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  • Jennifer M Mueller-Phillips
    Business Strategy and Auditor Reporting
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 09.04 Going Concern Decisions, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Business Strategy and Auditor Reporting
    Practical Implications:

    This study is informative for stakeholders when they are analyzing financial statements. It provides support that a going concern opinion for a prospector firm may not be as alarming as it appears. It also reveals that many influences are at play when auditors are determining which audit opinion is most appropriate for the situation.

    Citation:

    Chen, Yu, J. D. Eshleman, and J. S. Soileau. 2017. Business Strategy and Auditor Reporting. Auditing, A Journal of Practice and Theory 36 (21): 63-86.

    Keywords:
    business strategy; auditors; going concern; material weakness
    Purpose of the Study:

    This study examines the effects that a firm’s business strategy, whether prospector or defender, has on an auditor’s decision in areas requiring significant professional judgment. Specifically, the authors investigate areas involving material weakness and going concern opinions. Prospector business strategies focus on innovation and invest heavily in marketing and research and development. Alternatively, defender business strategies place a strong emphasis on cost efficiency and instead invest heavily in automated production and distribution processes. It is important to note the focus in the study is on business-level strategy, not corporate strategy. Business level-strategy is the way a firm competes within an industry, not what industries it competes in.

    Design/Method/ Approach:

    All firms in the study were placed into 3 categories: prospectors, analyzers, and defenders. The authors used 6 characteristics to measure strategy in order to categorize the firms. The final sample size was 4,332 firms from 2000-2013. Financial information was obtained about the firms from databases such as Compustat, Audit Analytics, and CRSP.

    Findings:

    The authors find that a firm’s decision to adopt a prospector versus defender strategy significantly increases the likelihood of an auditor issuing an unfavorable opinion.

     

    The authors find the reasoning behind this to be comprised of the following:

    • Prospector business strategies are rooted within innovation and therefore likely to take risks. Often times this leads to past performances being more volatile which reduces the auditor’s ability to accurately predict future outcomes. This results in auditors choosing the most conservative choice, a going of concern opinion.
    • Collectively, prospector strategy characteristics such as decentralized control, frequent product changes, and high executive turnover all lead to a higher probability of material weakness.

     

    Overall, auditors are more prone to Type II errors regarding the issuant of going concern opinions to prospector firms. The evidence suggests that auditors are less successful in predicting bankruptcy for these firms and the going concern opinion is not always warranted. 

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

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Auditor Tenure and Going Concern Opinions for Bankrupt...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Tenure and Going Concern Opinions for Bankrupt Clients: Additional Evidence
    Practical Implications:

    This study should be of particular interest because the findings represent evidence concerning the relationship between auditor tenure and audit failures. The tenure effect, which is pronounced in the early years, is particularly important to the non-Big 4 sample because approximately 75 percent of non-Big 4 clients in the author’s sample have auditor tenures of four years or less. This short tenure, coupled with association between tenure and Type II errors suggest the adverse impact of short tenure is concentrated in the non-Big 4 sample. With this in mind, the findings of this paper may help to inform the continuing debate regarding the possible adverse effects of long auditor tenure. 

    Citation:

    Read, W.J., and A. Yezegel. 2016. Auditor Tenure and Going Concern Opinions for Bankrupt Clients: Additional Evidence. Auditing: A Journal of Practice and Theory 35 (1): 163-179.

    Keywords:
    going concern opinions, Type II errors, and auditor tenure
    Purpose of the Study:

    Regulators and lawmakers in the U.S. periodically express concerns about a possible association between auditor tenure length and audit failure. The authors define audit failure as a bankrupt company not receiving a going concern modified audit opinion prior to bankruptcy, a Type II reporting error.  Geiger and Raghunandan began investigating this relationship in the early 2000’s; however, the authors of this study hope to extend this investigation in the three following ways:

    • Studies have shown that audit reporting companies in financial distress changed following the enactment of the Sarbanes-Oxley Act of 2002 and related legislature and media scrutiny of the auditing profession; ergo, a closer examination of more recent data would be a worthwhile measure.
    • The previous study did not examine differences between Big 4 and non-Big 4 audit firms, and studies show that there are significant differences between Big 4 and non-Big 4 auditors, including going concern decisions.
    • The previous study assumed and tested for a linear relationship between auditor tenure and audit reporting failures; however, more recent data leads the authors to allow the association between auditor tenure and audit quality to be nonlinear. 
    Design/Method/ Approach:

    The authors examine prior audit reports for a sample of 401 U.S. publicly held companies that filed for bankruptcy during the period 2002-2008. A quadratic model was used to control for potential nonlinearity in the relationship between audit tenure and audit reporting.

