Going-concern Modified Audit Opinions Research Articles

The Effect of Tenure, Specialization, Conservatism, and Fees on the Relationship between Going-Concern Opinions and Client Bankruptcy

ABSTRACT This paper uses the relationship between a going-concern modified audit opinion and client bankruptcy as an audit quality indicator to investigate factors that could affect audit quality. The setting is important because, although stakeholders often view bankruptcies without a preceding going-concern opinion as evidence of impaired auditor independence, there could be various reasons behind them. Using a matched sample of bankrupt and nonbankrupt clients, this paper finds that the relationship is less positive when auditors are nonspecialists, allow more income-increasing discretionary accruals, or receive higher audit fees. These results suggest that auditors provide lower audit quality when they lack sufficient industry knowledge, are less conservative, or are more reliant on audit fees. Data Availability: Data are publicly available from the sources identified in the paper.

Auditors’ Propensity and Accuracy in Issuing Going-Concern Modified Audit Opinions for Charities

This paper identifies the factors which impact auditors’ propensity to issue going concern modified audit opinions (GCOs) and examines their accuracy in issuing such opinions for charities by comparing with two outcomes, cancellation of ABN status and the revoking of operating status on the ACNC database. We find that GCOs are more likely for charities which are smaller, in greater financial distress, received a prior year GCO, had smaller proportion of donation income and had economic dependence on subsequent funding. Big 4 auditors are less likely to issue GCOs, but they do not show significant differences in GCO reporting mis-classification.

Abnormal disclosure tone and going concern modified audit reports

The evaluation of going-concern uncertainties and the issuance of going-concern modified audit opinions (GCOs) continue to be of significant interest to the public and the accounting profession. We examine the association between the abnormal tone of disclosures in 10-K filings and GCOs using data from the years 2000 to 2014. We find that abnormal positive disclosure tone is associated with a higher likelihood of a GCO. We also find that the abnormal tone of disclosures is associated with lower type II and type I errors for GCOs (i.e., bankrupt companies without a prior GCO and GCOs without subsequent failure, respectively).

Are going‐concern issues disclosed in audit reports associated with subsequent bankruptcy? Evidence from the United States

The Public Company Accounting Oversight Board (PCAOB) has expressed interest in the following issues related to going‐concern modified audit opinions (GCOs): auditor's communication of factors that led to the GCO, the role of liquidity versus other factors in GCOs, and the subsequent failures of clients with GCOs. We use a sample of 2,921 first‐time GCOs spanning the years 1999 to 2015 in the United States and find that profitability factors are cited in 81% of GCOs while liquidity issues are cited in 56% of GCOs. Overall, 16.8% of the first‐time GCO clients entered bankruptcy within one year. After controlling for the probability of bankruptcy, client size, and auditor type, for clients of Big N auditors, the disclosure of profitability factors in the GCO is associated with a higher likelihood of subsequent bankruptcy; in contrast, for clients of non–Big N auditors, disclosures of liquidity and solvency problems are associated with a higher likelihood of subsequent bankruptcy. Our findings provide an empirical grounding for the debates surrounding GCOs and provide useful information for standard‐setters and financial statement users.

Auditor independence impairment: bonding between clients and individual engagement partners

ABSTRACT In this study, I investigate whether the economic bond between an individual audit engagement partner and a client threatens auditor independence (and thus audit quality). As the propensity of the auditor to issue going-concern modified audit opinions (GCOs) is lower when there is auditor independence impairment, I examine to which extent fee dependency leads to a lower propensity to issue GCOs. Using archival data from Belgian private companies, I empirically examine a sample of 18,638 companies for the period 2008–2010 to test for the effect of the auditor-client bond on the audit opinion. None of my results support common concerns that client importance undermines auditors’ GCO reporting decisions, neither at the firm level nor at the partner level. Specifically, I find no evidence for a negative association between the likelihood that an auditor issues a GCO and the economic importance of that client to the auditor (firm or partner). These results are supported by analyses on an additional sample of 5,934 companies for the period 2011–2013. Despite broad concerns among academics and regulators about auditor independence and economic bonding, this is one of the first studies to investigate this issue at the partner level and for private clients.

