Auditing: A Journal of Practice & Theory American Accounting Association Vol. 32, Supplement 1 DOI: 10.2308/ajpt-50324 2013 pp. 353–384

Audit Reporting for Going-Concern Uncertainty: A Research Synthesis

Elizabeth Carson, Neil L. Fargher, Marshall A. Geiger, Clive S. Lennox, K. Raghunandan, and Marleen Willekens

SUMMARY: In this synthesis we review research on going-concern modified audit

opinions (GCOs) and develop a framework to categorize this research. We identify three

major areas of research: (1) determinants of GCOs that include client factors, auditor

factors, auditor-client relationships, and other environmental factors; (2) accuracy of GCOs;

and (3) consequences arising from GCOs. We identify method-related considerations for

researchers working in the area and identify future research opportunities.

Keywords: going-concern; audit reporting; bankruptcy.

INTRODUCTION

T he global financial crisis starting in 2007 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

Elizabeth Carson is an Associate Professor at The University of New South Wales, Neil L. Fargher is a Professor at The Australian National University, Marshall A. Geiger is a Professor at the University of Richmond and an Academic Fellow at the SEC, Clive S. Lennox is a Professor at Nanyang Technology University, K. Raghunandan is a Professor at Florida International University, and Marleen Willekens is a Professor at Katholieke Universiteit Leuven.

We greatly appreciate the research assistance of Afsana Hassan, Christophe Van Linden, Ashna R. Prasad, Qingxin Ye, and Qiang Wei. We thank Bill Read for the helpful provision of data.

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Marshall A. Geiger and do not necessarily reflect the views of the Commission or of the authors’ colleagues upon the staff of the Commission.

To facilitate the development of auditing and other professional standards and to inform regulators of insights from the academic auditing literature, the Auditing Section of the American Accounting Association (AAA) decided to develop a series of literature syntheses for the Public Company Accounting Oversight Board (PCAOB). This paper (article) is authored by one of the research synthesis teams formed by the Auditing Section under this program. The views expressed in this paper are those of the authors and do not reflect an official position of the AAA or the Auditing Section. In addition, while discussions with the PCAOB staff helped us identify the issues that are most relevant to setting auditing and other professional standards, the author team was not selected or managed by the PCAOB, and the resulting paper expresses our views (the views of the authors), which may or may not correspond to views held by the PCAOB and its staff.

Editor’s note: Accepted by Jeffery R. Cohen.

Submitted: March 2012 Accepted: October 2012

Published Online: October 2012

353

play in warning about such problems. These issues have sparked a series of high-level inquiries into

the role and effectiveness of independent auditing in the U.S. and internationally (e.g., PCAOB 2011;

European Commission 2010; House of Lords 2011; FRC 2011), with particular interest directed to the

auditor’s assessment and reporting on a company’s ability to continue as a going-concern.

The purpose of this review is to synthesize and discuss prior academic literature pertinent to the

auditor’s decision to issue an opinion modified for going-concern uncertainty (hereafter, GCO). We

limit our review to some of the major findings from the auditing literature over the past four decades.

We develop a framework that structures our categorization of the main themes explored in the extant

literature (Figure 1; see Carson et al. [2012] for a more complete discussion of GCO research). Since

early research found that auditors typically do not have difficulty identifying companies in financial

distress that may be candidates for a GCO (Kida 1980; Mutchler 1984), most research focuses on the

GCO decision for samples of distressed clients where going-concern uncertainty is likely to be an issue.

Therefore, in our review of the literature we focus more specifically on the determinants of GCOs (in

the second section); the accuracy of GCOs issued, or not issued, by auditors (in the third section); and

the consequences of GCOs on clients and auditors (in the fourth section). Based on our synthesis, we

also discuss research-method-related considerations pertaining to GCO studies (in the fifth section)

and propose avenues for future research (in the sixth section).

