Voluntary Assurance on Interim Financial Statements and Earnings Quality

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Voluntary Assurance on Interim Financial Statements

and Earnings Quality

Sati P. Bandyopadhyay

University of Waterloo

Efrim Boritz

University of Waterloo

Guoping Liu

Ryerson University

December 2007

We gratefully acknowledge the financial assistance of the CICA under the CICA/CAAA

research grant program.





Abstract

Under current Canadian securities regulatory requirements, public companies areable to choose whether to have their interim financial statements reviewed by external

auditors on a quarter by quarter basis, but they must disclose when there has been no

review performed. This differs from US practice where the Securities and ExchangeCommission (SEC) requires a timely review of interim financial statements by the

company’s auditor. In the context of a global trend towards harmonization of accounting,

auditing and securities regulations, various jurisdictions around the world, including

Canada, are contemplating the adoption of the mandatory review practices followed inthe US. Opponents of the mandatory review approach argue that were such practices

adopted, then a signalling opportunity for companies with higher quality earnings would

be lost.

Since all US companies must have a timely review there is little opportunity for

companies to signal their quarterly earnings quality and thereby differentiate themselves.Thus, the Canadian regulatory environment provides a natural laboratory to study the

association between the determinants of voluntary reviews and earnings quality. Our

study seeks to contribute to this debate by investigating the relationship betweenvoluntary assurance on interim financial statements and earnings quality, as measured by

the volatility of the accruals reported in those statements. We hypothesize and find

evidence that the voluntary choice mechanism permits Canadian firms to signal high

quality quarterly earnings. Consistent with Larcker and Richardson (2004), earningsquality is measured as the magnitude of discretionary accruals. Firms with lower

earnings quality contemplating a review would likely be dissuaded from making this

choice to avoid questions and challenges from their auditors about their highdiscretionary accruals.

Our results provide evidence that the voluntary review engagement has value as asignalling mechanism. Thus, there are benefits to keeping auditor reviews of interim

financial statements voluntary. This suggests that regulators who are considering

adopting mandatory review as in the case of US domestic firms should proceed carefullyso as not to lose the signalling benefits associated with voluntary reviews.





1. Introduction

Reporting on interim financial statements originated in the US, where public

accounting firms required an interim review engagement as a condition for undertaking

the year-end audit. However, prior to 2000, the US Securities and Exchange Commission

(SEC) allowed SEC registrants to have their interim financial statements either to be

reviewed prior to their filing (“timely review”) or to delay the review (“retrospective

review”) till the end of the fiscal year at the time of the annual audit. With effect from

March 2000, SEC registrants must have timely reviews of their interim financial

information except for SEC registrants that qualify as “foreign private issuers” that are

not subject to these mandatory review requirements.

Under current Canadian securities regulatory requirements, public companies are

able to choose whether to have their interim financial statements reviewed by external

auditors on a quarter by quarter basis, but they must disclose when there has been no

review performed. These disclosure rules were promulgated in March 2004. In other

words, Canadian regulators currently provide a similar level of flexibility regarding

auditor involvement with interim statements to Canadian firms that were available to

SEC registrants prior to 2000. About 55% of Canadian companies voluntarily have their

interim financial statements reviewed by their auditor (Boritz, 2006). Canadian public

companies that have not had a review performed must disclose this fact by a one-line

disclosure on the cover of the financial statements that the financial statements were not



reviewed by the company’s auditor.1 In this study we compare the quality of reviewed

versus non-reviewed interim earnings. This issue is important in the context of a global

trend towards harmonization of accounting, auditing and securities regulations.

Regulators in not only Canada, but those in Japan, Europe and other jurisdictions are

considering following the US mandatory assurance approach.

A number of commentators have argued that auditor involvement with the entity’s

financial statements can improve the quality of the reported earnings as well as the

credibility of the reported earnings. As far back as 1987, the Treadway Commission

(1987) concluded that review of interim financial statements will improve reliability of

quarterly statements and increase the likelihood of detection of fraudulent financial

reporting. This view was endorsed by the Blue Ribbon Committee set up by the SEC,

which reported its conclusions in 1999. This view is also echoed in academic literature.

For example, Manry, Tiras and Wheatley (2003) argue that timely review of interim

statements curbs earnings management. Mendenhall and Nichols (1988) conclude that

managers have greater opportunity to manipulate interim earnings when earnings reports

are unaudited.

Others argue that the current level of auditor involvement with respect to the

quarterly financial statements is insufficient and that review engagements add so little value

that they not be relied upon. Also, some regulators have expressed dissatisfaction about the

extent of audit work required in a review engagement.

1 This disclosure may not adequately distinguish entities that have had a review from those that have not.Because even reviewed financial statements carry the “unaudited” disclaimer, readers may not realize that

an additional one-line disclosure, saying that the statements “were not reviewed by the auditor,” implies

additional risk.



While many of the foregoing commentators and authors predict that there will be

less earnings management when interim earnings are reviewed prior their release as

compared to when they are not, no study so far has conducted a direct comparison of the

magnitude of earnings management adopted by these two groups of firms. For example,

Manry, Tiras and Wheatley (2003) use the strength of the contemporaneous correlation

between returns and earnings as a measure of earnings quality. Ettredge, Simon, Smith and

Stone (2000a) use the frequency of occurrence of extraordinary and other items to measure

the propensity of managers to manipulate earnings. Our paper contributes to this literature

by explicitly comparing the magnitude of discretionary accruals between Canadian firms

that voluntarily decide to have their interim statements reviewed versus those that do not.

This paper contributes in another way. The review/no-review decision is not a

random choice by firms but is motivated by differences in firm characteristics that cause

firms to self-select into the two groups. Ettredge, Simon, Smith and Stone (1994) provide

evidence of differences in firm characteristics between timely reviewed and retrospectively

reviewed SEC registrants in the pre-2000 period. A straightforward comparison of means

across the two groups is subject to self-selection estimation bias. In order to control for

potential self-selection bias we use a two-stage treatment effects model (Maddala, 1983;

Greene, 1997; Hogan, 1997; Kim et al., 2003). Neither Manry et al (2003) nor

Mendenhall and Nichols (1988) control for self-selection bias in their empirical tests

We provide evidence that after controlling for estimated bias arising from potential

self-selection of firms into the two groups, the voluntary choice mechanism permits

Canadian firms to report high quality quarterly earnings numbers through their review

choice. Consistent with Larcker and Richardson (2004), earnings quality is measured as



the magnitude of discretionary accruals (Jones 1991, Dechow, Sloan, and Sweeney 1995)

adopted by sample firms.

We also provide indirect evidence of the signalling benefits of voluntary reviews

versus mandatory reviews. We find that discretionary accruals of Canadian SEC

registrants that reviewed their interim statements are significantly greater than those of

other Canadian firms that also reviewed their interim statements. If we can assume that

the Canadian SEC registrants’ reviews are “less voluntary” than those of Canadian non-

SEC registrant firms due to the higher regulatory and litigation pressures in the U.S.,

(Baginski, Hassell and Kimbrough 2002)2

then these provide some indirect evidence that

voluntarily reviewed quarterly earnings are superior quality as compared to less voluntary

or quasi-mandatorily reviewed earnings.

When earnings are required by regulatory authorities to be reviewed, all firms

will likely purchase the lowest level of review from their external auditors in order to

satisfy the minimum regulatory requirements. On the other hand, when review is

voluntary, firms that choose to review will probably purchase the highest quality review

from their auditors in order to signal quality to the market and distinguish themselves

from other firms.

