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.

Voluntary Assurance on Interim Financial Statements

and Earnings Quality
Abstract
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. This differs from US practice where the Securities and Exchange
Commission (SEC) requires a timely review of interim financial statements by the
companys 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 in
the 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 between
voluntary 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), earnings
quality 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 high
discretionary accruals.
Our results provide evidence that the voluntary review engagement has value as a
signalling 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 carefully
so as not to lose the signalling benefits associated with voluntary reviews.

Voluntary Assurance on Interim Financial Statements

and Earnings Quality

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 companys 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 entitys
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.

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 nonSEC 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 nonreview 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. PaskellMede (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.

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 that
Canadian 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 carry
over 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 for
example, 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 regulators 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

http://www.cfainstitute.org/pressroom/03releases/03quarterly_reporting.html, accessed September 8,

2005.
5
The European Commissions proposal to have the EUs 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 file
quarterly 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 halfyearly 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 the
corresponding 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 EUs 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 their
impact 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 companys 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 issuers 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.

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 committees 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 auditors 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 companys 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 preparers financial expertise and integrity and the rigour of the
auditors 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 are
typically 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 earnings
announcement. 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 auditors 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 nonreviewed 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 Mills Ratio obtained in from the first stage model is included in the
second stage.

Review = b0 + b1 Size + b2 InvRec + b3MB + b4ChgTac + b5FCF + b 6Lev

+ b7 Auditor + b8USlist + b9TSXV + Industry Dummies + error (1)
where,
Review: 1 if current quarters 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 companys 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| = 0 + 1 Review + 2 Lambda + 3 Log (TA) + 4 OCF + 5 OCF+ +
6 PriorACC + 7 PriorACC+ + 8 ROA + 9 ROA + + 10 Leverage + 11Auditor
(2)
+ 12 Industry dummy +
where,
Review: 1 if reviewed in quarter q and 0 otherwise;

Lambda: Inverse Mills 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 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;
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 1 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 crosssectional regression model estimated for every industry grouping defined by the two-digit
SIC code, for every quarter during the sample period:
TAijq = 0jq + 1jq (Salesijq RECijq) + 2jq PPEijq + ijq

(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 from
operating activities;
Salesijq : the one year change in quarterly net revenues;
ARijt : one year change in quarterly accounts receivables;
PPEijq : gross property, plant and equipment;
ijq : 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
companys 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 auditor
to 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 Chisquare 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 Mills 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 Mills 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 nonreviewed 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

Audit Review Firms

Non-Audit Review Firms
Total

2005 Q1
77
50
127

2005 Q2
75
55
130

2005 Q3
78
52
130

2005 Q2
98
32
130

2005Q3
96
34
130

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

Layer1: TSE-listed/non-SEC registrants

Layer2: TSX Venture/non-SEC registrants
Total

2005 Q1
96
31
127

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

Mining
Finance, Insurance, and Real Estate
Manufacturing
Services

Transportation, Communications, Electric,

Gas, and Sanitary Services
Wholesale and Retail Trade
Public Administration
Total

2005 Q1
53
26
25
11

2005 Q2
55
28
25
10

2005 Q3
56
28
24
11

2
1
127

2
1
130

2
1
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
Variable

Group

DACC

Reviewed
Not reviewed
t
Z
Reviewed
Not reviewed
t
Z
Reviewed

|DACC|

+DACC

Not reviewed

-DACC

t
Z
Reviewed
Not reviewed

t
Z
Log(TA ) Reviewed
Not reviewed
t
Z
OCF
Reviewed
Not reviewed
t
Z
PriorACC Reviewed
Not reviewed
t
Z
ROA
Reviewed
Not reviewed
t
Z

2005 Q2

2005 Q3

Mean

Median

Mean

Median

Mean

Median

0.01152

0.00481

0.00685

0.00205

0.01043

0.01630

0.00823

0.00005

0.01657

0.01498

0.02221

0.02713

`1.68^

1.62

1.621

0.63

1.447

0.901

0.033030

0.017691

0.055037

0.026091

0.078983

0.053024

0.052239

0.030397

0.066950

0.035753

0.106588

0.077647

1.67^

0.92

1.74*

1.042

1.762^

0.022545
(n=34)

