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AN ANALYSIS OF THE EFFECT OF THE EXPECTATION
GAP STATEMENTS ON AUDITING STANDARDS
ON THE REPORTING OF GOING CONCERN
by
DIANA RUTH FRANZ, M.P.ACCT.
A DISSERTATION
IN
BUSINESS ADMINISTRATION
Submitted to the Graduate Faculty of Texas Tech University in
Partial Fulfillment of the Requirements for
the Degree of
DOCTOR OF PHILOSOPHY
Approved
May, 1993
T3 ^ TABLE OF CONTENTS iJ^ ) ^^^ - (''-
/Jo. 3
ABSTRACT v
LIST OF TABLES vii
LIST OF FIGURES viii
LIST OF ABBREVIATIONS X CHAPTER
I. INTRODUCTION AND THEORETICAL PERSPECTIVES . . 1 Introduction 1 The Role of Auditing 3 Theoretical Perspectives About The Auditor's
Reporting Decision 5 Professional Judgment Considerations . . 6 Power Struggle Theory 9 Agency Theory 11 Information Hypothesis 15 Insurance Hypothesis 17 Ethical Considerations 19 Synopsis 22
Research Objectives 23 Organization of the Study 27
II. LITERATURE REVIEW AND ANALYSIS 30 Introduction 30 Summary of Professional Guidance Regarding
Going Concern Reporting 30 Expectation Gap SASs 35
Audit Evidence 37 Assessment of Going Concern 4 0 Audit Reporting 45 Time Frame 47
Models Regarding the Auditor's Decision to Issue a Going Concern Report 48
Prediction of Going Concern Opinions . . . . 57 Mutchler [1985] 58 Dopuch et al. [1987] 62
Financial Variables 62 Market Variables 64 Method and Sample 65 Estimated Probability Levels . . . 67 Classification of Firms 69 Implications of Results 71
Implications for the Current Study 73 Models 74 Statistical Method 7 6
11
Summary 79
III. RESEARCH METHODOLOGY 87 Introduction 87 Sample Selection 88
Population of Companies 89 Selection of Going Concern Sample . . . 89
Pre-Expectation Gap SAS Period . . 89 Transition Period 90 Post-Expectation Gap SAS Period . . 92
Selection of Clean Companies 92 Data Collection 93 Research Hypotheses 94
Comparisons of the Difference in Means . 95 Differences Between the Pre-
Expectation Gap SAS and the Transition Period 97
Differences Between the Transition Period and the Post-Expectation Gap SAS Period . . 98
Differences Between the Pre- and the Post-Expectation Gap SAS Period 99
Test of Change in Report Odds 100 Limitations of the Study 103
IV. RESEARCH RESULTS 106 Introduction 106 Number of Companies 107 Multivariate Tests of Differences in Means . 109
Mean Values by Year 110 Liquidity Ratios 112 Solvency 113 Profitability 114 Prior Year Audit Report 114 Market Variables 115 Summary 116
Mean Values by Comparison Sub-Periods . 117 Difference in Mean Values 119
Logit Tests Regarding Change in Odds . . . . 121 Summary 12 5
V. SUMMARY OF RESULTS, IMPLICATIONS, AND FUTURE RESEARCH POSSIBILITIES 161 Summary of Results 161 Implications of Results 163 Limitations 163 Future Research Possibilities 168
BIBLIOGRAPHY 170
• a t
111
APPENDIX A. THE EXPECTATION GAP STATEMENTS ON AUDITING
STANDARDS 178
B. COMPARISON of PRE- and POST-EXPECTATION GAP SASs REGARDING AUDIT EVIDENCE 183
C. COMPARISON Of PRE- and POST-EXPECTATION GAP SASs REGARDING the ASSESSMENT of GOING CONCERN 187
D. COMPARISON of PRE- and POST-EXPECTATION GAP SASs REGARDING REPORTING 189
IV
ABSTRACT
In 1988, auditors' responsibility for evaluating and
reporting on material uncertainties, including going
concern, was changed by the issuance of nine Statements on
Auditing Standards (SAS). These statements are referred to
as the expectation gap (EG) SAS and were promulgated to
reduce the gap between public expectations of auditors'
responsibility and auditors' service level in providing
assurance that financial reporting is in accordance with
generally accepted accounting principles.
This research studied the impact of the EG SAS
requirements on the financial reporting of entities. Two
sub-periods were used for statistical comparisons. The
first, or pre-EG SAS period, began with the previous
guidance and extended to the transition period when the EG
SAS had been issued but were not required guidance. The
second sub-period included the transition to the post
period, when use of the EG SAS became a requirement. In
addition, the overall change from the pre- to the post-EG
SAS period was examined.
Changes in these periods were tested on two samples of
companies. The full sample consisted of all companies which
received a going concern audit opinion and a randomly
selected comparison group of companies that had received a
clean audit opinion. The restricted sample included those
previously identified going concern and comparison companies
that were publicly traded.
Multivariate tests evaluated whether the degree of
deterioration being experienced by companies flagged as
going concern had changed after the implementation of the EG
SAS. For both samples, the results indicated that the
difference between the characteristics of the companies
widened from the pre- to transition period. For both
samples, the difference narrowed from the transition to the
post-period. The overall test concluded that for the full
sample the difference was non-significantly narrowed but the
difference had widened for the restricted sample.
