in Table 2. Sample sizes were the same on all three dimensions; so they are given only once in the upper left-hand corner of the safety-dimension cells. The means can range from 1.00 (most credi- ble) to 7.00 (least credible).
7Linear models that are used to estimate expected values of populations and upon which restrictions are imposed in order to test hypothetical relationships among the expected values are referred to as "starting models." Such models and their choice are discussed in Ward and Jennings [19731.
The results of the interaction tests are:
Associated Dimension F Value Probability
Safety .7442 .5269
Qualification 1.2621 .2884
Dynamism .5243 .6661
From these results, it cannot be con- cluded that the messages of which man- agement is the perceived source interact with the type of audit report covering them. The data are consistent with the hypothesis that the effects of each of the exception-bearing opinions relative to an unqualified opinion are independent of the message that management transmits.
Of course, the (A - Aj) - (U - Uj) differ- ences, which appear to be constant across the two message categories, may be zero.
Their value is the subject of the stage-two tests.
In conducting the stage-two tests, either the necessarily-true model or the simpler no-interaction model can serve as the starting model. The one with the smaller error mean square yields the more powerful test. For the safety and dynamism ratings, the no-interaction models served as starting models. H3 was tested by imposing on these models the restrictions C1 = C2 = C3 = 0. The full
14-parameter model was used in testing the qualification ratings. The results of the tests are:
Associated Dimension F Value Probabilitt'
Safety 2.3915 .0685
Qualification .9469 .4620
Dynamism 1.4883 .2177
None of these F values is statistically sig- nificant at the .05 probability level; so H3 is not rejected on any dimension of source credibility.
The failure to reject H3 does not imply that H3 is true. It simply means that the
evidence collected in this study does not warrant a conclusion that any of the four opinions conveys information about management's credibility that is not con- veyed by the other opinions. Since an adverse opinion is among the four, the data do not corroborate Carmichael's
[1972, p. 126] conjecture that adverse opinions convey information about man- agement's intentions that derogates its credibility.
Test of H4
In testing H3, systematic financial-
statement differences between certain information sets were noted, and infor- mation sets with unaudited statements were used to control for the differences.
Control was necessary because it was reasonable to believe that the statements and notes would convey information about the company's management that would rival the audit reports as an expla- nation of a criterion difference. Financial statements are less apt to convey infor- mation about the credibility of an outside auditor. If they convey no such informa- tion, then there is no need to control differences in them.
A set of financial statements together with an audit report may convey informa- tion about the auditor's credibility, but the credibility signals are not conveyed through the financial statements per se.
The statements and notes merely create a potential for information to be con- veyed by the auditor's report about his credibility. Even if the statements bla- tantly violate GAAP, they convey no information about the outside auditor.
If such statements were accompanied by
a clean opinion, then the statements and
opinion together very likely would con-
vey information about the auditor's
credibility, but the information would
not be conveyed by just the statements
and notes. Hence, in testing H4, there isTABLE 3
ESTIMATED MEAN CREDIBILITY PERCEPTIONS OF THE AUDITOR
A UNQ ACON A GAAP AADV
Safety H 3.63 3.39 3.30 2.94 F=2.9980;p =.0314
Qualification | 3.02 |2.77 2.55 2.34 F=3.1914;p=.0243
Dynamism 4.28 3.89 3.89 3.60 F=3.0173; p=.0306
no need to control the systematic finan- cial-statement differences.
Table 3 displays the estimated means of each population. Sample sizes, which did not vary across dimensions, are shown only once. On each dimension, the null hypothesis was that the means of the four populations were equal. The results of the tests appear alongside the estimates.
All of the probability values associated with the F values are statistically sig- nificant at the .05 probability level; so H4 is rejected, and it is concluded that the credibility of the auditor depends on the type of report he issues. An auditor is perceived to be the least safe, the least qualified, and the least dynamic when he issues an unqualified opinion. His credi- bility increases with the severity of the qualification, reaching its maximum value when the opinion is adverse.
V.
LIMITATIONS AND CONCLUSIONSThe data reported in this paper may be limited in three respects. One is the response rate, which, across groups, ranged from 11 percent to 28 percent.