0.014643

1.190
0.060628
(n=36)

0.030164

0.072782
(n=33)

0.054923
(n=25)

0.034714

0.060660

0.044119

(n=20)

0.098643
(n=18)

0.00

1.33

2.74*
2.370*
0.03846
(n=43)
0.03847
(n=25)
0 00
0.00

0.453

0.063663
0.077685

1.438

0.02036

0.04278
(n=39)

0.02609

0.07145
(n=45)

0.05147

0.01311

0.06070
(n=35)

0.02800

0.08620
(n=34)

0.07512

0.776

1.34

0.99

1.018

1.0556

4.922619

5.273779

5.083090

5.312156

5.077995

5.381996

3.589106

3.798183

3.424483

3.786550

3.475065

3.670233

3.91**

4.81**

4.64**

3.812**

4.581**

4.423**

0.013308

0.011973

0.03396

0.03681

0.051635

0.057914

0.00590

0.00054

0.01056

0.00287

0.00296

0.00213

1.57

2.72**

2.58*

2.657**

3.228**

2.764**

0.07368

0.07740

0.02712

0.01544

0.02993

0.02859

0.03292

0.02823

0.00671

0.00022

0.01650

0.01337

2.26*

3.62**

2.284*

1.02

3.685**

1.695^

0.00552

0.00730

0.00509

0.00452

0.00028

0.00730

0.03196

0.00429

0.00992

0.00452

0.02082

0.00525

2.16*

0.59

2.13*

2.059*

0.943

2.716**

Leverage

Reviewed
Not reviewed
t
Z

0.171303

0.059016

0.205789

0.109117

0.000000

0.121113

1.64

2.10*

1.735^

0.093792

0.000000

2.221*

0.192144

0.094820

0.109289

0.000000

2.23*
2.376*

Panel B: Frequency distributions and chi-square tests on dummy variables between firms with
and without audit review

2005 Q1
Reviewed
Non-reviewed
Total
Chi-square

2005 Q2

Big 4
Auditor

Non-Big 4
Auditor

Big 4
Auditor

Non-Big 4
Auditor

Big 4
Auditor

Non-Big 4
Auditor

58
30
88

19
20
39

58
32
90

17
23
40

61
28
89

17
24
41

3.3458^

5.4635*

2005 Q1
Reviewed
Non-reviewed
Total
Chi-square

2005 Q3

2005 Q2

TSX

TSX
Venture

67
29
96

10
21
31

13.8298**

8.5740**

2005 Q3

TSX

TSX
Venture

TSX

TSX
Venture

67
31
98

8
24
32

68
28
96

10
24
34

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 = + 1 (Sales REC) + 2 PPE +
ACC: Total accruals in quarter q, calculated as (Income before Extraordinary Items - Net
Cash Flow from Operating Activities);
Sales: One year change in quarterly net sales;
REC: 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 data)
|DACC|
|DACC|
Review

0.33375**

OCF

0.03164
+

0.03667

PriorACC
+

PriorACC
ROA
ROA

Leverage
Lambda
Industry
dummy

Log(TA)

OCF

OCF+

PriorACC

0.16152^

0.33795**

0.10856

0.19809*

0.12422

0.09300

Log(TA)
OCF

Review

0.05877
0.24568**
0.02297
0.05593
0.10422
0.05659
0.03899

0.08086**
0.33984**
0.23695**
0.26282**
0.20374*
0.18996*
0.18365*
0.15113^
0.15483^
0.84625**
0.06974

0.13913
0.34268**

0.36827**
0.30082**
0.30590**
0.58087**
0.38783**
0.28075**
0.65078**
0.11354
0.24611**

