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    Are Auditors Professionally Skeptical? Evidence from...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
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    Title:
    Are Auditors Professionally Skeptical? Evidence from Auditors’ Going-Concern Opinions and Management Earnings Forecasts.
    Practical Implications:

    The decision process concerning a firm’s going-concern status is a crucial component of the overall audit. The authors provide new empirical evidence showing how auditors use potentially biased management forecasts in their going-concern decision process. Auditor professional skepticism is an important concept in audit practice as evidenced by its prominence throughout auditing standards. The authors show that auditors do not significantly overweight management forecasts on average, and even underweight management forecasts they perceive as being suspicious, indicating that auditors exercise professional skepticism when using management earnings forecasts. Thus, this paper is informative to regulators who are mainly concerned about auditors relying too heavily on what their clients tell them and failing to sufficiently test or challenge the forecasts, views, or representations of management.

    Citation:

    Feng, M., & Li, C. 2014. Are Auditors Professionally Skeptical? Evidence from Auditors' Going-Concern Opinions and Management Earnings Forecasts. Journal Of Accounting Research 52 (5): 1061-1085.

    Keywords:
    going-concern, management forecast, professional skepticism
    Purpose of the Study:

    This paper investigates whether auditors exercise professional skepticism about management earnings forecasts when assessing a client firm’s going-concern status. Professional skepticism is “an attitude that includes a questioning mind and a critical assessment of audit evidence”. Regulators have long been concerned that auditors rely too much on what their clients tell them rather than applying professional skepticism. For example, a lack of professional skepticism is one primary cause of SEC actions against audit firms.

    This paper sheds light on auditor professional skepticism due to the joint effect of three important factors.

    • Prospective financial information provided by managers is an important input to auditors when they evaluate the client’s going-concern status. Among this information, management earnings forecasts are particularly important because, if a financially distressed firm is expected to continue generating losses, the losses are likely to drain the firm’s limited cash resources and increase the firm’s likelihood of going bankrupt.
    • Financially distressed firms tend to issue optimistically biased forecasts. Because the firms to which auditors consider issuing a going-concern opinion are generally financially distressed, professional skepticism could be especially important in this setting.
    • Auditors could obtain management earnings forecasts through private communication with managers and/or public earnings forecasts.
    Design/Method/ Approach:

    The authors obtain data from financially distressed firms that have auditor reports available on Audit Analytics and are covered by the Compustat and First Call database for fiscal years 2000 through 2010. This results in final sample of 1,054 firm-year observations with 39 observations receiving going-concern opinions, and 33 filing for bankruptcy in the 12 months subsequent to the auditor opinion issuance date.

    Findings:

    The authors find that, when management earnings forecasts are higher, the firms are less likely to receive going-concern opinions and to subsequently go bankrupt. Moreover, the coefficient on management forecasts in the going-concern model is not significantly different from the coefficient in the bankruptcy model. Hence, there is no significant evidence showing that auditors, on average, overweight management earnings forecasts and thus fail to apply professional skepticism when evaluating the firms’ going-concern status.

    The authors find that auditors’ going concern decisions are not associated with management earnings forecasts with lower perceived credibility, but significantly and negatively associated with the other management earnings forecasts. In contrast, the likelihood of bankruptcy is significantly related to management earnings forecasts, regardless of auditor-perceived credibility. More importantly, the weight that auditors assign to management forecasts with low perceived credibility is significantly lower than the weight implied in the bankruptcy model. In other words, auditors’ underweight management earnings forecasts that are issued by managers who previously missed their own forecasts and management forecasts that predict high earnings increases or high earnings.

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions