Qualified Accounting Changes and Investor Assessments of Financial Performance and Representational Faithfulness

In this study we examine how an audit qualification of an accounting change affects investor assessments of the firm's current and future financial performance, and the representational faithfulness of the change. We investigate this issue for income-increasing and income-decreasing accounting changes, and across four apparent reporting strategies: reporting aggressively, taking a bath, creating hidden reserves, and employing no apparent strategy. Our results show that the effect of the qualification on assessments of current and future performance depends on whether the accounting change increases or decreases reported net income. When an income-increasing accounting change is qualified, investors decrease their assessments of current and future financial performance; when an income-decreasing accounting change is qualified, investor assessments of financial performance are either unaffected or decreased depending on the apparent reporting strategy. We also find evidence that assessments of representational faithfulness relate positively (negatively) to assessments of financial performance when accounting changes are income increasing (decreasing), and under all conditions qualifications reduce investor assessments of representational faithfulness. Avenues for future research are also discussed.