    Findings:
    • The authors did not find evidence of a significant relation between auditor tenure and going concern opinions issued by Big 4 firms to their subsequently bankrupt clients.
    • The authors did find evidence indicating a higher likelihood of Type II errors for non-Big 4 auditors in the early years of an audit; however, this relation weakens and after approximately year four of the engagement, the authors begin to observe no statistical association between tenure length and Type II errors for non-Big 4 auditors, either.
    • The authors’ results from the endogeneity analysis are consistent with their primary conclusions that non-Big 4 audit firms are more likely to make Type II reporting errors compared to Big 4 firms during the initial years of an audit engagement.
    • The authors find that long auditor tenure, of itself, is not associated with Type II reporting errors. 
    Category:
    Auditor Judgment
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    State Liability Regimes within the United States and Auditor...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    State Liability Regimes within the United States and Auditor Reporting
    Practical Implications:

    These results imply that auditors are more likely to render modified GC opinions for clients subject to regimes that hold auditors liable to a larger class of third parties and impose joint-and-several liability for third-party damages, both of which reflect greater liability exposure. The higher incidence of GC opinions accompanying stronger state-level litigation threats could reflect higher audit quality, but it could also stem from excessively conservative auditors protecting their interests by avoiding costly civil lawsuits, which could undermine audit quality in some circumstances. 

    Citation:

    Anantharaman, D., J. A. Pittman, and N. Wans. 2016. State Liability Regimes within the United States and Auditor Reporting. The Accounting Review 91 (6): 1545 – 1575.

    Keywords:
    auditor litigation risk, state common law, and going-concern opinions
    Purpose of the Study:

    The authors of this study analyze the relation between state regimes governing auditor liability and auditors’ propensity to modify their opinion to express uncertainty on financially distressed clients’ ability to continue as a going concern.  Extant research implies that auditors have strong incentives to conduct high-quality audits in order to reduce the litigation examining consequences stemming from an alleged audit failure; however, the bulk of this research focuses on auditor liability arising under federal statutory laws, not state laws. This study delves into the issue of state laws, including if and to what extent litigation exposure under state common law affects auditors’ reporting decisions. 

    Design/Method/ Approach:

    A previous study developed a state-level score that captures third-party liability standards, which the authors of this study rely on to measure auditor litigation exposure stemming from third-party liability standards. To evaluate variation in liability-sharing standards across states, the authors closely read the relevant law to construct a state-level index that identifies whether each state follows a joint-and-several approach or a proportional approach to liability sharing. The authors assign to each client firm the highest of the liability indices dependent on the states in which the firm does business, and they measure audit outcomes with the propensity to issue going-concern (GC) opinions to financially distressed clients. 

    Findings:
    • The authors find that auditors are significantly more likely to issue a GC opinion to clients from states applying:
      • A more expansive third-party liability standard, or
      • The joint-and-several liability (JSL) rule for apportioning damages among defendants.
    • The authors find that liability regimes primarily affect auditor reporting for clients that are inherently more likely to be sued, reinforcing the conclusion that state-level liability regimes matter more when litigation exposure is higher.
    • The authors find some suggestive evidence that the higher expected legal costs arising from state-level liability regimes have a stronger impact on Big 4 auditors that are more sensitive to litigation threats. 
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Going Concern Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    The effect of strategic and operating turnaround initiatives...
    research summary posted October 19, 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The effect of strategic and operating turnaround initiatives on audit reporting for distressed companies.
    Practical Implications:

    The results on the relations between management turnaround initiatives and going-concern decisions suggest that auditors consider strategic information when making going-concern decisions, and that there is a relationship between auditors’ strategic risk assessment (typically done in a business risk auditing context) and the outcome of the audit (i.e., the opinion). The results further indicate that auditors do not limit their evaluation of mitigating strategic actions to the management plans explicitly suggested in the audit standards. Furthermore, the evidence suggests that auditors are already adopting a long-term view when assessing client viability, which again suggests that the current discussion on expanding the time horizon for going-concern assessment would not affect current practice substantially.