0.14471
0.00936
0.76650**

0.97434**
0.48131**
0.42140**
0.54847**
0.51300**
0.04712
0.10372
0.02004

0.20330*
0.34474**
0.37204**
0.28561**

0.52053**
0.50916**
0.02483
0.16245^
0.04157

0.25256**
0.18230*
0.53117**
0.33826**
0.03213
0.76391**

0.48567**
0.37886**

PriorACC+

0.77141**
0.28544**
0.26182**
0.02149
0.10107
0.11750

ROA

ROA+

0.22355*

0.05184

0.20031*
0.56068**
0.55806**
0.25044**
0.26036**
0.40004**

0.36957**
0.30601**
0.24905**
0.04009
0.11671

0.07691
0.10316
0.41506**
0.42276**
0.19858*
0.14678^
0.60754**

0.96338**
0.10912
0.05073
0.22706*

Leverage

Lambda

0.06243

0.07522

0.14412

0.96823**

0.59182**

0.12533

0.05242

0.07656

0.12564

0.15645^

0.00965

0.14720^

0.20656*

0.08678

0.18110*

0.07537

0.13995

0.07239
0.01192

0.07554
0.07305
0.24610**

0.22577*
0.3883**

Industry
dummy
0.08086
0.06974
0.23209**
0.07547
0.09857
0.15140^
0.01501
0.13577
0.11903
0.33896**
0.03972

0.02091

Sample size N=56. Pearson correlations are above the diagonal line and Spearman correlations are below it. **, *, and ^: significant at 1%, 5%, and 10%, respectively (two-tailed).

Table 4
Logistic Regressions
(Wald-stat in parentheses)
Variable

2005Q1

2005Q2

2005Q3

Constant

-0.2608
(0.2736)
0.1198
(1.8470)
-0.1786
(0.0785)
0.0367
(0.4631)
0.5964
(0.1132)
0.2235
(0.1007)
0.8122
(2.3283)
-0.1998
(0.3762)
-0.7273
(4.8016)*
Included
n.s.

-0.6614
(1.6603)
0.1818
(4.1693)*
-0.1180
(0.0299)
0.0165
(0.1085)
1.3893
(0.8247)
-0.3114
(0.3083)
0.6117
(1.2519)
-0.1783
(0.3004)
-0.7317
(4.7329)*
Included
n.s.

-0.6141
(1.3495)
0.1365
(2.3416)
0.4312
(0.3911)
-0.0108
(0.0541)
-0.5571
(0.1851)
-0.7515
(2.2655)
0.6052
(1.1444)
0.0660
(0.0424)
-0.6974
(4.3349)*
Included
n.s.

147
172.891
21.5451*

149
170.932
27.3130**

149
169.884
26.7092**

Size
Invrec
MB
Chgtac
FCF
Leverage
Auditor
TSXV
Industry dummy
N
-2 log likelihood
Chi-square

Model:
Review = b0 + b1Size + b2Invrec + b3MB + b4Chgtac + b5FCF + b6Lev + b7Auditor +
b8TSXV + Industry Dummies + error
where,
Review: 1 if current quarters 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;
41

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

42

Table 5
Quarterly Regression Results
(t statistics in parentheses)
Variable

Q1 2005
Parameter Estimate

Model 1
Constant
Review
Lambda
Log(TA)
OCF
OCF+
PriorACC
PriorACC+
ROA
ROA+
Leverage
Auditor
Industry
dummy

N
Adjusted R2

0.12056
(3.50)**
-0.17176
(-2.29)*
0.05708
(2.11)*
-0.00220
(-0.42)
-0.43430
(-2.93)**
0.89395
(3.76)**
-0.00711
(-0.08)
0.00210
(0.01)
0.06668
(0.50)
0.05190
(0.13)
0.07630
(2.43)*
-0.00137
(-0.11)

Revised
Model 1
0.15742
(4.84)**
-0.15824
(-2.02)*

Q2 2005
Parameter Estimate

Model 1

Revised
Model 1

Model 1

Revised
Model 1

0.07309
(2.20)*
-0.00038
(-0.03)

0.12885
(3.81)**
-0.16956
(-1.89)^
0.06169
(1.90)^
-0.00345
(-0.49)
-0.31217
(-1.73)^
0.48286
(1.86)^
-0.47583
(-2.68)**
0.75372
(2.12)*
0.46556
(1.62)
-0.14693
(-0.23)
0.08303
(2.48)*
-0.00020
(-0.01)

Included
n.s.