The relative accrual quality hypothesis relating to voluntary review versus non-

review is tested with financial statement data for 127, 130 and 130 Canadian firms from

the first, second and third quarters of 2005, respectively, the first full fiscal year for

which the regulation is in effect, that have the necessary quarterly financial statement

data on Canadian COMPUSTAT. Canadian SEC registrants are excluded from this

2 ‘Canadian securities laws and judicial interpretations create a far less litigious environment than exists in

the U.S.’(page 25)



analysis for the following reasons. Clarkson and Simunic (1994) argue that Canadian

managers face less litigation-related costs than US managers. This argument applies

equally well to managers of Canadian firms that arte registered with the SEC. Paskell-

Mede (1994, 1999) and Grossman (1996) also conclude that Canadian managers face a

less litigious environment than their counterparts in the USA. There have also been

comments about less effective regulatory enforcement environment in Canada. Thus,

SEC registrants that decide to review possibly do so in order to reduce potential litigation

costs by providing evidence of due diligence rather than signal high quality to the market.

For this reason, quarterly earnings of Canadian SEC registrants are used as proxies for

mandatorily reviewed earnings in our comparison of quality of mandatorily reviewed

versus voluntarily reviewed quarterly earnings. We find from our empirical tests that the

discretionary accruals of 37 SEC Canadian registrants that have their statements reviewed

are greater than those of 84 other TSX listed firms Canadian firms, after controlling for

potentially confounding variables in multivariate tests.

This latter results, though preliminary, suggests that Canadian regulators proceed

cautiously before any decision is made to harmonize this regulation with the SEC.

Several other jurisdictions are also contemplating whether to require US style mandatory

review of quarterly financial statements. But, doing so might deprive firms the

opportunity to signal quality through their choice of reviewing or not reviewing of their

statements. However, our tests in this regard are preliminary and at best, indirect. We

plan on providing more direct evidence on the issue of mandatory versus voluntary

review of interim earnings by designing appropriate empirical tests to compare American



firms’ quarterly earnings that have to be reviewed under SEC regulations and those of

Canadian firms that voluntarily to get their interim statements reviewed.

Another cost of reviewing statements that we have not considered in this version of

this paper is its potential adverse effect on timeliness of interim reporting because

involvement of external auditors with interim statements might delay the release date of

interim earnings of reviewing firms relative to non-reviewing firms reduce earnings

relevance. However, an estimation of how much earnings timeliness is affected by the

review decision needs to control for the different filing deadlines faced by TSX Venture

exchange listed firms (60 days from fiscal quarter end date) versus other firms (45 firms).

Currently, we are collecting the necessary data to perform this analysis.3

The balance of this paper is organized in the following manner. Section 2 describes

the relationship of this research with prior research. Section 3 lays out the institutional

practises in Canada. Section 4 describes the research design and empirical models.

Section 5 describes the sample and Section 6 reports the results of empirical tests.

Chapter 7 provides compares earnings quality of voluntarily reviewed versus mandatorily

reviewed earnings. Conclusions are contained in Section 8.

3 Ettredge et al (2000a, note 3) argue that timely reviews might be delayed if there are significant fiscal

quarter-end accruals. These authors indeed report that timely review firms in the USA release their interim

statements two days, on average, earlier than those that are retrospectively reviewed, contrary to

predictions of opponents of timely review. However, the propensity of firms to release interim earnings

within the statutory period depends on the litigation environment that exists in a jurisdiction and the

intensity of enforcement of regulatory mechanisms. As stated earlier Clarkson et. al(1994) report thatCanadian managers face less litigation-related costs than US managers. Paskell-Mede (1994, 1999) and

Grosssman (1996) also arrives at similar conclusions. Thus, it not clear that the findings for US firms carryover to a Canadian setting. Thus, an examination of the effect of the review decision by Canadian firms on

timeliness of their earnings is warranted. Moreover, the issue of timeliness is not simply a matter of

counting the number of days elapsed between the fiscal quarter-end date and the earnings release date.

Timeliness relates to the speed with which accounting information is reflected in security prices (see forexample, Butler, Kraft and Weiss 2007). While our current small sample size does not permit estimation of

models suggested by Butler, Kraft and Weiss (2007), we plan to do so when we complete collection of data

for our larger sample.



2. Relationship to Prior Research

A number of US-based studies have examined the issue of voluntary choice of

review of quarterly earnings in the USA. Ettredge, Simon, Smith and Stone (1994)

examined the determinants of the voluntary choice of the timing of the review (timely

versus retrospective) and concluded that the choice depends on firm size, debt, and the

decision to issue stock. Manry, Tiras and Wheatley (2003) found that stock returns of

firms that chose timely review were more strongly correlated with contemporaneous

quarterly earnings than those of firms that chose retrospective review. Krishnan and

Zhang (2005) reported that in the post 2000 period, audit firms facing high expected

litigation risk were reluctant to disclose their review report. In a study based on Chinese

firms, Haw, Qi and Wu (2003) concluded that earnings response coefficients of firms that

voluntarily chose to have their semi-annual earnings audited was greater than those of

firms that did not. Mendenhall and Nichols (1988) use the frequency of fiscal period-end

accounting adjustments as the measure of managerial propensity to manipulate

accounting numbers.

Our research builds on the intuition provided by the foregoing studies to addresses

whether there is a difference in earnings quality of reviewed versus non-reviewed firms.

Our study differs from the prior literature in several ways. As discussed earlier, some

previous studies have examined the relative strength of association of returns and

earnings for timely versus retrospectively reviewed firms. In this paper, we tests

prediction of management accounting manipulations between reviewed and non-reviewed

statements by comparing discretionary accruals as a measure of earnings quality.

‘The accrual component of earnings contains accounting

estimates based on forecasts and is therefore more easy to



manipulate than cash flows. Thus, the flexibility offered by

accruals makes it a useful measure for examining the quality of

financial reports.’ Larcker and Richardson (2004, page 633).

Moreover, in their ERC tests, neither Manry et al. (2003) nor Haw et al. (2003) control

for potential self-selection bias arising from the endogenous nature of the review

decision. Our earnings quality tests control for the potential self-selection bias as

described in more detail below.

Our research is the first to focus on assurance issues in connection with quarterly

financial statements of Canadian companies. However, by providing evidence about the

comparative value of voluntary assurance choices by public companies it could have

important implications for other jurisdictions. Regulators in Canada, Japan, Europe and

other jurisdictions are considering following the US mandatory assurance approach.

Regulators play an important role in protecting investors, particularly unsophisticated

investors from being disadvantaged by a lack of credible, transparent and timely

information. However, since mandatory regulations can impose significant costs on all

capital market participants, it is important to have evidence of their benefits before

implementing such regulations. The voluntary assurance regime in Canada, provides an

important opportunity to address issues surrounding the regulation of capital markets.

While our study cannot address all of the issues related to the regulator’s rationale for

choosing a mandatory vs. voluntary regime, it can demonstrate the potential value of

voluntary assurance choices as signalling mechanisms.

3. Institutional Practises



Interim Reporting Practices

While practices vary throughout the world, there is a general trend toward more

frequent disclosure of financial information and continuing disclosure of price-sensitive

information. In Japan, quarterly financial statements are being phased in over a three-year

period (2004-2007). In Europe, although supported by a vast majority of European

investment professionals,4 the introduction of mandatory US style quarterly reporting for

all 7,000 listed companies has been delayed in certain jurisdictions such as the UK, which

gives more weight to continuing disclosure requirements of price-sensitive information.

