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Transcript of Carson Et Al. (WP, 2012)
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Electronic copy available at: http://ssrn.com/abstract=2000496
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Auditor Reporting on Going-Concern Uncertainty:
A Research Synthesis
Elizabeth Carson
University of New South Wales
Neil Fargher
Australian National University
Marshall Geiger
University of Richmond
Clive Lennox
Nanyang Technology University
K. Raghunandan
Florida International University
and
Marleen Willekens
Katholieke Universiteit Leuven
30 January 2012
Acknowledgements: We greatly appreciate the research assistance of Afsana Hassan, Christophe Van Linden, Ashna Prasad, Qingxin Ye, and Qiang Wei. We thank Bill Read for the helpful provision of data.
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Electronic copy available at: http://ssrn.com/abstract=2000496
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Executive Summary
In the following document we provide an extensive synthesis of the academic literature
broadly related to reporting by auditors with respect to the issue of going-concern. Our intent is
to provide information to the Public Company Accounting Oversight Board (PCAOB) that may
prove to be useful in their standard-setting efforts. Here we summarize our findings presented in
the document as follows:
1. What has been the trend in issuance of opinions modified for going-concern uncertainty
during the financial crisis?
While it is too early for published academic studies regarding the current financial crisis,
we have been able to identify descriptive trends in opinions modified for going-concern
uncertainty in the U.S. (section 3.2). A recent review of U.S. audit reports found that opinions
modified for going-concern uncertainty increased from a low of 14% of all companies for
financial years ending in 2003 to a peak of 21% for financial years ending in 2008 with a small
decline in 2009 to 19% (Cheffers et al. 2010). The trend in going-concern issuance in the U.S. is
shown in the table below:
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Table 1: U.S. Opinions Modified for Going-Concern Uncertainties 2002-2009 (Cheffers et al. 2010)
Fiscal year Total audit opinions Opinions modified for
going-concern uncertainty
Percentage
2002 17,191 2,817 16.39% 2003 17,766 2,552 14.36% 2004 16,794 2,554 15.21% 2005 16,784 2,709 16.14% 2006 16,462 2,864 17.40% 2007 16,601 3,300 19.87% 2008 15,848 3,328 21.00% 2009 15,395 2,994 19.45%
As would be expected, several of the causes frequently identified in opinions modified
for going-concern uncertainty were operating losses, working capital inadequacy, deficits in
retained earnings, short corporate operating history or increased threats from competitors
(Cheffers et al, 2010).
Recent international evidence also suggests that auditors have responded to the financial
crisis by a greater consideration of going-concern issues, as rates of opinions modified for going-
concern uncertainty increased during 2008 in the U.K., Australia, and France (Carson et al.
2011).
2. What is the relationship between a company's failure and whether the prior audit opinion
was modified for reasons of going-concern uncertainty?
We note that it is important to emphasize that the indicator of business failure used in
most studies is a bankruptcy filing. This may be overly restrictive to the extent that failing
companies are sometimes re-organized or taken over outside of formal bankruptcy proceedings.
However, the problem faced by researchers (and other interested users) is that concepts of
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business failure or going-concern are not precisely defined in the accounting or auditing
standards. Accordingly, bankruptcy filing is typically selected as the indicator of a company that
is no longer a going-concern.
In general, the research investigating samples of bankrupt companies (section 3.3) finds
that approximately half of companies filing for bankruptcy in the U.S. had not received a prior
opinion modified for going-concern uncertainty. This rate increased after 1995 (Reform Act) and
1998 (Uniform Standards Act) and declined after the Enron-SOX period but only temporarily.
We discuss recent analysis by Feldmann and Read (2010 and updated for this report) who
find that the rate of bankruptcies without a prior opinion modified for going-concern uncertainty
does not appear to have decreased markedly during the financial crisis period. The table below
summarizes their findings:
Table 3: Bankrupt Companies with Prior Year Opinion Modified for Going-
Concern Uncertainty (Feldmann and Read, 2010)
Year of Opinion Number of
Bankruptcies
With Opinion Modified for Going-
Concern Uncertainty in Year Prior to
Bankruptcy
2000-2001 257 53% 2002-2003 175 72% 2004-2005 70 59% 2006-2007 63 51% 2008-2009 63 52%
Less research is available on outcomes from first-time issuance of opinions modified for
going-concern uncertainty (section 3.4). In general, the research has found that in the U.S. 80-
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90% of listed companies that receive an opinion modified for going-concern uncertainty do not
fail in the subsequent year. This rate is quite consistent across time.
We note, however, that it is quite possible that several research design choices are overly
restrictive. For example, relaxing the Compustat availability restriction may yield different
results since many smaller companies would likely be included in the analysis. Further, a wider
definition of business failure will likely change how we measure the accuracy of auditors
opinions modified for going-concern uncertainty. For example, Nogler (1995) reports that of the
157 firms in his study that received going-concern reports (a) 33.1% filed for bankruptcy, and (b)
an additional 31.8% were acquired or merged with another firm within the subsequent five years.
This clearly illustrates that the relationship between business failure and prior opinions modified
for going-concern uncertainty is largely contingent on how one defines business failure and the
time horizon examined.
3. What is the relationship between opinions modified for going-concern uncertainty and
predictions of company failure (e.g., bankruptcy, reorganization, liquidation)?
Before assessing the predictive ability of opinions modified for going-concern
uncertainty we take a step back in the process and consider the nature of publicly available
information associated with these modified opinions which has been a significant area of
academic research. Our report covers the large body of research undertaken on the use of
financial and non-financial measures to predict opinions modified for going-concern uncertainty
for financially distressed firms (section 4).
This literature has also expanded into the area of auditor incentives, that is, whether the
opinion issued is appropriate given the characteristics of the client. Section 5 summarizes the
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research that has considered such factors as: economic dependence on large clients, audit fees,
auditor-client tenure, auditors compensation arrangements, auditor size and other possible
factors. The initial conclusion is that most of the results are mixed. That is, while some studies
argue that these factors impact auditors reporting decisions, there is no consistent, pervasive
evidence of these factors being strongly influential in reporting decisions.
Evidence considering whether investors view the announcement of an opinion modified
for going-concern uncertainty as predictive of company failure is reviewed in section 6.2. The
evidence suggests that investors react to unexpected opinions modified for going-concern
uncertainty or the issuance of an opinion modified for going-concern uncertainty when the
information is inconsistent with prior beliefs about the companys future viability. Recent
research has considered how investors change their valuation of financial information for
companies with an opinion modified for going-concern uncertainty and also whether investors
fully incorporate the risk of failure associated with an opinion modified for going-concern
uncertainty.
4. Can an opinion modified for going-concern uncertainty be used as an early warning
indicator of financial distress, bankruptcy, reorganization, or forced liquidation?
Prior studies consistently find a positive and statistically significant relationship between
opinions modified for going-concern uncertainty and the incidence of future bankruptcy. In other
words ignoring all other sources of information on a companys financial condition an
opinion modified for going-concern uncertainty can be used to predict the companys failure.
However, it is less clear whether the opinion modified for going-concern uncertainty is
incrementally informative for predicting a companys failure. In other words, when one takes
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into account all other publicly available sources of information on a companys financial
condition, there is mixed evidence on whether the opinion modified for going-concern
uncertainty conveys useful incremental information for predicting the companys failure.
Finally, there is evidence in the U.S. of a self-fulfilling prophecy effect whereby the
issuance of an opinion modified for going-concern uncertainty is associated with an increase in
the probability of a company filing for bankruptcy. Studies using samples from outside the U.S.
however yield mixed results regarding this effect.
