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  • Jennifer M Mueller-Phillips
    Debt Covenant Violations, Firm Financial Distress, and...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Debt Covenant Violations, Firm Financial Distress, and Auditor Actions
    Practical Implications:

    The findings from this study impact firms with debt covenant requirements. Violations from debt covenants occur frequently and are often due to tight restrictions rather than signs of financial distress. These types of violations often lead to renegotations or waivers instead of immediate repayment. However, this study shows that auditors will still have negative reactions regardless of whether or not the violation is due to financial difficulty. It is important for firms to not only consider the financial and lending consequences of a violation, but the auditing consequences as well.

    Citation:

    Bhaskar, Lori Shefchik, G. V. Krishnan, and W. Yu.2017. “Debt Covenant Violations, Firm Financial Distress, and Auditor Actions”. Contemporary Accounting Research 34.1 (2017): 186.

    Purpose of the Study:

    This study investigates auditor actions resulting from debt covenant violations for firms. The violations increase business risk and subsequently cause the auditor to respond negatively. The audit actions examined in this paper are:

    • Adjustments in the audit plan causing higher audit fees.
    • The issuance of a going concern opinion.
    • The resignation of the auditor.

    The authors also consider the financial health of the firms before the violation was given. It is hypothesized that auditors are more likely to have a negative reaction to firms that are already financially distressed.

    Design/Method/ Approach:

    The sample includes 4,267 violations occurring from 2000 to 2008. All of the firms were U.S. nonfinancial public companies. The authors gathered the information from databases such as Compustat and Audit Analytics. The analysis was performed by estimating models of the auditor actions based on different client characteristics.

    Findings:

    The authors find the following:

    • Firms with debt covenant violations have significantly higher audit fees.
    • Firms have an increased likelihood of receiving a going-concern opinion after a violation. This is increased even more for firms that are not financially distressed. The authors attribute this to the fact that auditors tend to act more strongly because the information was inconsistent with prior beliefs.
    • Debt covenant violations lead to an increased likelihood of auditor resignation.
    • There is a positive association between the Big 4 auditors and all three auditor actions listed above.
    Category:
    Accountants' Reporting, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Resignation Decisions
    Home:

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

  • 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
    Fraud Risk Awareness and the Likelihood of Audit Enforcement...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Fraud Risk Awareness and the Likelihood of Audit Enforcement Actions
    Practical Implications:

     This paper sheds light on the implications of a going concern opinion, specifically in the context of litigation against the auditor. While prior research has established that a going concern opinion reduces the likelihood of shareholder litigation in bankruptcy proceedings, this study shows that going concern opinions potentially open up the auditor to increased SEC litigation if the financial statements are found to be fraudulent. The authors suggest this should be taken into consideration when auditors are determining the extent of necessary documentation for fraud risk assessment, especially when the client is likely receiving a going concern opinion.

    Citation:

     Eutsler, J., E.B. Nickell, S.W. Robb. 2016. Fraud Risk Awareness and the Likelihood of Audit Enforcement Action. Accounting Horizons 30 (3): 379-392.

    Purpose of the Study:

     The authors aim to examine whether documented awareness of fraud risk affects the likelihood of SEC enforcement action against the auditor in cases of undetected fraud. They acknowledge that financial distress provides incentive for fraudulent activity, and therefore consider the possibility that a going concern represents information that may affect SEC assessment of the auditor’s fraud risk assessment. This study aims to address concern that regulator investigation of audited fraudulent financials may be biased by economic factors or other information that was unknown at the time of the audit. This concern contradicts prior research, which shows that going concern opinions deter litigation against auditors when the client subsequently goes bankrupt.

    Design/Method/ Approach:

     The authors review Accounting and Auditing Enforcement Releases (AAERs) issued by the SEC for companies alleged to have engaged in fraudulent activity between January 1995 and August 2012. They identify 314 instances of alleged fraud, of which 34 received a going concern opinion and 54 had auditor-involved sanctions.

