Question

Edmonds, Christopher T., Ryan D. Leece, Beth Y. Vermeer, and Thomas E. Vermeer (2020). The Information Value of Qualified and Adverse Audit Reports: Evidence from the Municipal Sector. Auditing: a Journal of Practice & Theory 39(1), February, 21-41.

1. Based on a review of the abstract, summarize the findings in one or two sentences.

2. Read Section II, Institutional Background. Summarize it in around 100 words using your own language. Be sure to mention the Single Audit Act of 1984.

Over the past 40 years, the SEC and others have consistently asserted that the information contained in an independent audit report is important to investors and, further, that expanded audit reporting enhances the transparency and stability of municipal markets (GFOA 2015; SEC 2012). Although the SEC cites anecdotal evidence to support the importance of the information provided by municipal independent audit reports, to our knowledge, there is no recent U.S. empirical evidence on the information value of qualified/adverse audit reports in the municipal sector. Using hand-collected data from 2000 to 2012, we find that municipal bond markets penalize governments with qualified/ adverse audit opinions for both primary market issuances and secondary trading. Specifically, in our propensity score matched sample, we find that municipalities receiving a qualified/adverse opinion suffer borrowing costs that are 34 basis points, on average, higher than municipalities receiving an unqualified opinion, holding all else constant. Overall, the weight of evidence is consistent with rejecting the null hypothesis that audit opinions on the fairness of GAAP financial statements are independent of borrowing costs in municipal markets. However, our archival research design cannot completely eliminate the threat of a correlated omitted variable. To our knowledge, recent research has not examined whether investors value the information content of qualified/adverse opinions on the fairness of the financial statements. Our results suggest that these auditor assurances are value relevant and that municipal investors differentiate between governments receiving unqualified and qualified/adverse opinions. However, similar to the for-profit sector, most governments receive an unqualified opinion (97 percent of our sample), which does not allow for differentiation among the majority of municipal audit reports. Our finding that the audit report is value relevant to municipal investors should be of interest to the SEC as they consider expanding municipal audit reporting, such as including communication of critical audit matters and auditor tenure (similar to the PCAOB auditor reporting standard adopted on June 1, 2017 ). Future research should examine whether the impact on municipal debt costs depends on the type of opinion received (i.e., qualified versus adverse) and/or the specific reasons provided (i.e., scope restriction versus departure from GAAP) for the nonstandard opinion. In an untabulated analysis, we found that the average yield for adverse audit opinions is higher than the average yield for qualified audit opinions (4.4 compared to 3.99, t-test statistic 1⁄4 1.95; p , 0.0653). However, we were unable to find significant differences in a multivariate model. Small samples also prevented us from determining whether investors differentiate based on the specific reasons provided (i.e., scope restriction versus departure from GAAP) for the nonstandard opinion. We also found no association between the choice of an independent CPA firm/state auditor and municipal debt costs (p-value 1⁄4 0.127). Future research should further explore this question as more data become available.

SECTION 2:

The overall purpose of an audit is to express an opinion on whether the historical financial statements are fairly stated in accordance with applicable accounting standards (Arens, Elder, and Beasley 2013). In both governmental and non-publicly traded companies, audits of historical financial statements must comply with generally accepted auditing standards (GAAS) and 8 statements on auditing standards (SASs) established by the American Institute of Certified Public Accountants. Although independent CPA firms audit most local governments, some municipalities are either audited by state audit agencies or the state agency reviews reports prepared by independent public auditors to ensure compliance with standards. While audits of governments, non-publicly traded companies, and U.S. publicly traded companies share a similar purpose, the municipal securities market has not been subject to the same level of audit regulation as other sectors of the U.S. capital market (SEC 2012). U.S. publicly traded companies are required to have audits under the Securities Act of 1933 and the Securities and Exchange Act of 1934 (1933 and 1934 Acts). Furthermore, an audit opinion that is qualified due to a scope limitation or departure from GAAP will not meet the stringent requirements under Rule 2-02(b) of Regulation S-X. While the SEC has broad regulatory control over the for-profit sector, the 1933 and 1934 Acts were passed with expansive exemptions for the municipal securities market (Gellis 1996). In fact, except for the antifraud provisions contained in these Acts, current federal securities laws do not provide the authority to the SEC or the Municipal Securities Rulemaking Board (MSRB) to require audited financial statements for municipal securities issuers. Although the SEC and MSRB have no direct authority to require municipal audited financial statements, larger municipal issuers typically have their financial statements audited due to rating agency requirements, other regulatory requirements, and voluntary disclosure guidelines from industry groups. Rating agencies generally demand audited financial statements to assign or maintain ratings. For example, Moody’s Investors Service requires audited financial statements within 12 months after the end of the fiscal year to assign or maintain a general obligation (GO) bond rating (Moody’s 2016). Further, Moors & Cabot, Inc., a leading financial advisor of municipal securities in the United States, notes that most analysts require audited financial statements as a condition of buying GO obligations. The two primary regulatory statutes requiring audited financial statements from local governments are the Single Audit Act of 1984 (federal government level regulation) and local government statutes (state level regulation). The Single Audit Act of 1984 requires that local governments with federal expenditures of $500,000 or more of federal financial assistance within a fiscal year have a Single Audit that includes an audit opinion on the historical financial statements. The Single Audit Act covers all 50 states and many of the more than 80,000 local governmental units (Freeman, Shoulders, Allison, and Smith 2013). In a similar manner, at the state level, the Utah State Auditor requires an annual financial statement audit for local government entities with greater than $750,000 in total annual revenues or expenses (Office of the Utah State Auditor 2016). In addition to the regulatory requirements of the Single Audit Act of 1984 and individual states, the Government Finance Officers Association (GFOA) Certificate of Achievement for Excellence in Financial Reporting is the primary voluntary industry group program requiring audited financial statements. Established in 1945 to encourage state and local governments to go beyond the minimum requirements of generally accepted accounting principles, the GFOA awarded the Certificate of Achievement to 4,231 organizations in 2015 (GFOA 2018). Although the SEC and MSRB cannot require audited financial statements from municipal issuers, rating agencies, other regulatory requirements, and voluntary industry programs ensure that local governments that issue GO bonds have their financial statements audited. Overall, the absence of audited municipal financial statements is more prevalent with less sophisticated issuers and non-governmental conduit borrowers (SEC 2012).

Answer 1

Point 1. Audited financial statement of both governmental and private companies must comply with the GAAS i.e Generally Audited Accounting standards and 8 statemnts of SAs i.e Standards on auditing.

Point 2 . State audit agencies either audit the financial statements of the municipalites or review the financial statements audited by independent CPA firms.

Point 3. Municipal securities market is subjected to lesser amount of audit regulation as compared to other US capital markets.

Point 4. SEC exercises larger regulatory control over the profit oriented sector whereas exempting municipal securites market from various provisions through act passed in 1933 and 1934.

Point 5. Except for anti fraud provision, the SEC and MSRB donot have power to require for Audited financial statement from the Municipal securities market. They only get the FS audited due to rating agency requirement .

Point 6. Single Audit Act ,1984 and local government statues are the two primary Acts demanding for audited financial statements of loval governments.

Point 7. Single Audit Act,1984 has prescribed a limit of 50,000$ in terms of federal expenditure and financial assistance in a fiscal year. In case the local government crosses or jumps under this limit he will be required to get the historical financial information audited.

Point 8. GFOA certificate is an encouraging programme started to inspire the local govrnments to get there historical financial information audited by complying with more than minimum requirements of GAAS.