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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.

Electronic copy available at: http://ssrn.com/abstract=2000496

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:

Electronic copy available at: http://ssrn.com/abstract=2000496

Table 1: U.S. Opinions Modified for Going-Concern Uncertainties 2002-2009


(Cheffers et al. 2010)
Fiscal year

Total audit opinions

2002
2003
2004
2005
2006
2007
2008
2009

17,191
17,766
16,794
16,784
16,462
16,601
15,848
15,395

Opinions modified for


going-concern
uncertainty
2,817
2,552
2,554
2,709
2,864
3,300
3,328
2,994

Percentage
16.39%
14.36%
15.21%
16.14%
17.40%
19.87%
21.00%
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 goingconcern 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

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 GoingConcern Uncertainty (Feldmann and Read, 2010)

Year of Opinion

Number of

With Opinion Modified for Going-

Bankruptcies

Concern Uncertainty in Year Prior to


Bankruptcy

2000-2001
2002-2003
2004-2005
2006-2007
2008-2009

257
175
70
63
63

53%
72%
59%
51%
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-

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

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

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

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 goingconcern 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.

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 goingconcern 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 goingconcern, 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.

Second, auditing standards require an auditor to issue an opinion modified for goingconcern 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 goingconcern 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 .................................................................................................................................. 14
2. BACKGROUND .................................................................................................................................... 18
2.1 The going-concern assumption .................................................................................................... 18
2.2 Development of going-concern reporting standards in the U.S. .................................................. 22
2.3 Substantial Doubt ...................................................................................................................... 26
2.4 The international experience ........................................................................................................ 30
2.5 Summary ...................................................................................................................................... 33
3. GOING-CONCERN REPORTING TRENDS ....................................................................................... 34
3.1 Introduction .................................................................................................................................. 34
3.2 Changes over time in the issuance of going-concern modified opinions ..................................... 36
3.3 Changes over time in the proportion of firms entering bankruptcy without a prior going-concern
modified opinion ................................................................................................................................ 41
3.4 Changes over time in the proportion of firms with an opinion modified for going-concern
uncertainty that do not subsequently fail ............................................................................................ 44
3.5 Variations in going-concern reporting misclassification across auditors .................................. 46
3.6 Effect of auditor tenure and non-audit fees on audit reporting misclassification ......................... 47
3.7 Self-fulfilling prophecy phenomenon ........................................................................................ 49
3.8 Summary ...................................................................................................................................... 51
4. CLIENT FACTORS AFFECTING THE OPINION DECISION ........................................................... 52
4.1 Introduction .................................................................................................................................. 52
4.2 Traditional bankruptcy prediction models ................................................................................... 52
4.3 Measures of the clients financial condition................................................................................. 54
4.4 Business strategy and company turnaround ................................................................................. 61
4.5 Empirical issues............................................................................................................................ 64
4.6 Summary ...................................................................................................................................... 68
5. AUDITOR INDEPENDENCE, OBJECTIVITY AND AUDIT QUALITY .......................................... 69
5.1 Introduction .................................................................................................................................. 69
5.2 Economic dependence on a large or important client .................................................................. 70
5.3 Audit and non-audit fees .............................................................................................................. 72
5.4 Auditor switching and opinion shopping ..................................................................................... 74
5.5 Auditor-client tenure .................................................................................................................... 76
5.6 Personal relationships between auditors and clients .................................................................... 77
5.7 Auditors compensation arrangements ......................................................................................... 78
5.8 Litigation ...................................................................................................................................... 78
5.9 External regulation ....................................................................................................................... 80
5.10 Auditor size ................................................................................................................................ 80
5.11 Industry specialization................................................................................................................ 81
5.12 Audit committees ....................................................................................................................... 82
5.13 Market structure and competition............................................................................................... 82
5.14 Audit report lag .......................................................................................................................... 83
5.15 Summary .................................................................................................................................... 84
6. OTHER AREAS OF GOING-CONCERN RESEARCH ....................................................................... 85
6.1. Going-concern opinions for financial institutions ....................................................................... 85
6.2 The stock market reaction to the issuance of a going-concern opinion ....................................... 86
7. CONCLUSIONS..................................................................................................................................... 90
7.1 Major findings of prior research ................................................................................................... 90
7.2 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) ..... 38
Table 2: Going-Concern Modification Rates for Non-Financial Loss-Making Firms (Carson et al. 2011)40
Table 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 goingconcern 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 goingconcern 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 goingconcern 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 goingconcern 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 goingconcern 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 goingconcern 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 goingconcern 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

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?

21

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

22

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 goingconcern 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.
23

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 goingconcern 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.
24

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 goingconcern, 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

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).
25

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
26

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
27

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

28

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

29

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 goingconcern 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.

30

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.

Before 2002, the IAASB was named the International Auditing Practices Committee (IAPC).
31

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

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.
32

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 goingconcern 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.

33

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.
34

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 goingconcern 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

35

revenue (C). It is straightforward to show the auditors economic incentive to issue a goingconcern 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

36

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

37

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 goingconcern 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.
38

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 goingconcern 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.
39

Table 2: Going-Concern Modification Rates for Non-Financial Loss-Making Firms


(Carson et al. 2011)
U.S.

U.K.

Australia

France

Germany

2003

20%

10%

20%

11%

22%

2004

21%

15%

23%

14%

20%

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%

Year

2005

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 goingconcern 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.

40

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-bebankrupt 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

41

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 preEnron (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.

42

We asked Professor Read to extend his analysis to provide a summary of bankruptcies


occurring through to 2010 and their audit opinion in the year prior to bankruptcy.14 This is
tabulated below:
Table 3: Bankrupt Companies with Prior Year Opinion Modified for GoingConcern Uncertainty (Feldmann and Read, 2010).
Year of Opinion

Number of
Bankruptcies

With Going-concern Modified Opinion


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%

(Source: Feldmann and Read, 2010, Table 2, page 273, updated).

The initial evidence for corporate bankruptcies during the 2007 to 2009 period suggests
that the rate at which companies went bankrupt with a prior going-concern did not increase
during this period. However, more research is needed to consider the reporting for financial
institutions and the exact nature of failure during this period.
Evidence from outside the U.S.
There is very little evidence on trends in going-concern reporting for failing firms outside
of the U.S. Evidence from Australia indicates that the proportion of companies failing with no
prior going-concern warning fell during the 2008-2009 period compared to 2005-2007,
consistent with auditors giving more warnings of going-concern issues during the global
financial crisis (Xu et al. 2011a).
14

The 628 firms reported here include the 565 bankruptcies between 2000 and 2008 reported in Feldmann and Read
(2010, table 2, page 273) plus an additional 63 bankruptcies occurring in 2009 and 2010. We thank Professor Read
for his sharing his data.
43

3.4 Changes over time in the proportion of firms with an opinion modified
for going-concern uncertainty that do not subsequently fail
While there has been a considerable amount of research on firms entering bankruptcy
without a prior opinion modified for going-concern uncertainty, there have been comparatively
few studies examining firms with a going-concern opinion that do not subsequently enter
bankruptcy. A partial explanation is the difficulty in determining the subsequent viability status
of the going-concern opinion recipients. Researchers often have difficulty obtaining accurate
subsequent viability data because financially troubled firms often do not make timely subsequent
filings, or get acquired by other firms, making an unequivocal determination of failure
subsequent to receiving the opinion modified for going-concern uncertainty problematic (Firth
1978; Nogler 1995).
In general, prior studies have consistently found that 80-90% of companies receiving an
opinion modified for going-concern uncertainty in the U.S. do not fail in the subsequent year.
For example, Mutchler and Williams (1990) find that only 9.2% of the manufacturing firms
receiving a first time going-concern modified opinion from a Big 8 firm in 1985 and 1986 failed
in the following year. Garsombke and Choi (1992) report a proportion of firms receiving a
going-concern opinion that do not fail (after one year) of 87.7% in the period 1982 to 1985.
Geiger et al. (1998) report that in their sample of manufacturing firms with a first time goingconcern modified opinion in 1990-1991, only 19% filed for bankruptcy in the subsequent two
years. Pryor and Terza (2001) find that 83% of the firms receiving first-time going-concern
opinions between 1989 and 1993 continued to remain viable through the subsequent fiscal year.
In a longitudinal study of auditor going-concern decisions and reporting error rates over the 11

44

year period 1990-2000, Geiger and Rama (2006) find that the long-run average rate of firms that
do not fail one year after receiving a going-concern opinion to be 87.7%.
Using a different longitudinal approach, Nogler (1995) identified 157 firms receiving
going-concern opinions in the period 1983 to 1991 and followed each firm to the final resolution
of their going-concern uncertainty. Of the 157 firms in the study, 52 (33.1%) eventually filed for
bankruptcy, 50 (31.8%) were acquired or merged with other firms, and 55 firms (35.0%)
remained viable and received an unmodified opinion in the subsequent years. Thus, his study
suggests that the proportion of firms that do not fail after receiving a going-concern opinion is
considerably lower than those reported in studies examining viability over horizons of just one or
two subsequent years.
In sum, the research examining firms that receive an opinion modified for going-concern
uncertainty suggest that the proportion of firms that do not fail within a short horizon (one to two
years) of receiving a going-concern opinion is around 80-90%. Further, these rates appear fairly
consistent over multiple time periods. However, Noglers (1995) longer-term perspective that
has a broader definition of corporate failure suggests survival rates of around 30-40%.
Evidence from outside the U.S.
In the U.K., the proportion of firms that do not fail in the year subsequent to a goingconcern opinion is approximately 76-80% (Citron and Taffler 1992; Lennox 1999a).15 In
Australia, Carey et al. (2008) find that the proportion of firms with going-concern opinions that
do not subsequently fail is 88% based on first-time going-concern recipients from 1994-1997.

15

Lennox (1999a) identifies failure as entering administration, liquidation or receivership in the year following the
financial period for which the audit report is issued. Citron and Taffler (1992) similarly define failure as placed in
receivership, placed in voluntary liquidation by creditors, or being compulsorily wound up in the reporting period
following the issue of the audit report modified for going-concern uncertainty.
45

Carey et al. (2011) report that the proportion of firms with opinions modified for goingconcern
uncertainty that do not subsequently fail is 90% for the 1995-1996 period, and 92% for the 20042005 period. Recent Australian evidence in Xu et al. (2011b) reports similar rates for periods up
to 2008. Further, Knechel and Vanstraelen (2007) find that the proportion of firms with goingconcern opinions that do not subsequently fail is 87% for a sample of stressed private companies
in Belgium during the period 1992-1996.

3.5 Variations in going-concern reporting misclassification across


auditors
Some studies examine whether the proportion of firms with going-concern modified
opinions that do not subsequently fail, and the proportion of firms entering bankruptcy without a
prior going-concern opinion, varies across auditors. The motivation for this research is to
determine whether auditors differ in terms of the accuracy of their reports as predictors of the
companys future financial status.
Geiger and Rama (2006) examine 1,042 manufacturing companies that receive first-time
reports modified for going-concern uncertainty over the 19902000 period and 710 bankrupt
companies over the 19912001 period. They find that both types of going-concern
misclassifications are significantly lower for the Big N auditors compared to the non-Big N.
These findings are noteworthy, because if the lower proportion of firms entering bankruptcy
without a prior going-concern modified opinion for the Big N firms were simply due to a
mechanical rule, i.e., a lower threshold for going-concern modified opinions, then the proportion
of firms with going-concern opinions not entering bankruptcy later would be higher for the Big
N firms. Geiger and Rama (2006) find no differences in the proportions of firms with going-

46

concern opinions not entering bankruptcy when comparing the non-Big N national firms with
smaller regional firms.
Bruynseels et al. (2010) use a sample of 148 U.S. manufacturing companies that went
bankrupt between 1999 and 2002, and find that the proportion of firms entering bankruptcy
without a prior opinion modified for going-concern uncertainty was lower for specialist auditors
relative to non-specialist auditors when management undertakes strategic turnaround initiatives.
In addition, contrary to expectations, Bruynseels et al. (2011) also find that audit firms that use a
business risk audit methodology are more likely to have a client entering bankruptcy without a
prior going-concern opinion if the client had undertaken operating initiatives to mitigate financial
distress.
Evidence from outside the U.S.
Similar to U.S. results, Lennox (1999d) finds that the audit reports issued by Big N
auditors in the U.K. have lower misclassification rates after controlling for the different client
characteristics of large and small auditors. Carey et al. (2008, 2011) find that in Australia top tier
audit firms have fewer clients with going-concern opinions not entering bankruptcy compared to
smaller audit firms. However, they find no difference between larger and smaller firms in terms
of the proportion of firms entering bankruptcy without a prior going-concern opinion.

3.6 Effect of auditor tenure and non-audit fees on audit reporting


misclassification
Should there be mandatory auditor rotation? This issue has long been of interest to
legislators and regulators. Most recently, the PCAOB has revisited the issue of auditor rotation
(PCAOB 2011). Geiger and Raghunandan (2002) examine audit opinions for 117 bankruptcies

47

during the period from 1996 to 1998, and find that prior opinions modified for going-concern
uncertainty are less likely during the initial years of an audit engagement; further, the tenure
effect appears to taper-off after the initial three years. Contrary to the traditional view that long
tenure makes the auditor more comfortable with the client, their results suggest that the threat to
auditor independence may be greater in the initial years and do not support the suggestion that
long auditor tenure significantly impairs auditor independence.
Robinson (2008) examines a sample of firms that filed for bankruptcy between 2001 and
2004, and finds a positive association between the level of tax service fees and the likelihood of
issuing a prior going-concern opinion; this is consistent with the argument that audit quality
improves from information spillover. Callaghan et al. (2009) examine firms that entered into
bankruptcy between January 1, 2001 and March 15, 2005, and find no association between the
likelihood of a prior going-concern modified opinion and non-audit fees, audit fees, total fees, or
the ratio of non-audit fees to total fees. Taken together, the results suggest that there is no
significant association between auditors fees and the proportion of firms entering bankruptcy
without a prior going-concern opinion.
Evidence from outside the U.S.
Outside the U.S., there is relatively little evidence on whether auditor tenure and nonaudit fees are associated with the proportion of firms entering bankruptcy without a prior opinion
modified for going-concern uncertainty. However, using Belgian data, Knechel and Vanstraelen
(2007) find that there is no change in the proportion of firms entering bankruptcy without a prior
going-concern opinion when auditor tenure increases, and that rates at which firms do not go
bankrupt subsequent to a going-concern opinion are lower with longer auditor tenure.

48

3.7 Self-fulfilling prophecy phenomenon


Even though the survival rate for firms receiving an opinion modified for going-concern
uncertainty is quite high, some studies have considered whether the auditors going-concern
opinion contributed to the failure of the client company. The self-fulfilling prophecy argument
is that the going-concern opinion can signal the auditors private information about the client and
this signal causes negative reactions from lenders, suppliers, and investors that precipitate the
companys failure. Thus, an opinion modified for going-concern uncertainty might result in the
financial demise of a company that would have survived if it had not received a going-concern
opinion.
Early behavioral research indicates that auditors do consider this aspect in their decisionmaking (Kida 1980; Mutchler 1984). Research on the relation between going-concern opinions
and subsequent failures in the U.S. has largely substantiated this concern. For example,
Garsombke and Choi (1992) examine going-concern firms and a matched sample of distressed
firms in the period 1980-1985. Their results indicate that the going-concern firms were
significantly more likely to file for bankruptcy than the matched distressed non-going-concern
firms. Likewise, Geiger et al. (1998) examine financially distressed firms (i.e., those having both
negative working capital and negative income in the same year) and first-time going-concern
opinion recipients from 1990 and 1991. They find that, after controlling for size, level of
financial stress and auditor type, going-concern modified firms were significantly more likely to
file for bankruptcy in the subsequent two years than the distressed non-going-concern modified
firms. Similarly, Pryor and Terza (2001) find that during 1989 to 1993 firms receiving a goingconcern modified audit opinion were significantly more likely to enter bankruptcy than

49

distressed non-going-concern modified firms; the going-concern opinion effect was more
prominent for the larger firms.
Louwers et al. (1999) use a discrete-time survival analysis and analyze 231 companies
that received a first time going-concern opinion in the period 1984-1991. They find that the
initial year after receiving a going-concern opinion is significantly more risky in terms of
bankruptcy filing for a financially troubled firm, and that this risk declines substantially in later
years. They argue that the increased probability of bankruptcy immediately following the
issuance of a going-concern opinion is consistent with the self-fulfilling prophecy argument.
Evidence from outside the U.S.
Non-U.S. studies in this area, however, yield mixed results. Citron and Taffler (1992,
2001) address this issue in two studies of U.K. firms, spanning the period 1979 through 1993.
They identify firms with opinions modified for going-concern uncertainty and match (based on
size, year, industry, and financial condition) the going-concern firms with similar non-goingconcern firms, and find that the probability of failing in the next period is not significantly
different for the two groups of firms. Thus, they conclude that there is no strong evidence of a
self-fulfilling prophecy in the U.K. Carey et al. (2008) examined Australian firms and find that
the probability of bankruptcy for going-concern recipients is no greater than for distressed firms
that do not receive opinions modified for going-concern uncertainty. However, Gaeremynck and
Willekens (2003) investigate private Belgian companies spanning the period 1995-1996. They
find that there is an endogeneous relationship between bankruptcy and the type of audit report.
Opinions modified for going-concern issues are more likely when firms face financial
difficulties, which in turn become more severe when after the receipt of a going-concern opinion.
This evidence suggests that the self-fulfilling prophecy holds in the Belgian setting.

50

3.8 Summary
In summary, the empirical evidence indicates that the likelihood of a issuing an opinion
modified for going-concern uncertainty varies across different regulatory and legal regimes. The
evidence suggests that auditors decisions depend on the relative costs of issuing opinions
modified for going-concern uncertainty or clean opinions. When legal or regulatory changes
reduce the cost of issuing a clean opinion, as in the case of the period from 1994 to 1998, the
likelihood of a going-concern modified opinion is reduced; conversely, when there are changes
that put the profession as a whole under the spotlight, as in the post-Enron period, the likelihood
of a issuing a going-concern modified opinion is higher. Accordingly, bankruptcies without prior
going-concern opinions are more (less) likely when the legal or regulatory environment becomes
more tolerant (stringent) for auditors. Auditors, it seems, are just like the rest of us: they respond
to incentives.
Contrary to often espoused concerns that long auditor-client relationships represent a
threat to auditor independence, the U.S. evidence does not consistently support the contention
that the proportion of firms entering bankruptcy without a prior opinion modified for goingconcern uncertainty increases with auditor tenure. In a similar vein, prior research does not
consistently show that there is an association between a failure to modify the audit reports of
subsequently bankrupt companies and the fees paid by clients for non-audit services. Despite
many firms not failing subsequent to a going-concern modified report, the evidence consistently
suggests that there is a higher degree of business failure following an opinion modified for
going-concern uncertainty, compared to non-going-concern firms that are matched based on
various criteria including financial stress, in the U.S.

51

4. CLIENT FACTORS AFFECTING THE OPINION DECISION


4.1 Introduction
In this section we review research over the past four decades that documents client
related factors associated with the issuance of going-concern reports. A major insight of this
research is that publicly available information about the clients financial condition is an
important factor affecting the auditors decision to issue an opinion modified for going-concern
uncertainty.

4.2 Traditional bankruptcy prediction models


While a going-concern modified opinion is not a prediction of bankruptcy, the auditors
assessment of the clients ability to continue as a going-concern fundamentally includes an
assessment of the risk of corporate failure. It is therefore relevant to briefly visit the state of the
art with respect to predicting corporate bankruptcy.16
The option pricing model of Black and Scholes (1973) and Merton (1974) (BSM) implies
a direct link between the market value of equity and the risk of credit default. The
characterization of debt and equity as contingent claims on the assets of a firm is not new,
however the explicit use of this structure for default risk measurement is a more recent
development partially led by the commercial success of the KMV Corporations equity based
measure of default risk and the subsequent adoption by Moodys KMV. Of particular interest is
the performance of such models relative to models linking default outcomes to financial
measures of risk and performance such as the Altman Z-score (Altman 1968, Altman and
Hotchkiss 2006).
16

For a comprehensive summary refer to De Servigny and Renault (2004).


52

Hillegeist et al. (2004) compare the relative information content of bankruptcy measures
based on the BSM option pricing model with the alternative specifications of Altman (1968) and
Ohlson (1980). Their results suggest that BSM default probabilities contain significantly more
information than the alternatives, and they conclude with the recommendation that researchers
use a BSM-prob score instead of the Z-score and O-score.
However, there is not universal endorsement of the BSM approach. For example, Bharath
and Shumway (2008) construct hazard models that outperform BSM probabilities in out-ofsample tests. Using U.K. data, Agarwal and Taffler (2008) find little difference between
predictions based on the contingent claims approach and the traditional z-score. More recently,
Das et al. (2009) find that equity and accounting based models have a complementary role in
capturing default related information in the spreads for credit default swaps (CDS). Campbell et
al. (2008) estimate a model using both equity market data, including stock returns and volatility,
as well as accounting data such as profitability and leverage. As might be expected in months
immediately preceding a bankruptcy filing, firms typically report losses, the value of debt is high
compared to assets, they have experienced extreme negative stock price returns over the past
month, and they had extremely high stock price volatility. Bankrupt firms tended to be smaller
and had only about half as much cash and short term investments in relation to the market value
of assets than non-bankrupt firms.
The importance of understanding the assumptions used in valuation models has been
highlighted in the recent global financial crisis. Rapid and unexpected changes in corporate
credit ratings reflect significant changes in the probability of default that can arise with changes
in the underlying model assumptions. There has also been an increased interest in understanding
and predicting systemic risk. Brownlees and Engle (2011) propose an empirical methodology to

53

measure systemic risk. When applied to a sample of large financial firms they find the metric
useful in identifying risky firms at various points during the financial crisis.
While the technology for predicting bankruptcy is important, the reliance on an
observable price for equity, traded debt, CDS, short interest or other market variables suggests
that many of these models simply identify firms that would be known by an auditor to be in
financial distress. Such models help to quantify the probability of default, and there is a need for
research examining the use of these models by auditors in assessing the clients going-concern
risk. However, such models may be of little value in identifying risks not already reflected in
market prices.