    Findings:

     The authors find that awareness of fraud risk—specifically noting a going concern issue—exposes the auditor to additional scrutiny of regulators when the financials are subsequently found to be fraudulent. Additionally, this paper points out an interesting contrast in the implications of a going concern opinion. Prior research has shown that auditors are less likely to be sued when a client with a going concern opinion subsequently goes into bankruptcy; however, the results in this paper show that auditors giving a going concern opinion are more likely to be sued when those financial statements are subsequently found to be fraudulent.

    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Going Concern Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    Audit Report Restrictions in Debt Covenants
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 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 Report Restrictions in Debt Covenants
    Practical Implications:

     Private debt lenders are more likely to include a covenant that prohibits the borrower from receiving an audit report with going-concern modifications (GCAR) when the borrower has poor creditworthiness and the loan term is long. The auditor choice is more likely to be specified in the loan agreement when a GCAR covenant is included. The borrower with a GCAR covenant experiences both increased audit fees and higher probability of getting a GCAR when financial distress occurs. The results imply the GCAR covenant may complement traditional financial covenants in protecting the lenders but comes with a cost borne by the borrowers. It also shows the lenders’ use of audit reports can influence the auditors’ behavior.

    Citation:

     Menon, K., and D. D. Williams. 2016. Audit Report Restrictions in Debt Covenants. Contemporary Accounting Research 33 (2): 682–717.

    Keywords:
    going concern, auditor choice, debt covenants, audit fees, audit reports
    Purpose of the Study:

    Prior studies on debt contracting mainly focus on financial covenants. This paper extends prior research by investigating why lenders put an audit-related covenant – GCAR covenant – into the loan agreement and the effect of this covenant on auditors. The authors argue a GCAR serves as an effective warning for potential defaults even if common financial covenants are not violated. They expect borrowing firms with low credit quality to have a GCAR covenant. They also expect long-term loans to have a GCAR covenant because the lenders face higher probability that the firm’s financial condition deteriorates before the loan matures. To prevent opinion shopping and for insurance purpose, lenders who impose a GCAR covenant are expected to restrict the borrower’s freedom on auditor selection. From the auditor’s stand point, the authors believe the GCAR covenant increases litigation risk to the auditor and/or require additional audit effort. As a result, audit fees are expected to increase and the borrowers are more likely to receive a GCAR.  

    Design/Method/ Approach:

    The initial sample comes from new private debt placement made by public companies between 2003 and 2009. The final sample consists of 7,749 loan contracts (firm-years) from 3,304 unique companies. The authors obtain debt information from DealScan, financial information from COMPUSTAT and audit-related data from Audit Analytics. The authors first test what factors determine the inclusion of a GCAR covenant and then examine the effect of this covenant on audit-related issues.  

    Findings:
    • Private debt lenders are more likely to impose a GCAR covenant in the loan contract when the credit quality of the borrower is poor and/or the debt’s maturity is long. Additional analyses show the GCAR covenant can capture events or situations lead to potential defaults even if traditional covenants are not violated.

     

    • If the loan contract contains a GCAR covenant, it is more likely that the lenders will require the borrower to engage a specific auditor. The auditors accepted by the lenders are usually the Big 4 auditors or at least national auditors. The auditor choice reflects the view that reputable auditors are stricter in going-concern assessment and have deep pockets to settle litigations.

     

    • Auditors charge higher audit fees on and are more likely to issue a GCAR to clients who have loan contracts contain a GCAR covenant, holding the degree of financial distress constant. The results are consistent with the argument that the GCAR covenant increases auditors’ perception on litigation risk and the demand on audit effort. 
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    There’s No Place Like Home: The Influence of Home-State G...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    There’s No Place Like Home: The Influence of Home-State Going-Concern Reporting Rates on Going-Concern Opinion Propensity and Accuracy
    Practical Implications:

    The findings of this study indicate that increased home-state GC rates lead to lower GC reporting accuracy for non-Big 4 auditors. This lower GC reporting accuracy imposes economic costs on the client and the auditor, which suggests that prior GC rates may be weighted too heavily in the minds of auditors.