This range reflects different self-selection, which may bias the data. However, even if the response were uniform across groups, complex selection-treatment in- teractions still could introduce bias that would threaten the internal validity of the experiment. An effort was made to detect nonresponse bias by comparing
early with late responses. No evidence of bias was uncovered, but the detection procedure is not foolproof.
Noteworthy is the fact that many CFAs do not respond to questionnaires, whatever their content. It is understood that at least some companies have adopted a policy that their employees not answer mail questionnaires. In such cases, the nonresponse and any resulting bias are not confined to any particular experimental treatment. Since the treat- ments were assigned randomly to the groups, in the long run, such nonre- sponses will be distributed over all groups. Hence, there is a chance that nonresponse bias, if it exists, may equally affect each group. If it does, then the conclusions will be unaffected.
Another limitation concerns the con- ditions under which the analysts re- sponded to the questionnaire. Nothing valuable was at stake when the CFAs analyzed the data in the information sets.
Without an economic incentive, analysts may study data and evaluate their signifi- cance less diligently than they would if money were involved. Nonetheless, re- spondents' unsolicited comments con- vinced the author that the analysts became quite involved in the experi- ment.8
8 The comments concerned such things as (1) addi- tional data that would have been useful in forecasting the company's sales and earnings, (2) the time spent in
A third possible limitation is that CFAs' exposure to the types of unaudited statements used in this study to test H3 may be rather limited. Hence, the possi- bility exists that the analysts may not have understood equally well the audited and unaudited data. This possible differ- ence in understanding may explain the failure to reject H3.9
The study uncovered no evidence that audit reports differ in the information they convey about the identity of the source of financial-statement messages.
Nor did it reveal convincing evidence that they differ in the information con- veyed about management's credibility.
Data indicate that CFAs perceive Net Earnings and Net Sales messages to emanate from different sources. Most analysts regard management as the source of the Net Earnings message and either the outside auditor solely or the outside auditor and management jointly as the source of the Net Sales message.
Even though most (65 percent) CFAs regard management as the sole source of the Net Earnings message, a sizable per- centage (33 percent) view the message as emanating in some way from the auditor.
Five percent of CFAs regard the auditor as the sole source of either the Net Earn- ings or Net Sales message.
A secondary hypothesis was tested, and it was concluded that the difference in perceived sources of the two messages is not due to the messages' relation to an audit-report exception. An explanation of the difference was offered.
The outcomes of the tests of H3 and H4 indicate that an auditor's report conveys more information about his own credi- bility than about management's. This information content has definite implica- tions for the acceptance of audit-report messages. Bailey [1980, p. 15] was unable to reject the hypothesis that,
relative to unaudited statements, unquali- fied opinions do not enhance the credi- bility of data reported in financial state- ments. In rejecting H4, it was concluded that the auditor's credibility depends upon his opinion and that his credibility is the lowest when his opinion is un- qualified. Whether it is low enough to cause his opinion to fail to enhance the credibility of financial-statement data is difficult to say, but it is a possibility deserving further research.
Since at least one-third of CFAs view the auditor as either the sole or a joint source of financial-statement messages, the information that an auditor's report conveys about his own credibility can affect significantly analysts' perceptions of financial-statement data. Analysts' perceptions of the test company's re- ported net sales number are a case in point. Displayed in Table 4 are empirically-estimated mean ratings of the perceived bias of the Net Sales message.
The ratings were obtained by having analysts evaluate the message on a seven- point scale, at opposite ends of which were the terms "Biased" and "Un- biased." These ratings were obtained as the second task described above in Part
completing the questionnaire, (3) the exercise itself and the feeling that it was interesting and thought-provoking, and (4) the fact that, after responding independently, co-workers compared their responses.
9 Accounting frequently is described as the language of business. As Katz [1966, p. 100] says (emphasis added):
Fluent speakers [of a language] both produce and understand sentences that they have never previ- ously encountered, and they can do this for indefi- nitely many such novel sentences. In the normal use of language, the production and comprehension of new sentences, created on the spot, is the rule rather than the exception.