Instead, listed companies are able to issue general trading statements every quarter and

financial statements twice a year.5,6,7

As reported by Boritz (2006) in Canada, quarterly financial statements must be

filed with securities regulators within 45 days after the end of the quarter (60 days for

venture exchange companies). The typical process for interim reporting involves closing

4 http://www.cfainstitute.org/pressroom/03releases/03quarterly_reporting.html, accessed September 8,2005.5 The European Commission’s proposal to have the EU’s 7,000 public companies adopt a quarterly

reporting approach similar to that of the US met opposition from several countries such as the UK, the

Netherlands and Denmark. Although the form of reporting adopted is different (i.e., companies may filequarterly “trading statements” with a general description of their financial position rather than full-blown

financial statements), there is a clear move toward more frequent periodic reporting in addition to the

requirements for continuing disclosure of price-sensitive information.6 The UK Listing Authority requires, as part of the Listing Rules (Section 9.9), companies to prepare a half-yearly report. (www.fsa.gov.uk). Quarterly financial statements are not currently required. The half-yearly

report does not require an OFR. All it requires is an explanatory statement including: (a) any significant

information enabling investors to make an informed assessment of the trend of the group's activities and

profit or loss; (b) information of any special factor that has influenced the group's activities and the profit

or loss during the period in question; (c) enough information to enable a comparison to be made with thecorresponding period of the preceding financial year; and (d) to the extent possible, a reference to the

group's prospects in the current financial year.7 The EU’s Transparency Directive, which has to be implemented by Member States from 2007, will

require more comprehensive half-yearly reports, including an interim “management report” (more like an

annual directors’ report than an OFR). This will also require “interim management statements,” providing:

an explanation of material events and transactions that have taken place during the relevant period and theirimpact on the financial position of the issuer and its controlled undertakings; and a general description of

the financial position and performance of the issuer and its controlled undertakings during the relevant

period.



off, preparation of subsidiary/divisional information, preparation of checklists and, where

applicable, sub-certification at divisional/subsidiary level, consolidation, review with

disclosure committee, preparation of package for audit committee/board, review with the

audit committee and, generally, the board. Many companies use checklists to document

this process and assist the business unit/subsidiary. Such checklists can run from 5-18

pages. Once the quarterly financial package is available, auditors spend three to five days

reviewing it (if engaged to do so). Then, the financial package is brought to the audit

committee for its review and to the board for its approval. Some companies have the

audit committee and board meetings on the same day, while others have the board

meeting the next day so that any issues raised by the audit committee can be addressed

before the board meeting.

The amount of time taken to complete the quarterly reporting process varies

dramatically, even among large sophisticated organizations. Some companies complete

the process in as little as 15 days, while others use the whole 45 days (60 days for venture

companies) allowed by the securities regulators.

Under current regulatory requirements (MI 52-109), a company’s CEO and CFO

each must certify that the filings do not contain any untrue statement of a material fact or

omit to state a material fact and that the financial statements, together with the MD&A,

present fairly the issuer’s financial condition, results of operations and cash flows. Under

MI 52-110, the audit committee8 must review the interim financial statements, MD&A

and earnings press release before the issuer publicly discloses this information.

8 While securities regulations permit the board to delegate approval of the interim financial statements and

MD&A to the audit committee, some companies require both the board and audit committee to approve

these documents.



Assurance Practices

Canadian securities regulators do not require auditors to conduct a review

engagement on interim financial statements. If a review is not performed, however, they

do require that this be disclosed in a notice accompanying the financial statements.9 An

examination of a sample of public company filings on System for Electronic Document

Analysis and Retrieval or SEDAR (a Canadian database of regulatory filings for listed

firms) for Q1 of 2005 indicates that most TSX-listed public companies have interim

review engagements, although some Canadian SEC registrants that qualify as foreign

private issuers opt out of having such a review performed. Overall, we found about 40%

exception rates.

It is noteworthy that the opt-out rate is so high for entities that could benefit from

having reviews performed. Such benefits include a more reliable quarterly financial

reporting process and more reliable quarterly financial statements, especially in terms of

the quality of estimates, accruals and earnings, which are key contributors to information

risk. In addition to benefits for the interim reports, there would be flow-through benefits

for the reliability of the annual financial statements and a potential reduction in the

frequency of both quarterly and annual financial statement restatements. For many

companies, the additional cost of having quarterly reviews could be offset by potential

cost reductions derived from improved financial reporting processes, better distribution

of audit effort, other efficiency gains and reductions in the cost of capital.

CICA Handbook Section 7050 sets out requirements for a review of interim

financial statements that are very similar to the US standards. Section 7050 sets out the

9 This requirement came into effect in March 2004. Prior to that, it was impossible to distinguish which

companies had a review and which ones did not. A review of a sample of interim financial statements for

Q1 of 2003 indicated that virtually none of them reported that no review was performed.



procedures to be undertaken and provides for an oral or written report to the audit

committee. The work effort prescribed by Section 7050 suggests various procedures,

including some audit procedures associated with an annual audit (e.g., reading

shareholder and director minutes). When auditors conduct a review of interim financial

statements, they must also comply with CICA Handbook Section 7500, which includes a

requirement to read the MD&A to see whether any information is inconsistent with the

financial statements.

Some audit firms exceed the work effort required by the review standard, the

scope being determined by the audit committee and the audit firm. Common issues that

involve additional audit work at quarter ends include revenue recognition, legal claims

and other contingencies, inventory valuations, taxes, accounts receivable allowances,

derivatives, foreign exchange and consolidation issues. The nature and extent of the

additional procedures appears to vary significantly among the firms and, perhaps, among

clients of the same firm. In some cases, the additional work is restricted to enquiry-based

review procedures. In others, however, auditors execute some audit procedures at the

same time as they conduct the review engagement. These could include examination of

material transactions undertaken in the period or in respect of the initial application of

accounting policies. When audit procedures are undertaken, documentation is usually

segregated between that required for the review engagement and that prepared as a result

of the procedures conducted as part of the annual audit. When major transactions are

examined, this activity may occur within the reporting period, rather than at its

conclusion.



The time auditors spend at quarter ends varies according to the nature of the

assignment and the extent to which they are involved with the audit committee’s review.

When a client wants a formal report for its audit committee, additional time is required,

as is the case when an audit or additional review procedures are performed. The range

appears to be 2-10 days.

Enquiries that extend to assessing changes in internal control over disclosures

(ICOD) and internal control over financial reporting (ICOFR) could add one to six days

to an engagement (CICA Handbook paragraph 7050.35 requires enquiry about internal

control and changes in internal control). This large range reflects the need for firms to

call in their systems group when there are changes in the IT-based internal control

processes.

The foregoing suggests that there are ample opportunities under current standards

and practices for companies to voluntarily vary the scope of the review engagement.

Thus, although the minimum requirements are “low”, actual practices may be “high”.

Form of Reporting

In both Canada and US, the results of the auditor’s reviews are communicated

privately to audit committees. No public reports are issued except in unusual

circumstances. Those communications can be oral or written, although we understand

that most are written. Also, when an auditor performs extended procedures during an

interim period, the extent of the procedures and the findings of those procedures are not

required to be communicated to the audit committee.



Overall, auditors report whether, based on their review, they have become aware

of any material modification that needs to be made for the financial statements to be in

accordance with generally accepted accounting principles (GAAP). A written report

would normally conclude that the auditor is not aware of any material modification that

needs to be made for the interim financial statements to be in accordance with GAAP.

Before that, however, it would explain that an interim review does not provide assurance

that the auditor would become aware of any or all significant matters that might be

identified in an audit. To some, this appears to be a convoluted, responsibility-avoiding

message. Others counter that it is designed to protect the auditor against litigation driven

by unreasonable expectations. A public report is not contemplated and the current

standard does not permit the auditor to consent to the release of a review engagement

report to third parties with the company’s interim financial statements unless required

pursuant to securities legislation, and requires inclusion in the report of a disclaimer of

any obligation on the part of the auditor to any third party who may rely on it.

Benefits of Voluntary Review of Interim Financial Statements

Interim financial statements are often not viewed as reliable, discrete, standalone

documents. There are good reasons for this, including seasonality factors that can

produce highly variable quarterly financial results, the lumpy structure of certain

revenues and costs that are received or paid in one quarter but apply to other quarters, and

uncertainties about costs that are not known until the fiscal year end. These factors result

in estimations of accruals and deferrals that can shift income from quarter to quarter

through the abuse of accruals, deferrals and estimates. About a third of the restatements



reported by US public companies in 2004 were attributable to restatements of interim

financial statements.10

Notorious “fourth quarter adjustments” of accruals made during

the previous three quarters can undermine the credibility of the quarterly reports and the

financial reporting system. Performing review engagements on such documents might not

appeal to some managers.

