Empirical Analysis of Audit Uncertainty Qualifications: Research Reports

Journal of Accounting Research
Vol. 29 No. 2 Autumn 1991

Printed in U.S.A.
Research Reports
Empirical Analysis of Audit

Uncertainty Qualifications
TIMOTHY B. BELL* AND RICHARD H. TABORt
1. Introduction
This study examines the usefulness of financial statement and other
data for modelingthe auditor'sdecision process leading to the modifica-
tion of audit reports for uncertainties. The auditor faces increased
responsibility to evaluate and report on uncertainty about a client's
continued existence under SAS No. 58 and SAS No. 59 (AICPA [1988]).
A model for predicting uncertainty qualifications would be useful as an
aid to this reportingdecision;it could be applied early in the audit when
the auditor forms an expectation of engagement risk and again at the
final stage when making the reportingdecision.
The model could also be used as an expectations model in studies of
the informationcontent of qualifiedaudit opinions and for investigating
changes in auditors'loss functions.' In addition, a model might provide
* KPMG Peat Marwick;tAuburn University. Funding for this researchwas provided,
in part, by the ResearchOpportunitiesin AuditingProgramof the Peat MarwickFounda-
tion and the Collegeof Business SummerResearchGrant Programat AuburnUniversity.
We express our appreciation for that support. In addition, we thank participants in
accountingworkshopsat the Universityof Wisconsin-Madison, OklahomaState Univer-
sity, and the Universityof Alabamafor valuablecommentson earlierversionsof this paper.
Special thanks go to Dick Dietrich of the University of Texas at Austin for his valuable
assistanceon mainframecomputingmatters.Finally,we expressour gratitudeto a diligent
reviewerfor many worthwhilesuggestions.
'See Mutchler[19851for a discussionof the first of these applications.
350
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AUDIT UNCERTAINTY QUALIFICATIONS 351
objective evidence in a legal action against the auditor for failing to

qualify the audit opinion of an auditee that subsequently experiences
business failure.For example,a low probabilityof qualificationgenerated
by the model would indicate that, at the time the opinion was rendered,
the auditee's financial and operating trends resembled those of firms
that typically receive a clean opinion.
We began our model developmentprocess by consideringseven finan-
cial factors and three additional measures to capture size, growth, and
return variability. Each of the seven factors was represented in three
different ways-ratio-level, rate-of-change, and industry-standardized
forms-yielding a total of 24 possible predictorvariables.The final model
contains five financial factors-Return on Investment, Inventory Inten-
siveness, ReceivablesIntensiveness, Short-TermLiquidity,and Financial
Leverage.Coefficientsigns on these factors are consistent acrossthe four
years studied, and the model predicts median (mean) probabilities of
qualificationof .83 (.63) for 108 holdout first-time qualificationsand .02
(.04) for 995 holdout unqualifiedfirms. Comparedto a naive strategy of
issuing all unqualified opinions, use of our model reduced expected
misclassificationcosts by a minimum of 40%.
In a related work, Mutchler [1985] analyzed the auditor's use of
informationcues to determine whether to issue a going-concernqualifi-
cation for firms in financial distress. Our sample includes healthy and
distressed firms. Dopuch, Holthausen, and Leftwich (henceforth DHL)
[1987]present a predictivemodel of audit opinion qualificationsin which
the variables with greatest predictive power were a categorical variable
indicatingwhether the firm recordeda loss duringthe year being audited
and the firm's change in residualstandarddeviation of returns. Consist-
ent with their findings, our model predicts a significantly higher average
probability of qualification for the more serious multiple uncertainty
qualification (including going-concern qualifications) compared to the
less serious specific (asset realization)uncertainty qualification.
Section 2 discusses formulation of the empirical model; section 3
describes sample selection issues; the remaining sections report results
and conclusions.
2. Audit ReportModificationsfor Uncertainties