    Citation:

    Blay, A.D., J.R. Moon, and J.S. Paterson. 2016. There’s No Place Like Home: The Influence of Home-State Going-Concern Reporting Rates on Going-Concern Opinion Propensity and Accuracy. Auditing: A Journal of Practice and Theory 35 (2): 23-51. 

    Keywords:
    auditor reporting, going-concern opinion, audit quality, Type I error, and Type II error
    Purpose of the Study:

    For a financially distressed client, the auditor’s decision to modify the audit report related to continue as a going-concern (GC) is generally considered the first public signal of imminent financial failure based on relatively private information; furthermore, a modified audit opinion is the auditor’s only means of informing outsiders of the organization’s financial condition. Consequently, two characteristics emerge regrading going-concern opinions. The first is that GC opinions can provide significant information to financial statement users. The second is that an auditor’s willingness to issue a GC opinion can signal both that the auditor is independent and that the audit is of high quality. Considerable research corroborates and relies upon the two characteristics described above. The majority of this research succeeds in identifying client financial characteristics that influence auditors’ going concern reporting decisions; however, there is not very much research that focuses on whether auditors’ circumstances and surroundings influence their propensities to issue modified opinions. This paper looks into whether auditors’ decisions to issue GC opinions are affected by the rate of GC opinions being given in the surrounding area. 

    Design/Method/ Approach:

    Partners and managers from a wide variety of accounting firms are interviewed by the authors to gain initial insight into the potential effects of state-based information. To measure the rate of proximate GC opinions, the authors analyzed 22,862 audit reports of financially distressed clients from 2001-2011. 

    Findings:
    • The authors found through their interviews with partners and managers that non-Big 4 auditors are likely more influenced by prior GC opinions within their state than Big-4 auditors are; ergo, the focus shifted to non-Big 4 firms for all subsequent analyses.
    • The authors find that prior-year first-time GC reporting at the state level is significantly and positively related to current-year first-time GC reporting.
    • The authors’ results show that GC reporting accuracy decreases significantly with increases in the state rate of GC opinions; furthermore, the increased issuance of GC opinions leads to increases in Type I error rates without decreases in Type II error rates.
    • The evidence found by the authors provides strong support that higher proximate GC rates impair GC reporting accuracy measured using Type I errors.
    Category:
    Accountants' Reporting
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    The Relation between Managerial Ability and Audit Fees and...
    research summary posted June 15, 2016 by Jennifer M Mueller-Phillips, tagged 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 Relation between Managerial Ability and Audit Fees and Going Concern Opinions
    Practical Implications:

     This research makes two primary contributions. The first is to the literature on audit pricing and going concern opinion by providing empirical evidence that after controlling for firm-level characteristics, managerial characteristics are also associated with audit fees and the propensity of auditors to issue going concern opinions. This evidence is particularly important because there is a paucity of empirical evidence on the relation between managerial characteristics and auditors’ decisions. The second contribution is providing two validation checks on the managerial ability measure developed by Demerjian which is becoming more widely used.

    Citation:

    Krishnan, G.V. and C. Wang. 2015. The Relation between Managerial Ability and Audit Fees and Going Concern. Auditing: A Journal of Practice and Theory 34 (3): 139-160.

    Keywords:
    managerial ability, audit fees, engagement risk, and going concern
    Purpose of the Study:

    Extensive literature exists that examines the determinants of audit pricing and the propensity of auditors to issue going concern opinions; however, much of this literature focuses on firm-level determinants as opposed to if managerial attributes of the client are informative to auditors. This study examines the relation between managerial ability, defined as the ability to transform corporate resources to revenues, and audit fees and the likelihood of issuing a going concern opinion.