4.3 Measures of the clients financial condition


An auditors decision with regard to going-concern modifications can be conceptualized
as a two-stage process. First, the auditor assesses whether the client has financial and economic
difficulties that affect the clients ability to continue as a going-concern. Second, the auditor
decides whether to issue an opinion modified for going-concern uncertainty (Mutchler 1985;
1986).
Prior research suggests that auditors have the ability to discern the financial difficulties of
their audit clients (Kida 1980; Mutchler 1984). However, some studies have found that opinions
modified for going-concern uncertainty are not particularly accurate measures of the probability
of bankruptcy when compared with the predictive accuracy of a statistical model of bankruptcy
(Hopwood et al. 1989; Lennox, 1999a). Moreover, there is mixed evidence as to whether goingconcern opinions convey useful incremental information about the likelihood of bankruptcy
beyond the information contained in other publicly measures of financial distress (Hopwood et

54

al. 1989; Hopwood et al. 1994; Foster et al. 1998; Lennox 1999a; Willenborg and McKeown
2001).
When assessing going-concern, 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, past research shows that auditors reporting decisions appear to be
systematically related to publicly available information concerning the clients financial
condition. In this section we review the auditors evaluation of public information as part of the
going-concern reporting process.

Financial statement variables


Many of the variables used to measure the clients financial condition are constructed
using information from the clients financial statements. In this section, we review the financial
statement variables that have been used to assess the degree of financial distress. In most studies,
these variables are measured in levels, but some studies also measure the changes in these
variables. For example, Menon and Schwartz (1987) and Raghunandan and Rama (1995) use
both the current ratio and the change in the current ratio to explain the auditors decision to issue
a going-concern opinion.
Profitability. Companies that are less profitable are more likely to file for bankruptcy.
Not surprisingly then, studies generally find that auditors are more likely to issue going-concern
opinions when companies are less profitable. Alternative measures of profitability include:
1)

Net income / Total assets (e.g., Kida 1980; Mutchler 1985; Dopuch et al. 1987)

2)

Retained earnings / Total assets (e.g., Altman and McGough 1974; Koh and
Killough 1990; Dopuch et al. 1987; Menon and Schwartz 1987)

55

3)

Earnings before interest and taxes / Total assets (e.g., Altman and McGough
1974)

4)

Net income before tax / Net sales (Mutchler 1985)

5)

Current and/or recurring losses (e.g., Dopuch et al. 1987; Lee et al. 2005).

Leverage. Companies are more likely to file for bankruptcy if they have more debt.
Therefore, studies generally find that going-concern opinions are more likely to be issued to
companies that have higher leverage. Alternative measures of leverage include:
1)

Market value of equity / Book value of debt (e.g., Altman and McGough 1974)

2)

Book value of net worth / Book value of debt (e.g., Kida 1980)

3)

Total long term liabilities / Total assets (Mutchler 1985)

4)

Total liabilities / Total assets (Dopuch et al. 1987; Raghunandan and Rama 1995).

Liquidity. Companies that have less short-term assets are less able to service their
liabilities and thus are more likely to file for bankruptcy, particularly if the liabilities are due to
be settled in the near term. Therefore, studies generally find that auditors are more likely to issue
going-concern opinions to companies that have lower liquidity. Alternative measures of liquidity
include:
1)

Current assets / Current liabilities (e.g., Kida 1980; Mutchler 1985; Menon and
Schwartz 1987)

2)

Interest expense / Earnings before interest and tax (Koh 1991)

3)

Cash / Current liabilities (e.g., Kida 1980; Koh and Killough 1990; Koh 1991;
Lennox 1999a)

4)

Working capital / Total liabilities (Mutchler 1985)

56

5)

Cash flow from operations / Total liabilities (Menon and Schwartz 1987;
Raghunandan and Rama 1995).

Company size. Several studies find that larger companies are less likely to receive goingconcern opinions (McKeown et al. 1991a; Mutchler et al. 1997; Geiger and Raghunandan 2001,
2002; Geiger and Rama 2006), although some studies find insignificant results for client size
(Dopuch et al. 1987).
Debt defaults. Chen and Church (1992) show that going-concern opinions are more
likely to be issued to companies that are in debt default at the financial statement date. A number
of studies therefore incorporate a debt default indicator variable when estimating models of
going-concern reporting (e.g. Carcello et al. 1995; Mutchler et al. 1997; Carcello et al. 2000;
Carcello and Neal 2000; Geiger and Raghunandan 2001; Behn et al. 2001; Geiger et al. 2005;
Bruynseels and Willekens 2011). These studies all find a highly significant positive association
between debt default and the issuance of a going-concern modification.
Prior going-concern reports. It usually takes time for a company to turn around its
performance sufficiently to justify the withdrawal of a going-concern opinion (Nogler 1995).
Moreover, when companies enter into financial distress, they usually do so after a period of poor
performance. Given that there is strong persistence in a companys financial condition, it is to be
expected that there would also be persistence in the issuance of going-concern reports.
Audit reporting will also display persistence if auditors are unwilling to change the
opinion that was issued to a company in the previous year. For example, if a company received a
going-concern opinion in the previous year, the auditor may reluctant to issue a clean opinion in
the current year unless there is compelling evidence of an improvement in the companys
financial condition. In the other direction, auditors may be reluctant to issue a first time going57

concern opinion due to concerns that such an opinion would cause the company to change
auditors in the subsequent year (Geiger et al. 1998; Lennox, 2000; Carcello and Neal 2003).
Consistent with these arguments, prior studies find strong evidence of persistence in
going-concern reporting. Mutchler (1985) was the first study to show that a company is more
likely to receive a going-concern opinion in the current year if the company received a goingconcern opinion in the previous year. Lennox (2000) also finds that reporting persistence is
significantly stronger when the opinions in both years are issued by the same auditor. He finds
that the persistence in going-concern reporting is significantly weaker in years that U.K.
companies change their auditors, indicating that a change of auditor increases the likelihood of a
change in the audit opinion.
Auditors perceptions regarding the relative importance of different financial ratios
The academic literature has found a large number of financial variables that are
associated with going-concern reporting. However, this does not necessarily reflect that auditors
rely on such variables in practice. Mutchler (1984) and LaSalle and Anandarajan (1996) provide
survey evidence from auditors about the relative importance of different financial ratios for their
going-concern reporting decisions. In Mutchler (1984), the top five ratios are found to be: 1)
Cash flow from operations / Total debt, 2) Current assets / Current liabilities, 3) Net worth /
Total debt, 4) Total debt / Total assets, and 5) Total liabilities / Total assets. In a later study by
LaSalle and Anandarajan (1996), the surveyed auditors state that the top five financial ratios are:
1) Net worth / Total liabilities, 2) Cash flows from operations / Total liabilities, 3) Current assets
/ Current liabilities, 4) Total liabilities / Total assets, and 5) Change in net worth / Total
liabilities.

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Non-financial statement variables


While financial statement variables have been found to explain the going-concern
reporting decision, the information contained in the financial statements is backward-looking. In
contrast, the auditor has to look forward to the future when making a decision about the
companys ability to continue trading as a going-concern. Therefore, studies have used variables
from sources other than the past financial statements in order to explain the auditors decision to
issue a going-concern opinion.
Market variables. Changes in market value capture the markets assessment of the
change in the companys expected future cash flows. To the extent that the auditor shares the
same assessment as the market, it is expected that stock returns would explain the auditors
decision to issue a going-concern opinion.
Dopuch et al. (1987) include both market variables and financial statement variables as
predictors of audit reporting decisions. The dependent variable in their study indicates the
issuance of audit reports disclosing all types of uncertainties, not just those relating to goingconcern. As expected, Dopuch et al. (1987) find that uncertainties are more likely to be disclosed
in audit reports when companies have lower industry-adjusted returns and higher return
volatility. Following Dopuch et al. (1987), many subsequent studies have incorporated market
variables into their going-concern models (e.g. Mutchler and Williams 1990; Bell and Tabor
1991; Monroe and Teh 1993; DeFond et al. 2002; Carey and Simnett 2006; Fargher and Jiang
2008; Xu et al. 2011a; Kausar and Lennox 2011). Such measures may be increasingly relevant to
going-concern reporting during the period of the global financial crisis given that markets
incorporate information faster than the lagged representation in financial statements.

59

Contrary factors and mitigating factors. Contrary factors are indicators that contradict
the going-concern assumption, i.e., factors indicating that a company is likely to enter
bankruptcy. Mitigating factors are indicators that mitigate concerns related to going-concern, i.e.,
factors indicating that a company is likely to continue as a going-concern. Current audit
reporting standards require auditors to evaluate both contrary and mitigating factors when
determining whether a going-concern modification is appropriate. Surprisingly, Mutchler (1985)
finds that the predictive accuracy of her going-concern model declines when the contrary factors
and mitigating factors are added to the set of independent variables.17 Thus, she finds little
evidence that auditors uniformly take into account the contrary and mitigating factors when
deciding to issue going-concern opinions. In a follow-up study, Mutchler et al. (1997) revisit the
issue of contrary and mitigating factors. They classify the contrary factors as either mild or
extreme negative news events, and they classify the mitigating factors as either mild or
extreme positive news events. Mutchler et al. (1997) find insignificant results for all news
events except one, namely extreme negative news prior to the audit report date. Thus, they
conclude that going-concern reporting is generally insensitive to publicly available mitigating
factors, but may be affected by serious contrary factors publicly announced prior to the audit
report date.
In contrast to the studies by Mutchler, more recent studies provide evidence that auditors
do in fact take account of mitigating factors. Behn et al. (2001) find that two mitigating factors
17

Based on the guidance in SAS No. 34, Mutchler (1985) classifies the following variables as contrary factors
indicating a high probability of bankruptcy: 1) default on debt, 2) inventory obsolescence, 3) loss of major customer,
4) accounts receivable factoring, 5) preferred divided arrears, 6) employee strike, 7) federal tax lien, 8) product
obsolescence, 9) lost money on a fixed-price contract, 10) loss of purchase discounts from suppliers, and 11)
reorganization. Mutchler (1985) classifies the following variables as mitigating factors indicating a low probability
of bankruptcy: 1) availability of a line of credit, 2) a successful new product, 3) increase in R&D expenditures, 4)
sale of common stock, 5) issuance of new debt, 6) forgiveness and restructuring of debt including preferred
dividends, 7) waivers obtained for violations of debt covenants, and 8) employee and supplier concessions.

60

management plans to issue equity and plans to borrow are negatively correlated with the
issuance of going-concern opinions. Abbott et al. (2003) argue that debtor-in-possession (DIP)
financing is a mitigating factor and, consistent with this argument, they find that DIP is
negatively associated with the issuance of going-concern reports.
Evidence from outside the U.S.
Although most of the research cited above is based on U.S. data, the results have
generally been found to hold across many jurisdictions. For example, early studies using
Australian companies (e.g., Monroe and Teh 1993), U.K. companies (e.g. Peel 1987; Lennox
1999a), and Belgian companies (Gaeremynck and Willekens 2003; Vanstraelen 2002) confirm
that measures of client financial distress have significant power in explaining the auditors
decision to issue a going-concern opinion.

4.4 Business strategy and company turnaround


The literature offers an extensive body of research on how firms reverse firm-threatening
performance declines to achieve successful company turnaround.18 This turnaround literature
could be insightful to build expectations about the effect of business strategy on going-concern
reporting. Adopting a business risk approach, auditors must gain a thorough understanding of a
clients business (e.g., Bell et al., 1997; Bell et al., 2005; Curtis and Turley, 2007; Knechel and
Vanstraelen 2007), including an assessment of managements plans and strategies to mitigate the
risk of business failure. SAS No. 59 states that non-financial matters are relevant to assess the
going-concern status of a client. Examples in SAS No. 59 include work stoppages or substantial
dependence on the success of a particular project, legal proceedings or the loss of a key

18

Successful turnaround can be defined as the reversal of a firms pattern of performance decline (Schendel et al.
1976).
61

franchise, license or patent. A general evolution towards business risk auditing is further
reflected in some of the new International Audit Risk Standards. In particular, ISA 315 requires
the auditor to develop an understanding of client objectives and strategies, as well as the related
business risks that may result in a material misstatement of the financial statements.
A widely adopted framework in the strategy literature categorizes management
turnaround actions into strategic and operating turnaround approaches (Hofer 1980). A strategic
turnaround approach aims at long-term profitability by solving external strategic problems.
Examples include changes in the firms alliances and cooperative agreements, launch of new
product lines or market penetration, and business divestments or acquisitions. An operating
turnaround approach, in contrast, focuses on solving internal operating problems. Examples
include cost cutting, increased efficiency, disposal of assets and improvement in sales (of
existing products). Whereas operating initiatives only aim at short-term improvement in financial
performance, strategic initiatives aim at long-term performance.
Overall, the evidence from the strategy literature suggests that (long-term) approaches are
more likely to be successful turnaround vehicles. However, not all strategic turnaround actions
generate improved liquidity in the short term. The evidence suggests that cooperative agreements
and alliances with other firms have a beneficial impact on company turnaround and performance
(see, Mitchell and Singh 1996; Barker and Duhaime 1997, Powell, Koput and Smith-Doerr 1996;
Stuart 2000). However, prior research reports that new product development involves great
levels of unpredictability, as it requires the development of new routines or the recombination of
old routines (e.g., Mishina et al. 2004). Consistent with no improvement in performance,
Mishina et al. (2004) find a negative association with the rate of short-term sales growth. In a
recent meta-analytic review of merger and acquisition performance, King et al. (2004) report that

62

acquisitions do not improve the short-term financial performance of acquiring firms, on average.
Instead, the authors indicate that the short-term returns for acquiring firms are insignificant or
negative beyond the day a merger or acquisition is announced.
Prior studies that examine the association between operating turnaround approaches and
successful company turnaround have focused on retrenchment activities and find mixed results.
Several studies report that classic retrenchment strategies are significantly associated with
turnaround success (e.g., Robbins and Pearce 1992), whereas other studies cast doubt on the
value of operating approaches as part of a companys turnaround approach (Barker and Mone
1994; Sudarsanam and Lai 2001). This mixed evidence seems to suggest that operating
turnaround strategies per se may not be capable of resolving deficiencies in a declining firms
strategic orientation.
While the importance of the clients business and strategy is recognized by auditing
practitioners, research about the effect of strategic plans on the likelihood of going-concern
opinions is scant. Bruynseels and Willekens (2011) provide a comprehensive empirical study on
the association between strategic risk information and going-concern decisions for distressed
clients in the U.S. manufacturing industry. They analyse whether a comprehensive set of
turnaround activities are regarded by auditors as distress-mitigating factors or as going-concern
risk factors. They draw on the evidence from the strategy literature discussed in the above
paragraphs and distinguish between two types of management turnaround initiatives: operating
turnaround initiatives and strategic growth initiatives. They further sub-divide the strategic
growth initiatives into two categories: strategic growth initiatives that have short-term positive
cash flow potential beyond their long-term positive cash flow potential (such as cooperative
agreements), and strategic growth initiatives that only have long-term positive cash flow

63

potential (such as innovation and expansion strategies). Overall, their findings suggest that
auditors strategic risk assessment is associated with the outcome of the audit process. They find
that both short-term cash flow potential as well as strategic growth and hence long-term cash
flow potential are necessary for strategic turnaround initiatives to have a mitigating impact on the
auditors going-concern decision. Strategic turnaround initiatives for which only one of these
two conditions holds and operating turnaround initiatives appear to function as going-concern
risk factors as they are associated with a higher likelihood that a going-concern opinion will be
issued. More specifically, they find that only new cooperative agreements are negatively
associated with the likelihood that a going-concern opinion is issued. On the contrary, new
mergers and acquisitions are positively associated with the likelihood that a going-concern
opinion is issued, which suggests that they are perceived as going-concern risk factors. The same
holds for cost reduction initiatives which also seem to increase the likelihood of a going-concern
opinion. These findings are in line with the strategy literature, which documents that acquisitions
do not improve the short-term financial performance of acquiring firms (King et al. 2004) and
that short-term fixes are often insufficient for firms with extremely poor performance to
successfully turn around (Sudarsanam and Lai, 2001). Finally, Bruynseels and Willekens (2011)
find that city-level industry specialists perceive the implementation of short-term operating
initiatives as a going-concern risk factor, whereas non-specialists do not seem to do so.

4.5 Empirical issues


Estimation methods
This section briefly discusses some method-related issues that need to be considered in
interpreting the academic research. The extant literature uses a variety of estimation methods to
model the auditors decision to issue a going-concern report. Early studies in the literature used

64

discriminant analysis before later moving on to employ neural network methods. More recently,
however, researchers have generally used logit and probit models to explain going-concern
reporting. In this section, we briefly review and comment on these different methodologies.
Discriminant analysis Early studies in the going-concern reporting literature used
discriminant analysis (DA) to estimate their models (e.g., Altman and McGough 1974; McKee
1976; Kida 1980; Levitan and Knoblett 1985; Mutchler 1985; Koh and Killough 1990; Barnes
and Huan 1993). However, the suitability of this procedure rests on two assumptions: 1) the
explanatory variables have a multivariate normal distribution, and 2) the covariance matrices are
equal across the two groups. Unfortunately, the variables that are typically used in studies of
bankruptcy and going-concern reporting typically violate these two assumptions (Eisenbeis
1977; McLeay 1986; Hamer 1983; Lennox 1999b). Therefore, more recent studies have moved
away from using discriminant analysis.
Neural networks During the 1990s, some authors were using the neural network
approach to predict the issuance of going-concern opinions (e.g., Udo 1993; Lenard et al. 1995).
However, this approach appears to have fallen out of favor in recent years.
The neural network approach is entirely statistical as the objective of the researcher is to
maximize the models predictive accuracy. There are concerns that such a data driven approach
could lead to data mining. More importantly, researchers in accounting are generally more
interested in testing theory than in finding a statistical model that has the greatest predictive
power. Neural network models do not generate easily interpretable coefficient estimates or tests
of statistical significance. Therefore, they are not commonly found in studies that are attempting
to test hypotheses relating to the going-concern reporting decision.

65

Logit and probit models Most studies in the recent literature use logit or probit models
to estimate the going-concern decision, although logit appears to be used more often. Typically
the logit and probit models generate very similar inferences and so there is usually little to
choose between the two methods in practice.19 Unlike discriminant analysis, logit and probit do
not require any assumptions about the distributions of the explanatory variables or the covariance
matrices.
However, a cautionary note should be made regarding the small sample sizes that are
used in some going-concern studies. The small sample behaviour of maximum likelihood
estimators is for the most part unknown (Long 1997).20 It is also not possible to provide a general
rule as to how large the sample needs to be, as this depends on other characteristics of the data
and the model to be estimated.21 Thus, one should be cautious in interpreting the results of
models that are estimated on small samples, particularly when the samples contain relatively few
going-concern opinions.
Similarly, care must be taken when interpreting the coefficients on interaction variables.
A number of studies have incorporated interaction variables in order to assess whether the impact
of one independent variable on the decision to issue a going-concern opinion depends on the
magnitude of another independent variable (e.g. Carcello et al. 2000, Carcello and Neal 2000).
Although interpreting product terms in linear models is straightforward, the intuition from linear

19

The probit and the logit differ in their assumptions about the distribution of the error term. This causes the scaling
of the coefficients to be different (Logit 1.6Probit). However, the signs of the coefficients, their significance levels
and the predicted probabilities are usually very similar (Long 1997).
20
The ML estimation properties of consistency, normality, and efficiency are asymptotic and prove to hold as the
sample size approaches infinity.
21
The adequate sample size depends on the characteristics of the model and data (Long 1997): the more parameters
in the model, the more the observations are needed; high levels of collinearity between independent variables require
more observations; little variation in the dependent variable (for example, very few observations with going-concern
modifications) also requires a larger number of observations.
66

models does not necessarily extend to non-linear models such as the logit and probit models. We
refer the interested reader to Ai and Norton (2003; 2004) for more on these issues.
Sample selection
Studies also differ in their sample selection criteria for identifying distressed firms. Some
studies examine going-concern reporting without imposing any restrictions on the sample,
whereas other studies utilize a matched sample in which the number of observations with a
going-concern opinion equals the number without a going-concern opinion (e.g. Mutchler 1985;
Chen and Church 1992; Behn et al. 2001; Geiger and Rama 2003). The observations with no
going-concern opinion are usually taken from a set of firms that are matched as closely as
possible on the level of financial distress, industry, year and size. Such choice-based sampling
(i.e. endogenous sample stratification) reduces data collection costs, which is an important
consideration when data is unavailable in machine-readable databases and have to be collected
by hand. It is, however, important that the necessary adjustments are made to the analysis to
accommodate the over-sampling of the going-concern opinion population (Hopwood et al. 1994;
Carey et al. 2008; Cram et al. 2009).
Some studies, by contrast, focus on bankrupt firms only. In such studies, the objective is
usually to explain why bankrupt companies were not issued with going-concern opinions prior to
the companys failure (e.g. Menon and Schwartz 1987; Carcello et al. 1995; Raghunandan and
Rama 1995; Mutchler et al. 1997; Geiger and Raghunandan 2001; Geiger et al. 2005). Given the
wide disparity in some of the results reported in the extant literature, we believe that more work
is needed to understand the ramifications of different sample selection methods.
Finally, all U.S. studies rely on data about publicly traded companies. We find no goingconcern study examining private U.S. companies. Additionally, several studies rely on data
67

contained in the Compustat and CRSP databases for analyses (e.g., DeFond et al. 2002;
Feldmann and Read 2010). Reliance on these databases that include only the larger publicly
traded companies would, by definition, exclude smaller companies from the analyses.
Accordingly, conclusions drawn from empirical studies in the U.S. may be more applicable to
the larger public companies than to smaller public firms and we have no research to date on
private U.S. companies.
4.6 Summary
In summary, this section documents a broad variety of mainly client related factors that
are associated with the issuance of opinions modified for going-concern uncertainty. A major
insight is that publicly available information about the clients financial condition is an important
factor affecting the auditors decision to issue a going-concern modification. A broad variety of
measures related to a clients financial condition affect the issuance of going-concern reports.
These include profitability, leverage, liquidity, company size, debt defaults and prior goingconcern reports, as well as non-financial statement related variables such as market variables.
The strategy literature on company turnaround indicates that strategic turnaround actions which
offer a prospect of short term cash relief should also function as mitigating factors in goingconcern assessment. However, operating turnaround strategies (such as cost cutting) do not
function as mitigating factors, presumably because they are indicative of going-concern
problems.