We have briefly considered the academic literature in finance, management, and strategy
on prediction of distress, bankruptcy, reorganization and other changes in corporate structure
(sections 4.2 and 4.3). We find that much of the recent research in finance has focused on
inferring the probability of default from market data. As might be expected, in months prior to
bankruptcy, firms typically made losses, had high debt relative to assets, had experienced
negative stock returns and high volatility. While the technology for predicting bankruptcy from
market data is important, the reliance on observable market prices reduces the usefulness of this
research for auditors. Section 4.4 summarizes recent research looking at business strategy and
company turnaround. This is of the nature of an emerging direction for research, for example,
assessing turnaround strategies and their likelihood of success.
5. Basis for the going-concern assumption
Currently, the financial statements are prepared by management on a going-concern basis
unless a company is in liquidation or liquidation is imminent (i.e., it is virtually unavoidable).
Auditors are then required to modify their audit opinions if they determine that they have
substantial doubt about the companys ability to continue in existence through the ensuing fiscal
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year. In our view, it would be worthwhile for standard setters and regulators to consider whether
this mode of financial reporting and audit reporting is optimal. In the case of financially
distressed companies, we question why the financial statements are prepared under an
assumption that has a high probability of being incorrect. We suggest that standard setters
consider an alternative framework for financial reporting when companies face high going-
concern uncertainty as follows:
Financial statements are prepared on the going-concern basis when management and the auditor assess that there is a very high probability of a firm being able to continue as a
going-concern (i.e., continue operating in the normal course of business) for the
foreseeable future.
Financial statements are prepared on the liquidation basis when management and the auditor assess that there is a very low probability of a firm being able to continue as a
going-concern for the foreseeable future.
When management and the auditor assess that there is significant uncertainty regarding the companys going-concern status (i.e., the probability of continuing as a going-concern
is between very high and very low), then the company prepares two sets of financial
statements (one on the going-concern basis and another set on the liquidation basis) with
the auditor opining on both sets of financial statements.
Only the third situation is different from what we have currently because it recognizes
that there is significant uncertainty underlying the proper basis for preparing the financial
statements.
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6. The economic purpose of the auditors opinion modified for going-concern uncertainty
In our opinion, standard setters should consider whether the standards relating to
auditors responsibility regarding reporting on going-concern uncertainties can be made clearer
in order to both increase auditor compliance with the standards as well as to provide users of the
financial statements a better understand the purpose of an audit opinion modified for going-
concern uncertainty. In particular, is the opinion modified for going-concern uncertainty meant
only to serve as a warning about the possible impact of business failure on the fair presentation
of the financial statements? Or, is the going-concern opinion only meant to serve as a warning
about the likelihood of business failure? Or is it intended to do both?
7. Further vagueness in reporting standards
We note that the prevailing standards on auditors responsibility regarding going-concern
uncertainty are also vague in at least three other respects. First, there is no clear definition of
what constitutes a going concern or a business failure. In the absence of a precise definition,
many researchers use the bankruptcy filing as a proxy for an entity that is no longer a going-
concern, or for a business failure. However, this could be overly narrow if standard setters have
in mind a broader definition of business failure than just bankruptcy. If bankruptcy is the wrong
way to measure going-concern status or business failure, then the documented performance of
auditors in their going-concern reporting decisions by researchers may be inaccurate. In the
absence of a precise and measurable definition of going concern or business failure it is
virtually impossible for researchers, regulators and investors to gauge whether auditors reports
serve their intended purpose.
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Second, auditing standards require an auditor to issue an opinion modified for going-
concern uncertainty when there is substantial doubt about the companys ability to continue as
a going-concern. However, the phrase substantial doubt does not have a clear meaning. Again,
it is difficult to determine auditor compliance in the absence of a clear definition for the phrase
substantial doubt. Moreover, there is evidence of significant differences between auditors and
other stakeholders interpretations of what is meant by the phrase substantial doubt (Ponemon
and Raghunandan 1994). These differences are likely to exacerbate the gap between what
financial statement users and regulators expect in terms of auditor reporting on going-concern
related uncertainties and what auditors actually provide.
Finally, there may be a need for consistency with respect to the time horizon that auditors
are required to consider when assessing the ability of an entity to continue as a going-concern.
U.S. auditing standards (SAS No. 59) state that the horizon is for a reasonable period of time,
not to exceed one year beyond the date of the financial statements being audited. In contrast,
International auditing standards (ISA 570) require the auditor to consider a period of at least - but
not limited to - 12 months from the balance sheet. We believe it is unlikely that there is a strong
economic rationale for the difference in these reporting standards. In addition, U.S. auditors are
faced with the 15 month problem in that they generally issue their report on the financial
statements three months after year end. This raises the pragmatic issue of whether they are held
to the date of next years financial statements or to the date they release their next audit opinion
on the financial statements of the distressed company. Improved standards with a clear definition
of the horizon for assessing the clients ability to remain a going-concern would likely improve
compliance and also allow for a more accurate assessment of auditor performance in this area.
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8. Allow flexible going-concern modification wording
The PCAOB could consider allowing more flexibility in the wording of reports modified
for going-concern uncertainty. Research on companies receiving SAS No. 59 opinions modified
for going-concern uncertainty prior to the mandated use of the terms going concern and
substantial doubt indicate that companies receiving modified reports not using the now
required phrases exhibited less financial stress and were less likely to file for bankruptcy than
those receiving modified reports containing the terms going concern and substantial doubt.
Allowing more report wording flexibility would be consistent with the International Auditing
and Assurance Standards Board (IAASB) position with respect to audit reporting. While ISA 700
requires auditors to express a written opinion on the financial statements, and prescribes the
overall structure, headings and the minimum content required under each heading, it does not
mandate the precise wording to be used. Further, the PCAOB could revisit the issue of allowing
an explanatory paragraph with contingent or conditional wording for reports modified for going-
concern uncertainty.
Increased flexibility with respect to the wording of opinions modified for going-concern
uncertainty offers auditors the opportunity to more clearly explain their assessment of the current
circumstances regarding the audited entity, and may lead to more nuanced auditor reports and
better communication of differences in auditor assessments of going-concern. This
recommendation should be considered in conjunction with the PCAOBs other concurrent efforts
with respect to improving communications in the auditors report.
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CONTENTS 1. INTRODUCTION .................................................................................................................................. 142. BACKGROUND .................................................................................................................................... 18
2.1 The going-concern assumption .................................................................................................... 182.2 Development of going-concern reporting standards in the U.S. .................................................. 222.3 Substantial Doubt ...................................................................................................................... 262.4 The international experience ........................................................................................................ 302.5 Summary ...................................................................................................................................... 33
3. GOING-CONCERN REPORTING TRENDS ....................................................................................... 343.1 Introduction .................................................................................................................................. 343.2 Changes over time in the issuance of going-concern modified opinions ..................................... 363.3 Changes over time in the proportion of firms entering bankruptcy without a prior going-concern modified opinion ................................................................................................................................ 413.4 Changes over time in the proportion of firms with an opinion modified for going-concern uncertainty that do not subsequently fail ............................................................................................ 443.5 Variations in going-concern reporting misclassification across auditors .................................. 463.6 Effect of auditor tenure and non-audit fees on audit reporting misclassification ......................... 473.7 Self-fulfilling prophecy phenomenon ........................................................................................ 493.8 Summary ...................................................................................................................................... 51
4. CLIENT FACTORS AFFECTING THE OPINION DECISION ........................................................... 524.1 Introduction .................................................................................................................................. 524.2 Traditional bankruptcy prediction models ................................................................................... 524.3 Measures of the clients financial condition ................................................................................. 544.4 Business strategy and company turnaround ................................................................................. 614.5 Empirical issues............................................................................................................................ 644.6 Summary ...................................................................................................................................... 68
5. AUDITOR INDEPENDENCE, OBJECTIVITY AND AUDIT QUALITY .......................................... 695.1 Introduction .................................................................................................................................. 695.2 Economic dependence on a large or important client .................................................................. 705.3 Audit and non-audit fees .............................................................................................................. 725.4 Auditor switching and opinion shopping ..................................................................................... 745.5 Auditor-client tenure .................................................................................................................... 765.6 Personal relationships between auditors and clients .................................................................... 775.7 Auditors compensation arrangements ......................................................................................... 785.8 Litigation ...................................................................................................................................... 785.9 External regulation ....................................................................................................................... 805.10 Auditor size ................................................................................................................................ 805.11 Industry specialization ................................................................................................................ 815.12 Audit committees ....................................................................................................................... 825.13 Market structure and competition ............................................................................................... 825.14 Audit report lag .......................................................................................................................... 835.15 Summary .................................................................................................................................... 84
6. OTHER AREAS OF GOING-CONCERN RESEARCH ....................................................................... 856.1. Going-concern opinions for financial institutions ....................................................................... 856.2 The stock market reaction to the issuance of a going-concern opinion ....................................... 86
7. CONCLUSIONS ..................................................................................................................................... 907.1 Major findings of prior research ................................................................................................... 907.2 Specific regulatory and standard-setting issues ............................................................................ 92
REFERENCES ......................................................................................................................................... 101
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LIST OF TABLES Table 1: U.S. Opinions Modified for Going-Concern Uncertainties 2002-2009 (Cheffers et al. 2010) ..... 38Table 2: Going-Concern Modification Rates for Non-Financial Loss-Making Firms (Carson et al. 2011)40Table 3: Bankrupt Companies with Prior Year Opinion Modified for Going-Concern Uncertainty (Feldmann and Read, 2010). ....................................................................................................................... 43
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1. INTRODUCTION
The decision as to what type of audit report to issue to a client requires professional
judgment by the auditor. Nowhere is this more clearly illustrated than in the auditors decision to
issue an opinion modified for going-concern uncertainty to a financially distressed client. Issuing
an opinion modified for going-concern uncertainty can be costly for the client as it can restrict
access to funding sources, adversely impact the companys stock market valuation, and can even
hasten the companys ultimate failure. Therefore, not surprisingly, clients typically do not like to
receive any report other than a standard, unmodified audit report (Kida 1980; Mutchler 1984).