    Citation:

    Bruynseels, L., and M. Willekens. 2012. The effect of strategic and operating turnaround initiatives on audit reporting for distressed companies. Accounting, Organizations & Society 37 (4): 223-241.

    Keywords:
    corporate turnarounds, strategic planning, auditors’ report, going-concern decision
    Purpose of the Study:

    Audit reporting of distressed companies is more relevant than ever as management and auditors face the consequences of the global financial crisis and economic downturn. In the midst of this economic turmoil, standard setters are considering revisions to the auditing standard on the auditor’s evaluation of a company’s ability to continue as a going concern.

    This paper examines two issues related to the current debate about the time horizon and scope of information considered in going-concern decision-making: In particular, the authors ask: (1) do auditors take into account management plans and strategic actions to overcome financial difficulties, and (2) do auditors only assess short-term viability, or do they adopt a long-term view when making a going-concern decision. To that purpose the authors investigate whether and how a broad array of strategic and operating turnaround initiatives taken by management of financially distressed firms affect the auditor’s going-concern decision. In addition, the authors examine whether auditor industry specialization amplifies the extent to which auditors rely on strategic or operating turnaround initiatives in this context. The authors argue that their knowledge of industry best practices will allow specialist auditors to evaluate the adequacy and appropriateness of proposed management turnaround initiatives better, which in turn leads to an increased use of this type of information in going-concern decision-making.

    Design/Method/ Approach:

    The authors select a sample adopting a matched pair design. The authors select a sample of companies that received a first-time going-concern opinion and then a match sample of distressed companies that did not receive a going-concern opinion. They identify manufacturing companies from the Compustat database that received a qualified opinion or unqualified opinion with an explanatory paragraph. This results in a final sample of 389 manufacturing companies that received a non-clean audit opinion in fiscal years 1998 2001. To test the going-concern model, they match the going-concern opinion (GCO) sample with a sample of distressed companies that did not receive a going-concern report. The final sample consists of 174 distressed firm observations. 

    Findings:
    • The presence of strategic turnaround initiatives that are likely to generate positive cash flow effects in both the short run and the long run is negatively associated with the likelihood that a going-concern opinion is issued.
    • Cooperative agreements provide positive signals about the going-concern status of the firm and therefore can be interpreted as a distress-mitigating factor.
    • In contrast, the authors find that strategic initiatives that are likely to generate positive cash flow effects only in the long run are positively associated with the likelihood that a going-concern opinion is issued.
    • The evidence suggests that new mergers and acquisitions are not perceived as mitigating factors but rather as going-concern risk factors.
    • Only particular operating turnaround initiatives are associated with a higher likelihood that a going-concern opinion is issued.
    • More detailed analysis shows that cost reduction initiatives are perceived as additional going-concern risk factors, increasing the likelihood of a going-concern opinion.
    • City-level industry specialists perceive the implementation of short-term operating initiatives as a going-concern risk factor, whereas non-specialists do not.
    • Together with the finding that there is no difference between specialists and non-specialists in their use (and evaluation) of information regarding strategic turnaround initiatives, the authors find only partial confirmation for the expectation that industry specialists rely more on turnaround initiatives in their going-concern decision.
    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    The changing relationship between audit firm size and going...
    research summary posted October 19, 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The changing relationship between audit firm size and going concern reporting.
    Practical Implications:

    The results raise an interesting policy issue related to the ability of financially stressed clients to hire an audit firm. While the results of the study indicate that financially stressed clients are still able to hire an audit firm, their options appear to be decreasing over time. To the extent that their audit firm options continue to shrink over time, some financially stressed public companies may be unable to hire an audit firm in the future. Evaluating the implications and potential consequences to these firms represents an important area for further research. 

    Citation:

    Kaplan, S. E., and D. D. Williams. 2012. The changing relationship between audit firm size and going concern reporting. Accounting, Organizations & Society 37 (5): 322-341.

