«Audit Reporting for Going-Concern Uncertainty: A Research Synthesis Elizabeth Carson, Neil L. Fargher, Marshall A. Geiger, Clive S. Lennox, K. ...»
Auditing: A Journal of Practice & Theory American Accounting Association
Vol. 32, Supplement 1 DOI: 10.2308/ajpt-50324
Audit Reporting for Going-Concern
Uncertainty: A Research Synthesis
Elizabeth Carson, Neil L. Fargher, Marshall A. Geiger, Clive S. Lennox,
K. Raghunandan, and Marleen Willekens
SUMMARY: In 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.
Keywords: going-concern; audit reporting; bankruptcy.
We greatly appreciate the research assistance of Afsana Hassan, Christophe Van Linden, Ashna R. Prasad, Qingxin Ye, and Qiang Wei. We thank Bill Read for the helpful provision of data.
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Marshall A. Geiger and do not necessarily reﬂect the views of the Commission or of the authors’ colleagues upon the staff of the Commission.
To facilitate the development of auditing and other professional standards and to inform regulators of insights from the academic auditing literature, the Auditing Section of the American Accounting Association (AAA) decided to develop a series of literature syntheses for the Public Company Accounting Oversight Board (PCAOB). This paper (article) is authored by one of the research synthesis teams formed by the Auditing Section under this program. The views expressed in this paper are those of the authors and do not reﬂect an ofﬁcial position of the AAA or the Auditing Section. In addition, while discussions with the PCAOB staff helped us identify the issues that are most relevant to setting auditing and other professional standards, the author team was not selected or managed by the PCAOB, and the resulting paper expresses our views (the views of the authors), which may or may not correspond to views held by the PCAOB and its staff.
Editor’s note: Accepted by Jeffery R. Cohen.
play in warning about such problems. These issues have sparked a series of high-level inquiries into the role and effectiveness of independent auditing in the U.S. and internationally (e.g., PCAOB 2011;
European Commission 2010; House of Lords 2011; FRC 2011), with particular interest directed to the auditor’s assessment and reporting on a company’s ability to continue as a going-concern.
The purpose of this review is to synthesize and discuss prior academic literature pertinent to the auditor’s decision to issue an opinion modiﬁed for going-concern uncertainty (hereafter, GCO). We limit our review to some of the major ﬁndings from the auditing literature over the past four decades.
We develop a framework that structures our categorization of the main themes explored in the extant literature (Figure 1; see Carson et al.  for a more complete discussion of GCO research). Since early research found that auditors typically do not have difﬁculty identifying companies in ﬁnancial distress that may be candidates for a GCO (Kida 1980; Mutchler 1984), most research focuses on the GCO decision for samples of distressed clients where going-concern uncertainty is likely to be an issue.
Therefore, in our review of the literature we focus more speciﬁcally on the determinants of GCOs (in the second section); the accuracy of GCOs issued, or not issued, by auditors (in the third section); and the consequences of GCOs on clients and auditors (in the fourth section). Based on our synthesis, we also discuss research-method-related considerations pertaining to GCO studies (in the ﬁfth section) and propose avenues for future research (in the sixth section).
DETERMINANTS OF GCOsUnder SAS No. 59 (AICPA 1988), auditors have a responsibility to evaluate whether there is substantial doubt regarding an entity’s ability to continue as a going-concern for a reasonable period of time (not exceeding 12 months from the balance sheet date). Under U.S. Generally Accepted Accounting Principles (GAAP), the going-concern basis for presentation of ﬁnancial statements is assumed in the absence of information to the contrary. Accordingly, auditors’ evaluations are made based on knowledge obtained from audit procedures, and knowledge of conditions and events existing at or prior to the completion of ﬁeldwork that relates to the validity of the going-concern assumption and the use of the going-concern basis for preparing the ﬁnancial statements. Auditors are required to obtain information about management’s plans to mitigate any concerns and assess the likelihood of successful implementation of such plans. If the auditor still has substantial doubt about the entity’s ability to continue as a going-concern, the auditor should consider the adequacy
of management’s disclosures in the ﬁnancial statements and the auditor must modify his/her opinion to include an explanatory paragraph outlining the reasons for concern.1 Our framework commences with the auditor’s assessment of an underlying uncertainty regarding the going-concern assumption, and moves to the observable factors that explain an auditor’s decision to issue a GCO. As noted earlier, little extant research solely addresses the auditor’s identiﬁcation of companies experiencing ﬁnancial pressure such that they may violate the going-concern assumption. The vast majority of archival research to date has attempted to identify which characteristics (client, audit ﬁrm, etc.) are associated with auditors rendering a GCO to an audit client.
As a foundation for our subsequent discussion, we ﬁrst present data on the overall frequency of GCOs issued in the U.S. We then proceed to classify the archival literature on the determinants of GCOs into four broad categories: client factors, auditor factors, auditor-client relationship factors, and environmental factors.2 Overall GCO Rates We review the overall frequency of GCOs for the period using data from Audit Analytics.