Issuing an opinion modified for going-concern uncertainty can also be costly for the auditor
because a disgruntled client that receives what is perceived to be an unwarranted going-concern
modification is much more likely to switch to a different auditor resulting in a loss of revenues
from both auditing and non-audit services (Geiger et al. 1998; Carcello and Neal 2003; Lennox
2000). On the other hand, shareholders, lenders, creditors, regulators and other users of the
financial statements rely on the auditor to give timely warning of impending corporate failure.
When auditors neglect to give such a warning and companies subsequently fail, regulators and
the business press react by expressing serious concerns about the quality, objectivity, and
independence of public auditors (U.S. House of Representatives 1985, 1990; Carcello and
Palmrose 1994; Weil 2001; Geiger and Raghunandan 2002; House of Lords Select Committee
on Economic Affairs 2011).
The current global financial crisis has resulted in a significant increase in company
failures and has generated renewed interest in auditor reporting on financially troubled clients.
Issues of immediate concern relate to the exceptional risks faced by companies at the height of
the liquidity and credit problems during 2007 and 2008 and the role that auditors had to play in
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warning about such problems. These issues have sparked a series of high-level inquiries into the
role and effectiveness of audit in the U.S. and internationally (e.g., PCAOB 2011a; European
Commission 2010; House of Lords Select Committee on Economic Affairs 2011; Sharman
Inquiry 2011) with particular interest directed to the auditors ability to assess and report on a
companys ability to continue as a going-concern.
The purpose of this review is to synthesize and discuss prior academic literature pertinent
to the auditors decision to issue an opinion modified for going-concern uncertainty in an attempt
to assist the PCAOB in establishing current auditing standards for public companies. While we
also attempt to incorporate research related to the current financial crisis, it is important to
recognize that there is typically a lag of several years between important economic events and
rigorous research on those events being conducted and then published in peer-reviewed journals.
Accordingly, at the time of writing, there are relatively few studies that specifically examine
audit reporting in the period 2007-2008 and even fewer studies have been subject to critical peer
review. Nevertheless, we believe that studies conducted on events prior to 2007 can shed light on
the auditors current decision to issue an opinion modified for going-concern uncertainty to a
distressed company and that such research is likely to be relevant to current policy discussions.
We initially provide some background and context to the auditors decision to issue an opinion
modified for going-concern uncertainty. We review the development of the professional
standards relating to going-concern reporting in the U.S. and internationally. In considering the
standards, we place particular emphasis on variations in interpretation of the phrase substantial
doubt.
We then consider recent trends regarding the issuance of opinions modified for going-
concern uncertainty. It is perhaps not surprising to find that the likelihood of opinions modified
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for going-concern uncertainty varies with regulatory and legal regimes, consistent with auditors
responding to the costs and benefits of issuing such an opinion. When the legal or regulatory
changes reduce the threat to auditors (such as the period from 1995 to 2000), the likelihood of an
opinion modified for going-concern uncertainty is lower; conversely, when there are changes
that put the whole profession under the spotlight (such as the post-Enron period), the likelihood
of issuing an opinion modified for going-concern uncertainty is higher.
Next, we provide an overview of the extensive research literature that examines the
information cues that auditors rely upon when assessing their clients financial condition. As part
of the going-concern assessment, auditors evaluate a voluminous amount of public and private
information pertaining to their client. While researchers and others are not privy to private client
information, we review past research showing that auditors reporting decisions appear to be
systematically related to publicly available information concerning the clients financial
condition. In addition to financial factors (e.g. profitability, leverage, liquidity, company size,
debt defaults and prior going-concern reports), various non-financial factors are associated with
the incidence of a going-concern opinion (e.g. market variables). We also briefly review major
findings in the strategy literature on company turnarounds as auditors are expected to assess the
presence of mitigating factors in a potential going-concern problem.
In a subsequent section we provide an overview of factors that have been alleged to affect
auditor competence, effort, objectivity, and independence, and thus affect the auditors decision
to issue an opinion modified for going-concern uncertainty. The following factors have been
examined in prior research: 1) economic dependence on the client, 2) audit fees and non-audit
services, 3) auditor switching and opinion shopping, 4) auditor-client tenure, 5) personal
relationships between auditors and clients, 6) auditors compensation arrangements, 7) litigation,
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8) external regulation, 9) auditor size, 10) industry specialization, 11) audit committees, 12)
market structure and competition, and 13) audit report lag. We find that in many cases, the
results from prior studies have been mixed.
Next, we briefly consider research on market reactions to an opinion modified for going-
concern uncertainty and the information content of such opinions. Auditors have access to a
richer set of information than what is available in the public domain upon which to make their
judgment about an entitys ability to continue as a going-concern. To the extent that an opinion
modified for going-concern uncertainty reflects information not available to investors about the
companys financial condition, it is expected that the issuance of an opinion modified for going-
concern uncertainty would have information content to market participants.
We conclude our paper with an overview of the main findings in the literature, and a
discussion of issues identified as being relevant to standard-setters addressing auditor
responsibility for assessing going-concern.
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2. BACKGROUND
The audit report plays a critical role in warning market participants of a firms ability to
continue as a going-concern (DeFond et al. 2002; Geiger et al. 2006).1 In this section we discuss
the development of the professional standards relating to opinions modified for going-concern
uncertainty in the U.S. and internationally.
2.1 The going-concern assumption
Companies are required to prepare financial statements on a going-concern basis unless
(a) a plan of liquidation has been approved by the entitys owners or (b) the plan to liquidate is
being imposed by other forces and it is very unlikely that the entity will remain a going-concern
in the future.2 In these two exceptional circumstances, the financial statements are prepared on a
liquidation basis rather than the going-concern basis.