The quality of interim financial statements is a joint result of interim financial

reporting standards, the preparer’s financial expertise and integrity and the rigour of the

auditor’s review process. Interim reviews of public company financial statements are

based on audit-based knowledge but require only enquiry, discussion and analysis. Such

procedures may not be sufficient to establish that material transactions, such as business

combinations, restructuring provisions, major contracts, lawsuits and other such material

events are accounted for properly in the quarter. That could result in fourth-quarter

adjustments, when more focused audit procedures are actually performed on those events

and transactions. Such adjustments can cast doubt on the integrity of the financial

reporting system and the value of quarterly reports.11

10 Huron Consulting Group, 2004 Report on Financial Reporting Matters (February 28, 2005),

www.huronconsultinggroup.com, 1-866-229-8700.11 A study by Joshua Livnat and Christine Tan (“Restatements of Quarterly Earnings: Evidence on Earnings

Quality and Market Reactions to the Originally Reported Earnings” Unpublished Manuscript Stern School

of Business Administration, 2004) of restatements of quarterly earnings by US companies between 1988

and 2002 reports a quarterly restatement rate of 3.4%. (Note that companies with mergers and acquisitions,

discontinued operations and fiscal-year changes were specifically excluded.) Quarterly restatements aretypically smaller than annual restatements and are often not announced in press releases, becoming known

only when a Form 8-K is filed with earnings that differ from those released in the quarterly earningsannouncement. The restating companies are generally smaller. Most (62%) of the restatements are

downward to correct previously overstated earnings. The most frequently restated components of earnings

were cost of goods sold and tax expense. The fourth quarter had noticeably fewer restatements than the

other quarters, presumably due to the auditor’s involvement in that quarter. (Note that, during most of the period of the study, auditors were not required to perform a “timely” quarterly review (i.e., at the end of the

quarter the financial statements were issued), but could do it “in retrospect” as part of their annual/fourth

quarter audit. This was changed starting March 15, 2000.)



The minimum review procedures under section 7050 might not add sufficient

value to the interim reporting of entities that currently are not having reviews done and

some securities regulators in Canada would like to see the work effort prescribed in the

current review engagement standard expanded. As mentioned in the previous section, this

is consistent with many companies’ existing practices. To avoid surprise fourth-quarter

restatements, they often request their auditors to perform more than the minimum effort

required by Section 7050. Since there are no established standards for the extended

procedures, however, the extent of the additional procedures can vary from auditor to

auditor and even from client to client for the same auditor.

In summary, there is an important, unresolved question about the value of the

review engagement. This paper addresses this question by investigating the impact of

reviews on the financial statements of companies that voluntarily choose to have such

reviews performed compared with companies that do not.

4. Hypotheses Development

As stated earlier, Canadian firms can use the voluntary choice mechanism allowed

by the Canadian regulators to signal the quality of their financial statements. Firms with

lower financial statement quality electing to have a review will face questions from their

auditors about higher discretionary accruals or potential misstatements. Mendenhall and

Nichols (1988) discuss numerous cases of expenses and revenues that require managers’

judgement and use of estimates in reporting quarterly earnings. This implies that

managers have significant opportunities to manipulate interim earnings. Involvements of

auditors in the process are likely to reduce incidents of earnings manipulations.



The following hypothesis, stated in alternate form, will be tested:

Ha1: Earnings of Canadian firms in the post 2004 period whose quarterly

financial statements are reviewed by their auditor are subject to less

accounting manipulations, and higher earnings quality than those of non-reviewed firms.

Earnings quality is likely to be different for different quarters because of the

amount of discretionary accruals incorporated in accounting earnings. Discussions with

analysts have indicated that firms’ behaviour in connection with accruals varies

systematically by quarters. Also, certain costs like warranty costs, annual repairs etc. are

allocated to interim quarters as a percentage of expected annual sales which is subject to

greater uncertainty in the earlier quarters as compared to later fiscal quarters of the year

(Mendenhall and Nichols 1988). Thus, the magnitude of total accruals and discretionary

accruals are likely to be different in different quarters. Gu, Lee and Rosett (2005) argue

that fourth quarter earnings are likely to have the largest amount of discretionary accruals

Consequently, the foregoing hypothesis will be tested separately for each quarter.

5. Research Design

Two-stage treatment effects model

The foregoing hypothesis is tested by regressing a measure of earnings

management on a dummy revision/no-revision variable and other control variables.However, since firms self select into the review and the non-review groups, estimated

OLS regression coefficients will be biased. To control for the potential self-selection

bias, we use a two-stage treatment effects model (Maddala, 1983; Greene, 1997; Hogan,

1997; Kim et al., 2003).



First stage logit model

In the first stage, following Boritz and Liu (2006), we estimate the following

multivariate logit model, where the dependent variable, Pr (Review) is the probability that

the firm will choose to have its quarterly statements reviewed. They argue that the

demand for interim review is based on the need for firms to reduce agency costs arising

from firm complexity, growth opportunities, assurance needs and insurance needs of the

firms. The inverse Mill’s Ratio obtained in from the first stage model is included in the

second stage.

Review = b0 + b1 Size + b2 InvRec + b3 MB + b4ChgTac + b5FCF + b 6 Lev

+ b7 Auditor + b8 USlist + b9TSXV + Industry Dummies + error (1)

where, Review: 1 if current quarter’s interim financial statements are reviewed by auditors and 0

otherwise;

Size: Log of total average assets;

InvRec: (Inventory + Receivables) / Total assets in q-4; MB: Market value of equity / Book value of equity;

ChgTac: Change in total accruals from q-4 to the current quarter, deflated by the total

assets in q-4, where total accruals are calculated as (Income before

extraordinary items – net cash flows from operating activities);FCF : (Net cash from operating activity + interest paid + net cash flow from investing

activity – capitalized interest ) / Total assets in q-4;

Lev: Long-term debt / Total assets in q -4; Auditor: 1 if the auditor is Big 4 and 0 otherwise;USlist: 1 if the company’s shares are publicly traded in US and 0 otherwise;TSXV : 1 if the company is a TSE Venture company and 0 otherwise;

Industry dummies: Dummies for one-digit SIC industries in which there are at least 10

observations in the sample.

Following Knechel, Niemi and Sundgren (2005), we use firm size (Size) and the

ratio of inventory and receivables to total assets ( InvRec) to proxy for complexity of a

firm. Complexity of firms increases agency costs, thus enhancing owners’ and creditors’

demand for auditor assurance (Simunic and Stein 1987; Abdel-khalik 1993; Hay and

Davis 2004). Corporate governance research suggests that the cost of monitoring firms

with high growth opportunities is relatively higher because outsiders are less effective in



monitoring such firms (Gaver and Gaver 1993; Lehn, Patro and Zhao 2003; Yang, Linck

and Netter 2004 ). Managers can use accounting discretion for opportunistic

manipulation (i.e., opportunism) or communicating private inside information (i.e.,

signalling). We use the ratio of market value of equity to book value of equity ( MB) to

reflect the extent of growth opportunities (see e.g., Lehn, Patro and Zhao 2003; Yang,

Linck and Netter 2004). Further, auditing can provide not only assurance services but

also a type of insurance service (Doogar, Sougiannis and Xie 2003; Asthana, Balsam and

Krishnan 2003). Following DeAngelo (1986), we use the change in total accruals

(ChgTac) to reflect the extent of assurance needs for audit and consistent with Doogar,

Sougiannis, and Xie (2003), we use free cash flow (FCF ) to reflect the extent of either

insurance or assurance value of review engagements.