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5. AUDITOR INDEPENDENCE, OBJECTIVITY AND AUDIT


QUALITY
5.1 Introduction
As explained in Section 3, the clients financial condition has a high degree of association
with the auditors decision to issue a going-concern opinion. Nonetheless, the relative accuracy
of audit opinions as predictors of future corporate failure has sometimes been found wanting,
particularly when compared with the predictive accuracy of bankruptcy prediction models
(Altman and McGough 1974; Altman 1982; Levitan and Knoblett 1985; Mutchler et al. 1997).
Concerns about the accuracy and reliability of going-concern reporting are particularly salient in
the context of the global financial crisis where auditors have been criticized for failing to warn
the public and regulators about the financial problems of the banking sector.
In an attempt to resolve this conundrum, the academic literature has investigated whether
proxies for auditor independence22 and audit quality explain the auditors decision to issue a
going-concern opinion. The basic idea is that the audit report may be a less accurate predictor of
future bankruptcy if the going-concern reporting decision depends on factors other than the
clients financial distress. In other words, are there situations in which auditors do a worse (or
better) job at identifying a clients future viability status through the issuance of a going-concern
modified opinion? Further, are there situations in which auditors appease their clients by not
issuing going-concern modifications?

22

Academic literature typically equates what is referred to as auditor independence in the academic literature with
what is referred to as auditor objectivity in the professional standards. Academic research typically does not assess
whether auditors comply with the independence standards of the profession when evaluating whether auditors
appear to act independent of the client.
69

Studies on auditor independence and audit quality posit that an auditor will issue a goingconcern opinion when two conditions are met:
1)

the auditor has collected sufficient competent evidence that indicates the existence
of a potential going-concern problem, and

2)

the auditor is sufficiently independent from the client to issue a going-concern


opinion even if the client would prefer a clean opinion.

Audit quality is believed to depend on factors that could affect auditor competence
(factor 1) and auditor independence (factor 2). In order to assess these two factors, researchers
attempt to control for the existence of financial problems by controlling for the clients financial
condition.
The existing literature has tested various factors that could have an impact on the
auditors competence or the auditors independence. These factors include the following: 1)
economic dependence on a large or important client, 2) magnitude of audit fees, 3) provision of
non-audit services, 4) auditor switching and opinion shopping, 5) the length of auditor-client
tenure, 6) personal relationships between auditors and clients, 7) auditors compensation
arrangements, 8) litigation, 9) external regulation, 10) audit firm size, 11) industry specialization,
12) audit committees, 13) audit market structure and competition, and 14) audit reporting lag.
The evidence on each of these factors is discussed in the following sub-sections.

5.2 Economic dependence on a large or important client


Economic dependence has long been a concern for the public accounting profession due
to the fact that audit clients pay fees directly to their auditors (Mautz and Sharaf 1961). An
auditors economic dependence has been measured in various ways in the literature. One strand

70

of research examines the possible effect of large or important clients on audit decision-making.
An audit firms reliance on a large or important client may create a heightened economic
dependence that causes the auditor to issue an unmodified report even when a going-concern
modification is warranted. The major concern is that an auditor may lack independence when
auditing a client that accounts for a large proportion of the auditors revenue.
The evidence from U.S. studies generally fails to support the idea that client importance
significantly affects going-concern reporting decisions. Reynolds and Francis (2001) find no
evidence that the size of the client relative to the size of the audit office affects the type of report
that is issued. Further, Li (2009) finds no significant association between the fee ratios (i.e., total
fees from the client divided by total office fees for all clients) and the auditors propensity to
issue a going-concern opinion during the pre-SOX period. However Li (2009) finds that the audit
fee ratio is positively associated with the auditors propensity to issue a going-concern opinion
during the early post-SOX period. That is, clients paying higher audit fees were more likely to
receive going-concern modifications. Rather than reducing auditor independence by increasing
the auditors economic dependence, this suggests that a higher audit fee ratio indicates that the
auditor has performed additional procedures, and is therefore more likely to detect, and report,
going-concern issues. Similarly, Hunt and Lulseged (2007) find that non-Big N auditors are at
least as likely to issue a going-concern report to their large financially distressed clients as they
are to their smaller distressed clients. This result holds at both the audit office level and the audit
firm level, providing additional support that dependence on large audit clients generally does not
appear to impair auditor reporting decisions in the U.S.
In a recent study, Ettredge et al. (2011) revisit this issue in the context of the global
financial crisis of 2007-2009. They measure economic dependence as the proportion of the audit

71

firms local office revenue accounted for by a client. They find that auditors are less likely to
issue first time going-concern opinions to clients that contribute large proportions of revenue in
2008 (mid-crisis) compared with in 2006 (pre-crisis). Their findings suggest that the state of the
macro-economy may affect the relationship between fees and going-concern reporting.
Evidence from outside the U.S.
In Australia, Craswell et al. (2002) find that the level of fee dependence on large clients
does not affect an auditors propensity to issue unqualified audit opinions. This finding holds at
both the audit firm level and the office level. Using data on Belgian private companies,
Vandenbogaerde et al. (2011) investigate the relationship between audit fee dependence at the
individual partner level (the proportion of an audit partners revenue accounted for by a client)
and find no significant association with going-concern reporting. Evidence from China, however,
suggests that client importance might be an important factor. Chen et al. (2010) find that the
propensity of Chinese auditors to issue modified audit opinions is negatively correlated with
client importance from 1995 to 2000. However, from 2001 to 2004, when the institutional
environment became more investor-friendly, they find that the propensity to issue modified
opinions is positively associated with client importance.

5.3 Audit and non-audit fees


A second strand of the literature measures economic dependence using data on audit and
non-audit fees rather than the clients relative importance. DeFond et al. (2002) find no
association between audit fees and going-concern reporting decisions, while studies by Geiger
and Rama (2003) and Geiger and Blay (2011) find that distressed companies that pay high audit
fees are more likely to receive a going-concern modification from their auditor. This positive
association between audit fees and going-concern report modifications likely reflects the fact that
72

auditors work more in order to ensure the appropriateness of the report modification, as well as
auditors charging a higher risk premium when they recognize that their clients face a high goingconcern risk.
Providing substantial amounts of non-audit services to audit clients may make it more
likely that auditors concede to the wishes of client management when faced with difficult
judgments. Yet, studies examining the initial fee disclosures of U.S. companies have not found
the hypothesized negative relationship between non-audit fees and the issuance of going-concern
opinions. Specifically, DeFond et al. (2002) and Geiger and Rama (2003) examine audit reports
along with the initial fee disclosures mandated by the SEC in 2001 and find no significant
association between non-audit fees and audit reporting decisions in the U.S.
However, using data from the post-SOX period, studies by Griffin and Lont (2010) and
Geiger and Blay (2011) find a significant negative association between the level of non-audit
service fees and the likelihood of auditors issuing a going-concern opinion. Therefore, clients
that pay higher non-audit fees appear less likely to receive going-concern opinions in the more
recent post-SOX period.
In addition, Geiger and Blay (2011) examine the relation between current going-concern
reporting decisions and future fee receipts from incumbent audit clients. They find that fees
received in future periods (i.e., over the subsequent two years) are negatively related to auditors
current going-concern modification decisions. That is, firms paying higher subsequent total fees
(audit fees and non-audit fees combined) are less likely to receive a going-concern modification.
These results suggest that the economic bond of potential future fee receipts may impair current
reporting decisions. However, additional research in this area is needed in order to more fully
understand the complex relationship between future fee receipts and current decision-making.

73

Evidence from outside the U.S.


Hope and Langli (2010) investigate non-listed Norwegian firms and find no significant
association between unexpected audit fees and going-concern opinions. Earlier studies in the
U.K. (Lennox 1999c) and Australia (Craswell 1999; Craswell et al. 2002) also find no significant
association between non-audit fees and going-concern modifications. However, more recent
U.K. studies by Firth (2002) and Basioudis et al. 2008) report a negative association between
non-audit fees and the auditors propensity to issue a modified opinion. Similar findings have
also been reported more recently for Australia (Sharma et al. 2001; Basioudis et al. 2009; Ye et
al. 2011). Overall, it appears that more recent research finds that fees received from non-audit
services may impair auditor independence and therefore make it less likely that auditors issue
going-concern modified reports. However, these findings are far from conclusive and need future
replication and additional investigation.

5.4 Auditor switching and opinion shopping


An auditors economic dependence on a client is affected not only by the fees received
from the client, but also by the risk that the auditor would lose those fees if the auditor issues an
unfavorable opinion and the client switches auditors. Thus, several studies have examined the
relationship between auditor reporting and clients decisions to dismiss their auditors.
Numerous studies from the U.S. find that auditors are more likely to be dismissed in the
year after they issue going-concern modified audit reports to their clients (e.g., Chow and Rice
1982; Smith 1986; Geiger et al. 1998; Carcello and Neal 2003). This provides strong empirical
support for the argument that auditor dismissal represents a potential economic threat to an
auditor contemplating a going-concern report modification. In other words, auditors know that
they are much more likely to lose their clients, and the revenues they provide, if they issue
74

going-concern modified reports to them. However, Hoitash and Hoitash (2008) report fewer
dismissals of auditors following going-concern modifications issued during the post-SOX era,
suggesting that this threat may be lower in the current audit environment than in previous
periods.
Another question is whether such switching behavior is successful in terms of removing
the going-concern report modification (i.e., opinion shopping). In other words, are clients less
likely to receive going-concern reports when they switch away from auditors who issued the
initial going-concern reports? Early research in the U.S. generally finds no association between
switching to a new auditor and a subsequent improvement in the audit opinion (Chow and Rice
1982; Krishnan 1994; Krishnan and Stephens 1995; Krishnan et al. 1996; Geiger et al. 1998).
Thus, these studies contend that switching auditors as a strategy for opinion shopping is
generally not successful.
In contrast, Lennox (2002) argues that earlier U.S. empirical findings do not necessarily
mean that opinion shopping is futile. Rather than comparing observed pre- and post-switch audit
reports, he tests for opinion-shopping by predicting the opinions that U.S. companies would have
received had they made switch decisions opposite to those that actually occur. For companies
that switch auditors, he predicts the likelihood that these clients would have received unfavorable
opinions if they had instead retained their auditors. Likewise, for companies that retain their
auditors, he predicts the likelihood that these clients would have received unfavorable opinions if
they had instead switched to different auditors. His results indicate that companies would have
received less favorable opinions if they had made switch decisions opposite to those actually
observed. Based on these results, Lennox (2002) infers that opinion shopping is indeed
successful in the U.S. Consistent with Lennox (2002), Carcello and Neal (2003) also find that

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among companies that receive modified audit opinions in the prior yearthe likelihood of another
modified opinion in the current year is lower for companies that change their auditor. Further,
Carcello and Neal (2003) show that such opinion shopping behavior is more likely to be
successful when companies have a higher percentage of affiliated directors (i.e., individuals that
were formerly employed with the companys current external audit firm) on the audit committee.
Evidence from outside the U.S.
All studies to date, regardless of country, have found that auditors are more likely to be
dismissed in the year after they issue going-concern reports to their clients. This finding has been
documented in studies of auditor switching in the U.K., Australia, China, and Belgium (e.g.,
Craswell 1988; Lennox 2000; Vanstraelen 2003; Chan et al. 2006; Carey et al. 2008).
When assessing opinion shopping in Australia, Craswell (1988) concludes that his
sample of switching firms was more likely to receive a clean opinion than those that did not
switch. These findings are consistent with the U.S. studies of Lennox (2002) and Carcello and
Neal (2003), which contend that opinion shopping can be a successful strategy for avoiding
modified opinions in audit reports.