Federal Judge Ideology and the Going Concern Reporting Incentives of Big 4 and Non-Big 4 Auditors

We analyze how variation in federal level legal liability associated with judge ideology is associated with the likelihood of firms receiving going-concern modified audit opinions, separately for Big Four and non-Big Four clients. With auditors trading off between Type I and Type II reporting errors, the threshold value (of client bankruptcy probability) above which auditors issue going-concern reports is decreasing and convex in the level of federal litigation risk. Building on literature showing that federal judge ideology affects the likelihood and outcome of lawsuits, we find that Big Four and non-Big Four auditors converge in their going-concern reporting decisions as federal litigation risk increases and that this convergence is caused by the greater effect of judge ideology on non-Big Four than on Big Four auditors. The key results remain with firm-fixed effects and are not driven by the effects of judge ideology on auditor choice or bankruptcy probability.

Market Reaction to the Going-Concern Modified Audit Opinions of Public Companies After the IFRS Adoption

The objective of this paper is to analyze the market reaction to the auditors’ going-concern audit opinions after the IFRS adoption in Brazil. The event study methodology was applied for the analysis of three public non-financial companies in the first year in which they received a qualified opinion about uncertainties as to their capacity to continue operating. We observed that there was just one company with a market reaction for stock price and traded volume on the day the auditors’ report was released. The results of this study are relevant because they present new evidence in the Brazilian context, which may be added to the existing literature and can be used as practical examples to understand the complexity and importance of the theme.

Managerial Overconfidence And Going-Concern Modified Audit Opinion Decisions

We examine how auditors perceive managerial overconfidence during audit reporting by testing the relationship between managerial overconfidence and the likelihood of issuing a first-time going-concern modified audit opinion to financially distressed firms. After controlling for the factors affecting auditor’s going-concern modified audit opinion decision, we find that the likelihood of issuing a first-time going-concern modified audit opinion is positively associated with managerial overconfidence, suggesting that auditors adversely value overconfident management in financially distressed firms and thus tend to issue a first-time going-concern modified audit opinion to them. We also find that the positive association above is reinforced with capital market uncertainty.

Going-concern modified audit opinions for non-profit organizations

Non-profit organizations constitute an important share of the U.S. economy, and recent audit failures and GAO findings highlight the importance of auditor reporting decisions in this sector. In this study, we examine going-concern modified audit opinions for non-profit organizations. Using audit opinion data for 3,567 non-profits exhibiting some signs of financial stress, we find that non-profits are more likely to receive a goingconcern modified opinion if they are smaller, are in worse financial condition, expend less on program-related activities, and have more internal control related audit findings. Our analysis of the subsequent resolution of the going-concern uncertainties suggest that only 27 percent of the non-profits receiving an initial going-concern modified audit opinion filed for dissolution in the subsequent four fiscal years. Our findings fill a gap in an important area that has received little research attention, and provide a useful benchmark for non-profits and their auditors.

Audit Reporting for Going-Concern Uncertainty: A Research Synthesis

SUMMARYIn this synthesis we review research on going-concern modified audit opinions (GCOs) and develop a framework to categorize this research. We identify three major areas of research: (1) determinants of GCOs that include client factors, auditor factors, auditor-client relationships, and other environmental factors; (2) accuracy of GCOs; and (3) consequences arising from GCOs. We identify method-related considerations for researchers working in the area and identify future research opportunities.

The Relation between Going－Concern Modified Audit Opinion and Petition for Legal Reconstruction －In the Case of KOSDAQ Market－

The Relation between Going－Concern Modified Audit Opinion and Petition for Legal Reconstruction －In the Case of KOSDAQ Market－

The Auditor's Going-Concern Opinion as a Communication of Risk

SUMMARYIn this study, we examine the proposition that the auditor's going-concern modified opinion is a valuable risk communication to the equity market that results in a shift of the market's perception of financially distressed firms. Specifically, our analyses reveal that the market valuation is significantly altered from a focus on both the income statement and balance sheet to a balance sheet-only focus in the year a company receives a first-time going-concern modified opinion. These results hold even after controlling for several common measures of financial distress and when examining a larger control sample of distressed firms. We also document that the market devalues a company's inventory and places increased weight on cash, receivables, and long-term assets and liabilities as a result of the auditor's modification. This indicates that the going-concern modification provides incremental information specifically related to abandonment or adaptation risk. Our results provide evidence that the market interprets the going-concern modified audit opinion as an important communication of risk that results in a substantial shift in the structure of the market valuation for distressed firms.Data Availability: All data are available from public sources.JEL Classifications: M41.