We modeled the auditor's propensity to modify audit reports in the
years 1980-83 that were not modified in the preceding year, using a
dependentvariable equal to one if -the client receivedeither a specific or
multipleuncertainty qualification,and equal to zero otherwise.The logit
model given below allows the estimation of weights for the linear com-
bination of client attributes (Zi) that representsthe auditor'spropensity
to issue an uncertainty qualification.
Pi ==1 + e7-'
(1)
352 JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1991
wherePi representsthe conditionalprobabilityof qualification.We used

the Newton-Raphsonnonlinearestimation methodto computemaximum
likelihood estimates of the coefficients on Z. We selected predictor
variables(client characteristics)based on guidelinesgiven in the auditing
standardsand empiricalevidence from past research.
SAS No. 58 and SAS No. 59 (AICPA [1988])present guidelinesrelated
to the auditor's responsibility for audit report modification when a
question arises about an entity's ability to continue as a going concern.
These standardsindicatethat negativetrends,such as recurringoperating
losses, workingcapital deficiencies, negative cash flows from operations,
and adverse key financial ratios, may indicate client solvency problems.
In addition,prior empirical studies have providedevidence that receiva-
bles and inventory are high-risk accounts with respect to auditor loss
exposure. Measures of the intensity of these two accounts could be
correlatedwith the degree of uncertainty about their recoverability.
Past studies have provided empirical evidence of the redundancyof
various ratios as indicators of the factors given in SAS Nos. 58 and 59.
Pinches, Mingo, and Caruthers [1973] factor analyzed 48 ratios com-
monly used for financial statement analysis of manufacturingfirms and
identified seven nonredundantand reasonably stable financial patterns
that explained an average of 91% of the variance in the original data.
Gombolaand Ketz [1983] observedthat roughlythe same factor patterns
were applicable to retail firms. We chose the ratio from each factor
pattern with the highest averagefactor loading to represent each factor.
These ratios and related factors are presented in table 1.
The guidelines given in paragraph5 of SAS No. 56 (AICPA [1988])
suggest that client financial information should be evaluated over time
and relative to industry measures. Based on these guidelines, we con-
verted the ratios listed in table 1 into both rate-of-changeand industry-
standardizedmeasures.The rate-of-changetransformationis given by:
RC(Xi,t) = [Xit - Xi,t1]/Xi,t-j (2)
where RC(Xi,t)= the rate-of-change in ratio X for firm i and year t,

where Xi is measuredas of the end of the year t under audit and the end
of the precedingyear, t-1.
The transformationfor conversion into industry-standardizedform is
given by:
ST(Xi,t) = [Xit - X,t]/SD(Xt, 1) (3)
where ST(Xi,t) = the deviation of a firm's ratio X for the year t under
auditfromthe industrymean ratioXI for year t-1, dividedby the standard
deviation of ratio X across firms in industry I for year t-1. An industry-
standardizedvariable indicates the relative standing of the client within
its industry distribution. The prior year's industry distribution is used
because in a practical setting the distributionof industry ratios as of the
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354 T. B. BELL AND R. H. TABOR
end of the year being audited is not available on a timely basis. The
industry means and standard deviations were estimated using all firms
on the Compustattape within the same four-digit Standard Industrial
Classification (SIC) code. If the number of firms within the four-digit
code was less than 15, then firms within the same three-digit (or two-
digit, if necessary) SIC classification were added.
We included variables intended to capture size, growth, and return
variability. We measuredsize as industry-standardizedsales, growth as
rate-of-change in sales; and return variability as the variance of the
client's daily stock returns measuredover the audit year and the preced-
ing year.
The return on investment factor is includedto capturethe probability
of recurringclient losses. Its expected sign is negative because we believe
that larger downturns and weaker relative performance in return on
investment will be associated with recurringlosses. Additional support
is provided by Zmijewski [1983] who observed a significant negative
correlation between return on investment and the incidence of bank-
ruptcy.
Our measuresof return on investment were adjustedfor a few sample
observationswhere application of equations (2) and (3) yielded counter-
intuitive results. For the ratio-level, rate-of-change,and industry-stand-
ardized forms we changed the sign to negative whenever there was a
current-year loss and the unadjusted computation yielded a positive
value. Given a current-year loss, a counterintuitive positive measure
could result from a current-yearnegative net worth or, in the case of the
rate-of-change computation, from a prior-year loss in excess of the
current year's loss. We found this ad hoc adjustment provided better
predictive ability comparedto alternative measures (e.g., net income to
total assets). Adjustmentswere requiredfor five qualified firms and one
unqualified firm from the total sample of 1,348 observations covering
four years.
The short-termliquiditymeasuresare includedas indicatorsof possible
deficiencies in working capital, and the cash position measures are
included as indicators of the client's ability to generate adequate future
cash flows. We expect a negative sign on all these variables.The industry-
standardizedmeasures should provide an indication of the strength of
the client's current working capital or cash position (i.e., degree of
deficiency). A negative trend in either cash-to-fund expendituresor the
current ratio implies a tendency toward an insufficient future cash or
workingcapital position.
The leverage measures are included as indicators of the potential for
violations of loan agreements.Debt covenants typically include restric-
tions on borrowers'capital intensiveness to ensure that owners continue
sharing a portion of the risk. The net worth to sales ratio is a margin-of-
safety indicator for creditors;a large positive coverage implies that the
equity is sufficient to absorb a significant reduction in sales. Therefore,
we expect that these variables are negatively related to the probability