DETERMINANTS OF GCOs

Under SAS No. 59 (AICPA 1988), auditors have a responsibility to evaluate whether there is

substantial doubt regarding an entity’s ability to continue as a going-concern for a reasonable period

of time (not exceeding 12 months from the balance sheet date). Under U.S. Generally Accepted

Accounting Principles (GAAP), the going-concern basis for presentation of financial statements is

assumed in the absence of information to the contrary. Accordingly, auditors’ evaluations are made

based on knowledge obtained from audit procedures, and knowledge of conditions and events

existing at or prior to the completion of fieldwork that relates to the validity of the going-concern

assumption and the use of the going-concern basis for preparing the financial statements. Auditors

are required to obtain information about management’s plans to mitigate any concerns and assess

the likelihood of successful implementation of such plans. If the auditor still has substantial doubt

about the entity’s ability to continue as a going-concern, the auditor should consider the adequacy

FIGURE 1 Audit Reporting of Going-Concern Uncertainty Research Framework

354 Carson, Fargher, Geiger, Lennox, Raghunandan, and Willekens

Auditing: A Journal of Practice & Theory Supplement 1, 2013

of management’s disclosures in the financial statements and the auditor must modify his/her

opinion to include an explanatory paragraph outlining the reasons for concern.1

Our framework commences with the auditor’s assessment of an underlying uncertainty

regarding the going-concern assumption, and moves to the observable factors that explain an

auditor’s decision to issue a GCO. As noted earlier, little extant research solely addresses the

auditor’s identification of companies experiencing financial pressure such that they may violate the

going-concern assumption. The vast majority of archival research to date has attempted to identify

which characteristics (client, audit firm, etc.) are associated with auditors rendering a GCO to an

audit client.

As a foundation for our subsequent discussion, we first present data on the overall frequency of

GCOs issued in the U.S. We then proceed to classify the archival literature on the determinants of

GCOs into four broad categories: client factors, auditor factors, auditor-client relationship factors,

and environmental factors.2

Overall GCO Rates

We review the overall frequency of GCOs for the period using data from Audit Analytics.

Audit Analytics covers all SEC registrants including trust funds, pension funds, and other entities

that are not publicly traded, but we are more interested in companies that are publicly traded. In

addition, we require information on market capitalization in order to investigate how the GCO

frequency varies by company size. We exclude any audit reports that are signed after a company

files for bankruptcy (Chapter 7 or Chapter 11). The resulting sample comprises 88,359 company

year observations over the 11-year period 2000 to 2010.

The results are reported in Table 1. The overall frequency of GCOs increases from 9.82 percent

in 2000 to 13.74 percent in 2001 and 16.57 percent in 2002. Similarly, Geiger et al. (2005) and

Sercu et al. (2006) find that auditors are more likely to issue GCOs after December 2001. These

findings are consistent with auditors reporting more conservatively following the events of 2001–

2002; i.e., the Enron scandal, the indictment of Andersen, and the passage of SOX. It is also

consistent with a significant increase in insurance- and other liability-related costs during the post-

SOX period (Rama and Read 2006). Since 2002, there has been only a marginal increase in the

overall GCO frequency from 16.57 percent in 2002 to 17.01 percent in 2010.

Table 1 further indicates that it is generally the smaller companies that receive GCOs. The

GCO frequency is 36.70 percent among companies whose market capitalizations are no greater than

$75 million. In contrast, the GCO frequency is 3.66 percent for companies whose market

capitalizations are between $75 million and $500 million. Among the very large companies (market

capitalizations in excess of $500 million), the GCO frequency is just 0.33 percent. It is clear from

Table 1 that the increase in the GCO frequency is driven by firms whose market capitalizations are

less than $500 million. Among companies whose market capitalizations are no greater than $75

million, the GCO frequency more than doubles from 20.14 percent in 2000 to 42.08 percent in

2010. Likewise, among companies whose market capitalizations are between $75 million and $500

million, the GCO frequency more than triples from 1.25 percent in 2000 to 4.91 percent in 2010. In

contrast, there is virtually no change in the GCO frequency among the companies whose market

capitalizations are in excess of $500 million (0.33 percent in both 2000 and 2010).

1 If the auditor believes that adequate disclosure is not provided in the financial statements and notes, then he/she is required to issue a qualified report due to a departure from GAAP.

2 While we focus on archival research, we do not wish to understate the considerable potential for further behavioral and qualitative research on auditor judgment and decision making with respect to GCOs.