Auditor Independence Impairment: Bonding between Clients and Individual Engagement Partners

In this study, I investigate whether the economic bond between an individual audit engagement partner and a client threatens auditor independence (and thus audit quality). As the propensity of the auditor to issue going-concern modified audit opinions (GCOs) is lower when there is auditor independence impairment, I examine to which extent fee dependency leads to a lower propensity to issue GCOs. Using archival data from Belgian private companies, I empirically examine a sample of 18,638 companies for the period 2008–2010 to test for the effect of the auditor-client bond on the audit opinion. None of my results support common concerns that client importance undermines auditors’ GCO reporting decisions, neither at the firm level nor at the partner level. Specifically, I find no evidence for a negative association between the likelihood that an auditor issues a GCO and the economic importance of that client to the auditor (firm or partner). These results are supported by analyses on an additional sample of 5,934 companies for the period 2011–2013. Despite broad concerns among academics and regulators about auditor independence and economic bonding, this is one of the first studies to investigate this issue at the partner level and for private clients.

Does Mandatory Audit Firm Rotation Enhance Auditor Independence? Evidence from Spain

SUMMARY: In this study, we document evidence on the impact of mandatory rotation of audit firms on auditor independence using Spanish archival data. Rotation of audit firms every nine years was mandatory in Spain from 1988–1995. Although the rule was never enforced, the Spanish context provides a unique setting to examine the effects that mandatory audit firm rotation has on auditor behavior. We examine audit reports for a sample of financially stressed companies from 1991–2000 to compare audit reporting behavior in a regime with rotation (mandatory rotation period: 1991–1994) and one without rotation (post-mandatory rotation period: 1995–2000). We test two competing hypotheses concerning the impact of mandatory rotation on the likelihood of auditors' issuing going-concern modified audit opinions. We find no evidence to suggest that a mandatory rotation requirement is associated with a higher likelihood of issuing going-concern opinions. Our results suggest that auditors' incentives to protect their reputation have a positive impact on the likelihood of issuing going-concern opinions, while auditors' incentives to retain existing clients did not impact on their decisions in both the mandatory rotation and post-mandatory rotation periods. Overall, our results provide empirical support for the arguments put forward by opponents of mandatory rotation.

Were Former Andersen Clients Treated More Leniently Than Other Clients? Evidence from Going-Concern Modified Audit Opinions

In the wake of the collapse of Enron and Andersen, several questions were raised about Enron's accounting and the behavior of its auditor. An important question is whether ex-Andersen's clients received more conservative treatment by their new auditors, either due to a greater perceived litigation risk because of their previous association with Andersen or because of a “correction” of alleged lax auditing by Andersen. We examine going-concern modified audit opinions for former clients of Arthur Andersen, and compare them with opinions issued for other newly acquired clients. We find that auditors were less likely to issue going-concern modified audit opinions to small clients who switched from Andersen than to their existing clients. However, this trend reverses with an increase in client size, with large former Andersen clients more likely to receive going-concern opinions. Our results are consistent with suggestions that increased litigation risk associated with the larger ex-Andersen clients led to increased conservatism by the new auditors. We conjecture that the reduced conservatism for the smaller ex-Andersen clients is likely due to high ex ante conservatism of the Big 4 in not accepting clients perceived to be risky.