of qualification.Although in periods with abnormallylow sales the ratio
can be artificiallyhigh, Pinches, Mingo, and Caruthers[1973] found that
net worth to sales was significantly correlatedwith the factor containing
other ratios less sensitive to this problem,such as cash flow to sales and
net income to sales.
The reportingof a specific uncertainty could be used to reduceauditor
loss exposurefor either receivablesor inventorieswhen futurerealization
of their reported values is highly uncertain. Of course, uncertainty
concerning realization of these accounts would also affect the multiple
uncertaintyfactors given in SAS Nos. 58 and 59. Based on the results of
prior studies (e.g., St. Pierre and Anderson [1984] and Simunic [1980]),
we expect positive signs on the receivables intensiveness and inventory
intensiveness variables.
We expect a negative sign on the size variable, based on Ohlson's
[1980] finding that size is negatively correlated with bankruptcy. For
similarreasons,we expect the sign on the growthvariableto be negative.
Finally, we expect a positive sign on the stock return variable. As stock
returns become more variable, significant stock price declines are more
likely and therefore auditor loss exposure is increased. Zmijewski[1983]
found that total stock return variance was positively correlated with
bankruptcyand DHL [1987] observed a positive relation between the
change in residual standard deviation of returns and the issuance of
contingencyqualifications.
3. Sample Selection
The sample of qualified firms was identified using the NAARS docu-
ment retrieval system. Table 2 presents the results of our sampling
procedure.We identified 1,196 annual reportsfor 665 firms that included
uncertainty qualifications during 1979-84.2 For convenience, we com-
bined the firms with annual reports for fiscal years ending in late 1979
(three firms) and.early 1984 (five firms) with the 1980 and 1983 groups,
respectively.
We deleted regulated firms, financial institutions, and service firms
because we believe they requiredifferent models than retail and manu-
facturing firms. We also excluded firms that had been qualified every
year back to 1978 because we wanted a more current sample.3
2
The 1,196 observationsare composedof 3 firmsthat were includedfor five consecutive
years,60 firmsincludedfor fouryears, 74 firms includedfor three years, 191 firmsincluded
for two years, and 337 firms includedonly once.
'The orderin which we deleted firms affects the frequenciesreportedin each category
in table 2. For example, a firm deleted because it is regulatedmay have had a litigation
qualification,but it wouldnot be includedin the litigationcategoryof deletions.We deleted
firms followingthe order given in table 2 (i.e., regulatedfirms deleted first, followed by
financialinstitutions,etc.).
TABLE 2
SampleSelectionResults
1980 1981 1982 1983 Totals
Identification of Qualified Sample
Uncertainty qualifications on
NAARS data base ......... 227 174 127 137 665
Less DeletionsFrom Sample:

Regulated firms ............. 28 18 9 23 78
Financial institutions ........ 44 27 22 17 110
Service firms . . . . . .......... 13 14 10 10 47
Qualifiedbackto 1978 ....... 70 29 13 15 127
Tax and litigation uncertainties 37 38 19 22 116
Bankrupt in first year qualified 6 5 4 7 22
29 43 50 43 165
Less firms with missing data . . 6 7 9 12 34

Total first-timequalifications . 23 36 41 31 131
Composition of Qualified Sample

Specific-assetrealization ..... 8 11 10 7 36
Multiple-goingconcern ....... 15 25 31 24 95
Qualified Sample Firms Listed on CRSP Daily Returns File