Audit Reporting for Going-Concern Uncertainty: A Research Synthesis 355

Auditing: A Journal of Practice & Theory Supplement 1, 2013

GCOs and Bankruptcy

Next, we examine the incidence of bankruptcy within our sample. An observation is coded as

going ‘‘bankrupt’’ if the firm files for Chapter 7 or Chapter 11 within one year of the audit opinion

signature date. This yields a sample of 396 bankrupt observations. We then examine whether the

audit opinion issued immediately prior to the bankruptcy filing contained a GCO. Table 2 finds that

60.10 percent of bankruptcy filings are preceded by opinions that are modified for going-concern

uncertainties. This is similar to prior studies that examine the audit opinions issued to companies

prior to bankruptcy. There are 87,963 surviving observations, i.e., where companies do not file for

bankruptcy within one year of the audit opinion date. The proportion of surviving observations that

receive GCOs is 15.71 percent. Mirroring the increase in the GCO frequency that was shown in

Table 1, Table 2 finds that the proportion of surviving observations that receive GCOs increases

from 9.77 percent in 2000 to 16.44 percent in 2002 and 16.83 percent in 2010. Finally, Table 2

shows that the vast majority of firms that receive GCOs do not file for bankruptcy within 12 months

of the audit opinion date. In fact, 98.31 percent of firms survive for at least 12 months after they are

issued a GCO.

Again, as shown in Table 2, the proportion of bankrupt firms that receive a prior GCO

(GCO%) is 60.10 percent—i.e., of soon-to-be-bankrupt firms, 60.10 percent receive GCOs in their

final reports prior to bankruptcy. In contrast, the proportion of surviving firms that receive a prior

GCO (GCO%) is just 15.71 percent. This is consistent with a self-fulfilling prophecy: a GCO is

more likely to be issued to a company that will file for bankruptcy than to a company that will

TABLE 1

U.S. Opinions Modified for Going-Concern Uncertainties (2000–2010)

Year

Full Sample Market Cap � $75m $75m , Market Cap

� $500m Market Cap . $500m

n GCO% n GCO% n GCO% n GCO%

2000 5,642 9.82% 2,631 20.14% 1,515 1.25% 1,496 0.33%

2001 7,336 13.74% 3,525 27.69% 1,955 1.43% 1,856 0.22%

2002 8,336 16.57% 4,158 31.77% 2,145 2.56% 2,033 0.25%

2003 8,882 15.74% 3,805 34.61% 2,524 2.85% 2,553 0.35%

2004 9,084 15.15% 3,514 36.68% 2,686 2.90% 2,884 0.31%

2005 9,156 16.52% 3,444 40.71% 2,730 3.83% 2,982 0.17%

2006 8,677 16.35% 3,110 41.06% 2,614 5.20% 2,953 0.20%

2007 8,388 17.10% 3,061 42.11% 2,471 5.22% 2,856 0.56%

2008 8,372 17.44% 3,645 36.63% 2,316 4.88% 2,411 0.50%

2009 7,471 17.67% 3,076 39.76% 1,932 4.50% 2,463 0.41%

2010 7,015 17.01% 2,614 42.08% 1,692 4.91% 2,709 0.33%

Total 88,359 15.91% 36,583 36.70% 24,580 3.66% 27,196 0.33%

Source: Audit Analytics. n ¼ number of observations; and GCO% ¼ percentage of observations receiving a going-concern audit opinion.

356 Carson, Fargher, Geiger, Lennox, Raghunandan, and Willekens

Auditing: A Journal of Practice & Theory Supplement 1, 2013

survive (i.e., 60.10 percent . 15.71 percent).3 It is also consistent with many auditors’ perceptions

of the consequences of issuing GCOs. In a survey by Kida (1980), 61 percent of auditors indicated

that the issuance of a GCO could cause problems for a company that actually has no problem.4

In the remainder of this section, we review research on the factors that affect an auditor’s

decision to issue a GCO. After that, we describe research on the accuracy of GCOs as predictors of

future bankruptcy.

Client Factors

The literature documents a broad variety of client characteristics that are associated with the

issuance of GCOs. A major insight from such research is that publicly available financial statement

information is an important factor associated with the auditor’s decision to issue a GCO. These

financial statement items include profitability, leverage, liquidity, company size, debt defaults, and

prior GCO. However, non-financial-statement-related client variables are also important. These

include market variables, strategic initiatives, and governance characteristics.

