A Theoretical Examination of the Market Reaction to Auditors' Qualifications.

This article develops conditions under which audit qualifications arise in equilibrium and study the relation between litigation exposure and audit-qualifications. The authors use a model of audit qualifications to re-examine the documented market's reaction to a qualified opinion and the appropriate empirical specification to test for such reaction. Examples of qualified audit opinions that are ex pos avoidable are asset realization, timing of revenue recognition, amount of reserves for future losses and GAAP compliance. The authors present and analyze an equilibrium model in which a manager rationally accepts a qualified audit report because doing so enables him to convey credibly favorable private information that will increase the market value of the firm.