Specific-assetrealization 5 7 7 6 25
Multiple-goingconcern ....... 10 17 18 8 53
Total CRSP qualifiedsample . 15 24 25 14 78
Unqualified Sample
Firms on Compustatand
CRSP (fromsame industries)
that receivedclean audit
opinions ................. 222 283 310 402 1217
We excluded specific litigation and tax uncertainty qualifications for

two reasons. First, the auditor is less likely to require a financial-
statement-baseddecision aid for these situations. Second, these qualifi-
cations are less predictable using financial statement information than
other types of uncertainty qualifications. For example, the decision to
qualify for litigation requires a model that incorporatesan estimate of
the expected gain or loss, including estimates of the probabilities of an
arrayof potential settlements.
Finally, we deleted firms that filed for bankruptcyin the same year as
that covered by a first-time qualification.We are more interested in the
qualification decision when the auditor faces greater uncertainty, espe-
cially if our model is to be a useful decision aid. These selection criteria
yielded 165 firms; 34 lacked some data requiredby our model, resulting
in a final sample of 131 qualifiedfirms.
The sample contains 36 firms with specific asset-realization uncer-

tainty qualifications and 95 firms with multiple uncertainty qualifica-
tions. We did not partition the multiple uncertainty group because
preliminarytests indicated no significant differences in estimated prob-
abilities across these subsets. Moreover,it is often difficult to distinguish
an opinion based on continued existence uncertainties from an opinion
based on future financing uncertainties.
Data for the qualifiedfirms were primarilyobtained from the Compu-
stat tapes and Moody'sIndustrial Manual. For tests involving the stock
returnvariablewe imposed the additional requirementthat firms had to
be listed on the CRSP (NYSE/ASE) daily returns file. Our qualified
sample for these tests included 78 firms; 25 received specific asset-
realization uncertainty qualifications and 53 received multiple uncer-
tainty qualifications.
Our sample of unqualifiedfirms was also identified using the NAARS
document retrieval system. We found 2,547 annual reports with accom-
panying unqualifiedopinions or opinions that included only consistency
exceptions. We then cross-matchedthis list of firms with the CRSP and
Compustatdata sources and eliminated regulated,financial, and service
firms and firms with missing data. The remainingsample contains 1,217
annual reportsfor retail and manufacturingfirms. Ourapplicationof the
same sampling procedures as applied to the qualified sample should
mitigate the estimation bias caused by choice-basedsampling. The ratio
of unqualifiedto qualifiedopinions is greaterthan 9 to 1. Also, given the
large unqualified sample size, conclusions about the model's ability to
predict clean opinions can be drawnwith greaterconfidence.
A potential shortcomingof our samplingprocedureis the completedata
bias discussedin Zmijewski[1984]. If firms are sampledcontingent upon
the availability of complete data, and if the probability of qualification
given complete data is significantly different from the probabilitygiven
incomplete data, the estimated model will be biased. Firms selected into
our samplehad to be includedin the NAARS data base. AlthoughNAARS
requests annual reports from publicly traded companies, not every com-
pany submits its report.If the probabilitiesof qualificationfor submitters
and nonsubmitters are significantly different, then our parameteresti-
mates will be biased.
There are other potential sources of sample selection bias related to
our sampling procedure. For example, because firms included on the
Compustatdata base must meet certain size criteria, our model might
not be appropriatefor very small firms. Also, the frequencies of firms
found on NAARS that had missing or inappropriatedata differedfor the
qualifiedand unqualifiedsamples. Twenty-one percent of the total qual-
ified sample (34 of 165 firms) and 11% of the unqualifiedfirms (150 of
1,367 firms) had missing or inappropriatedata. The primary cause of
inappropriatedata for both groupswas fiscal year-end changes.
4. Empirical Results
4.1 DESCRIPTIVE STATISTICS AND UNIVARIATE MODELS
Initially, we investigatedthe univariaterelationbetween each predictor