    Keywords:
    decentralization in management, financial stress, going concern report
    Purpose of the Study:

    Under Generally Accepted Auditing Standards (GAAS), audit firms have the responsibility to evaluate the going concern status of each of their clients and to include explanatory language in their report when they conclude that there is “substantial doubt” about a client’s ability to continue as a going concern (GC) over the next year. This responsibility has been controversial, as well as consequential. Generally, managers of public companies prefer not to receive a GC report, in part because equity markets react negatively when a GC report is issued. However, issuing a GC report presumably lessens the litigation risks audit firms face from investors seeking to recover their losses.

    The purpose of the current study is to provide longitudinal evidence on the changing relationship between audit firm size and auditor going concern reporting. The study focuses on three classes of audit firms (e.g., Big N, national, and regional) across four different ERAs. Over time, the authors expect that financially stressed public companies will increasingly be audited by regional audit firms, who in turn will increasingly report more conservatively as demonstrated by a higher propensity to issue a GC audit report.

    Design/Method/ Approach:

    The authors collected data for public companies over a 22-year period between 1989 and 2010, primarily derived from COMPUSTAT and supplemented by Compact Disclosure, CRSP, AuditAnalytics, and SEC filings. The authors refer to the 199,921 firm-year observations as the All Firms sample. Two other samples were also identified.

    Findings:

    The authors document that across the ERAs, financially stressed public companies are increasingly audited by regional audit firms. Specifically, the evidence indicates that regional firms only audited approximately 16% of financially stressed public companies in the first two ERAs, but over 30% in the last two ERAs. While a variety of factors are involved, this change reflects, in part, a decreasing willingness by larger audit firms to audit financially stressed public companies.

    The authors also document that for their financially stressed public companies, regional audit firms were more likely to issue a GC report in the latter ERAs, whereas Big N and national audit firms were increasingly less likely to issue a GC report. In the case of regional firms, the authors believe this change reflects, in part, increases in regional firms’ exposure to catastrophic litigation. They also believe the change among Big N firms reflects, in part, increases in Big N firm reliance on client screening as a mechanism to control their firm’s exposure to litigation risks.

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    Audit Reporting for Going-Concern Uncertainty: A Research...
    research summary posted October 20, 2014 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Audit Reporting for Going-Concern Uncertainty: A Research Synthesis
    Practical Implications:

    This study provides a summary of the literature examining the auditor’s GCO decisions. Determinants of GCOs include client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), auditor factors (e.g. audit firm size), auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and environmental factors (e.g. changes in regulations, auditing standards and audit market structure). Important findings are that auditors will change the likelihood of issuing GCOs in response to changes in the environment (whether due to changes in regulation or changes in the economy) and that the majority of companies that receive GCOs do not subsequently file for bankruptcy.

    For more information on this study, please contact Elizabeth Carson.

    Citation:

    Carson, E., N. L. Fargher, M. A. Geiger, C. S. Lennox, K. Raghunandan, and M. Willekens. 2013. Audit reporting for going-concern uncertainty: A research synthesis. Auditing: A Journal of Practice & Theory 32 (Supp): 353-384.

    Keywords:
    going-concern; audit reporting; bankruptcy
    Purpose of the Study:

    The global financial crisis in 2007 has resulted in an increased incidence of company failures. This led to renewed interest from regulators, standard setters and investors in the auditor’s assessment and reporting on a company’s ability to continue as a going concern. In order to facilitate the understanding of the role and effectiveness of independent audit, this study conducts a comprehensive review to synthesize and discuss the extant academic literature on auditors’ decisions to issue a modified opinion based on going concern uncertainty (hereafter, GCO).

    Design/Method/ Approach:

    This study synthesizes major findings from audit research since the 1970s. Most of the research reviewed is archival; however, a few studies using experimental designs are also cited. A framework is developed to structure the categorization of the extant GCO literature. Three main themes are identified: (1) Determinants of GCOs, (2) Accuracy of GCOs, and (3) Consequences of GCOs. This study also provides a discussion on issues related to research methodology and identifies areas for further research.

    Findings:

    Under the category of “Determinant of GCOs”, the synthesis shows that:

    • Auditors are more likely to issue GCOs after December 2001, which is in response to the accounting and auditing scandals in early 2000s (e.g. collapse of Enron). Also, smaller companies more likely to receive GCOs.
    • In the ten-year period between 2000 and 2010, 60.10% of bankruptcy filings are preceded by GCOs.
    • Determinants of GCOs include: (1) client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), (2) auditor factors (e.g. audit firm size), (3) auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and (4) environmental factors (e.g. changes in regulations, auditing standards and audit market structure).

