Has the lack of use of the qualified audit opinion turned it into the “Rotten Kid” threat?

Although the PCAOB describes the auditor’s report as utilizing a “pass/fail model,” auditing standards provide auditors with a reporting option that is not strictly “pass” or “fail” – a qualified audit opinion. Qualified opinions provide assurance that the financial statements are fairly presented in conformity with Generally Accepted Accounting Principles (GAAP), except for a particular matter (e.g., a non-pervasive material misstatement). Despite having the option to issue qualified opinions, auditors rarely use this option. This is not surprising when one considers that the Securities and Exchange Commission (SEC) considers financial statements filed with anything other than an unqualified opinion to be in violation of securities laws, resulting in possible suspension or delisting of the registrant’s securities. A proponent of strong penalties would argue that the SEC’s stance toward qualified opinions improves financial reporting quality by encouraging GAAP compliance. In this paper, we argue that the opposite may be true. Relying on the auditor-client negotiation literature and economic game theory, we argue that the severe consequences associated with qualified opinions in the US have caused them to become a non-credible threat in the eyes of audit clients, similar to the outcome of the Rotten Kid Game. As a result, auditors are less able to negotiate GAAP compliance by threatening to qualify the audit opinion, resulting in reduced financial reporting quality. We discuss the implications of such an outcome and provide suggestions regarding alternative methods used in foreign securities markets for responding to financial statements filed with a qualified opinion.