Included
n.s.

Included
n.s.

Included
n.s.

Included
n.s.

Included
n.s.

127

`127

130

130

130

130

0.2401

0.1331

0.2056

0.1300

0.3497

0.2171

0.05554
(1.96)^
-0.00796
(-1.48)
0.04449
(0.49)
n/a
-0.03261
(-0.56)
n/a
-0.00240
(-0.02)
n/a

43

0.17948
(5.84)**
-0.14927
(-1.63)
0.05707
(1.71)^
-0.01053
(-1.48)
-0.05355
(-0.44)
n/a

Q3 2005
Parameter Estimate

0.21113
(5.51)**
-0.00691
(-0.07)
0.00459
(0.13)
-0.02736
(-3.79)**
0.14089
(1.01)
n/a

0.08732
(2.50)*
-0.00615
(-0.37)

0.16879
(4.61)**
-0.08692
(-0.94)
0.02979
(0.89)
0.01882
(-2.76)**
-0.12703
(-0.58)
0.47787
(1.69)^
-0.28861
(-1.51)
1.31325
(3.16)**
0.33655
(1.24)
-0.90984
(-1.32)
0.06966
(1.68)^
0.01477
(0.80)

-0.22323
(-1.43)
n/a
0.45552
(1.86)^
n/a

0.11432
(0.75)
n/a
-0.02904
(-0.12)
n/a
0.04837
(1.09)
0.00304
(0.15)

Model 1:
|DACC| = 0 + 1 Review + 2 Lamba + 3 Log (TA) + 4 OCF + 5 OCF+ + 6
PriorACC + 7 PriorACC+ + 8 ROA + 9 ROA + + 10Leverage + 11Auditor
+ 12 Industry dummy +
Revised Model 1:
|DACC| = 0 + 1 Review + 2 Lamba + 3 Log (TA) + 4 OCF + 5 PriorACC + 6
ROA + 7Leverage + 8 Auditor + 9 Industry dummy +
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;
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).
**, *, ^: significant at 1%, 5% and 10%, respectively (two-tailed).

44

Table 6
All Reviewed Firms
Revised Model 1:
|DACC| = 0 + 1 SEC Registrant + 2 Log (TA) + 3 OCF + 4 PriorACC + 5 ROA +
6Leverage + 7 TSXV + 8 Auditor + 9 Industry dummy +
Variable

Constant
Canadian SEC
Registrant
Log(TA)
OCF
PriorACC
ROA
Leverage
TSXV
Auditor
Industry
dummy

N
Adjusted R2

Q1 2005
Parameter Estimate

Q2 2005
Parameter Estimate

Q3 2005
Parameter Estimate

Revised Model 1

Revised Model 1

Revised Model 1

0.09147
(5.81)**
0.02708
(2.61)*
-0.01176
(-3.21)**
0.29971
(3.70)**
0.04205
(0.74)
-0.33606
(-4.06)**
0.03327
(1.28)
-0.04233
(-2.55)*
0.0006
(0.05)

0.08499
(3.48)**
0.00754
(0.54)
-0.00207
(-0.41)
-0.12160
(-0.85)
-0.34201
(-1.90)^
0.17944
(0.65)
-0.01488
(-0.44)
-0.01104
(-0.48)
-0.01967
(-1.13)

0.15989
(5.85)**
0.01767
(1.02)
-0.01582
(-2.61)*
-0.00004
(-0.00)
-0.00454
(-0.03)
-0.04151
(-0.17)
-0.00346
(-0.08)
0.01309
(0.46)
0.00521
(0.26)

Included
n.s.

Included
n.s.

Included
n.s.

121

118

118

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;
45

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

46