5.5 Auditor-client tenure


Many countries require audit firms and partners to be rotated off audits due to concerns
that long periods of tenure between auditors and their clients threaten auditor independence.
Conversely, there is a competing argument that long tenure can improve audit quality by
increasing the auditors knowledge and understanding of the client. Given these opposing
arguments, it is unclear whether mandatory auditor rotation would increase or reduce the
frequency with which auditors issue going-concern opinions.

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Geiger and Raghunandan (2002) find a positive association between audit firm tenure and
the propensity to issue a going-concern opinion prior to bankruptcy. Their results support the
argument that longer time with the client enables the auditor to gain additional insights into the
client, allowing the auditor to better report on the going-concern uncertainty.
Evidence from outside the U.S.
Jackson et al. (2008) find a positive association between going-concern modifications and
auditor tenure using Australian data. However, in Belgium, Vanstraelen (2002) reports a
negative association between audit-firm tenure and the issuance of a going-concern opinion.
In addition, while data is not available in the U.S., some overseas studies examine
whether the length of tenure between the audit partner and the client explains the audit reporting
decision. Using data from Australia where partners are required to sign their audit reports, Carey
and Simnett (2006) and Ye et al. (2011) find that long tenure partners are less likely to issue
going-concern opinions. However, Knechel and Vanstraelen (2007) find no association between
audit partner tenure and going-concern opinions for a sample of private companies in Belgium,
an environment where they argue that partner tenure is more likely to have a negative effect on
audit quality. Likewise, Ruiz-Barbadillo et al. (2009) find no evidence that mandatory partner
rotation in Spain is associated with a higher propensity to issue going-concern opinions. So, the
international evidence is mixed with respect to the effects of audit firm tenure and audit partner
tenure on going-concern reporting.

5.6 Personal relationships between auditors and clients


Personal relationships between auditors and clients are difficult to observe due to their
sensitive nature. However, a study by Lennox (2005) attempts to identify connections

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(affiliations) between auditors and the management teams of the clients they audit. He defines
an executive as being affiliated with the auditor if the executive previously worked for the
employers audit firm. Lennox (2005) finds that most affiliations (71.3%) occur when auditors
become employees of audit clients (employment affiliations), but affiliations can also arise as a
result of companies hiring their executives former audit firms (alma mater affiliations). For
both types of affiliation, the affiliated companies are significantly less likely than unaffiliated
companies to receive going-concern opinions. Similarly, Ye et al. (2011) find that in Australia
going-concern opinions are less likely to be issued when the client and auditor are affiliated.

5.7 Auditors compensation arrangements


Carcello et al. (2000) examine the effect of partner compensation plans on the auditors
decision to issue a going-concern opinion. They find no evidence that going-concern reports are
affected by partner compensation plans (small pool/local office profits versus large
pool/worldwide firm profits). However, they do find that going-concern opinions are affected by
the interaction between partner compensation plans and client size (a measure of economic
dependence). Their results suggest that auditors in small-pool firms may be more sensitive to
client size than partners in large-pool firms when making going-concern opinion decisions.

5.8 Litigation
Numerous studies examine how litigation (or the threat of litigation) affects auditor
reporting. Geiger et al. (2006) examine the impact of the Private Securities Litigation Reform
Act (PSLRA) which reduced the threat of litigation against auditors. They find that the
likelihood of a going-concern opinion decreased significantly after the enactment of the PSLRA,
and the change was particularly pronounced for the Big 6 audit firms.

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Some studies argue that the threat of litigation increased subsequent to SOX and
consistent with this argument, there is evidence that auditors are more likely to issue goingconcern opinions during the post-SOX period (Geiger et al. 2005; Sercu et al. 2006; Nogler
2008; Myers et al. 2008; Fargher and Jiang 2008). However, Feldman and Read (2010) find that
the heightened going-concern reporting rates subside in the years after SOX and revert to their
pre-SOX levels by 2006. (A limitation of these studies, however, is that the PSLRA and SOX
affected all auditors in the U.S. at exactly the same point in time. This means that the studies are
unable to utilize a control sample of audit firms that were not affected by the PSLRA and SOX.
Consequently, it is difficult to determine whether the changes in going-concern reporting really
are attributable to the PSLRA and SOX or to other concurrent changes in the economy.)
Evidence from outside the U.S.
Two recent studies examine whether the threat of litigation embedded within the audit
firms organizational form affects its audit reporting decisions. Using a sample of Chinese audits
in the period 2000 to 2004, Firth et al. (2011) compare audit reporting practices by auditors that
are unlimited liability partnerships and auditors that are limited liability corporations. They find
that auditors in unlimited liability partnership firms are more likely to issue modified audit
opinions than are auditors in limited liability corporations, and conclude that a limited liability
regime induces lower auditor reporting conservatism. However, a limitation of this study is that
it compares unlimited liability audit partnerships with limited liability audit corporations. Thus,
it is unclear whether the change in audit reporting practices is driven by the switch from the
partnership form to the corporate form, or by the switch from unlimited liability to limited
liability.

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In a related study, Lennox and Li (2011) examine the U.K. where auditors were allowed
to switch from unlimited liability partnerships to limited liability partnerships after 2001. Their
study is different from Firth et al. (2011) because they examine the switch from unlimited to
limited liability, holding constant the audit firms organizational form (i.e., each audit firm
remained as a partnership). Lennox and Li (2011) find no evidence that the switch from
unlimited to limited liability affects the audit reporting decision.

5.9 External regulation


Regulatory oversight might also affect the auditors decision on whether to issue a goingconcern opinion. Gramling et al. (2011) focus on the regulatory oversight provided by PCAOB
inspectors. Specifically, they test whether non-Big 4 auditors are more likely to issue goingconcern opinions after they are inspected. They find that auditors receiving unfavorable
inspection reports are more likely to issue going-concern opinions subsequent to their
inspections. Their findings are consistent with regulatory oversight having on impact on the
auditors decision to issue going-concern reports.

5.10 Auditor size


Many studies include an indicator variable to identify whether the audit opinion is issued
by a large international audit firm or by a smaller auditor. However, the results are rather mixed.
Mutchler et al. (1997) include a dummy variable that indicates whether the auditor was a Big 6
or non-Big 6 audit firm. They find no significant difference in going-concern reporting rates
between Big 6 and non-Big 6 auditors. More recently, Boone et al. (2010) find weak evidence
that the Big 4 have a higher propensity to issue going-concern opinions compared with the
smaller non-Big 4 auditors. On the other hand, several studies find that Big 4 clients are

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significantly less likely to receive going-concern opinions (Reichelt and Wang 2010; DeFond et
al. 2011; DeFond and Lennox 2011; Numan and Willekens 2011). These latter authors attribute
the negative relationship to the fact that Big 4 clients are in better financial condition and are
therefore less likely to warrant a going-concern modified report.
Francis and Yu (2009) argue that within the Big 4 firms, it is the larger audit offices that
supply higher quality audits due to their greater in-house expertise. Using a sample of 6,568 U.S.
audits by 285 unique Big 4 offices, they find that larger offices are more likely to issue goingconcern opinions. This is consistent with their argument that larger offices are better able to
detect and report going-concern issues.

5.11 Industry specialization


It has also been argued that auditors supply higher quality audits when they are specialists
in the clients industry. Reichelt and Wang (2010) find that an auditor who is both a national and
a city-specific industry specialist is more likely to issue going-concern opinions. However,
Minutti-Meza (2011) contends that the results in Reichelt and Wang (2010) are actually
attributable to differences in the characteristics of clients that hire industry specialists and clients
that hire non-specialists. He finds no significant differences in audit reporting between these two
groups of clients when they are matched on industry, size, and performance.
Some studies have postulated that the benefits of industry expertise are context specific.
For example, Lim and Tan (2008) argue that industry specialists are more likely than nonspecialists to benefit from knowledge spillovers arising from the provision of non-audit services.
They find that the propensity of industry specialists to issue going-concern opinions increases
with the level of non-audit fees.

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5.12 Audit committees


Carcello and Neal (2000) argue that an independent and effective audit committee can
help to safeguard audit quality. Consistent with this argument, they find that auditors are more
likely to issue going-concern reports to companies that have more independent audit committees.
Independent and effective audit committees can also help to protect an auditor against the
risk of being dismissed for issuing a going-concern report. Carcello and Neal (2003) find that
audit committees with greater independence, greater governance expertise, and lower
stockholdings are more effective in shielding auditors from dismissal after the issuance of new
going-concern reports. Similar results have also been reported in Spain (Lopez, 2010).

5.13 Market structure and competition


Regulators have often expressed their concerns about the high level of concentration in
the audit market and the effect that this might have on audit quality. A recent study by DeFond
and Lennox (2011) examines changes in the structure of the audit market following the
introduction of SOX. They find a large reduction in the number of small audit firms operating in
the public company market following the passage of SOX. In fact, of the 1,233 small audit firms
that were active in the U.S. public market during 20012008, they find that 607 audit firms
exited the market, with most of the exits occurring in the years immediately after SOX. DeFond
and Lennox (2011) find that going-concern opinions are more likely to be issued to the clients of
exiting audit firms when they are audited by their new successor auditors than when they were
audited by the exiting small firm. Other findings reported in DeFond and Lennox (2011) suggest
that this change in going-concern reporting is driven by the relatively low quality of the exiting
auditors. Overall, their results suggest that the exiting auditors had been supplying low quality

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audits prior to SOX, and the enactment of SOX induced these low quality auditors to exit the
market. Contrary to regulators concerns that there are too few auditors operating in the market,
their findings suggest that the reduction in the number of small auditors has actually resulted in
higher quality auditing.
A recent study by Numan and Willekens (2011) focuses more directly on the role of
competition, as distinct from the number of suppliers in the market. They investigate whether
competitive pressure from a close competitor, i.e., a competitor that is similar in terms of
industry expertise, affects auditor reporting. Using U.S. office level data, they find that auditors
are less likely to issue going-concern reports when they face a high level of competition from
their closest rivals. Interestingly, their results suggest that the previously documented association
between industry expertise and going-concern reporting disappears after controlling for the
auditors relative dominance over its closest competitor. Thus, Numan and Willekens (2011)
argue that it is the level of competition rather than industry specialization per se that affects audit
quality.

5.14 Audit report lag


The audit report lag is the number of days between the fiscal year-end and the date that
the audit report is issued. Many prior studies find that the likelihood of a going-concern report is
higher in the presence of a longer audit report lag (e.g., McKeown et al. 1991a; Carcello et al.
1995; Mutchler et al. 1997; DeFond et al. 2002; Geiger et al. 2005; Li 2009; Geiger and Blay
2011). However, the direction of causality underpinning this association is unclear. On one hand,
it could be that more extensive and time-consuming testing improves the ability of auditors to
detect going-concern issues with their clients. On the other hand, it could be that auditors take
longer to complete the audit and determine the appropriate opinion when their clients have

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going-concern problems. This may be particularly true when the auditor is in negotiations with a
client that wants to avoid receiving a going-concern modification.