    Design/Method/ Approach:

    For the measurement of managerial ability, the managerial ability measure, a recently developed measure, was used. The audit fee sample consists of nearly 31,000 firm-year observations representing more than 5,000 unique firms for the period 2000 through 2011. For the going concern analysis, a sample of financially distressed firms consisting of 11,257 firm-year observations was used.

    Findings:
    • The authors find that their research strongly supports their hypothesis that managerial ability is negatively associated with audit fees after controlling for firm-level characteristics.
    • The authors’ findings are also consistent with the notion that greater managerial ability mitigates the auditor’s engagement risk.
    • The authors’ findings support the notion that when the incoming CEO/CFO is deemed to be more efficient than the outgoing CEO/CFO, audit fees are lower, consistent with lower engagement risk.
    • The authors find that the likelihood of issuing a going concern opinion is negatively related to firm size, cash flows, beta, stock return, and investments, and positively related to leverage, prior-year loss, distress, stock return volatility and audit report lag.
    • The authors’ findings support the hypothesis that after controlling for firm-level characteristics, managerial ability is negatively associated with the likelihood that an auditor will issue a going concern opinion.
    • The findings support the notion that the managerial ability is informative to auditors.
    Category:
    Accountants' Reporting
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Discussion of “Does the Identity of Engagement Partners M...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.03 Impact of New Accounting Pronouncements, 05.0 Audit Team Composition, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions, 15.0 International Matters, 15.01 Audit Partner Identification by Name in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Discussion of “Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions”.
    Practical Implications:

    This discussion emphasizes significant caution when interpreting the results of the study. Mainly, it is unclear if results of the study can generalize to the broader public company market in the US. Furthermore, if the results are misinterpreted (i.e., individual auditors are not systematically aggressive but, instead, high quality auditors are systematically assigned the riskiest clients) then regulation requiring audit partner identification could actually have overall negative effects on overall audit quality.

    Citation:

    Kinney, W.R. 2015. Discussion of “Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions”. Contemporary Accounting Research 32 (4):1479-1488.

    Keywords:
    auditor attributes, reporting style, auditor identification, audit quality, going concern opinion, Type I error, Type II error, credit risk, insolvency risks, statutory audits
    Purpose of the Study:

    The author reviews the paper's content, analyzes its predictive validity, and discusses its multiple implications. He provides constructive suggestions for improvements. Based on predictive validity analysis, the author concludes that engagement partner assignment strategy is an important and acknowledged omitted variable that affects the study's internal validity via both the independent variable (partner's prior performance measure) and the dependent variable (borrower's cost of debt capital). The omission also affects construct validities and, if audit firms are applying a plausible assignment strategy, then interpretation of the study's main results would be reversed. Finally, the lack of a standards intervention noted by the authors and the extreme size and other differences between audits of Swedish private companies and U.S. public companies impair external validity and generalization to the U.S. intervention.

    Design/Method/ Approach:

    This article is a discussion.

    Findings:

    The discussion emphasizes the following points:

    • KVZ (the reviewed paper’s authors Knechel, Vanstraelen and Zerni) main analyses are for statutory (not financial statement) audits of small, private, Swedish companies. Therefore, these results may have more limited generalizability. 
    • KVZ use publically available data for private companies without considering the significant amount of private information available to private lenders and audit firms.
    • KVZ acknowledge and cannot rule out a potential competing hypothesis whereby audit firms follow a “best partner to riskiest engagements” strategy. In this case, the highest quality partners may appear to have the most aggressive reporting strategy because that partner serves riskier clients with harder to predict bankruptcy risk. To confirm/disconfirm this competing hypothesis occurs, KVZ could ask audit firm management to describe their audit partner assignment strategies and rank a sample of partners accordingly. This information could be correlated with KVZ’s reporting style measures.    
    • Regulators, academics, and popular/business press articles may be similarly over-generalizing KVZ’s results. Furthermore, misinterpretation of results could have the ill-effects of high quality audit partners being assessed as low quality. This false characterization may lead high quality auditors to refuse to audit riskier clients where their skills are most needed. As such, any interpretations of KVZ’s results should proceed with much caution.
    Category:
    Accountants' Reporting, Audit Team Composition, International Matters, Standard Setting
    Sub-category:
    Audit Partner Identification by Name, Changes in Audit Standards, Diversity of Skill Sets (e.g. Tenure & Experience), Going Concern Decisions, Impact of New Accounting Pronouncements
  • Jennifer M Mueller-Phillips
    Does the Identity of Engagement Partners Matter? An Analysis...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.03 Impact of New Accounting Pronouncements, 05.0 Audit Team Composition, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions, 15.0 International Matters, 15.01 Audit Partner Identification by Name in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions.
    Practical Implications:

    Auditor aggressive/conservative reporting style may be a systematic audit partner attribute and non-randomly distributed across engagements. Particular market participants (in this case, lenders) appear to recognize and price these differences in reporting style. While the particular mechanism through which these different reporting styles occur is not possible to determine, the results suggest the importance of individual audit partners in influencing audit reporting decisions. Therefore, current regulations in both the US and EU to identify the individual partner’s identity could potentially offer valuable information to market participants.

    Citation:

    Knechel, W. R., A. Vanstaelen, and M. Zerni. 2015. Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions. Contemporary Accounting Research 32 (4):1443-1478.

    Keywords:
    auditor attributes, reporting style, auditor identification, audit quality, going concern opinion, Type I error, Type II error, credit risk, insolvency risks, statutory audits
    Purpose of the Study:

    Current debate exists as to whether requiring individual auditor identification would enhance audit quality and, if so, whether investors understand and respond to these differences. This study provides empirical evidence to support the assertions that:

    1. Reporting style (i.e. consistently conservative or aggressive reporting) is an individual partner attribute that systematically differs between partners.  
    2. Investors understand and respond to these differences when assessing a company’s risk.

    This study is especially relevant given both the EU’s decade old requirement to disclosure of audit engagement partner and the recent, similar PCAOB requirement that US audit partners do the same.

    Design/Method/ Approach:

    The authors use archival methods. They acquired panel data between 2001  2008 of the total clienteles of individual Big 4 audit partners of statutory audits for small, private companies in Sweden. This excludes non-Big 4 auditors and joint auditors.

    Findings:

    In general, the frequency of Type I and II reporting errors is correlated over time for an individual partner both (1) across time for the same client and (2) between clients. As such, aggressive or conservative accounting appears to be a systematic partner attribute. Regarding investors, they appear to understand that partner reporting style is systematic across time and between clients and penalize firms audited by partners with a history of aggressive reporting via higher interest rates, lower credit ratings, and higher credit/insolvency risk. These results are, generally, economically significant.

    More specific results include:  

    • Predictive ability of both accruals and cash flows on future OCFs are lower when prior reporting errors of either Type have previously occurred.
    • Prior aggressive reporting results in lower persistence of current accrual estimates.  
    • Type I (Type II) reporting errors are negatively (positively) associated with abnormal accruals.
    • Conservative accrual reporting is positively (negatively) associated with Type I (Type II) reporting errors in all settings. Aggressive accrual reporting is positively (negatively) associated with Type II (Type I) reporting errors in low-risk settings.  
    • Clients of partners with aggressive reporting style have higher implicit interest rates, lower credit ratings, higher assessed insolvency risk, and lower Tobin’s Q. Conservative reporting styles has no effect on these credit measures.  
    • Past partner reporting style differentially affects market reaction to a new Going Concern Opinion.
    • Past partner Type II reporting errors has an economically marginally-significant effect on insolvency risk.
    Category:
    Accountants' Reporting, Audit Team Composition, International Matters, Standard Setting
    Sub-category:
    Audit Partner Identification by Name, Changes in Audit Standards, Diversity of Skill Sets (e.g. Tenure & Experience), Going Concern Decisions, Going Concern Decisions, Impact of New Accounting Pronouncements
  • 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