variable and the incidence of qualificationby comparingpredictor-vari-
able means and medians for the unqualifiedand qualifiedsamples. Table
3 presents these descriptive statistics together with the expected signs
for the 24 predictorvariablesand approximatet-statistics associatedwith
Wilcoxon Rank Sum Tests for significant differences between group
medians. We tested for differences in medians because Kolmogorov-
Smirnov (KS) tests for normality indicated that the predictorvariables
were not normallydistributed.
Table 3 reveals that most differences between the median predictor-
variable values across samples are significant and consistent with the
expected signs. The exceptions were for the inventory and receivables
intensiveness variables and for the cash position variable in ratio-level
form.4
We also estimated univariate logit models for each predictorvariable
and each sampleyear (1980-83) so that we could assess the intertemporal
stability of each variable.For ten of the univariatemodels the coefficient
signs are consistent with expected signs and significant for each of the
four years. These models include financial leverage and short-term li-
quidity in all three measurementforms: capital intensiveness measured
in the rate-of-change and ratio-level forms, and return-on-investment
measured in the industry-standardizedand ratio-level forms. Also, re-
turn-on-investmentin rate-of-changeform and size wereboth significant
in three of the four years and had consistent signs across all four years.
To summarizethe results to this point, our initial exploratoryanalyses
indicatethat firms that receivefirst-time uncertaintyqualificationsdiffer
most from firms receiving clean opinions in terms of return on invest-
ment, financial leverage,short-term liquidity, capital intensiveness, and
firm size. These results are not surprising. The factors that do not
consistently differ between samples include inventory intensiveness,
receivables intensiveness, growth, cash position, and the change in the
variabilityof stock returns.
4.2 MULTIVARIATE RESULTS
Our first multivariateanalysis involved estimating the logit model for
each single-year period using the 17 industry-standardizedand rate-of-
change variables detailed in table 1. For comparativepurposes, we also
estimated the models substituting the seven ratio-level measures for the
industry-standardizedand rate-of-changevariables.This resulted in the
testing of three models: (1) a 17-variable Industry-Standardized/Rate-
4Descriptive statistics for the specific and multiple uncertainty qualifications (not
reported)differedslightly from the total sampleresults.
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of-ChangeModel, (2) a 16-variableRatio-Level/Rate-of-ChangeModel,

and (3) a 15-variable Ratio-Level/Industry-StandardizedModel. This
comparisonis useful for the purpose of model specification and because
there is a cost associated with the collection of data requiredto carryout
the industrytransformation.
Table 4 presents goodness-of-fit measures and within-sample classifi-
cation results for the three models."Themodel chi-squaresgiven in table
4 are based on the likelihood ratio test and can be interpretedsimilar to
the F-test for a linear regression. As another measure of model fit, we
used the R-Value, derivedfrom Akaike's informationcriterion. It can be
interpreted in a manner similar to the multiple correlation coefficient
from a linear model.5For two of the four years studied, the Industry-
Standardized/Rate-of-ChangeModel had the highest R-Values.For 1980,
the Ratio-Level/Rate-of-Change Model had the highest R-Value. For
1982 the Industry-Standardized/Rate-of-ChangeModel had the lowest
R-Value,but all three models were similar. The model chi-squaresfor all
models in every period have observedprobabilitiesof less than .0000.
Since our primary objective was to develop a useful decision aid for
predictingfirst-time uncertainty qualifications,we were most interested
in the comparative within-sample classification results for the three
models and preliminary prediction results on holdout samples. The
Classification Results section of table 4 gives the mean and median
probabilities of qualification for the unqualified and qualified samples
for each of the four years.
To assess the predictive ability of the three alternative model formu-
lations, we appliedeach model estimated on the 1980 sample to the 1981-
83 samples. Next, we aggregatedthese forecasts and compared means
and medians for the qualifiedand unqualifiedsamples. Based on prelim-
inary results indicating that the Industry-Standardized/Rate-of-Change
Model is superiorto the models containing the ratio-level variables, we
focusedon the industry-standardizedand rate-of-changevariablesduring
the process of specifying a final model. However, once the final model
was identified,we allowedratio-levelvariablesto enter alternativemodels
for testing against our final model.
4.3 FINAL MODEL SPECIFICATION

We have observedthat transformingfinancial ratios to include bench-
marks suggested in the auditing standardscan enhance the explanatory
power of these ratios. However, we also found that the rate-of-change
variablewas often significantly correlatedwith the correspondingindus-
try-standardizedvariable. The two largest correlationsare .667 between
5R is the value such that R2= [modelchi-square- 2p]/-2Lo, wherep is the numberof
variablesin the model excludingthe intercept and Lois the maximumlog-likelihoodwith
only the intercept in the model. So, the model chi-squaremust increase by at least two
upon the inclusion of an additionalvariablebeforethe R-valuewill increase.
the two financial leverage measures in rate-of-change and industry-