Discussion regarding the preparation of financial statements on the basis of going-
concern or on a liquidation basis is briefly mentioned in the Financial Accounting Standards
Boards (FASB) Statement of Financial Accounting Concepts (SFAC) No. 1. Footnote number
ten in that document states that:
Investors and creditors ordinarily invest in or lend to enterprises that they expect to continue in operation an expectation that is familiar to accountants as the going
1 An entity has the primary responsibility for assessing its ability to continue as a going-concern (FASB 2010). The U.S. guidance for considering an entitys ability to continue as a going-concern is located in AICPA Statement on Auditing Standards No. 1, Codification of Auditing Standards and Procedures, Section 341, "The Auditors Consideration of an Entitys Ability to Continue as a Going Concern," and states that the auditor has a responsibility to evaluate whether there is substantial doubt about the entitys ability to continue as a going-concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited. 2 For international financial reporting, International Accounting Standards (IAS) No. 1 requires preparers of the financial statements to assess the ability of their enterprise to continue as a going-concern, and if there is significant doubt about their ability to continue as a going-concern to report that doubt in the financial statements. However, the financial statements can still be prepared using a going-concern basis in the presence of significant doubt, but need to be prepared on a non-going-concern basis if management intends to liquidate or if management has no other alternative but liquidation.
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concern assumption. Information about the past is usually less useful in assessing prospects for an enterprises future if the enterprise is in liquidation or is expected to enter liquidation. Then, emphasis shifts from performance to liquidation of the enterprises resources and obligations. The objectives of financial reporting do not necessarily change if an enterprise shifts from expected operation to expected liquidation, but the information that is relevant to those objectives, including measures of elements of financial statements, may change. (FASB 1978, p. 19).
However, while the going-concern assumption has been described as one of the most
important concepts in accounting (Sterling 1968), SFAC No. 1, nor other professional guidance
elaborates on when the going-concern assumption is no longer valid as a basis for financial
reporting. Similarly, there has been relatively little discussion or justification in the academic
literature for the going-concern assumption, or when it is no longer valid as a basis for financial
reporting. Paton and Littleton (1940) have asserted that the possibility of an abrupt cessation of
activity cannot afford a foundation in accounting. However, while this assertion is generally
satisfactory for the vast majority of reporting entities at any given time, it conflicts with the fact
that financial statements should be prepared on a liquidation basis when companies are being
liquidated (or they are soon to be liquidated). Contrary to Paton and Littleton (1940), Sterling
(1968) argues that the going-concern assumption is unnecessary as a principle in accounting as
some entities operate for a finite period rather than on an indefinite continuing basis.
Consistent with SFAC No. 1, Sterling (1968) argues that the going-concern basis is
reasonable for a company that is expected to continue for the indefinite future, whereas a
liquidation basis is applicable for firms that are likely to discontinue their operations in the near
future (e.g., companies with recurring losses). This is somewhat different from what we observe
in the current U.S. reporting environment where companies with recurring losses have their
financial statements prepared on a going-concern basis rather than the liquidation basis. And,
once the financial statements are prepared on a going-concern basis, the companys auditor is
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then required to modify their audit opinion to indicate that there is substantial doubt about the
ability of the company to continue as a going-concern through the next fiscal year. The obvious
(and unresolved) question, then, is why are the financial statements of a financially troubled
company prepared on a basis that is likely to be uninformative in the event of bankruptcy?
An alternative scenario would be for distressed companies to prepare their financial
statements on a liquidation basis in addition to the standard going-concern basis. Presumably,
two sets of financial statements would inform investors and management about the relative
benefits of selling off the companys assets versus allowing the company to continue operating
as a going-concern. As noted by Sterling (1968, 484): There are other [valuation] models that
also could serve. At best the going-concern is a choice from among alternative models.
Likewise Fremgen (1968) argues that more attention needs to be given to whether the going-
concern basis or the liquidation basis is the more appropriate assumption for a given company. A
memorandum prepared by Arthur Andersen in 1960 rejects the presumption that the financial
statements should generally be prepared on a going-concern basis (Arthur Andersen 1960).
Arthur Andersen argued that the going-concern assumption is not a proper accounting axiom
and, worse still, it was alleged that financially distressed companies are apt to abuse the going-
concern assumption by downplaying the risk that their assets will be subject to a forced sale.3
The preparation of two sets of financial statements for distressed firms (one on the going-
concern basis, the other on a liquidation basis) would have another advantage. It is sometimes
argued that a warning about the companys future can itself trigger the companys liquidation, a
3 Chambers (1966) highlights the important distinction between a forced liquidation and the realizable values of assets that are sold in the normal course of business. In a forced liquidation, the initiative rests with the companys creditors and assets are sold under duress at prices that are often disadvantageous to the enterprise as a whole. When assets are sold in the normal course of business, the initiative rests with the shareholders (or their representatives, management) and assets are sold at relatively favourable prices.
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phenomenon sometimes known as the self-fulfilling prophecy. The argument is that preparing
the accounts on a liquidation basis may lead investors to withdraw funding, thereby precipitating
the companys failure. In other words, the company is more likely to be liquidated if the accounts
are prepared on a liquidation basis whereas the company is more likely to survive if the accounts
are prepared on a going-concern basis. This causes a logical circularity problem because then the
companys expected future state (liquidation or survival) cannot be used to determine the
appropriate current basis for preparing the accounts. This problem is avoided if two sets of
accounts are prepared using both the going-concern basis and the liquidation basis.
Another problem is that the going-concern assumption is itself loosely defined. As noted
in SFAC No. 1, as well as SAS Nos. 2 and 34, and the academic literature, it is generally taken to
mean that the company will continue in operation for the foreseeable future and the company
will be able to utilize and realize assets, and discharge liabilities in the normal course of
operations. However, this definition raises the problem of trying to determine whether operations
are normal or abnormal. When assets are being liquidated during a formal bankruptcy
process, most people would perceive the situation to be abnormal and thus the going-concern
basis not to be appropriate. But the situation is less clear in the situation where a financially
distressed company intends to sell some or all of its assets outside of bankruptcy in order to meet
its debt and payment obligations. Should such a sale be considered as part of normal operations
or should it be viewed as abnormal? When answering this question, should it make a difference
whether the assets form a core part of the companys operations, or the disposed assets are
merely part of some ancillary operations? If this does make a difference, how can the company
and its auditor decide whether the assets are a core part of the companys operations?
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In short, the universal suitability of the going-concern assumption for preparing the
financial statements is unclear, particularly in the context of companies that are financially
distressed. Moreover, the definition of going-concern is somewhat vague and open to
alternative interpretations. This theme of definitional vagueness is continued in the next section
that reviews the historical development of going-concern auditing standards.
2.2 Development of going-concern reporting standards in the U.S.
External auditor reporting on company financial statements has a long history. In the U.S.
the debate regarding the development of a standardized report format and wording for the
auditors opinion has been with us for well over a century (Carmichael and Winters 1982). In the
absence of authoritative accounting or auditing standards, auditors often wrote free-form
narrative certificate reports that were different for every engagement (Geiger 1993). It was not
until 1934 that the profession adopted required rather than suggested wording for the audit
report, and even then it was initially only required for audits of companies traded on the NYSE
(Carmichael and Winters 1982).
The first time that audit reporting on financially distressed companies was addressed by
U.S. standard-setters was in 1962 by the Securities and Exchange Commission (SEC) in
Accounting Series Release (ASR) No. 90, followed quickly in 1963 by Statement on Auditing
Procedure No. 33 from the American Institute of Certified Public Accountants (AICPA). Both of
these pronouncements required auditors to evaluate the adequacy of the reporting companys
disclosure of their financial difficulties, as well as the recoverability and classification of assets
and the amounts and classification of liabilities (Asare 1990). If the auditor believed that the
disclosure was inadequate, then a qualified opinion (due to a departure from GAAP) was
required. If there was still uncertainty with respect to the valuation of assets and liabilities at the
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balance sheet date, they were to qualify their opinion subject to the resolution of the
uncertainties. Accordingly, these pronouncements mark the first instance that U.S. professional
standards required auditors to issue qualified reports on their financially distressed clients, but
only if disclosure was inadequate or uncertainties precluded reasonable determination of the
amounts and classifications of recorded assets and liabilities.