Audit Analytics covers all SEC registrants including trust funds, pension funds, and other entities that are not publicly traded, but we are more interested in companies that are publicly traded. In addition, we require information on market capitalization in order to investigate how the GCO frequency varies by company size. We exclude any audit reports that are signed after a company ﬁles for bankruptcy (Chapter 7 or Chapter 11). The resulting sample comprises 88,359 company year observations over the 11-year period 2000 to 2010.
The results are reported in Table 1. The overall frequency of GCOs increases from 9.82 percent in 2000 to 13.74 percent in 2001 and 16.57 percent in 2002. Similarly, Geiger et al. (2005) and Sercu et al. (2006) ﬁnd that auditors are more likely to issue GCOs after December 2001. These ﬁndings are consistent with auditors reporting more conservatively following the events of 2001– 2002; i.e., the Enron scandal, the indictment of Andersen, and the passage of SOX. It is also consistent with a signiﬁcant increase in insurance- and other liability-related costs during the postSOX period (Rama and Read 2006). Since 2002, there has been only a marginal increase in the overall GCO frequency from 16.57 percent in 2002 to 17.01 percent in 2010.
Table 1 further indicates that it is generally the smaller companies that receive GCOs. The GCO frequency is 36.70 percent among companies whose market capitalizations are no greater than $75 million. In contrast, the GCO frequency is 3.66 percent for companies whose market capitalizations are between $75 million and $500 million. Among the very large companies (market capitalizations in excess of $500 million), the GCO frequency is just 0.33 percent. It is clear from Table 1 that the increase in the GCO frequency is driven by ﬁrms whose market capitalizations are less than $500 million. Among companies whose market capitalizations are no greater than $75 million, the GCO frequency more than doubles from 20.14 percent in 2000 to 42.08 percent in
2010. Likewise, among companies whose market capitalizations are between $75 million and $500 million, the GCO frequency more than triples from 1.25 percent in 2000 to 4.91 percent in 2010. In contrast, there is virtually no change in the GCO frequency among the companies whose market capitalizations are in excess of $500 million (0.33 percent in both 2000 and 2010).
If the auditor believes that adequate disclosure is not provided in the ﬁnancial statements and notes, then he/she is required to issue a qualiﬁed report due to a departure from GAAP.
While we focus on archival research, we do not wish to understate the considerable potential for further behavioral and qualitative research on auditor judgment and decision making with respect to GCOs.
GCOs and Bankruptcy Next, we examine the incidence of bankruptcy within our sample. An observation is coded as going ‘‘bankrupt’’ if the ﬁrm ﬁles for Chapter 7 or Chapter 11 within one year of the audit opinion signature date. This yields a sample of 396 bankrupt observations. We then examine whether the audit opinion issued immediately prior to the bankruptcy ﬁling contained a GCO. Table 2 ﬁnds that
60.10 percent of bankruptcy ﬁlings are preceded by opinions that are modiﬁed for going-concern uncertainties. This is similar to prior studies that examine the audit opinions issued to companies prior to bankruptcy. There are 87,963 surviving observations, i.e., where companies do not ﬁle for bankruptcy within one year of the audit opinion date. The proportion of surviving observations that receive GCOs is 15.71 percent. Mirroring the increase in the GCO frequency that was shown in Table 1, Table 2 ﬁnds that the proportion of surviving observations that receive GCOs increases from 9.77 percent in 2000 to 16.44 percent in 2002 and 16.83 percent in 2010. Finally, Table 2 shows that the vast majority of ﬁrms that receive GCOs do not ﬁle for bankruptcy within 12 months of the audit opinion date. In fact, 98.31 percent of ﬁrms survive for at least 12 months after they are issued a GCO.
Again, as shown in Table 2, the proportion of bankrupt ﬁrms that receive a prior GCO (GCO%) is 60.10 percent—i.e., of soon-to-be-bankrupt ﬁrms, 60.10 percent receive GCOs in their ﬁnal reports prior to bankruptcy. In contrast, the proportion of surviving ﬁrms that receive a prior GCO (GCO%) is just 15.71 percent. This is consistent with a self-fulﬁlling prophecy: a GCO is more likely to be issued to a company that will ﬁle for bankruptcy than to a company that will
Source: Audit Analytics.
An observation is coded as ‘‘bankrupt’’ if the ﬁrm ﬁles for Chapter 7 or Chapter 11 within one year of the audit opinion date. An observation is coded as ‘‘surviving’’ if the ﬁrm does not ﬁle for Chapter 7 or Chapter 11 within one year of the audit opinion date.
n ¼ number of observations; GCO% ¼ percentage of ﬁrm observations receiving a going-concern audit opinion; and Surviving% ¼ percentage of going-concern observations that do not ﬁle for Chapter 7 or Chapter 11 within one year of the audit opinion date.