    Under the category of “Accuracy of GCOs”, the synthesis shows that:

    • Since the adoption of SAS No.59, 40-50% of bankruptcy firms did not receive a prior GCO.
    • 80-90% of companies receiving a GCO do not file for bankruptcy in the subsequent year.

    Under the category of “Consequences of GCOs”, the synthesis shows that:

    • Issuance of GCOs is associated with negative excess returns, and the reaction is more negative when problems with obtaining financing are cited.
    • In the U.S., the issuance of GCO can be a “self-fulfilling prophecy” and cause the financial demise of company that would have survived if it had not received a GCO.

    With regards to issues in research methods, this study cautions the use of small samples in analysis and the interpretation of interaction variables in the statistical models. The study also finds general limitations in extant research due to the varying sample selection criteria for identifying financial stressed firms and the exclusion of private companies from samples examined.

    This study suggests further research could (1) examine the relations between auditor independence and GCO decisions, (2) investigate auditor’s GCO decisions and the related issues for financial institutions, non-profit organisations and government entities, (3) replicate research on GCO accuracy in different time periods with different samples, (4) examine the information usefulness of GCOs to a wide set of market participants, and (5) properly distinguish between the roles of management, audit committee and auditor in the disclosure and discussion of going-concern. 

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    Did SOX Influence the Association between Fee Dependence and...
    research summary posted February 20, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Did SOX Influence the Association between Fee Dependence and Auditors’ Propensity to Issue Going-Concern Opinions?
    Practical Implications:

    This research note presents evidence that the question of whether new standards or regulations have achieved the objective of altering the behavior of their intended target cannot be adequately assessed shortly after they have come into effect, as the implementation often requires a steep learning curve and is frequently accompanied by intense public debates and media scrutiny. From the policy standpoint, it suggests that the concern expressed by the U.S, Treasury Department officials about auditors’ applying an overly strict approach in their audits to counter elevated liability after SOX may not be warranted.

    For more information on this study, please contact Wenjun Zhang.

    Citation:

    Kao, J. L., Y. Li., and W. Zhang. 2014. Did SOX influence the association between fee dependence and auditors’ propensity to issue going-concern opinions? Auditing: A Journal of Practice and Theory 33 (2): 165-185

    Keywords:
    Fee dependence, going-concern opinion, auditor independence, SOX
    Purpose of the Study:

    Li (2009) shows that the association between fee dependence (FEEDEP) and auditors’ likelihood to issue qualified going-concern audit opinions (GCO) changes from insignificant in 2001 to positive in 2003. Since then, several studies have quoted Li’s (2009) findings as evidence that SOX has led auditors to behave more conservatively with respect to going-concern reporting.

    This research note extends Li’s (2009) post-SOX sample period from 2003 to 2011 and demonstrates that her findings for 2003 do not hold over a much longer post-SOX period, implying that SOX has had little effect on auditors’ behavior with respect to going-concern reporting for their large financially distressed clients. These results call into question whether the positive FEEDEP-GCO association identified by Li (2009) indeed represents new audit practice in the post-SOX era.

    This research note is motivated by Feldmann and Read (2010), who showed that the incidence of qualified going-concern opinions issued to subsequently bankrupt companies reverted back to the pre-Enron level by 2006-2007 after a brief increase in 2002-2003, suggesting that the year right after the passage of SOX was not typical. Thus, by focusing on 2003, researchers merely capture a transitory reaction by the audit profession to intense public scrutiny following SOX.

     

    Reference: Li, C. 2009. Does client importance affect auditor independence at the office level? Empirical evidence from going-concern opinions. Contemporary Accounting Research 26 (1): 201-230.

    Design/Method/ Approach:

    The authors run ten annual regressions (2001; 2003-2011) of auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients (GCO) on a fee dependence measure (FEEDEP). Comparing the association between GCO and FEEDEP before versus after the passage of SOX, the authors draw inferences about whether the more conservative going-concern reporting documented by Li (2009) indeed represents a long-term equilibrium behavior in the post-SOX audit market. 