5.15 Summary
Following the corporate collapses and regulatory responses in the 2000 to 2002 period,
there has been increased interest in the study of audit quality. There are factors that have been
alleged to affect auditor competence, effort, or independence, and thus affect the auditors
decision to issue a going-concern opinion.
Based on the most recent U.S. research, we find that, in general, going-concern modified
opinions are more likely to be issued when clients pay relatively high audit fees, in times when
public, legal and regulatory scrutiny of auditors is high, the client has a strong audit committee,
there is low client-specific competition, and audit report lags are longer. In addition, goingconcern modified opinions are less likely to be issued when client management has a personal
affiliation with the audit firm or when companies change their auditor after receiving modified
reports in the previous year.
However, the findings of studies on whether going-concern reporting is affected by an
auditors economic dependence on large audit clients or by the provision of non-audit services
are mixed. This is disappointing because these are precisely some of the issues of concern to
regulators. Moreover, there are often no obvious explanations for some of the contradictory
findings. Clearly, further research is needed to better understand the conditions under which
audit quality and independence is enhanced or impaired and how that translates into goingconcern opinion decisions.

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6. OTHER AREAS OF GOING-CONCERN RESEARCH


6.1. Going-concern opinions for financial institutions
Prior research on going-concern reporting in the U.S. has typically not focused on
financial institutions, and yet research on financial institutions during the recent global financial
crisis is certainly warranted. In fact, the House of Lords (2011, paragraph 138) raises the
pertinent issue: The banking crisis of 200709 raised the question (among others) why there
was so little warning that so many banks were in trouble and that the worlds financial system
was at risk.
At present there is little to no research on whether auditors are, or should be, reluctant to
issue going-concern reports to financial institutions. There is a concern that the modified report
may reduce the publics confidence in a banks ability to continue as a going-concern and could
become a self-fulfilling prophecy by precipitating the banks failure. While the self-fulfilling
prophecy can potentially affect any company that receives a going-concern opinion, financial
institutions are of particular interest because a bank failure can precipitate a financial crisis
throughout the entire financial system due to systemic risk. It is an open question whether this
affects the willingness of auditors to issue going-concern reports to financial institutions.
A further consideration is that because of the systemic risks associated with financial
institutions there is the potential prospect of national and state support for banks and financial
institutions in order to prevent them from failing. It is an open question whether national and
state support for the banking sector affects the willingness of auditors to issue going-concern
reports to these financial institutions. Do auditors issue fewer report modifications because they
believe the support systems in place will usually not let the bank fail, resulting in a reduced need

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for going-concern modifications? If so, then what assurances can auditors obtain from
governmental agencies that sufficient support will be provided to prevent the banks failure?
Given that the government is not a disinterested party, how can the auditor become convinced
that assurances of financial support from the government are in fact credible? Do governments
put any pressure on auditors not to issue going-concern opinions to troubled financial
institutions?
There has been very little research, in the U.S. or abroad, on these important issues.
Nevertheless, the House of Lords report alleges that the complacency of bank auditors was a
significant contributory factor with respect to banking failures in the United Kingdom during
2008 and 2009 (paragraph 167).

6.2 The stock market reaction to the issuance of a going-concern opinion


As discussed in Section 3.2, there is plenty of evidence that publicly available
information regarding the clients financial condition explains the auditors decision to issue a
going-concern opinion. However, auditors are privy to information not in the public domain and
thus have access to a richer set of information upon which to make their judgment about an
entitys ability to continue as a going-concern. To the extent that going-concern opinions reflect
the auditors private information (i.e., information not available to investors), it is expected that
the issuance of a going-concern opinion would affect the companys stock market valuation.
Thus, studies have attempted to assess the information content of going-concern opinions by
testing whether the news causes a drop in the companys stock price.
The majority of early studies examined the market reaction to going-concern opinions
issued by auditors in the U.S. (Chow and Rice 1982; Elliott 1982; Banks and Kinney 1982;
Davis 1982; Dodd et al. 1984). Most studies found large negative abnormal returns in the weeks
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preceding the issuance of the going-concern opinion, but no response to the issuance of the
going-concern opinion itself. Thus, it was concluded that going-concern opinions simply reflect
what investors already knew about the companys financial condition and the issuance of the
opinion did not of itself provide new information. However, these early studies did not all
reach the same conclusion. Dopuch et al. (1986) find a negative price reaction to the media
announcement of a going-concern opinion, while Keller and Davidson (1983) conclude from
their analysis of trading volume (rather than returns) that the going-concern opinion does have
information content.
In an examination of the change in auditor reporting requirements, Holder-Webb and
Wilkins (2000) examine the differential stock market reaction to bankruptcy announcements
following SAS No. 59 modified going-concern reports compared to bankruptcy announcements
after the former SAS No. 34 qualified going-concern reports. They find that share price reaction
to bankruptcy announcements under SAS No. 59 is less negative than for firms receiving prior
unmodified reports, and for firms receiving SAS No. 34 subject-to qualified reports. They also
report that the difference between the going-concern bankruptcy surprise and clean opinion
bankruptcy surprise is greater under SAS No. 59 than under SAS No. 34. They conclude that
investors have benefitted from the heightened auditor responsibility and reporting requirements
of SAS No. 59 compared to those of SAS No. 34.
Several studies attempt to decompose the going-concern opinion into an expected
component and an unexpected component. The reason for this approach is that the expected
opinion should already be priced by an informationally efficient market prior to the audit opinion
being released. That is, a rational market should only respond to the issuance of an unexpected
going-concern opinion. Consistent with this idea, studies generally report significant negative

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reactions to the issuance of unexpected going-concern opinions (e.g., Loudder et al. 1992; Fleak
and Wilson 1994; Jones 1996).23 In fact, Blay and Geiger (2001) find a negative market reaction
among companies that receive going-concern opinions but eventually survive, but no significant
reaction among companies that receive going-concern opinions and subsequently fail. They
argue that the market has an accurate expectation of the risk of bankruptcy and it only reacts to
the issuance of a going-concern opinion when this information is inconsistent with the markets
belief about the companys future viability.
In a more recent study, Blay et al. (2011) find that the going-concern opinion is
associated with a change in the set of information that the market uses to value the firm. In
particular, they find a shift in the markets valuation of a firm away from a focus on net income
and balance sheet items toward a valuation primarily of balance sheet assets and liabilities. Thus,
they conclude that the going-concern modification provides additional company-specific
valuation information to the market beyond the information that is already publicly available.
Several studies have examined whether the market responds fully to the news of a goingconcern modification. In other words, does the market respond fully when the going-concern
opinion is announced, or is there a further downward drift in abnormal returns in the weeks after
the opinions release. Ogneva and Subramanyam (2007) perform tests for market mispricing in
the U.S. and Australia around the issuance of going-concern opinions and report no evidence of a
market anomaly. However, their U.S. results have been disputed by Kausar et al. (2008) who
conclude that U.S. investors underreact to the going-concern announcements, resulting in a

23

Other studies have examined the situation where there is an announcement of a standard opinion after a previous
going-concern modified opinion. This is argued to be a less predictable event. Fields and Wilkins (1991) find that
the announcement of the removal of a previous going-concern issue can provide information to investors. Similarly
Fargher and Wilkins (1998) find a reduction in risk around the period of the qualification withdrawal announcement.

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downward drift of 14% over the one-year period subsequent to the going-concern opinion. In
their additional analyses, Kausar et al. (2008) report that their results are different from those of
Ogneva and Subramanyam (2007) due to methodological issues related to the calculation and the
testing of market pricing anomalies.
Evidence from outside the U.S.
Consistent with recent U.S. studies, Citron et al. (2008) provide evidence from the UK
that there is a significant negative market reaction when auditors issue first time going-concern
opinions to publicly traded companies. Further, contrary to Ogneva and Subramanyams (2007)
findings for Australia, Taffler et al. (2004) find significant market underreaction to the
publication of first-time going-concern reports in the UK.
A recent study by Kausar and Lennox (2011) analyzes distressed U.K. firms and posits
that the going-concern opinion serves as a warning to investors that the realizable values of
assets in the event of bankruptcy could be substantially less than their book values. They find
that for companies that enter bankruptcy, the issuance of a prior going-concern opinion has
predictive information content with respect to the difference between the book values of assets
and their future liquidation values. Further, for companies that are at risk of bankruptcy, they
find that auditors are more likely to issue going-concern opinions when book values are high
relative to expected liquidation values. Their results suggest that going-concern reporting by
auditors performs two economic roles. First, the going-concern opinion is a warning to investors
that the company has a high probability of failure. Second, the going-concern opinion provides a
warning that the book values of assets substantially overstate the liquidation values of assets in
the event that the company is forced to liquidate.

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7. CONCLUSIONS
The recent Global Financial Crisis has resulted in a significant increase in the frequency
of company failures and has generated renewed interest in auditor reporting on financially
troubled firms. Investors, creditors and regulators are very concerned when auditors fail to
modify reports prior to company failure. These issues are not new and predate the financial
crisis. Nevertheless, concerns have been raised regarding exceptional risks to the going-concern
assumption faced by companies at the height of the liquidity problems during 2007 and thereafter
(e.g., PCAOB 2011a; European Commission 2010; House of Lords Select Committee on
Economic Affairs 2011). Additionally, there has been a renewed interest in managements ability
and responsibility to assess and report on the adequacy of the going-concern basis for financial
reporting (FASB 2010).
In the remainder of this concluding section, we summarize what can be learned from
prior research. Next, we discuss the extent to which prior research can shed light on some issues
that we believe should be considered by the PCAOB, and other regulators and standard-setters,
as they formulate professional guidance with respect to reporting on the going-concern
assumption.

7.1 Major findings of prior research


It is clear that financial distress is a major factor affecting the auditors decision to issue a
going-concern report. Studies have consistently shown that accounting variables constructed
from the financial statements help to explain opinions modified for going-concern uncertainty. In
particular, auditors are more likely to issue opinions modified for going-concern uncertainty to
companies that: are less profitable, have higher leverage, have lower liquidity, and are in default.

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In addition, market variables such as stock returns and return volatility are strongly associated
with the auditors decision to issue a going-concern opinion. Prior studies also find strong
persistence in audit reporting, i.e., the audit opinion often does not change from one year to the
next. However, there is less reporting persistence when companies change auditor. This means
that a newly appointed auditor is more likely to issue a different opinion compared with the
opinion issued in the previous year by the outgoing auditor. There is also some evidence that the
audit reporting decision is associated with factors that either contradict or mitigate the goingconcern assumption. For example, auditors are more likely to issue opinions modified for goingconcern uncertainty when there are extreme negative news events prior to the audit report date
(Mutchler et al. 1997), and auditors are less likely to issue going-concern opinions when clients
initiate turnaround strategies that are likely to improve future cash flows in both the short term
and the long term (Bruynseels and Willekens 2011).
There is some evidence that after controlling for the existence of financial distress the
auditors going-concern reporting decision is affected by factors that could impair auditor
independence and the quality of the audit opinion. Going-concern opinions are less likely to be
issued when: clients pay low audit fees; clients have weak audit committees; clients are
personally affiliated with their auditors; and when clients change their auditors after receiving a
modified report in the previous year. Moreover, opinions modified for going-concern uncertainty
are less likely to be issued when public, legal and regulatory scrutiny of auditors is low and when
there is high competition.
However, the findings of studies that examine economic dependence on large audit
clients, audit firm size, and non-audit services are mixed. A few studies indicate that these
factors impair auditor independence resulting in fewer going-concern opinions being issued,

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while other studies indicate no such effect. Further research is needed to better understand the
association between auditor independence and going-concern reporting decisions.