We include the Leverage, Auditor (Big 4 or not), USlist (SEC Registrant or not),

and TSXV (TSX Venture exchange listed or not) in the model to control for the potential

effects of corporate financing policy, auditor type, and listing status on companies’

incentives to have their interim financial statements reviewed. We also add industry

dummies in the model to control for industry effects.

Second stage discretionary accruals regression

The hypothesized difference in earnings quality (discretionary accruals) between

reviewed and non-reviewed firms is tested using the following regression models for each

sample quarter:

|DACC| = β0 + β1 Review + β2 Lambda + β3 Log (TA) + β4 OCF + β5 OCF+ +

β6 PriorACC + β7 PriorACC+ + β8 ROA + β9 ROA + + β10 Leverage + β11Auditor

+ β12 Industry dummy + η (2)

where, Review: 1 if reviewed in quarter q and 0 otherwise;



Lambda: Inverse Mill’s Ratio obtained from first stage regression Log(TA): Log of total assets in quarter q;OCF : Operating Cash Flow in quarter q, deflated by TA in quarter q-1;

OCF +: Equals 0 if negative OCF and retains the original value of OCF otherwise;

PriorACC : Total Accruals in quarter q-1, deflated by TA in quarter q-2;

PriorACC

+

: Equals 0 if negative PriorACC and retains the original value of PriorACCotherwise;

ROA: Net Income in quarter q-1 divided by TA in quarter q-2; ROA

+: Equals 0 if negative ROA and retains the original value of ROA otherwise;

Leverage: Total Long Term Debt in quarter q divided by TA in quarter q-1;

Auditor: 1 if the auditor is Big 4 and 0 otherwise;

Industry dummy: 1 if one-digit sic is 1, and 0 otherwise (all n<10).

Consistent with Chung and Kallapur (2002) and others12

, the absolute value of

DACC is used as the dependent variable. Chung and Kallapur (2002: 939) argue that this

is the appropriate measure of discretionary accruals because managers often adopt both

positive and negative accruals in order to undertake ‘cookie-jar accounting’.

Total assets, OCF, ROA and leverage have been added to the right hand side of

equations (1) and (2) to control for factors that might affect the magnitude of

discretionary accruals (Chung and Kallapur, 2002, and Dechow, Richardson and Tuna

2003). A negative and significant value of β1 is consistent with the hypothesis that

earnings quality of reviewed statements is superior to those of non-reviewed statements,

after controlling for covariates. Note that consistent with Chung and Kallapur (2002) we

allow firms with positive and negative OCF to have different coefficients by including

the OCF+ dummy variable. PriorACC (and Prior ACC+ dummy) allows for normal

relation between successive accruals.

12 See, for example, Cohen et al (2005), Chung and Kallapur (2003), , Dechow and

Dichev (2002), Frankel et al. (2002) and Becker et al. (1998).



Measurement of discretionary accruals

The earnings quality measure used in this paper is discretionary accruals using the

modified Jones model (Jones 1991, Dechow, Sloan, and Sweeney 1995). Specifically,

discretionary accruals (DACC) is calculated as the residual in the following cross-

sectional regression model estimated for every industry grouping defined by the two-digit

SIC code, for every quarter during the sample period:

TAijq = α0jq + α 1jq (ΔSalesijq – ΔRECijq) + α 2jq PPEijq + ξijq (3)

where (all variables are divided by average total assets)

TAijq : total quarterly accruals for firm i in industry j and quarter q, and it is computed as

the difference between net income before extraordinary items and cash flow fromoperating activities;

ΔSalesijq : the one year change in quarterly net revenues;

ΔAR ijt : one year change in quarterly accounts receivables;

PPEijq : gross property, plant and equipment;

ξijq : error term.

6. Sample Selection and Data

As noted previously, if a Canadian firm does not have its financial statements

reviewed, this needs to be disclosed in a notice accompanying the financial statements.

This requirement came into effect in March 2004. Thus, 2005 is the first full year for

which the regulation became mandatory for all Canadian public companies. Prior to that

period, adoption of this regulation was voluntary. Prior to March 2004, it is impossible

to distinguish which companies had a review and which ones did not. A review of a

sample of interim financial statements for the first quarter of 2003 indicated that virtually

none of them reported that no review was performed.

The sample selection started with 230 Canadian companies that have quarterly

financial statement data on Canadian COMPUSTAT. From this list, we exclude



Canadian SEC registrants for reasons discussed earlier. Missing observations reduce our

sample to 127, 130 and 130 firms for the first, second and third quarters of 2005

respectively.

We examined the interim financial statements published on SEDAR to identify

whether these firms’ 2005 Q1, Q2 and Q3 financial statements had been reviewed by the

company’s auditor.13

About 61% of these firms had their quarter one statements

reviewed and the balance did not (Table 1, panel A). The corresponding percentages for

quarters 2 and 3 are 58% and 60%. About 76% of the sample firms are TSX listed (Table

1, panel B). Table 1, panel C shows that about 40% of the sample belongs to the mining

sector.

7. Descriptive Statistics and Comparisons

Table 2 provides descriptive statistics for the sample firms. Reviewed firms are

significantly larger (median log of total assets of 5.273,5.312 and 5.282 in first, second

and third quarters respectively) than non-reviewed firms (median log of total assets of

3.79, 3.79 and 3.67 in first, second and third quarters respectively). They also have larger

operating cash flows (OCF). The median OCF of reviewed firms are 0.011, 0.036 and

0.058 in the first, second and third quarters respectively. The corresponding figures for

non-reviewed firms are -0.000, 0.002 and 0.002 . They also have higher leverage

13 Oral reporting as contemplated by Section 7050 can lead to vagueness as to whether or not a complete

review in accordance with Section 7050 was conducted. This can lead to anomalies in situations where a

company that has not had a formal Section 7050 review sends the interim financial statements to its auditorto read. In some such cases, companies may not include a notice in their interim filings to the effect that no

review was performed because they believe that any auditor involvement with interim financial statements

constitutes a review, taking comfort in the fact that the statement are marked “unaudited.”



(median leverage of 0.59, 0.093 and 0.094) than those of non reviewed firms (0.000,

0.000 and 0.000) at p<.01, p<.10, p<.05 and p<.05 in quarters 1, 2 and 3 respectively.

Four proxies of earnings management are reported in table 2. Unsigned values of

modified Jones discretionary accruals (DACC), absolute values of discretionary accruals

(|DACC|), positive values of discretionary accruals (+ DACC) and negative values of

discretionary accruals (-DACC). Of the four measures, the DACC and the –DACC

variables are indistinguishably different between the review and non-reviewed firms in

all the three quarters. The mean and median +DACC variable for Review firms are not

significantly different from those of non-Review firms in the second quarter but is greater

in both the first quarter and third quarters. The median values of DACC+ are 0.014 and

0.063 for reviewed firms as compared to 0.044 and 0.077 for non-reviewed firms in the

first and third quarters respectively. This is consistent with the notion that non-reviewed

firms undertake more income increasing discretionary accruals than reviewed firms.

The median values of |DACC| for reviewed firms are 0.018 and 0.053, significantly

lower (p<.05) as compared to 0.030 and 0.077 for non reviewed firms in the first and

third quarters respectively. These results are consistent with H1. However, these results

are at the univariate level. Multivariate analyses after controlling for potetial self

selection bias are reported in table 5.

Panel B of Table 2 shows that reviewed firms (non reviewed) tend to be audited by

Big 4 (non-Big 4) auditors. A chi-square test rejects the null of no-relation between

review and auditor selection decison ar p <.01 level in every quarter.



Correlations

Table 3 provides the correlation matrix of independent and dependent variables for

quarter 3. The correlations matrix is similar for the other quarters. Many of the

explanatory variables are correlated. As a result there is concern about the

multicollinearity in the data matrix. The effect of multicollenearity on estimated

coefficients is discussed in a later section.