standardizedform and -.546 between financial leverage and return on
investment (both in industry-standardizedform).
We used the results of the univariate analyses and preliminarymulti-
variate analyses to guide our specification of a final model. Table 5
presents the parameterestimates, goodness-of-fit measures, and classi-
fication results for the final model that we judged to be best among the
alternatives we tested. Results are presented for each year from 1980
through 1983 based on the use of cumulative estimation samples. For
example, the 1980 and 1981 samples would be combinedto estimate the
model to be applied to 1982 year-end client data. If coefficients are
consistent across time, then cumulative samples may provide greater
confidence due to increased sample size. Annual samples would be
warranted if estimated coefficients are inconsistent across time. We
estimated models using just the annual samples and tested them for
predictiveability on the other holdout samples. The results were essen-
tially the same as those given for the cumulativemodels.
Table 5 presents results that show short-term liquidity, return on
investment (industry-standardizedform), and financial leverage were
significant in all four cumulative periods. Inventory intensiveness was
significantin three of the four periods,and receivablesintensiveness was
significant in two periods. Model goodness-of-fitmeasures (R-Value,chi
square)all indicate good model fit, and the model's classificatorypower
is significant.
4.4 FINAL MODEL PREDICTION RESULTS

Table 6 presents cumulativefrequencydistributionsof predictedprob-
abilities of qualification (similarity indexes) for the qualified and un-
qualified firms resulting from application of the cumulative estimation
models to the one-year-aheadsamples;for example, predictedprobabili-
ties for the 1981 sample were generatedusing the 1980 model;those for
the 1982 sample were generated using the 1980-81 cumulative model,
and so on. The total number of holdout firms from the years 1981-83 is
1,103 (995 unqualifiedand 108 qualified firms). The predictedprobabil-
ities for these three samples are combined into one overall frequency
distribution.
Table 6 shows that 91% of the unqualified firms and 15.7% of the
qualified firms were assigned a predicted probability of qualification of
less than .1. The models produce predicted probabilitiesgreaterthan .9
for 52 of the 108 qualifiedfirms (48.1%)and 1 of the 995 (.1%)unqualified
firms. These results indicate that a client that receives a predicted
probability of qualification greater than .9 very much resembles firms
that received qualifications in the recent past. At a cutoff of .5, the
models correctlypredict 99.2%of the 995 unqualifiedfirms and 60.2%of
the 108 qualified firms. The lower portion of table 6 presents summary
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TABLE 6
PredictionResultson CombinedSamples
(CumulativeFrequencyDistributionsby Subsample)
CumulativeEstimationModels
PredictedProbability Unqualified Qualified

Cum. Cum. Cum. Cum.
Freq. % Freq. %
P ' .10 905 91.0 17 15.7
P s .20 959 96.4 29 26.9
P ' .30 971 97.6 35 32.4
P '.40 986 99.1 38 35.2
P ' .50 987 99.2 43 39.8
P* .60 988 99.3 44 40.7
P ' .70 991 99.6 46 42.6
P ' .80 992 99.7 51 47.2
P '.90 994 99.9 56 51.9
P' 1.0 995 100.0 108 100.0
Total Number of Observations:
Qualified-specific ....... ....... 28
-multiple ....... ...... 80
Total qualifiedfirms ....... ...... 108
Unqualifiedfirms ........ ....... 995
Predicted Probability: Mean Median

Qualified firms .629 .826
Specific ................... .354 .197
Multiple ............. ........ .641 .978
t-statistic ............ ........ 4.570* 4.490*
Unqualified firms .044 .021
Test for Significance of a Proportion:

Z-statistic...................... 12.93
* Significantat the .05 level.
statistics for the holdout predictions,with the Z-statistic indicating that