TABLE 2

U.S. Opinions Modified for Going-Concern Uncertainties and Corporate Bankruptcies (2000–2010)

Year

Bankrupt Firms Surviving Firms GCO Firms

n GCO% n GCO% n Surviving%

2000 10 40.00% 5,632 9.77% 554 99.28%

2001 9 55.56% 7,327 13.69% 1,008 99.50%

2002 25 60.00% 8,311 16.44% 1,381 98.91%

2003 40 60.00% 8,842 15.54% 1,398 98.28%

2004 38 63.16% 9,046 14.95% 1,376 98.26%

2005 28 71.43% 9,128 16.36% 1,513 98.68%

2006 34 41.18% 8,643 16.26% 1,419 99.01%

2007 75 52.00% 8,313 16.78% 1,434 97.28%

2008 83 66.27% 8,289 16.95% 1,460 96.23%

2009 27 81.48% 7,444 17.44% 1,320 98.33%

2010 27 59.26% 6,988 16.83% 1,192 98.66%

Total 396 60.10% 87,963 15.71% 14,055 98.31%

Source: Audit Analytics. An observation is coded as ‘‘bankrupt’’ if the firm files for Chapter 7 or Chapter 11 within one year of the audit opinion date. An observation is coded as ‘‘surviving’’ if the firm does not file for Chapter 7 or Chapter 11 within one year of the audit opinion date. n ¼ number of observations; GCO% ¼ percentage of firm observations receiving a going-concern audit opinion; and Surviving%¼ percentage of going-concern observations that do not file for Chapter 7 or Chapter 11 within one year of the audit opinion date.

3 The proportion of GCO firms that do not file for bankruptcy within 12 months of the audit opinion date is 98.31 percent. Although this percentage is high, it is important to note that this does not imply that there is no self- fulfilling prophecy effect. The reason that the 98.31 percent statistic is large is that the denominator is the number of firms that receive a prior GCO. In contrast, the 15.71 percent statistic is calculated using the number of surviving firms in the denominator. The number of surviving firms is much larger than the number of GCO firms (87,963 vs. 14,055 in Table 2). Accordingly, 15.71 percent is much smaller than 98.31 percent.

4 We review the literature on the ‘‘self-fulfilling prophecy’’ in the ‘‘Consequences of GCOs’’ section.

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Measures of Financial Distress Obtained from the Financial Statements

Studies generally find that auditors are more likely to issue GCOs when companies are less

profitable (Kida 1980; Mutchler 1985; Dopuch et al. 1987; Altman and McGough 1974; Koh and

Killough 1990; Menon and Schwartz 1987; Lee et al. 2005), have higher leverage (Altman and

McGough 1974; Kida 1980; Mutchler 1985; Dopuch et al. 1987; Raghunandan and Rama 1995),

have lower liquidity (Kida 1980; Mutchler 1985; Menon and Schwartz 1987; Koh and Killough

1990; Koh 1991; Lennox 1999a; Raghunandan and Rama 1995), and are smaller (Dopuch et al.

1987; McKeown et al. 1991; Mutchler et al. 1997; Geiger and Raghunandan 2001). Furthermore,

various studies find a highly significant positive association between debt default and the issuance

of a GCO (Chen and Church 1992; Carcello et al. 1995, 2000; Mutchler et al. 1997; Carcello and

Neal 2000; Geiger and Raghunandan 2001; Behn et al. 2001; Geiger et al. 2005; Bruynseels and

Willekens forthcoming). Prior research also documents strong evidence of persistence in GCOs,

showing that a company is more likely to receive a GCO in the current year if the company received

a GCO in the previous year (Mutchler 1985). The reasons for such persistence have not been

thoroughly examined. However, Lennox (2000) demonstrates that there is more reporting

persistence for companies that retain their incumbent auditors than for companies that change

auditor. This suggests that reporting persistence is at least partly attributable to idiosyncratic

characteristics of the relationship between auditor and client.

There are many studies that examine the determinants of bankruptcy and going-concern

reporting, and the set of independent variables varies from study to study. It is therefore helpful to

learn which variables auditors actually rely on 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.

As the audit environment changes, there is an ongoing need to update evidence on what financial

statement variables auditors rely on in practice when making GCO decisions.

Measures of Financial Distress Obtained from Outside the Financial Statements

Besides financial statement variables, the literature documents other measures of a client’s

financial condition that are associated with the issuance of GCOs. A first category relates to market

variables, such as industry-adjusted returns and return volatility (see, for example, Dopuch et al.