Results:

First stage logistic regression

Results of the first stage logistic regression are reported in table 4. The TSXV

variable is the only significant variable (coefficients of -0.72, -0.73 and -0.69 in the first,

second and third quarters respectively, significant at the p<.01 level). The model Chi-

square is significant for all quarters (Ch-square values of 21.54, 27.31 and 26.71 in the

first, second and third quarters. The -2log likelihood values are also significant in every

quarter. These results indicate that the Canadian firms’ decision to have interim

statements reviewed is not a random decision and there is need to control for the resulting

self-selection bias whenn regresssing earnings management proxies on the Review

variable. This is accomplished by including the inverse Mill’s ratio values obtained from

estimating equation (1) as a right hand side variable in equation (2).

Second Stage Regression results

Table 5 presents the results from estimating equation (2). In view of the concern

about multicollenearity in the data matrix, we also estimate a variant of equation (2) with

OCF+, ROA+ and PriorACC+ dropped from the model. Both the models however,



control for potential self-selection bias by including the inverse Mill’s Ratio (the lambda

variable) in the specifications. However, the adjusted R square for the revised model 1 is

lower in all quarters and results for model 1 is discussed below. The adjusted R square of

model 1 varies from .20 to .35.

The PriorACC+ variable is significant in all 3 quarters and positive. The

coefficient on this variable are 0.89, 0.48 and 0.48 in the 3 quarterly respectively at

p<.01, p<.10 and p<.10. The Leverage variable is positive (0.07, 0.08 and 0.08) and

significant at p<.05 level.

Consistent with H1, Review is negative (-0.17, -0.17) and significant at p<.05 and p<

.10 levels in the first and third quarters respectively. These results indicate that

discretionary accruals of reviewed statements are, on average, smaller than those of non-

reviewed statements after controlling for covariates and self-selection bias. This result is

consistent with the hypothesis that earnings quality of firms with reviewed earnings is

superior to that of firms that do not have reviews of their quarterly financial statements.

The condition indices for none of the models in any quarter exceed 40, whereas Belsely,

Kuh and Welsch (1980) suggest that 100 is the condition index at which multicollinearity

starts ‘harming’ the estimation process. These authors also point out that if estimated

coefficents are significant and have the hypothesized sign, the hypothesized effects must

be strong enough to overcome any harmful effects of multicollinearity.

8. Mandatorily Reviewed Versus Voluntarily Reviewed Quarterly Statements

In this section we provide preliminary and indirect evidence that voluntarily

reviewed earnings are better quality than mandatorily reviewed earnings. As discussed



earlier, we view earnings of Canadian SEC registrants as proxies for mandatorily

reviewed earnings because Canadian SEC registrants likely wish to reduce litigation

related costs that affect American managers and would get review of their interim

statements done in order to prove due diligence rather than signalling quality to the

market. In fact, an overwhelming 74% the 50 Canadian SEC registrants in our sample

had their statements reviewed as compared to about 60% for the other sample firms.

Preliminary results (not shown in any table) indicate that the median |DACC| the

Canadian SEC registrants is 0.040 as compared to that of 0.018 for the other sample

firms. In the next set of regressions (results reported in table 6), quarterly statements of

all sample firms have been reviewed. Note that the Review variable in revised model 1

has been replaced by the Canadian SEC registrant variable that takes a value of one if the

firm is an SEC registrant and zero otherwise. A positive and significant coefficient on

the SEC registrant variable is consistent with the notion that discretionary accruals of

SEC registration are greater than those of non-registrants even though quarterly

statements of both sets of firms are reviewed. The results show that, for the first quarter,

this dummy variable is positive (0.026) and significant at the 5% level. In the other

quarters, the coefficient is positive though not significant. This indicates that

discretionary accruals of Canadian SEC registrants are significantly greater than those of

other Canadian firms in the sample after controlling for the effects of covariates. If we

can assume that the Canadian SEC registrants’ reviews are “less voluntary” than those of

Canadian non-SEC registrant firms due to the higher regulatory and litigation pressures in

the U.S., (Baginski, Hassell and Kimbrough 2002) then these provide some indirect



evidence that voluntarily reviewed quarterly earnings are superior quality as compared to

less voluntary or quasi-mandatorily reviewed earnings.

9. Conclusions and Future Research

In this paper, we attempt to provide some insight into the question whether

voluntary reviews of quarterly statements add value. This is part of the larger question of

whether reviews should continue to remain voluntary or should be made mandatory in

line with the practise in the US. Regulations can impose significant costs on the affected

firms and it is important to have evidence of their benefits before implementing such

regulations. Results reported in the paper indicate that voluntary reviews are associated

with reduced discretionary accruals which, in turn, imply higher quality earnings. The

review decision is used by firms to signal high quality earnings. Firms with poor quality

earnings would probably not choose to have reviews of their quarterly statements since if

they did they would face questions and challenges from their auditors about the high

discretionary accruals. This appears to be a classic case of signalling where the cost of

false signalling by low earnings quality firms is quite significant.

However, requiring review for all firms might be potentially costly in terms of the

extra time that that external auditors might need before earnings are ready to be released

to market participants. This could reduce the timeliness of reported earnings and impair

earnings relevance.

The conclusions in the paper are subject to a number of caveats. First, the study

uses data from the first, second and third quarters of 2005 only. An extension of this

study could examine the robustness of these results to other time periods. Another



extension could be to investigate the valuation consequences of the review/no review

decision by estimating earnings response coefficients for the two types of firms. Other

extensions could involve using performance matched accruals in line with Kothari, Leone

and Wasley (2005) and performing Basu (1997)-type conditional conservatism tests on

(a) voluntarily reviewed versus non-reviewed interim statements and (b) mandatorily

versus voluntarily reviewed interim statements.

Regulators in Canada, Japan, Europe and other jurisdictions are considering

following the US mandatory assurance approach. However, since mandatory regulations

can impose significant costs on all capital market participants, it is important to have

evidence of their benefits before implementing such regulations. Our results provide

preliminary evidence that there are benefits to voluntary auditor reviews of interim

financial statements as per current Canadian practice. However, the evidence provided in

this paper is not sufficient to provide a recommendation whether such reviews should

remain voluntary or mandatory. On the one hand, it is possible that the benefits of

voluntary reviews could be lost if they were to become mandatory, since their signalling

value could be reduced or eliminated. On the other hand, companies that opt out of

voluntary reviews may be appropriate targets of regulatory action. However, in our

sample, the only variable in our logistic regressions (see table 4) that distinguishes

companies that opted out of voluntary reviews is membership on the TSX Venture

exchange and the reason for this may be the costs of having reviews performed on

interim statements exceed their perceived benefits. This suggests that Canadian regulators

need to proceed carefully before adopting a mandatory requirement for review of interim

financial statement for all listed firms as in the case of US domestic firms.





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Table 1

Sample Descriptions

Panel A: Frequencies and percents of firms whose 2005 Q1-Q3 financial statements were

reviewed or not reviewed by auditors

2005 Q1 2005 Q2 2005 Q3

Audit Review Firms 77 75 78

Non-Audit Review Firms 50 55 52

Total 127 130 130

Panel B: Frequencies and percents of firms in each sample layer

2005 Q1 2005 Q2 2005Q3

Layer1: TSE-listed/non-SEC registrants 96 98 96

Layer2: TSX Venture/non-SEC registrants 31 32 34

Total 127 130 130

Panel C: Frequencies and percents of firms across SIC industry divisions

2005 Q1 2005 Q2 2005 Q3

Mining 53 55 56

Finance, Insurance, and Real Estate 26 28 28

Manufacturing 25 25 24Services 11 10 11

Transportation, Communications, Electric,Gas, and Sanitary Services 9 9 8

Wholesale and Retail Trade 2 2 2

Public Administration 1 1 1

Total 127 130 130



Table 2

Descriptive Statistics and Comparisons

Panel A: Descriptive statistics and comparisons on continuous variables between firms with and

without audit review

2005 Q1 2005 Q2 2005 Q3Variable Group Mean Median Mean Median Mean Median

DACC Reviewed ‐0.01152 ‐0.00481 0.00685 ‐0.00205 ‐0.01043 ‐0.01630

Not reviewed 0.00823 ‐0.00005 ‐0.01657 ‐0.01498 ‐0.02221 ‐0.02713

‘t’ `1.68^ ‐1.62 ‐0.63

Z 1.621 ‐1.447 ‐0.901

|DACC| Reviewed 0 .03 303 0 0.0 17 691 0.05 50 37 0. 02 609 1 0 .07 898 3 0.053024