    Findings:
    • The authors find no association between auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients and the fee dependence measure over an extended post-SOX period (i.e., 2003-2011), implying that SOX has had no observable lasting effect on auditor conservatism with respect to going-concern reporting.
    • The authors find that while auditors were equally cautious in issuing qualified going-concern opinions to clients that eventually failed, both before and after SOX, they have made more Type I misclassifications in 2003 by issuing qualified going-concern opinions to clients that remained solvent within two years of financial statement dates. 
    Category:
    Auditor Judgment, Independence & Ethics, Standard Setting
    Sub-category:
    Going Concern Decisions, Impact of Fees on Decisions by Auditors & Management, Impact of SOX
  • Jennifer M Mueller-Phillips
    Threats to Auditor Independence: The Impact of Relationship...
    research summary posted December 3, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Threats to Auditor Independence: The Impact of Relationship and Economic Bonds
    Practical Implications:

    The results of the study suggest that establishing close auditor-client relationships can reward audit firms with higher NAS revenues from clients. In particular, longer audit firm tenure and audit firm alumni directors benefit the audit firms with higher NAS provision. This indicates that a successful strategy for audit firms may be to develop long-term associations with clients at the firm level (rather than at the partner level) and to establish active alumni networks. At the same time audit firms should ensure that adequate procedures are in place to ensure that appropriate audit reports are issued, most particularly when strong auditor-client relationships are present.

    For more information on this study, please contact Elizabeth Carson.

    Citation:

    Ye, P., E. Carson, and R. Simnett. 2011. Threats to auditor independence: The impact of relationship and economic bonds. Auditing: A Journal of Practice & Theory 30 (1): 121-148.

    Keywords:
    Independence and ethics; non-audit services; going concern decisions; alumni
    Purpose of the Study:

    Auditor independence is the foundation of high quality audit services and a crucial component in the statutory corporate reporting process. The cases of high-profile corporate failure associated with auditing scandals in early 2000s have cast doubts over auditor independence and the value of auditing. Most regulatory concerns regarding auditor independence have centered on three alleged independence threats:

    • Auditor’s economic dependence on the client due to the provision of non-audit services (NAS)
    • Auditor’s familiarity with the client due to lengthy audit tenure
    • The personal relationships between the audit engagement partner and client’s directors

    Relevant regulatory reforms have taken place in both the U.S. (SOX, 2002) and Australia (CLERP 9, 2004) to mitigate such concerns. However, empirical evidence only provides limited support to the regulations, and two fundamental questions underlying the independence issue remain unanswered:

    • What factors influence a company’s decision to purchase NAS from its incumbent auditor?
    • How do the economic and social bonds between auditors and clients affect auditor independence?

    This paper addresses the questions to inform regulation by examining:

    • Whether client’s NAS purchase from the incumbent auditor is affected by four identified auditor-client relationships: (1) audit firm tenure, (2) audit partner tenure, (3) relationship tenure (ongoing personal interactions between audit engagement partner and client’s director), and (4) client’s director being an alumnus of the audit firm. 
    • Whether auditor’s propensity to issue a going-concern opinion (as the manifestation of auditor independence) is affected by the provision of NAS and the four identified auditor-client relationships.
    Design/Method/ Approach:

    The study uses 2002 Australian data on publicly-traded companies. 2002 is chosen as a period when the audit environment was still relatively unregulated. Data was hand-collected from companies’ annual reports. The impacts of various factors on auditor independence are examined using statistical analysis.

    Findings:

    The study finds:

    • Some evidence that increased audit firm tenure and the presence of directors with alumni connections to the incumbent audit firm is associated with an increased likelihood of clients’ NAS purchase from the incumbent audit firm. Such impact is stronger in companies with lower leverage and higher ownership concentration.
    • No evidence that audit partner tenure or relationship tenure (between audit partner and client director) impacts client’s NAS purchasing decisions.
    • Evidence that higher levels of NAS provision and longer audit partner tenure are associated with a lower propensity in auditor’s issuance of going-concern opinions.
    • No evidence that audit firm tenure, relationship tenure or the presence of client director’s alumnus status impacts on auditor’s propensity to issue going-concern opinions.
    • Evidence that auditors are less likely to issue a going-concern opinion when there is a high-level NAS provision to the client and the client has an incumbent audit firm alumni director.
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Going Concern Decisions, Non-audit Services