The Effect of Going-Concern Opinion Reliability on Market Prices

Abstract

Large unexpected corporate failures associated with the global financial crisis heightened investors’ and regulators’ concerns about the diagnosticity of auditors’ going-concern opinions. Consistent with these concerns, extant research indicates that going-concern opinions are only moderately diagnostic at best, with only fifty to sixty percent of financially distressed firms receiving going-concern audit opinions prior to bankruptcy. Using an experimental market, we show that under conditions of moderate diagnosticity, investors discount the going-concern signal. Compared to a market with high diagnosticity, investors penalize the stock prices of non-bankrupt firms and fail to adequately discount the prices of bankrupt firms, even in instances when the going-concern signal accurately predicted the bankruptcy outcome. Interestingly, we find that a market with moderately diagnostic going-concern opinions provides no greater informational value than a market without going-concern opinions altogether. Specifically, we demonstrate that stock price behavior and, in turn, average investor earnings are no different in a market with moderate diagnosticity as compared to a market that lacks any going-concern signal. These findings have implications for regulators who are interested in improving the quality of going-concern opinions.