7.2 Specific regulatory and standard-setting issues


In this section, we discuss the extent to which evidence from the academic literature can
potentially assist the PCAOB and other regulators in their standard-setting efforts in regard to
auditor reporting on going-concern uncertainty.
What has been the trend in opinions modified for going-concern uncertainty during the financial
crisis?
The trend in going-concern issuance is reported in the Going Concern Review published
by Audit Analytics (Cheffers et al. 2010). The report documents an increasing trend in overall
going-concern rates (all types of SEC filers) over 2003-2008. Note that the trend also shows a
modest increase in the frequency of going-concern opinions around the time of the financial
crisis with the going-concern reporting frequency reaching a peak in 2008. This is consistent
with the fact that more companies were filing for bankruptcy in this period.
Interestingly, the U.S. evidence in an international study by Carson et al. (2011) suggests
that the going-concern rate for the sample of loss-making non-financial firms did not gradually
increase over 2003, but ranges between 20-22% over the entire period, except for 2007. This
study also documents that the reported increase in the going-concern rate in 2008 actually only
brought that rate back to a level comparable to that of the pre-2007 period. Overall, the
comparison of the going-concern rates reported in Cheffers et al. (2010) (all firms) and Carson et
al. (2011) (loss-making non-financial firms) suggests that the increasing trend in going-concern
reporting in the U.S. over the 2003-2008 period is attributable to an increase in the going-

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concern rates of financial and/or profit-making firms. This is consistent with a trend towards
more conservative audit reporting.
What is the relationship between a company's failure and whether the prior audit opinion was
modified for going-concern?
Evidence from the U.S. suggests that in the post-SAS No. 59 period approximately half
of companies going bankrupt in the U.S. had not received a going-concern modification in their
most recent audit report prior to filing for bankruptcy. In the immediate aftermath of the
Enron/Andersen failures, the proportion of bankruptcies with a prior going-concern modified
audit report increased significantly, but then returned to the normal levels documented in prior
years.
It is important to emphasize that prior studies generally use bankruptcy filings as the
indicator of business failure. This may be overly restrictive to the extent that failing companies
are sometimes re-organized or taken over outside of formal bankruptcy proceedings. The
concepts of business failure or going-concern are not precisely defined in the auditing standards.
Therefore, it is difficult to know which proxy for business failure should be used for assessing
the performance of auditors going-concern reporting. In most studies, bankruptcy is used as the
proxy for business failure (or non-going-concern status) because a bankruptcy filing is a discrete
legal event that is considered by most individuals as an indication of business failure. However,
it is quite possible that this research design choice is overly restrictive. A wider definition of
business failure will likely change the results for how we measure the accuracy of auditors
going-concern reports. For example, Nogler (1995) reports that nearly two thirds of his sample
firms were dissolved, acquired, or filed for bankruptcy as their final outcome within five years of
receiving a going-concern opinion. This study clearly illustrates that the relationship between

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business failure and the prior going-concern opinion is contingent on how one defines business
failure.
Can a going-concern opinion be used to predict the company's failure; in other words is it an
early warning indicator of financial distress, bankruptcy, reorganization, or forced liquidation?
Prior studies consistently find a positive and statistically significant relationship between
going-concern opinions and the incidence of future bankruptcy. In other words ignoring all
other sources of information on a companys financial condition the going-concern opinion can
be used to predict the companys failure.
However, it is less clear whether the going-concern opinion is incrementally informative
for predicting a companys failure. In other words when one takes into account all other
sources of information on a companys financial condition there is mixed evidence on whether
the going-concern opinion conveys useful incremental information for predicting the companys
failure (Hopwood et al. 1989; Hopwood et al. 1994; Foster et al. 1998; Lennox 1999a;
Willenborg and McKeown 2001). Furthermore, the studies that investigate this research question
are quite old and therefore their findings may not apply to the most recent financial crisis.
Finally, there is evidence in the U.S. and Belgium of a self-fulfilling prophecy effect whereby the
issuance of a going-concern opinion directly increases the probability of a company filing for
bankruptcy (Garsombke and Choi 1992; Geiger et al. 1998; Louwers et al. 1999; Pryor and Terza
2001; Gaeremynck and Willekens 2003). By contrast, in the U.K. and Australia, there is little
evidence that going-concern opinions are a self-fulfilling prophecy (Citron and Taffler 1992;
Lennox 1999a; Citron and Taffler 2001; Carey et al. 2008).

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Basis for the going-concern assumption


The financial statements are prepared on a going-concern basis unless a company is in
liquidation or liquidation is imminent (i.e., it is virtually unavoidable). However, in many
situations there is significant doubt about the validity of the going-concern assumption even
when the company is not in liquidation and liquidation is not a virtual uncertainty. Currently,
companies in this situation are required to prepare their accounts on a going-concern basis and
auditors are then required to modify their audit opinions in order to alert investors that there is
substantial doubt about the validity of the going-concern assumption.
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. If there is substantial
doubt about ability of the entity to continue as a going-concern, and therefore the validity of the
going-concern assumption, then it must also follow that there is substantial doubt over whether
the financial statements would be presented more fairly under the going-concern assumption or
the liquidation assumption. In other words, we question why the financial statements are
prepared under an assumption that has a high probability of being incorrect. We suggest that
standard setters can 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 the auditor
assesses that there is a very high probability of a firm being able to continue
operating in the normal course of business for the foreseeable future.

Financial statements are prepared on the liquidation basis when the auditor
assesses that there is a very low probability of a firm being able to continue
operating in the normal course of business for the foreseeable future.

95

When an auditor assesses that there is significant uncertainty regarding the


companys going-concern status (i.e., the going-concern probability 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 both sets of financial statements being audited by the auditor.

The first two situations above would not be any different from that currently. 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.
We acknowledge that this alternative framework for financial reporting would represent a
radical departure from the current framework, in which a company is assumed to be a goingconcern unless liquidation is imminent or unavoidable. We do not make this a
recommendation but we do consider that the appropriate basis for financial reporting is worthy
of further consideration by accounting standard setters and auditing standard setters. As far back
as 1960, Arthur Andersen rejected the general presumption that financial statements should be
prepared on a going-concern basis. In fact, Andersen claimed 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. The reason for this is that the realizable values of assets are
higher when assets are sold in the normal course of business compared with when assets are sold
under duress (Chambers 1966). Thus, the going-concern assumption allows clients to choose
non-conservative reporting in which the book values of assets are reported at a premium relative
to their liquidation values (Kausar and Lennox 2011).

96

The economic purpose of the auditors going-concern opinion


We consider that greater clarity may be needed with respect to the economic role of the opinion
modified for going-concern uncertainty. Many practitioners, regulators, and academic researchers
consider that the purpose of a going-concern audit opinion is to warn investors when there is substantial
doubt regarding the ability of the entity to continue as a going-concern. However, the rationale for this is
not made clear. For one thing, it has traditionally been the credit ratings agencies who take responsibility
for warning about the risk of default (which is closely associated with the risk of failure). Therefore, if
going-concern reporting by an auditor is supposed to serve the same purpose, it would suggest that there
is significant overlap between the role of the auditor and the role of the credit ratings agency.
Second, the wording of professional auditing standards suggests that there is a second economic
role for reporting going-concern uncertainty, beyond simply warning about uncertainty regarding the
ability of the business to continue as a going-concern. In particular, Paragraph 10 of SAS No. 59 states
that when there is substantial doubt about the companys ability to remain a going-concern, the auditor
should:

consider the possible effects on the financial statements and the adequacy of the related
disclosure. Some of the information that might be disclosed includes [] information
about the recoverability or classification of recorded asset amounts.
Thus, the auditor has to consider not only the likelihood that the client can no longer
continue as a going-concern assumption may be a false basis for preparing the financial
statements, but also consider how this would impact the recoverability or classification of
recorded assets which are reported under the (potentially false) going-concern assumption. This
suggests that going-concern reporting has two economic purposes. First, it serves as a warning
about the likelihood of business failure. Second, it alerts the financial statement user to the likely
impact of business failure on the book values of the companys assets.

97

Nevertheless, auditing standards are vague as to the precise economic role of the current
going-concern reporting model. In our opinion, standard setters could consider whether the
standards on going-concern reporting can be made clearer in order to improve auditor
compliance and so that users can understand the purpose of the opinion modified for goingconcern uncertainty. In particular, is the going-concern modified opinion meant only to serve as
a warning about the likelihood of business failure? Or is the going-concern modified opinion also
meant to serve as a warning about the possible impact of business failure on the fair presentation
of the financial statements?
Vagueness in the reporting standards on going-concern
We note that the prevailing standards on going-concern reporting are vague in at least
three respects. First, there is no clear definition of what constitutes a business failure. In the
absence of a precise definition, many researchers use the bankruptcy filing as a proxy for
business failure. The advantage of the bankruptcy filing is that it is a discrete legal event that
most would consider to be a clear unequivocal indication of business failure. However, this
definition may be overly narrow to the extent that standard setters have in mind a broader
definition of business failure than just bankruptcy. This issue is important because academic
researchers (and regulators) examine the association between going-concern opinions and
bankruptcy in order to assess the accuracy and predictive information content of the audit report.
If bankruptcy is the wrong way to measure business failure, then this documented association
may be an unreliable way to measure the performance of auditors in their going-concern
reporting decisions. In the absence of a precise and measurable definition of business failure it
is virtually impossible for researchers, regulators and investors to gauge whether auditors
reports serve their intended purpose.

98

Second, auditing standards require an auditor to issue a going-concern modification in the


audit report when there is substantial doubt about the companys ability to remain a goingconcern. However, the phrase substantial doubt does not have a clear numerical meaning.
Further, research also shows that there is greater divergence in the meaning associated with
substantial doubt than with other probability phrases, such as reasonably possible and
probable, that are used in the context of financial accounting standards related to loss
contingencies. Again, it is difficult to assess compliance in the absence of a clearer numerical
expression for the phrase substantial doubt. Moreover, there is evidence of significant
differences in 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
going-concern reporting and what auditors actually provide.
Finally, there is some inconsistency internationally with respect to the time horizon that
auditors are required to consider when assessing the risk of business failure. 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. In contrast, 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. We think it is unlikely that there is a strong economic
rationale for the difference in reporting standards, with international standards imposing a
minimum period of one year whereas U.S. standards impose one year as a maximum. More
importantly, in the absence of a clear definition of the horizon for assessing the risk of a
company not continuing as a going-concern, it is more difficult to assess auditor compliance with
professional standards.

99

Allow flexible going-concern modification wording


The PCAOB could consider allowing more flexibility in the wording of the goingconcern report modification. 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 Board (IAASB) position with respect to audit reporting generally and goingconcern more specifically. For example, an explanatory paragraph for reporting going-concern
uncertainty could use conditional language (e.g., if the company can do X, then Y is more likely
to occur).
Increased flexibility with respect to the wording of opinions modified for going-concern
uncertainty offers auditors the opportunity to more clearly explain 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 uncertainty. This
recommendation should be considered in conjunction with the PCAOBs other concurrent efforts
with respect to improving communications in the auditors report.

100

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