Not reviewed 0 .05 223 9 0.0 30 397 0.06 69 50 0. 03 575 3 0 .10 658 8 0.077647

‘t’ 1.67^ 0.92 1.74*

Z 1.042 1.190 1.762^

+DACC Reviewed 0.022545

(n=34)

0.014643 0.060628

(n=36) 0.030164 0.072782

(n=33)

0.063663

Not reviewed 0.054923

(n=25)

0.034714 0.060660 (n=20)

0.044119 0.098643

(n=18)

0.077685

‘t’ 2.74* 0.00 1.33

Z 2.370* 0.453 1.438

-DACC Reviewed ‐0.03846

(n=43)

‐0.02036 ‐0.04278

(n=39)

‐0.02609 ‐0.07145

(n=45)

‐0.05147

Not reviewed ‐0.03847

(n=25) ‐0.01311

‐0.06070

(n=35)

‐0.02800 ‐0.08620

(n=34)

‐0.07512

‘t’ ‐0.00 ‐1.34 ‐0.99

Z 0.776 ‐1.018 ‐1.0556

Log(TA ) Reviewed 4 .92 261 9 5.2 73 779 5.08 30 90 5. 31 215 6 5 .07 799 5 5.381996

Not reviewed 3 .58 910 6 3.7 98 183 3.42 44 83 3. 78 655 0 3 .47 506 5 3.670233

‘t’ ‐3.91** ‐4.81** ‐4.64**

Z ‐3.812** ‐4.581** ‐4.423**

OCF Reviewed 0.013308 0.011973 0.03396 0.03681 0.051635 0.057914

Not reviewed ‐0.00590 ‐0.00054 ‐0.0 10 56 0. 00 287 ‐0.00296 0.00213

‘t’ ‐1.57 ‐2.72** ‐2.58*

Z ‐2.657** ‐3.228** ‐2.764**

PriorACC Reviewed ‐0.07368

‐0.07740

‐0.02712

‐0.01544

‐0.02993 ‐

0.02859

Not reviewed ‐0.03292 ‐0.02823 0.00671 ‐0.00022 ‐0.01650 ‐0.01337

‘t’ 2.26* 3.62** 1.02

Z 2.284* 3.685** 1.695^

ROA Reviewed ‐0.00552 0.00730 ‐0.0 05 09 0. 00 452 ‐0.00028 0.00730

Not reviewed ‐0.03196 ‐0.00429 ‐0.00992 ‐0.00452 ‐0.02082 ‐0.00525

‘t’ ‐2.16* ‐0.59 ‐2.13*

Z ‐2.059* ‐0.943 ‐2.716**



LeverageReviewed 0.171303 0.059016 0.205789 0.093792 0.192144 0.094820

Not reviewed 0.109117 0.000000 0.121113 0.000000 0.109289 0.000000

‘t’ ‐1.64 ‐2.10* ‐2.23*

Z ‐1.735^ ‐2.221* ‐2.376*

Panel B: Frequency distributions and chi-square tests on dummy variables between firms with

and without audit review

2005 Q1 2005 Q2 2005 Q3

Big 4

Auditor Non-Big 4

Auditor

Big 4

Auditor

Non-Big 4

Auditor

Big 4

Auditor Non-Big 4

Auditor

Reviewed 58 19 58 17 61 17

Non-reviewed 30 20 32 23 28 24

Total 88 39 90 40 89 41

Chi-square3.3458^ 5.4635* 8.5740**

2005 Q1 2005 Q2 2005 Q3

TSX

TSX

Venture

TSX

TSX

Venture

TSX

TSX

Venture

Reviewed 67 10 67 8 68 10

Non-reviewed 29 21 31 24 28 24

Total 96 31 98 32 96 34

Chi-square 13.8298** 18.5875**

17.9493**

Discretionary accrual (DACC) is calculated as the residual in the following crosssectional

regression model estimated for every industry grouping defined by the two-digit SIC

code, for every quarter during the sample period:

ACC = α + α1 (ΔSales – ΔREC) + α2 PPE + ξ

ACC: Total accruals in quarter q, calculated as (Income before Extraordinary Items - NetCash Flow from Operating Activities);

ΔSales: One year change in quarterly net sales;

ΔREC: One year change in quarterly receivables;PPE: Gross property, plant and equipment in quarter q;

All variables are deflated by TA at the beginning of quarter q.

Review: 1 if reviewed in quarter q and 0 otherwise; Log(TA): Log of total assets in quarter q;

OCF : Operating Cash Flow in quarter q, deflated by TA in quarter q-1;OCF

+: Equals 0 if negative OCF and retains the original value of OCF otherwise;

PriorACC : Total Accruals in quarter q-1, deflated by TA in quarter q-2;



PriorACC +: Equals 0 if negative PriorACC and retains the original value of PriorACC

otherwise; ROA: Net Income in quarter q-1 divided by TA in quarter q-2;

ROA+: Equals 0 if negative ROA and retains the original value of ROA otherwise;

Leverage: Total Long Term Debt in quarter q divided by TA in quarter q-1.

**, *, ^: significant at 1%, 5% and 10%, respectively (two-tailed).



Table 3

Correlations

(Based on 2005 Q1 dat

|DACC| Review Log(TA) OCF OCF + PriorACC

|DACC| ‐0.16152^ ‐0.33795** ‐0.10856 0.19809* 0.12422

Review ‐0.09300 ‐0.08086** 0.13913 0.14471 ‐0.20330*

Log(TA) ‐0.33375** 0.33984** 0.34268** 0.00936 ‐0.34474**

OCF ‐0.03164 0.23695** 0.36827** 0.76650** ‐0.37204**

OCF + 0.03667 0.26282** 0.30082** 0.97434** ‐0.28561**

PriorACC 0.05877 ‐0.20374* ‐0.30590** ‐0.48131** ‐0.48567**

PriorACC + 0.24568** ‐0.18996* ‐0.58087** ‐0.42140** ‐0.37886** 0.77141**

ROA ‐0.02297 0.18365* 0.38783** 0.54847** 0.52053** ‐0.28544**

ROA+ 0.05593 0.15113^ 0.28075** 0.51300** 0.50916** ‐0.26182**

Leverage ‐0.10422 0.15483^ 0.65078** 0.04712 0.02483 ‐0.02149

Lambda 0.05659 0.84625** ‐0.11354 0.10372 0.16245^ ‐0.10107

Industry

dummy

‐0.03899 ‐0.06974 ‐0.24611** ‐0.02004 ‐0.04157 ‐0.11750

Sample size N=56. Pearson correlations are above the diagonal line and Spearman correlations are below it. **



41

Table 4

Logistic Regressions

(Wald-stat in parentheses)

Variable 2005Q1 2005Q2 2005Q3

Constant -0.2608

(0.2736)

-0.6614

(1.6603)

-0.6141

(1.3495)

Size 0.1198

(1.8470)

0.1818

(4.1693)*

0.1365

(2.3416)

Invrec -0.1786

(0.0785)

-0.1180

(0.0299)

0.4312

(0.3911)

MB 0.0367

(0.4631)

0.0165

(0.1085)

-0.0108

(0.0541)

Chgtac 0.5964

(0.1132)

1.3893

(0.8247)

-0.5571

(0.1851)

FCF 0.2235(0.1007)

-0.3114(0.3083)

-0.7515(2.2655)

Leverage 0.8122

(2.3283)

0.6117

(1.2519)

0.6052

(1.1444)

Auditor -0.1998

(0.3762)

-0.1783

(0.3004)

0.0660

(0.0424)

TSXV -0.7273

(4.8016)*

-0.7317

(4.7329)*

-0.6974

(4.3349)*

Industry dummy Included

n.s.