The author has found CFAs to be quite fluent in speaking the accounting and auditing languages, and this fluency was a major factor in the decision to use CFAs in the study rather than some other class of user.
II. The means can range from 1.00 (ex- tremely unbiased) to 7.00 (extremely biased).
Whereas the UGAAP-AGAAP difference is not statistically significant, it is in the same direction as the UGAAP-AADV dif- ference, which is statistically significant (p=.030). This result is very interesting for two reasons. First, since the Net Sales message is unrelated to the audit-report exceptions, it is the same in all of the information sets. Second, analysts per- ceive the message to be less biased when the auditor's report is adverse.10 This credibility effect can be explained by the fact that (1) when the statements are audited, many CFAs regard the outside auditor as actively involved in transmit- ting the Net Sales message, and (2) the auditor is perceived to be most credible when his opinion is adverse.
If audit reports convey information about either management or the outside auditor, then they convey information about the two as a joint source of infor- mation. It follows from the rejection of H4 that the four opinions differ in infor- mation content regarding the credibility of management and the outside auditor as a joint source of financial-statement messages.
This study indicates that the process through which audit reports influence users' perceptions of financial-statement messages involves the source of the messages. It also indicates that CFAs per- ceive auditors to be much more involved in the process than what many auditors publicly state. The perceived involvement and the information that audit reports convey about the auditor's credibility combine to produce some unexpected credibility effects. Since false expectations imply either false theory or false initial conditions, this study suggests that some aspect(s) of the received doctrine of audit
TABLE 4
ESTIMATED MEAN BIAS RATINGS OF REPORTED NET SALES
UGAAP AGAAP AADV
Net Sales ] 4.44 1
3.90 3 3.59 1
reports may need revision. Further re- search on these issues is needed. Such research should include exceptions stem- ming from accounts other than inventory, and it should encompass other classes of users besides CFAs.
APPENDIX
This appendix explains the logic of the procedure used to test H3. The explana- tion refers to the following matrix, each cell of which is assigned a number for identification purposes:
U1 U2 A, A2
Net Earnings 1 2 3 4
Net Sales 5 6 7 8
A, and A2 denote information sets characterized by different types of audit reports. To accommodate these particu- lar opinions, the financial-statement com- ponents of A1 and A2 also differ. U1 and U2 denote unaudited information sets.
The financial statements and notes in U1 and A1 are identical as are those in U2 and A2. To detect a difference in the effects of the audit-report components of A1 and A2 on analysts' perceptions of management, one must compare the dif- ference in reactions to A1 and A2 with the difference in reactions to U1 and U2." In
"The Net Earnings message was perceived to be significantly (p=.006) more biased when covered by the adverse opinion than when transmitted through un- audited statements.
' Simply comparing responses to A 1 with those to A2
will not isolate the information conveyed specifically by
terms of expected values (EV), Expres- sions (1) and (2) below represent the comparative effects of the audit-report components of A1 and A2 at the Net Earnings and Net Sales categories, re- spectively:
(EV3 - EV4) - (EV1 - EV2) (1) (EV7 - EV8) - (EV5 - EV6)
(2)
If the audit reports' effects are indepen- dent of the message categories, then Expressions (1) and (2) are equal. Such an independence means that the audit reports do not interact with the financial- statement messages. Rejection of the"no-interaction" hypothesis implies that the two expressions are unequal. If they are unequal and if one expression equals zero, then the other is nonzero. If either
expression is nonzero, then the audit reports differ in effects. Hence, rejection of the "no-interaction" hypothesis would imply that H3 is false. If the no-interac- tion hypothesis is not rejected, then a second test is needed to reach a decision about H3. The object of the second test would be the null hypothesis that Ex- pressions (1) and (2) are both zero.
the audit-report components of the information sets.
The financial-statement components of the sets also differ systematically, and it is reasonable to believe that financial statements and the accompanying notes convey information about the company's management. If they do, then the financial statements and notes rival the audit reports as an explanation of a criterion difference in responses to Al and A2. Comparing the difference in reactions to A 1 and A2 with the difference in reactions to U1 and U2 controls for the effects of the financial- statement differences. This point is developed in more detail in Bailey [19821.
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