SAS No. 2, issued by the AICPA in 1974, addressed the auditors general reporting
responsibility. SAS No. 2 provided the first reference to specific financial statement
characteristics or circumstances (e.g., recurring operating losses, an inability to raise additional
funds sufficient to sustain operations, etc.) that should be considered by auditors in their going-
concern assessment. SAS No. 2 continued to advise auditors that where material uncertainties
exist they should consider qualifying the opinion subject to resolution of the uncertainties, or
disclaim their opinion. It is also important to note that SAS No. 2 explicitly mentions that
auditors are not required to make determinations regarding the outcome of future events where
management is unable to do so.4
After several attempts to modify the standards on audit reporting, SAS No. 34 was issued
in 1981. This standard more specifically addressed procedures to be followed when the auditor
questions the clients ability to continue as a going-concern. SAS No. 34 was the first to discuss
the examination of both contrary and mitigating evidence with respect to the going-concern
assumption. However, the auditors assessment of going-concern risk was still framed in the
context of when information comes to his attention that raises a question about an entity's
ability to continue in existence (SAS No. 34, para. 1) and stopped short of requiring auditors to
make assessments of the clients continued viability as part of their audit responsibility. This 4 Specifically SAS No. 2 (para. 8) states that: The auditor's function in forming an opinion on financial statements does not include estimating the outcome of future events if management is unable to do so.
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position was taken because, in the absence of information to the contrary, an entity's continuation
is assumed under U.S. GAAP and it was the prevailing opinion that auditors did not need to
specifically test this assumption.
As discussed in SAS No. 34, the auditors decision process for reporting on going-
concern uncertainties was a 2-step process. Paragraph 11 in SAS No. 34 indicates that:
the auditor may conclude that a substantial doubt remains about the entity's ability to continue in existence. In such a case, he should consider the recoverability and classification of recorded asset amounts, and the amounts and classification of liabilities, in light of that doubt. Identifying the point at which uncertainties about recoverability, classifications, and amounts require the auditor to modify his report is a complex professional judgment. (AICPA 1981)
Thus, under SAS No. 34, the auditor must first conclude that there is substantial doubt
about the entitys ability to continue as a going-concern. Then they must consider the impact on
the financial statements regarding the recoverability and classifications of assets and liabilities,
and if the recorded amounts or classifications are uncertain. Thus, rendering a qualified opinion
due to the existence of going-concern uncertainty in SAS No. 34 was ultimately a financial
reporting issue, not solely an issue of continuance of the enterprise.
The most recent modification to going-concern reporting came in the form of SAS No. 59
which was adopted in 1988.5 SAS No. 59 was issued along with nine other SASs as part of the
Auditing Standards Boards (ASB) Expectations Gap project, which was a response to
considerable Congressional scrutiny of the auditing profession in the mid-1980s. The ten SASs
released in 1988 were an attempt to raise auditing standards to be closer with what Congress and
the investing public expected from auditors. The primary changes embodied in SAS No. 59
were: (1) the requirement to explicitly consider the clients ability to continue as a going-concern
5 As noted in the next section, SAS Nos. 64 and 77 were issued in 1990 and 1995, respectively, to address technical issues related to the wording of the explanatory paragraph.
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in every audit, and (2) if the auditor determines that there is substantial doubt about the entitys
ability to continue as a going-concern, then this should be disclosed in the audit report in the
form of an additional explanatory paragraph. That is, SAS No. 59 required a modification to the
unqualified audit report for going-concern uncertainty and removed the previous requirement to
qualify the opinion in this situation.6
SAS No. 59 continued the use of the phrase substantial doubt, but, in essence elevated
its prominence because auditor reporting responsibility switched from the SAS No. 34 2-step
decision process to a single-step process. Under SAS No. 59 the auditor is required to modify
their opinion for going-concern uncertainty if there is substantial doubt about the ability of the
entity to remain a going-concern for the ensuing fiscal year, regardless of the classification and
recorded amounts of the financial statement elements. Thus, the reporting threshold for issuing
an opinion modified for going-concern is solely based on the auditors assessment of whether
there is substantial doubt with respect to the entitys ability to continue as a going-concern.
However, extant professional standards do not provide unambiguous guidance as to how
auditors are to incorporate contrary and mitigating evidence into their assessments of going-
concern, what level of uncertainty constitutes substantial doubt, or what determines whether a
company is a going-concern. These critical decisions are left to the auditors professional
judgment.7
6 Throughout this paper, the term going-concern opinion refers to audit opinions modified or qualified for reasons of going-concern uncertainty. 7 Standards regarding auditor reporting responsibility when entities switch to the liquidation basis of reporting is found in AU9508, Reports on Audited Financial Statements: Auditing Interpretations of Section 508 (PCAOB 2010).
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2.3 Substantial Doubt
SAS No. 59 uses the phrase substantial doubt about the ability of [company name] to
continue as a going concern. However, immediately following its adoption there were instances
of auditors issuing going-concern modified reports without the specific phrases substantial
doubt or going concern. In addition, there were also instances of auditors issuing conditional
going concern reports (for example, using wording such as if event X does not happen, then
there is substantial doubt...). Accordingly, SAS No. 64 (AICPA 1990), applicable for audit
reports dated after December 31, 1990, was issued to clarify that auditors must use the phrases
substantial doubt and going concern in any going-concern modified report. However, the
conditional going concern reports continued to be issued in some instances before SAS No. 77
(AICPA 1995) required that conditional going concern phrases not be used in audit reports
issued after December 15, 1995.
Substantial Doubt Increased reliance on an ambiguous probability phrase
SAS No. 34 formerly required auditors to determine if the was substantial doubt about
the ability of the entity to continue as a going-concern, but then required assessment of the
classifications and amounts reported for the financial statement elements in determining the
appropriateness of an opinion modified for going-concern uncertainty. As noted earlier, SAS No.
59 continued and heightened the notion of the probability phrase substantial doubt. However,
there has been no professional guidance in the accounting or auditing standards as to what level
of doubt constitutes substantial doubt.
Prior to SAS No. 34, Statement on Financial Accounting Standards (SFAS) No. 5 had
used phrases such as remote, reasonably possible, and probable in the context of
accounting for loss contingencies. Substantial doubt is unlike any other probability phrase used
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in accounting or auditing standards. After the series of congressional hearings held by the U.S.
House of Representatives Committee on Energy and Commerce in the 1980s, Rep. Ron Wyden
started to introduce bills to mandate certain procedures in audits of SEC registrants (U.S. House
of Representatives, 1991, 1992, 1993). Such bills proposed codification of the requirement for
going-concern evaluation and reporting by auditors, and used the substantial doubt language of
SAS No. 59. Rep. Wydens efforts culminated in the inclusion of the going-concern related
provisions (along with audit procedures related to certain other areas, such as fraud detection and
related party transactions) as part of the much broader Private Securities Litigation Reform Act
of 1995 (PSLRA). The PSLRA, thus codified the substantial doubt phrase as part of law.
Numerical equivalents of verbal probability phrases
There is a long line of research that finds significant differences in how people translate
verbal probability phrases, and studies have shown that such differences exist in a variety of
contexts and constructs. Teigen and Brum (2003, 126) summarize such studies by noting:
The recurrent findings in these studies are (1) a reasonable degree of between-group
consistency, combined with (2) a high degree of within-group variability. In other words, mean
estimates of very probable, doubtful and improbable are reasonably similar from study to
study, supporting the claim that probability words are translatable; but, at the same time, the
interindividual variability of estimates is large enough to represent a potential communication
problem.
Several studies have also shown that there are substantive between-subject differences in
the ways that other professionals - including physicians (Bryant and Norman 1980; Kong et al.