Included

n.s.

Included

n.s.

N 147 149 149

-2 log likelihood 172.891 170.932 169.884Chi-square 21.5451* 27.3130** 26.7092**

Model:

Review = b0 + b1Size + b2 Invrec + b3 MB + b4Chgtac + b5FCF + b6 Lev + b7 Auditor +

b8 TSXV + Industry Dummies + error

where,

Review: 1 if current quarter’s interim financial statements are reviewed by auditors and 0

otherwise;

Size: Log of total average assets; Invrec: (Inventory + Receivables) / Total assets in q-4;

MB: Market value of equity / Book value of equity;Chgtac: Change in total accruals from q-4 to the current quarter, deflated by the total

assets in q-4, where total accruals are calculated as (Income before

extraordinary items – net cash flows from operating activities);FCF : (Net cash from operating activity + interest paid + net cash flow from investing

activity – capitalized interest ) / Total assets in q-4;



42

Leverage: Long-term debt / Total assets in q -4; Auditor: 1 if the auditor is Big 4 and 0 otherwise;TSXV : 1 if the company is a TSE Venture company and 0 otherwise;

Industry dummies: Dummies for one-digit SIC industries in which there are at least 10

observations in the sample.




43

Table 5

Quarterly Regression Results

(t statistics in parentheses)

Variable

Q1 2005

Parameter Estimate

Q2 2005

Parameter Estimate

Q3 2005

Parameter Estimate

Model 1

Revised

Model 1 Model 1

Revised

Model 1 Model 1

Revised

Model 1

Constant 0.12056

(3.50)**

0.15742

(4.84)**

0.12885

(3.81)**

0.17948

(5.84)**

0.16879

(4.61)**

0.21113

(5.51)**

Review -0.17176

(-2.29)*

-0.15824

(-2.02)*

-0.16956

(-1.89)^

-0.14927

(-1.63)

-0.08692

(-0.94)

-0.00691

(-0.07)

Lambda 0.05708

(2.11)*0.05554

(1.96)^

0.06169

(1.90)^

0.05707

(1.71)^

0.02979

(0.89)

0.00459

(0.13)

Log(TA) -0.00220

(-0.42)

-0.00796

(-1.48)

-0.00345

(-0.49)

-0.01053

(-1.48)

0.01882

(-2.76)**

-0.02736

(-3.79)**

OCF -0.43430

(-2.93)**

0.04449

(0.49)

-0.31217

(-1.73)^

-0.05355

(-0.44)

-0.12703

(-0.58)

0.14089

(1.01)

OCF + 0.89395

(3.76)**

n/a 0.48286

(1.86)^

n/a 0.47787

(1.69)^

n/a

PriorACC -0.00711

(-0.08)

-0.03261

(-0.56)

-0.47583

(-2.68)**

-0.22323

(-1.43)

-0.28861

(-1.51)

0.11432

(0.75)

PriorACC + 0.00210

(0.01)

n/a 0.75372

(2.12)*

n/a 1.31325

(3.16)**

n/a

ROA 0.06668

(0.50)

-0.00240

(-0.02)

0.46556

(1.62)

0.45552

(1.86)^

0.33655

(1.24)

-0.02904

(-0.12)

ROA+ 0.05190

(0.13)

n/a -0.14693

(-0.23)

n/a -0.90984

(-1.32)

n/a

Leverage 0.07630

(2.43)*

0.07309

(2.20)*

0.08303

(2.48)*

0.08732

(2.50)*

0.06966

(1.68)^

0.04837

(1.09)

Auditor -0.00137

(-0.11)

-0.00038

(-0.03)

-0.00020

(-0.01)

-0.00615

(-0.37)

0.01477

(0.80)

0.00304

(0.15)

Industry

dummy Included

n.s.

Included

n.s.

Included

n.s.

Included

n.s.

Included

n.s.

Included

n.s.

N 127 `127 130 130 130 130

Adjusted R 2 0.2401 0.1331 0.2056 0.1300 0.3497 0.2171



44

Model 1:

|DACC| = β0 + β1 Review + β2 Lamba + β3 Log (TA) + β4 OCF + β5 OCF+ + β6

PriorACC + β7 PriorACC+ + β8 ROA + β9 ROA + + β10Leverage + β11Auditor

+ β12 Industry dummy + η

Revised Model 1:|DACC| = β0 + β1 Review + β2 Lamba + β3 Log (TA) + β4 OCF + β5 PriorACC + β6

ROA + β7Leverage + β8 Auditor + β9 Industry dummy + η

where,

Review: 1 if reviewed in quarter q and 0 otherwise;

Log(TA): Log of total assets in quarter q;OCF : Operating Cash Flow in quarter q, deflated by TA in quarter q-1;OCF

+: Equals 0 if negative OCF and retains the original value of OCF otherwise;

PriorACC : Total Accruals in quarter q-1, deflated by TA in quarter q-2;PriorACC

+: Equals 0 if negative PriorACC and retains the original value of PriorACC

otherwise; ROA: Net Income in quarter q-1 divided by TA in quarter q-2; ROA

+: Equals 0 if negative ROA and retains the original value of ROA otherwise;

Leverage: Total Long Term Debt in quarter q divided by TA in quarter q-1;






45

Table 6

All Reviewed Firms

Revised Model 1:

|DACC| = β0 + β1 SEC Registrant + β2 Log (TA) + β3 OCF + β4 PriorACC + β5 ROA +β6Leverage + β7 TSXV + β8 Auditor + β9 Industry dummy + η

Variable

Q1 2005

Parameter Estimate

Q2 2005

Parameter Estimate

Q3 2005

Parameter Estimate

Revised Model 1 Revised Model 1 Revised Model 1

Constant 0.09147

(5.81)**

0.08499

(3.48)**

0.15989

(5.85)**

Canadian SEC

Registrant

0.02708

(2.61)*

0.00754

(0.54)

0.01767

(1.02)

Log(TA) -0.01176

(-3.21)**

-0.00207

(-0.41)

-0.01582

(-2.61)*

OCF 0.29971

(3.70)**

-0.12160

(-0.85)

-0.00004

(-0.00)

PriorACC 0.04205

(0.74)

-0.34201

(-1.90)^

-0.00454

(-0.03)

ROA -0.33606

(-4.06)**

0.17944

(0.65)

-0.04151

(-0.17)

Leverage 0.03327

(1.28)

-0.01488

(-0.44)

-0.00346

(-0.08)

TSXV -0.04233

(-2.55)*

-0.01104

(-0.48)

0.01309

(0.46)

Auditor 0.0006

(0.05)

-0.01967

(-1.13)

0.00521

(0.26)

Industry

dummy Included

n.s.

Included

n.s.

Included

n.s.

N 121 118 118

Adjusted R 2 0.3842 0.0285 0.1178

Canadian SEC Registrant= 1 if the sample firm is Canadian US registrant that had its quarterly

statements reviewed and zero if the firm is not a SEC registrant.(Non reviewed firms are not in

this sample) Log(TA): Log of total assets in quarter q;

OCF : Operating Cash Flow in quarter q, deflated by TA in quarter q-1;PriorACC : Total Accruals in quarter q-1, deflated by TA in quarter q-2;



ROA: Net Income in quarter q-1 divided by TA in quarter q-2; Leverage: Total Long Term Debt in quarter q divided by TA in quarter q-1;TSXV : 1 if the company is a TSE Venture company and 0 otherwise;




Documents

Voluntary Assurance on Interim Financial Statements and Earnings Quality