1987; Mutchler and Williams 1990; Bell and Tabor 1991; DeFond et al. 2002; Kausar and Lennox

2011). The general findings from these studies are that auditors are more likely to issue a GCO

when companies have lower industry-adjusted returns and higher return volatility. However, extant

research has not specifically addressed whether auditors use these market measures in making their

GCO determinations or whether these measures are simply a different, yet consistent reflection of

distressed companies that receive a GCO from their auditor.

Another category includes contrary factors and mitigating client information. Current audit

reporting standards require auditors to evaluate both contrary and mitigating factors when

determining whether a GCO is appropriate. The early evidence in Mutchler (1985) and Mutchler et

al. (1997) provides little supporting evidence on such factors.5 However, more recent studies

5 However, Mutchler et al. (1997) do find a significant relation between extreme negative news releases prior to the opinion and a higher probability of auditors rendering a going-concern modification.

358 Carson, Fargher, Geiger, Lennox, Raghunandan, and Willekens

Auditing: A Journal of Practice & Theory Supplement 1, 2013

provide evidence that auditors do in fact take account of mitigating factors. Behn et al. (2001) find

that two mitigating factors—management plans to issue equity and plans to borrow—are negatively

correlated with the issuance of a GCO. 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 GCOs. Bruynseels and Willekens (forthcoming) analyze whether a

comprehensive set of turnaround activities are regarded by auditors as distress-mitigating factors or

as going-concern risk factors. 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 auditor’s GCO decision.

Financial Reporting Quality

Several studies find significant associations between accounting accruals (a proxy for low

financial reporting quality) and the auditor’s issuance of modified audit reports (see Francis and

Krishnan [1999], Bartov et al. [2000], and Bradshaw et al. [2001] for U.S. evidence, and Arnedo et

al. [2008] for evidence from Spain). The central premise of these studies is that low financial

reporting quality prompts auditors to issue modified audit opinions. However, this inference is

disputed by Butler et al. (2004) for two reasons. First, the association between accounting accruals

and modified audit opinions is driven by the opinions that are modified for GC issues rather than

accounting policy choices. Second, auditing standards do not require an auditor to issue a GCO

when a company has poor financial reporting quality. Rather, auditors are required to issue GCO

reports when companies are in financial distress.6 Consistent with their critique, Butler et al. (2004)

find that the relation between accounting accruals and GCOs is driven by companies that have large

negative accruals, and these negative accruals seem to reflect the poor financial condition of GCO

companies rather than earnings management.

Corporate Governance

Carcello and Neal (2000) find that auditors are more likely to issue GCOs to companies that

have more independent audit committees. Moreover, in the pre-SOX period 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 GCOs.7

Book Values and Liquidation Values

Under conservative accounting, the book value of assets should reasonably proxy their

liquidation value, thereby allowing lenders to better monitor the borrower’s ability to repay.

According to professional auditing standards, the economic purpose of the GCO is to warn financial

statement users that the accounts are prepared on a going-concern basis rather than on a liquidation

basis. This warning is important because the liquidation values of assets in bankruptcy are typically

less than their book values. The wedge between book values and liquidation values is of interest not

only to stockholders, but also to lenders, because as senior claimholders, they are largely concerned

6 See Holder-Webb and Cohen (2007) for a discussion of the ethical issues related to the relationship between disclosure, distress, and failure.

7 SOX requires that all audit committee members be independent. An interesting issue for future research is to extend Carcello and Neal (2003) by examining other audit committee director characteristics, such as financial expertise, tenure, and background.

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with their downside risk. That is, lenders need to know whether the realizable value of the

company’s assets will be sufficient to cover the value of their claims.

Kausar and Lennox (2011) examine whether auditors issue GCOs as a warning to financial

statement users that the book values of assets would be higher than their realizable values in the

event of bankruptcy. They argue that the issuance of a GCO serves as a warning that, in the event of

bankruptcy, the realizable values of assets will be less than their book values. Consistent with this

argument, they find that auditors are more likely to issue GCOs when the book values of assets are

high relative to their expected realizable values.

Auditor Factors

The decision to issue a GCO is complex and requires judgment by the auditor. Experimental

research has considered how factors other than the likelihood of client failure may be evaluated by

auditors when considering a GCO. Archival studies have investigated the association between

GCOs and auditor characteristics, including an auditor’s economic dependence on the client,

auditor size, industry specialization, and compensation arrangements.

Auditor Judgment

The decision to issue a GCO requires considerable auditor judgment. This is an area where

experimental research design

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