1986; Reagan et al. 1989) and political analysts (Beyth-Marom 1982) - make judgments about
verbal probability phrases. In fact, the ambiguity associated with verbal probability phrases led
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the National Weather Service to express forecasts using numerical rather than verbal phrases
(Murphy and Winkler 1974). Using auditors as subjects, Schultz and Reckers (1981), Jiambalvo
and Wilner (1985), Raghunandan et al. (1991) and Amer et al. (1994) document that there is
substantial variation between auditors in their interpretations of remote, reasonably possible,
and probable. Moreover, such differences persist even when the analysis is restricted to
auditors within the same audit firm.
In the context of the going-concern opinion, extant standards require the use of the
substantial doubt phrase as part of the modified, unqualified audit report. Ponemon and
Raghunandan (1994) examined auditors and other stakeholders interpretations of substantial
doubt. Their subjects included 45 auditors (36 audit partners and 9 audit managers from four of
the then Big Six firms), 95 commercial loan officers, 88 financial analysts from two large
investment and brokerage firms, and 32 District or Superior court judges from a New England
state. The mean (median) numerical probability value associated with substantial doubt for the
different groups was as follows: auditors, 0.57 (0.51); bank loan officers, 0.72 (0.75); financial
analysts, 0.71 (0.70); and judges 0.33 (0.30). Thus, loan officers and financial analysts, on
average, assigned a higher probability of failure than did auditors. This suggests that users could
view a going-concern report as indicating a higher probability of failure than what the auditor
may have intended. Conversely, judges expected that a going-concern opinion would be issued at
a much lower probability than did the auditors. This suggests that judges would employ a stricter
standard than auditors, and is not welcome news to auditors in the context of litigation risk.
Interestingly, Ponemon and Raghunandan (1994) find much greater consensus between
the groups for the SFAS No. 5 terms possible or probable: the mean values ranged from 0.38
to 0.41 for possible and from 0.68 to 0.73 for probable suggesting that research in
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psychology and other areas might suggest more commonly understood terms than a phrase such
as substantial doubt.
Should there be flexibility with respect to the wording of going-concern opinions?
As noted earlier, from 1989 to 1995, some going-concern audit opinions did not include
the phrases substantial doubt or going concern. In addition, some clients received the
conditional substantial doubt opinions. Carcello et al. (2003) find that clients receiving such
non-standard going-concern opinions (a) have more established auditor-client relationships and
lower levels of financial distress, and (b) are less likely to subsequently declare bankruptcy,
compared with companies receiving standard going-concern reports. This raises an important
question: should more flexibility be permitted in the context of going-concern reporting?
Carcello et al. (2003) note that in the absence of requirements for mandatory use of the
substantial doubt phrase clients exerted pressure on auditors to soften the blow by either
omitting the substantial doubt phrase or using a conditional going-concern opinion. Thus, while
more flexibility with respect to going-concern reporting offers auditors the opportunity to better
explain his or her assessment of the issue, it also leads to auditors being subject to additional
pressure from the client.
While the ASB has moved away from giving auditors flexibility in the language used in
going-concern reporting, at the international level standard-setters have encouraged greater
flexibility in reporting regarding going-concern issues. The International Auditing Practices
Committee (IAPC) which is the predecessor to the International Auditing and Assurance
Standards Board (IAASB) issued ISA 570 in 1999, effective 31 December, 2000. Whilst this
version of the standard is no longer in effect, it provides an example of an explanatory paragraph
for reporting going-concern uncertainty. More generally in relation to audit reporting ISA 700
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mandates a structure for the audit opinion but not the precise wording to be employed. As efforts
to harmonize international standards increase, the costs and benefits associated with increased
flexibility in reporting must be considered. Such flexibility may lead to more nuanced auditor
reports and better communication of differences in the likelihood of failure, but it may also
increase the amount of pressure that management exerts over the auditor for favorable wording.
Summary
Substantial doubt is the threshold probability phrase used in SAS No. 59. However,
there is no professional guidance with respect to how to determine what substantial doubt is,
and there is evidence of differences in the interpretation of the numerical probability associated
with the phrase substantial doubt. More importantly, there is a significant divergence between
the views of auditors and other stakeholders, such as financial statement users and judges. Given
that international auditing standards seek to provide greater flexibility in the wording of going-
concern opinions, one question to consider is whether more flexibility should be extended to
U.S. auditors as a means of improving communication in the audit report.
2.4 The international experience
Regulators, standard-setters, auditors and companies world-wide have had to consider
audit issues arising from the global financial crisis. In fact, several high-level inquiries into the
role and effectiveness of auditing and going-concern assessments have recently been undertaken
by other countries (European Commission 2010; House of Lords Select Committee on Economic
Affairs 2011). Accordingly, it is important to understand both the similarities and differences
across countries when making current assessments with respect to auditing standards in the U.S.
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Comparison of international standards with U.S. standards on going-concern
The International Federation of Accountants (IFAC) and the International Auditing and
Assurance Standards Board (IAASB)8 have become increasingly important since the issuance of
the first International Auditing Guidelines in 1979. In 1991 the guidelines were renamed
International Standards on Auditing (ISA) and in 1994 a codified core set of ISAs were issued.
ISAs have rapidly gained acceptance from national regulatory bodies. There are now over a
hundred countries that either use ISAs or are in the process of incorporating them into their
national standards (IFAC 2011a).
Both the U.S. and international standards are similar in the sense that the auditor is
required to take an active approach to evaluating the going-concern assumption. In addition, both
sets of standards rely on principles to guide the auditors interpretation of what constitutes a
going-concern issue and when this warrants the inclusion of a going-concern modification in the
audit opinion.
As in the U.S., the international standards state that the continuation of an entity as a
going-concern is assumed in financial reporting. Therefore, general purpose financial statements
are prepared on a going-concern basis. SAS No. 59 (para. 1) states that the going-concern basis
is not appropriate if the entity is unable to [] meet its obligations as they become due without
substantial disposition of assets outside the ordinary course of business, restructuring of debt,
externally forced revisions of its operations, or similar actions. Similarly, ISA 570 (para. 2)
states that the going-concern assumption is inappropriate if [] management either intends to
liquidate the entity or to cease operations, or has no realistic alternative but to do so.
8 Before 2002, the IAASB was named the International Auditing Practices Committee (IAPC).
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Consequently, under both standards the going-concern assumption is inappropriate if the entity
cannot pay its debts as and when they fall due.
Fundamentally, and particularly from a research perspective, the auditor is ultimately
faced with two judgments: first, assessing the probability of an audit client not continuing as a
going-concern within the foreseeable future9; and second, whether this probability is higher or
lower than substantial doubt (under SAS No. 59) or significant doubt (under ISA 570),
which would trigger an opinion modified for going-concern uncertainty. While the dictionary
meaning of the two words is broadly comparable - significant means sufficiently great or
important to be worthy of attention and substantial means of considerable importance (Oxford
Dictionaries 2010) - these words may be interpreted differently in practice.10 However, as
discussed previously in relation to substantial doubt in the U.S., there is similarly no precise
guidance for non-U.S. auditors making a judgment as to what constitutes significant doubt.
Auditing standards do, however, give guidance concerning the conditions and events that
should be given consideration. SAS No. 59 (para. 6) lists four categories: negative trends, other
indications of possible financial difficulties, internal matters, and external matters. ISA 570
(para. A4) lists events or conditions in the following three categories: financial, operating, and
other. However, besides listing these categories, both sets of auditing standards are unclear as to
9 Although the bankruptcy codes of Australia, United Kingdom, and United States originate from the same common law legal system (LaPorta et al. 1998), there are differences in the specific rules and regulations with respect to corporate bankruptcy. The U.S. has less onerous legal entry criteria for entering bankruptcy proceedings than the U.K. and Australia, where directors have an incentive to place a company in bankruptcy proceedings to avoid being personally liable for wrongful and insolvent trading. Because of limitations on the rights of creditors under U.S. bankruptcy proceedings, there is a greater incentive for secured creditors in the U.S. to seek private restructuring compared to entering into bankruptcy proceedings. There are also differences in operationalization of the bankruptcy procedures between the U.K. and Australia. These differences may affect auditors assessment of the going-concern assumption. 10 That substantial doubt and significant doubt are to a large degree interchangeable terms is evidenced in FASB Board meeting handout on June 3, 2009, detailing the proposed FASB Statement on Going Concern. Two of the four alternatives to address constituent concerns regarding the definition of substantial doubt involved changing it to significant doubt so as to be consistent with international standards.