the models correctly predict a greater number of holdout observations
than would be expected by chance.
Table 6 also presents separate comparisons of the mean and median
predictedprobabilitiesfor specific and multipleuncertaintyqualifications
and relatedsignificancetests. These results revealthat mean and median
predictedprobabilitiesfor specific uncertainty qualifications are signifi-
cantly lower than the means and medians for multiple uncertainty
qualifications.6
6 These differences across types of qualifications might occur because a different model
applies to each opinion type. To investigate this possibility, we estimated separate models
for specific and multiple uncertainty qualifications using our six-variable final model. For
the multiple uncertainty model, results were consistent with our overall model for all four
periods. For the specific uncertainty model, results were consistent with our overall model
4.5 PREDICTIVE ABILITY RESULTS IN TERMS OF EXPECTED
MISCLASSIFICATION COSTS
Evidence that our final model generates predicted probabilities of
qualification that are significantly greater for qualified firms than for
unqualifiedfirms does not indicate whether using this model is superior
to other strategies in terms of expected misclassificationcosts. To make
this assessment, we use a technique used by DHL [1987];the technique
involves estimating a cutoff probabilitythat minimizes expected misclas-
sification costs and then using it to determine the percentage reduction
(or increase) in costs relative to a rule which classifies all clients as
unqualified.
We used the 1980-81 sample to estimate cost-minimizingcutoffs under
the followingassumptionsabout the relative cost of type I errorsin terms
of $1 cost of type II errors:.5:1, 1:1, 5:1, 10:1, and 20:1. As is customary,
a type I error is defined as a misclassified (or mispredicted) qualified
firm, and a type II error relates to a misclassified unqualifiedfirm. The
alternative cutoffs should be useful in a practical setting where the
auditor can choose the cutoff associated with the best estimate of the
client-specificrelativecost of misclassifyingthe opinion. Also, evaluating
an arrayof relative cost assumptionsprovides evidence on the minimum
percentagereductionin expected costs due to using the model instead of
a naive strategy.7As describedbelow, the model outperformsthe naive
strategy under all assumed cost configurations.
Althoughtype I errors are sometimes assumed to be more costly than
type II errors,this is mere speculation.Kida [1980] reportedthat auditors
perceived the following possible repercussionsfrom rendering an inap-
propriate qualification: (1) loss in audit firm revenue due to auditor
switching;(2) lawsuit by client against the accounting firm; (3) negative
effect on the auditor'sreputation in the business community;(4) deteri-
oration in relations with the client; and (5) the so-called self-fulfilling
prophecy-the qualification itself jeopardizes client survival, which in
turn increases the probability that consequences (1) through (4) will
occur. Moreover, the fact that auditors do not qualify every client
experiencingfinancial difficulty (sometimes even bankrupt clients have
never received a qualified opinion) indicates that qualifyingis not cost-
less. For these reasons, we included a case where type II errorsare more
costly than type I errors.
except for the coefficienton industry-standardizedreturnon investment for 1980. Predic-
tion results for the multiple uncertainty model were not very different from our overall
model, but the specific uncertainty model generated relatively inferior predictions and
lowergoodness-of-fitmeasures.
'As the relative cost of type I errors decreases,the cost-minimizingcutoff approaches
one. However,once the cutoff reaches the point where all estimation-samplefirms with
higher probabilitiesare qualified firms, this maximumestimated cost-minimizingcutoff
will remain fixed for all lower relative type I errorcosts, and the percentagereductionin
expectedcosts due to model use versus use of the naive strategywill be at a minimum.
Table 7 presents the estimated cost-minimizing cutoffs for each as-

sumed cost configuration, the type I and type II error rates, and the
overall sample errorrates for each cutoff. In panel A we used our sample
proportionsas estimates of prior probabilities.We also report (in panel
B) the estimated cutoffs using proportions reported by DHL [1987].
Using the within-sample estimated probabilitiesfrom the 1980-81 sam-
ple, the minimum percentage reduction in expected costs due to using
our model in lieu of the naive strategy is 52.5%;this reductionincreases
as type I errorsbecome more costly. At a relative cost of 20:1, our model
reduces the expected cost of the naive strategy by 86.8%, using our
sample proportions,and by 81.7%using DHL's [1987] estimated popu-
lation proportions.The minimumpercentagereductionin expected mis-
classification costs is 40.2%when the estimation model is appliedto the
1982-83 holdout sample, and at the relative cost of 20:1, the percentage
reductions are 73.0%and 69.1%using our prior probabilitiesand those
of DHL [1987], respectively. Using the DHL [1987] priors, which give
more weight to type II costs, results in higher cost-minimizingcutoffs at
each assumed relative cost. This is because the cost-minimizingcutoff is
an increasing function of the prior probability of a type II error and a
decreasingfunction of the prior probabilityof a type I error (e.g., if the
prior probability of a type I error is zero, then all firms should be
unqualified).8
5. ConcludingRemarks
This study reportsthe results of extensive exploratoryanalyses under-
taken to develop an audit decision aid to predict uncertainty reporting
decisions. We identified and tested a comprehensiveset of independent
client financial factors, measuredto include benchmarkssuch as prior-
period amounts (to capture trends) and industry norms (to capture the
client's relative position within its industry).
The final model contains six measures representing five financial
factors-return on investment, inventory intensiveness, receivables in-
tensiveness, short-term liquidity, and financial leverage. The model's
estimated coefficients are consistent with expected signs for all periods
studied. We found that the change in variance of firm-specific stock
returns and the sign of the current year's net income did not provide
significant incremental explanatorypower when included in our multi-
variatemodel.Ourmodel significantlyreducedexpected misclassification
costs from the naive strategy for a variety of misclassification cost
assumptions.
8Results computedusing the multiple uncertaintyqualificationsmodel are even more

