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    Investor Reaction to Going Concern Audit Reports
    research summary posted March 9, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
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    Title:
    Investor Reaction to Going Concern Audit Reports
    Practical Implications:

    The evidence suggests that institutional investors drive the reaction to the GCAR, since there is no detectable reaction at low levels of institutional ownership. The market reaction gets more negative as the level of institutional ownership increases, and there is a decline in institutional ownership after the GCAR is issued. These results are due to sophisticated investors’ awareness of the firm’s financing needs and the covenants carried by the firm’s debt.

    The literature contributes primarily to the line of auditing research on GCARs. First, this study provides relatively unambiguous evidence that going concern audit reports provide useful information. Second, it provides insight into the reasons that investors find the GCAR to be useful by showing that GCARs that cite financing problems result in a more negative reaction than do other GCARs. Third, while there is evidence of the importance of restrictive debt covenants in other areas of accounting research, there is little or no evidence in auditing. Finally, this study adds to the literature by showing that institutional investors use the information in audit reports.

    For more information on this study, please contact Krishnagopal Menon.

    Citation:

    Menon, K. and D. D. Williams. 2010. Investor Reaction to Going Concern Audit Reports. The Accounting Review 85 (6): 2075-2105. 

    Keywords:
    audit reports; going concern; debt covenants; institutional ownership
    Purpose of the Study:

    There is a long-standing debate on the usefulness of the going concern audit report (GCAR). Auditors have expertise in assurance audits, not in judging the going concern status of a firm, and their assessment may not add to what investors already know. On the other hand, auditors have access to information unavailable to investors and can reveal this information through the GCAR.

    One way of judging the usefulness of the GCAR is to see whether investors react to GCAR announcements. If the auditor’s unfavorable assessment provides new information on the firm, then the price of the firm’s securities should decline.

    This study provides evidence on this issue, using a substantially larger sample than those used in previous studies, and provides mixed evidence on whether investors find audit reports modified for going concern reasons to be useful. 

    Design/Method/ Approach:

    Using a substantially larger sample than previous studies, the authors observe negative excess returns when the GCAR is disclosed. The sample for the study consists of firms that receive an initial GCAR in the period 1995 to 2006. We identify firms receiving an initial GCAR by searching the Compact Disclosure database, the Audit Analytics database, Compustat, and the business media, and then confirming the existence of a first-time GCAR by reading audit reports in current and previous 10-K filings. All American Depositary Receipts (ADRs) are excluded. The research includes only the first GCAR received by the firm in the sample, even if the firm obtains a GCAR, or several consecutive GCARs, is then issued an unmodified opinion, and later receives a GCAR once more. 

    Findings:

    The study finds that investors react more adversely to GCARs that cite financing problems. Further, since many firms carry debt with a covenant that requires the firm to present GCAR-free financial statements, the GCAR can a trigger covenant violation that results in stricter loan terms. It is shown by the study that the reaction to the GCAR is worse for firms that violate a covenant when they receive a GCAR.

    The study also finds that the price reaction to the GCAR varies inversely with the level of institutional ownership. In addition, the negative market reaction for firms with GCARs citing financing problems or for firms violating a debt covenant by receiving a GCAR is observed only at higher levels of institutional ownership. The differences are attributed to institutional investors likely having greater knowledge of the terms of the firm’s debt contracts.

    Category:
    Auditor Judgment
    Sub-category:
    Going Concern Decisions