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how the auditor is to interpret and assess these events or conditions. Thus, auditors are left to rely
on their own judgment when assessing whether a firms probability of not continuing as a going-
concern is sufficiently high to justify issuing an opinion modified for going-concern uncertainty.
It should be noted, however, that the period of assessment in the two standards differ and
may be longer under the international standard compared to its U.S. counterpart. ISA 570
requires the auditor to consider the same period as that used by management in making its
assessment, a period of at least, but not limited to, 12 months from the balance sheet date. SAS
No. 59 requires the auditor to evaluate whether there is substantial doubt for a reasonable
period of time, not to exceed one year beyond the date of the financial statements being audited.
Consequently, ISA 570 specifies a minimum time period of assessment, whereas SAS No. 59
specifies a maximum.
2.5 Summary
While the latest financial crisis has once again highlighted the difficulty of warning
investors regarding the appropriateness of the going-concern assumption, the evolution of the
practices and standards reminds us that the problems are mostly not new and the current
practices have resulted from previous attempts to specify appropriate standards. The issue of
defining substantial doubt in the U.S. or significant doubt internationally is highlighted as an
ongoing problem despite the existence of a long line of research in psychology and accounting
about differences in interpretation of probability phrases. Flexibility in wording of going-concern
opinions has been approached differently by standard-setters at the international level compared
to the U.S. Another area of difference between the U.S. and international standards is the period
of assessment to be considered when evaluating matters related to going-concern.
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3. GOING-CONCERN REPORTING TRENDS 3.1 Introduction
Financial statement users typically expect that there should be a going-concern warning
prior to a clients failure. Without a precise definition of going-concern in the accounting or
auditing standards, researchers have typically used bankruptcy filing as the proxy for business
failure or for identification of a non-going-concern. Bankruptcy filing is a discrete, legal
event that signals the end of the company in its present form, and is generally considered by most
individuals as a clear, unequivocal indication of business failure. Therefore, in order to minimize
any judgment bias on the part of the researcher, bankruptcy filing is typically used as to indicate
companies that are no longer a going-concern, and accordingly to identify those that should have
received a prior going-concern modified opinion.11
Of key concern to legislators and regulators is the situation where a client enters into
bankruptcy a short time after receiving an audit opinion unmodified for going-concern
uncertainty (Weil 2001). It is important to bear in mind that an audit has not necessarily failed if
the auditor does not issue a going-concern warning prior to the clients financial failure. This is
because the going-concern outcome is inherently uncertain and an auditor cannot be expected to
have perfect foresight when looking to the future. Thus, SAS No. 59 states:
The auditor is not responsible for predicting future conditions or events. The fact that the
entity may cease to exist as a going-concern subsequent to receiving a report from the auditor
that does not refer to substantial doubt, even within one year following the date of the financial
statements, does not, in itself, indicate inadequate performance by the auditor. Accordingly, the
11 We note that the combination of uncertainties in defining business failure together with the evaluation of the time horizon for assessing the risk of failure presents methodological issues for researchers.
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absence of reference to substantial doubt in an auditor's report should not be viewed as providing
assurance as to an entity's ability to continue as a going-concern.
Given the interest shown by legislators and standard-setters in the audit reports issued to
companies shortly prior to bankruptcy, this topic has attracted substantial academic research. A
number of studies show that less than half of bankrupt companies received going-concern
modified opinions prior to bankruptcy during the pre-SAS No. 59 period (Altman and McGough
1974; Altman 1982; Menon and Schwartz 1987; Hopwood et al. 1989; McKeown et al. 1991;
Chen and Church 1992). Such empirical evidence led Carmichael and Pany (1993, 55) to ask:
How can a business fail shortly after receiving an unmodified audit report? If an audit cannot
provide an early warning of impending business failure, what good is it?
Given such concerns, prior researchers have examined the association between opinions
modified for going-concern uncertainty and bankruptcy. This approach gives rise to two types of
reporting misclassifications. A type I misclassification arises if the auditor issues a going-
concern modified opinion and the client does not subsequently fail. A type II misclassification
arises when the auditor does not issue a going-concern modified opinion and the client later fails.
It is important to bear in mind that both types of misclassifications are based on a statistical
decision rule and so the word misclassification should not be taken to mean that the audits were
necessarily sub-standard.
Each type of misclassification entails potential costs. For example, an auditor who does
not issue a going-concern modified opinion and the client later fails may incur costs related to
litigation and loss of reputation (C). Similarly, it is costly for an auditor to issue a going-concern
opinion when the client does not subsequently fail because issuing an apparently unwarranted
going-concern opinion is likely to make the client unhappy and may result in the loss of audit
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revenue (C). It is straightforward to show the auditors economic incentive to issue a going-
concern opinion depends on the ratio of these two costs, i.e., C/C. When the ratio is higher the
auditor is more likely to issue a going-concern opinion because the cost of failing to do so is
greater. As noted by Francis (2011, 128-129) while the proportion of firms entering bankruptcy
without a prior going-concern modified opinion is high, the number of firms entering bankruptcy
without a prior going-concern modified opinion in the population of audits is very low
representing less than 1% of audit engagements.
Many factors can be expected to influence the relative cost ratio. For example, changes in
legal or regulatory regimes can alter the costs of not issuing a going-concern opinion when such
an opinion is warranted. We now review studies that have examined the effect of such changes in
auditors going-concern decisions.
3.2 Changes over time in the issuance of going-concern modified opinions
The SEC (2000) notes that legal and regulatory changes during the period from 1994 to
1998 significantly reduced the likelihood of success in private lawsuits against auditors and thus
lowered the liability related threats for auditors. Specifically, the Commission cited the following
legal developments: (1) Central Bank of Denver case in 1994 that eliminated liability in private
litigation for aiding and abetting a securities fraud violation; (2) Private Securities Litigation
Reform Act of 1995 (PSLRA, or Reform Act) that (a) affected pleading standards in lawsuits
against auditors, (b) substituted proportionate liability in lieu of joint and several liability, and (c)
eliminated the threat of treble damage liability following amendment of the Racketeer Influenced
and Corrupt Organization Act; and (3) Securities Litigation Uniform Standards Act of 1998 that
pre-empted state or common law claims in securities fraud actions against auditors in both state
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and federal court. Together, the above factors make it less likely that auditors would issue a
going-concern opinion after the above legal changes than in earlier periods.
Geiger and Raghunandan (2002b) show that, after controlling for financial condition,
company size, and default status, going-concern opinions were issued less often in (a) 199697
compared to 199293, and (b) 19992000 compared to 199697. Francis and Krishnan (2002)
also document that auditors were less likely to issue going-concern modified audit reports in the
post-Reform Act period than in prior years. The combined evidence from these two studies is
consistent with fewer going-concern opinions being issued when there is a lower litigation threat.
After the events of 2002 (i.e., the collapse of Andersen, the passage of SOX, and the new
oversight by PCAOB), the risk associated with auditing increased dramatically. Further, the
insurance-related and other liability-related costs also increased significantly in the post-SOX
period (Rama and Read 2006). Hence, it seems likely that auditors would report more
conservatively in the post-Enron/SOX period. Geiger et al. (2005) indeed find that auditors in
general are more likely to issue going-concern opinions after December 2001. Similar results are
reported by Sercu et al. (2006). Overall, the evidence is consistent with market and regulatory
incentives leading to increased propensity to issue going-concern modified opinions in the
immediate aftermath of SOX.