The Going-Concern Market Underreaction Anomaly: A Behavioral Explanation

We explore the medium-term market reaction to going-concern modified audit opinions (bad news) and their withdrawal (good news) for a large sample of firms from 1994 to 2005. Results show asymmetric market response to these accounting system disclosures. The market underreacts to going-concern opinions, resulting in a subsequent downward drift of around -9% over the one-year period subsequent to the going-concern opinion, but fully anticipates their withdrawal. More importantly, to explore the source of this anomaly we test the overreaction hypothesis of the DHS model. We find strong support for the behavioral theory in our bad news as well as in good news case suggesting that market underreaction to going-concern opinions is a consequence of prior market overreaction resulting in incorrect classification of going-concern firms by investors into categories based on prior long-term performance. Further tests show that the post-GC drift phenomenon is concentrated in high past performers which are significantly larger in size, low in distress risk and have better stock prices relative to low past performers confirming our behavioral story. Additionally, this result reduces the likelihood of a pure liquidity based explanation for this anomaly. Analysis of stockholder trading activities reveals that institutions seem to reduce their holdings in such stocks on a timely basis in contrast to retail investors. Finally, we find evidence that the Sarbanes Oxley Act which improves the information environment has weakened the GC underreaction anomaly; a result consistent with behavioral models of mispricing. Our results are original, and present out-of-sample evidence in support of behavioral theories suggesting such biases influence decisions. However, regulatory changes can help improve market efficiency.

Anomalous Price Reaction and Differential Stockholder Response to Going-Concern Audit Opinions and Withdrawals

We explore the medium-term market reaction to going-concern modified audit opinions and their withdrawal for a large sample of firms from 1994 to 2002. Results show asymmetric market response to these accounting system disclosures. The market underreacts to going-concern opinions, resulting in a subsequent downward drift of around -16% over the one-year period subsequent to the going-concern opinion, but fully anticipates their withdrawal. This post-going-concern announcement drift is distinct from other established anomalies; however, it is limited to those going-concern cases with negative earnings surprise. Nonetheless, adjusting for transactions costs, the opportunity to earn profits by trading on this anomaly is limited and risky. Analysis of stockholder trading activities reveals that institutions reduce their holdings in such stocks on a timely basis in contrast to retail investors. Our results are original, and indicate that auditors are providing clear messages to financial statement users in the going-concern context but their information content is not being fully impounded by the market on a timely basis.

Recent Changes in the Association between Bankruptcies and Prior Audit Opinions

The intense legislative and media scrutiny after a series of high-profile corporate failures, coupled with the paradigm shift in the regulation of the auditing profession brought forth by the Sarbanes-Oxley Act, suggests that auditors' decisions would be more conservative in the period after December 2001. Based on analyses of 226 financially stressed companies that entered bankruptcy during the period from 2000 to 2003, we find that auditors are more likely to issue going-concern modified audit opinions in the period after December 2001. Since the post-December 2001 period coincides with recovery from a recession in the U.S., we also examine prior audit opinions for 93 companies entering bankruptcy in 1991 and 1992. We find that auditors were also more likely to issue prior going-concern modified audit opinions in 2002–03 than in the earlier recession recovery period. Following the technique used in Francis and Krishnan (2002), we document that the increase in going-concern modification rates for bankrupt companies after December 2001 is due to changes in auditor reporting decisions and not solely due to differences in client characteristics between the time periods studied.

Audit Fees, Nonaudit Fees, and Auditor Reporting on Stressed Companies

The SEC and legislators have expressed concerns that independence may be negatively impacted if auditors perform significant nonaudit services for their audit clients, and that providing lucrative nonaudit services to clients may make it more likely that auditors will “see things the client's way.” Such concerns are particularly salient in the context of issues that involve significant auditor judgment, as in the case of reporting decisions related to going-concern uncertainties for financially stressed clients.In this study we examine the association between the magnitude of audit and nonaudit fees and auditor report modification decisions for financially stressed manufacturing companies. In our analysis we control for financial stress, company size, reporting lag, default status, audit committee effectiveness, and management plans. The results indicate a significant positive association between the magnitude of audit fees and the likelihood of receiving a going-concern modified audit opinion, but we find no significant association between nonaudit fees and audit opinions. Additional analyses also find no significant relationship between the ratio of nonaudit service fees to audit fees and reporting decisions, and indicate that our results are robust across alternative model, variable, and sample specifications. We also control for the potential endogeneity of audit opinions, audit fees, and nonaudit fees, and find the same positive association of audit fees with opinions, but no association between nonaudit fees and audit opinions. Overall, we find no evidence of a significant adverse effect of nonaudit fees on auditor reporting judgments for our sample of distressed companies.