impressive.The minimumpercentagereductionin expectedcosts fromthe holdoutsample
predictionsis 54.5%,and for a 20:1cost configurationthe reductionis over 80%(basedon
our sampleproportions).
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REFERENCES
AMERICANINSTITUTEOF CERTIFIEDPUBLICACCOUNTANTS.
AICPA Professional Stand-
ards.Vol. 1. Chicago:CommerceClearingHouse, 1988.
DOPUCH,N.; R. HOLTHAUSEN;
AND R. LEFTWICH."Predicting Audit Qualifications with
Financialand MarketVariables."The AccountingReview(July 1987):431-54.
M. J., ANDJ. E. KETZ. "Financial Ratio Patterns in Retail and Manufacturing
GOMBOLA,
Organizations." FinancialManagement(Summer1983):45-56.
KIDA,T. "An Investigation into Auditors' Continuity and Related QualificationJudg-
ments."Journalof AccountingResearch(Autumn1980):506-23.
MUTCHLER, J. F. "A Multivariate Analysis of the Auditor's Going-ConcernOpinion
Decision."Journal of AccountingResearch(Autumn1985):668-82.
OHLSON, J. S. "FinancialRatios and the ProbabilisticPredictionof Bankruptcy."Journal
of AccountingResearch(Spring 1980):109-31.
PINCHES,G. E.; K. A. MINGO;ANDJ. K. CARUTHERS.
"The Stability of Financial Patterns
in IndustrialOrganizations."Journal of Finance (May 1973):389-96.
SIMUNIC, D. "The Pricing of Audit Services:Theory and Evidence."Journal of Accounting
Research(Spring 1980):161-90.
ST. PIERRE,K., ANDJ. A. ANDERSON."An Analysis of the Factors Associated with Lawsuits
Against Public Accountants."The AccountingReview(April 1984):242-63.
ZMIJEWSKI, M. E. "MethodologicalIssues Related to the Estimation of FinancialDistress
PredictionModels."Journalof AccountingResearch(Supplement1984):59-82.
. "Predicting Corporate Bankruptcy:An Empirical Comparisonof the Extant
Financial Distress Models."Workingpaper, State University of New York at Buffalo,
1983.

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Journal of Accounting Research

Vol. 29 No. 2 Autumn 1991

Empirical Analysis of Audit

objective evidence in a legal action against the auditor for failing to

2. Audit ReportModificationsfor Uncertainties

wherePi representsthe conditionalprobabilityof qualification.We used

where RC(Xi,t)= the rate-of-change in ratio X for firm i and year t,

C/) COD COD COD COD C/~~~~~~~)

we expect that these variables are negatively related to the probability

Less DeletionsFrom Sample:

Less firms with missing data . . 6 7 9 12 34

Composition of Qualified Sample

Qualified Sample Firms Listed on CRSP Daily Returns File

We excluded specific litigation and tax uncertainty qualifications for

The sample contains 36 firms with specific asset-realization uncer-

Initially, we investigatedthe univariaterelationbetween each predictor

-Q-A L iCicl cli ici II6r: 40 cli iiL II 6o II

al 0 0 0 -~d o 9r-4 4 0rO-4

CD r-f Ci00 t- 00t0 0r e

4Q0 O'00l c )0 ) 00mcoC M 0D D-~4r I)

of-ChangeModel, (2) a 16-variableRatio-Level/Rate-of-ChangeModel,

4.3 FINAL MODEL SPECIFICATION

the two financial leverage measures in rate-of-change and industry-

4.4 FINAL MODEL PREDICTION RESULTS

U g . 00 ?r C,X> n CS, X O s (fi]o ,M

PredictedProbability Unqualified Qualified

Predicted Probability: Mean Median

Test for Significance of a Proportion:

statistics for the holdout predictions,with the Z-statistic indicating that

Table 7 presents the estimated cost-minimizing cutoffs for each as-

8Results computedusing the multiple uncertaintyqualificationsmodel are even more

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