In addition, a recent review of U.S. audit reports for the 2002-2009 period by Audit
Analytics found that reports modified for uncertainty relating to the going-concern assumption
increased from a low of 14% of all companies for financial years ending in 2003 to 21% for
financial years ending in 2008 (Cheffers et al. 2010). Cheffers et al. (2010) analyze the causes
identified in the going-concern opinions and find that the most frequently mentioned were
operating losses, working capital inadequacy, deficits in retained earnings, short corporate
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operating history or increased threats from competitors. Their findings are reproduced in the first
four columns of the table below.
Table 1: U.S. Opinions Modified for Going-Concern Uncertainties 2002-2009 (Cheffers et al. 2010)
Fiscal year Total audit opinions Cheffers et al. (2010)
Going-concern opinions
Cheffers et al. (2010)
Overall opinion
Percentage
GC rate for loss-making non-financial
firms: Carson et al.
(2011)
2002 17,191 2,817 16.39% 22%
2003 17,766 2,552 14.36% 20%
2004 16,794 2,554 15.21% 21%
2005 16,784 2,709 16.14% 22%
2006 16,462 2,864 17.40% 21%
2007 16,601 3,300 19.87% 18%
2008 15,848 3,328 21.00% 21%
2009 15,395 2,994 19.45% 19%
The U.S. evidence in the last column of the above table comes from Carson et al. (2011)
who examine non-financial companies that reported net losses for the year. Their results suggest
that the going-concern rate for loss-making non-financial firms remained fairly stable over time
(around 21%), except for 2007 and 2009. Comparison of these findings for loss-making firms
with the U.S. going-concern rates for all firms suggests that the increasing trend in overall going-
concern reporting does not relate to all types of firms, but appears to relate to financial and/or
profit-generating firms.12
12 This conclusion triggers an interesting related question, i.e. how this apparently more conservative reporting on profit-generating or financial firms affects: the rate at which firms received a going-concern opinion and then did not subsequently fail, and the proportion of bankrupt firms that did not have a prior going-concern opinion.
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Evidence from outside the U.S.
Relatively little research has attempted to compare going-concern reporting frequencies
across countries because of the difficulty in controlling for the many differences in legal and
institutional environments. Nevertheless, it is important to investors as well as standard-setters in
a global economy to know the variation in audit reporting practices between countries.13 Martin
(2000) has shown that in the period 1987-1991, the U.S. had a higher going-concern
modification rate compared to Germany and France.
We also identify international evidence that finds auditors have responded to the financial
crisis by a greater consideration of going-concern issues. As a comparison to the rate of going-
concern issuance in other economies, Carson et al. (2011) tabulate rates for opinions modified
for going-concern uncertainty for non-financial firms reporting current year losses in five
countries. From this it is clear that going-concern rates have increased in the U.K., Australia, and
France in 2008. Examining the ratio of going-concern modified opinions relative to the number
of net loss firms reveals that auditors are least conservative at reflecting financial distress in
modified opinions (i.e., issued the lowest proportion of going-concern modifications) in France,
then followed by the U.S., U.K., with Germany and Australia being the most conservative by
issuing the highest proportion of going-concern modified opinions.
13 Studies have of course examined the frequency of opinions modified for going-concern uncertainty in most countries. For example, DeFond et al. (2000) document a nine-fold increase in the frequency of modified opinions in China with the adoption of new auditing standards in 1994.
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Table 2: Going-Concern Modification Rates for Non-Financial Loss-Making Firms (Carson et al. 2011)
Year U.S. U.K. Australia France Germany
2003 20% 10% 20% 11% 22%
2004 21% 15% 23% 14% 20%
2005 22% 16% 21% 11% 23%
2006 21% 15% 19% 10% 26%
2007 18% 13% 16% 9% 23%
2008 21% 19% 27% 14% 27%
2009 19% 20% 28% 8% 18%
7 Year Average 20% 15% 22% 11% 23%
Changes in the overall frequency of opinions modified for going-concern uncertainty are
important because they change the relative frequency of (a) going-concern opinions without
subsequent client failure and (b) firms entering bankruptcy without a previous opinion modified
for going-concern uncertainty. Holding everything else constant, an increase in the frequency of
opinions modified for going-concern uncertainty will result in a higher proportion of going-
concern opinions where the firm does not subsequently fail, and a lower proportion of firms
entering bankruptcy without an opinion modified for going-concern uncertainty. The proportion
of firms entering bankruptcy without a prior opinion modified for going-concern uncertainty
have garnered the most attention because investors and regulators are particularly concerned
about cases in which companies fail after being issued clean audit opinions. Therefore, the next
section discusses the evidence on changes over time in the proportion of firms entering
bankruptcy without a prior opinion modified for going-concern uncertainty. We then present the
research on the frequency of opinions modified for going-concern uncertainty where the firm
does not subsequently fail.
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3.3 Changes over time in the proportion of firms entering bankruptcy
without a prior going-concern modified opinion
In general, the research investigating the proportion of firms entering bankruptcy without
a prior going-concern opinion has consistently found that since the adoption of SAS No. 59,
approximately half of companies going bankrupt in the U.S. had not received a prior opinion
modified for going-concern uncertainty.
Auditors and others suggest that SAS No. 59 increased auditors' responsibility vis-a-vis
going-concern (Ellingsen et al. 1989; Bell and Tabor 1991). This leads Raghunandan and Rama
(1995) to note that the costs to the auditor associated with a firm entering bankruptcy without a
prior opinion modified for going-concern uncertainty would be higher in the post-SAS No. 59
period. Consequently, auditors propensity to issue going-concern modified reports can be
expected to increase after SAS No. 59 became effective; in turn, this should lead to a reduction
in the number of firms entering bankruptcy without a prior going-concern opinion. Raghunandan
and Rama (1995) find that the proportion of bankruptcies with a prior going-concern report was
39 percent in the pre-SAS No. 59 period, and 62 percent in the post-SAS No. 59 period. In a
contemporaneous study, Carcello et al. (1995) find that the proportion of bankruptcies with a
prior going-concern report increased from 49% in the pre-SAS No.34 period to 51% during the
SAS No. 34 period and 55% during the SAS No. 59 period. Their multivariate analysis reveals
that the propensity of a Big N audit firm to issue a going-concern opinion to a soon-to-be-
bankrupt client increases after the issuance of SAS No. 34, but not after the issuance of SAS
No.59. Carcello et al. (1997) reconcile the results discussed in the above two studies, and show
that the effect of SAS No. 59 is sensitive to the transition-period treatment, and that a significant
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SAS No. 59 effect can be found only if 1988 financial statements are included in the pre-SAS
No. 59 period.
Geiger and Raghunandan (2001) argue that the PSLRA made it less likely for auditors to
issue going-concern modified opinions. Consistent with this expectation, they find that the
proportion of bankrupt companies receiving a prior going-concern modified opinion was 59
percent in the pre-PSLRA period and drops to 45 percent in the post-PSLRA period. However, if
the PSLRA reduced the threat of litigation against auditors, the reduced pressure did not last
long. Consistent with the heightened exposure of auditors following the large financial reporting
failures in 2001 and the enactment of SOX in 2002, Geiger et al. (2005) find that the proportion
of bankrupt firms with a prior going-concern modified audit report was 40 percent in the pre-
Enron (i.e., pre-December 2001) period, but increases to 70 percent in the post-Enron period.
The time period effect persisted after controlling for financial stress, default status, client size,
bankruptcy and reporting lags, industry type, and auditor type.
Whenever there is a sudden external shock, it is natural to think that there will be an
immediate reaction; a more important question, perhaps, is how long such an effect lasts.
Feldmann and Read (2010) examine if the post-Enron conservatism persists over time using 565
U.S. bankruptcies from 2000 to 2008. They find that the initial spike in the proportion of
bankruptcies with a prior going-concern modified audit opinion tapers off and declines to the
pre-Enron levels by 2006. Thus, the increase in going-concern reporting observed in the
immediate post-Enron period appears to have been only temporary.