Logit analyses tested whether the odds of receiving
going concern audit reports had changed during the periods
in this study. The logit results were consistent with the
multivariate analysis. From the pre- to transition period,
the odds had decreased in both samples. The odds increased
from the transition to post period, for both samples, but
the change was non-significant for the restricted sample.
The overall test of the change from the pre- to the post-
period indicated that for the full sample, the probability
of receiving a going concern opinion had increased. For the
restricted sample of companies, the results indicated a
decline in the odds of a company receiving a going concern
opinion.
VI
LIST OF TABLES
2.1 Summary of Empirical Research on Model versus Auditor Accuracy 81
2.2 Summary of Recent Empirical Research Predicting Going Concern Opinions 84
4.1 Number and Percentage of Companies Receiving Audit Reports Indicating Going Concern Uncertainties . . 127
4.2 Type of Audit Report Received by Remaining Companies With Going Concern Uncertainties . . . . 128
4.3 Expected Change in Model Variables 129
4.4 Mean Values for Companies With Going Concern Opinions 13 0
4.5 Mean Values for Companies With Clean Audit Opinions 131
4.6 Mean Values for Going Concern Companies by Comparison Periods 132
4.7 Mean Values for Companies with Clean Audit Opinions by Comparison Periods 133
4.8 Mean Values for Difference Ratios by Comparison Periods 134
4.9 MANOVA Results for Differences Between Periods Using Differenced Ratios 135
4.10 Logit Results for Changes Between Periods . . . . 136
Vll
LIST OF FIGURES
1.1 The Auditor's Responsibility for Assessing and Reporting on Going Concern (GC) Under SAS No. 34 (Pre-Expectation Gap) 28
1.2 The Auditor's Responsibility for Assessing and Reporting on Going Concern (GC) Under SAS No. 59 (Transition and Post-Expectation Gap) 29
3.1 Audit Time Line 105
4.1 CFTL by Year 137
4.2 CACL by Year 138
4.3 NWTL by Year 139
4.4 LTDTA by Year 140
4.5 TLTA by Year 141
4.6 NIBTS by Year 142
4.7 PYAR by Year 143
4.8 TLIST by Year 144
4.9 DBETA by Year 144
4.10 DRSTD by Year 145
4.11 EXRTN by Year 145
4.12 CFTL By Period 146
4.13 CACL By Period 147
4.14 NWTL By Period 148
4.15 LTDTA By Period 149
4.16 TLTA By Period 150
4.17 NIBTS By Period 151
4.18 PYAR By Period 152
4.19 TLIST by Period 153
viii
4.20 DBETA by Period ^53
4.21 DRSTD by Period . . . 154
4.22 EXRTN by Period . . 154
4.23 DCFTL by Period ^55 4.24 DCACL by Period . . .
• 155 4.25 DNWTL by Period . . .
156
4.26 DLTDTA by Period . . ,^^ 156
4.27 DTLTA by Period . . . 157
4.28 DNIBTS by Period . . 157
4.29 DPYAR by Period -^o
4.30 DTLIST by Period -^^
4.31 DDBETA by Period
4.32 DDRSTD by Period . . . . , « 159
4.33 DEXRTN by Period
IX
LIST OF ABBREVIATIONS
AICPA American Institute of Certified Public Accountants
ASB Auditing Standards Board
ASOBAC A Statment of Basic Auditing Concepts
ASR Accounting Series Release
AudSEC Auditing Standards Executive Committee
BVTA Book Value of Total Assets (Natural Logarithm of)
CACL Current Assets/Current Liabilities
CFTL Cash Flow (working captital from operations)/Total Liabilities
CRSP Center for Research in Security Prices
CYL Current Year Loss
DBETA Change in Beta
DCACL Difference in CACL
DCFTL Difference in CFTL
DDBETA Difference in DBETA
DDRSTD Difference in DRSTD
DEXRTN Difference in EXRTN
DINV Change in Ratio of Inventory to Total Assets
DLEV Change in Ratio of Total Liabilities to Total Assets
DLTDTA Difference in LTDTA
DNIBTS Difference in NIBTS
DNWTL Difference in NWTL
DPYAR Difference in PYAR
DREC Change in Ratio of Receivables to Total Assets
DRSTD Change in Residual Standard Deviation of Returns
DTLIST Difference in TLIST
DTLTA
EXRTN
F-C
F-GC
FY
GC
GCAR
IMPROVE
LTDTA
NCFFR
NGCAR
NIBTS
NWTL
OTC
SAP
SAS
SEC
TLIST
TLTA
PYAR
R-C
R-GC
WESML
Difference in TLTA
Excess Returns
Full Sample of Companies with Clean Opinons
Full Sample of Companies with Going Concern Opinons
Fiscal Year
Going Concern
Going Concern Audit Report
Improvement in Company's Performance
Total Long-Term Liabilities/Total Assets
National Commission on Fraudulent Financial Reporting
Non-going Concern Audit Report
Net Income Before Tax/Net Sales
Net Worth/Total Liabilities
Over the Counter
Statement on Auditing Procedures
Statement on Auditing Standard
Securities and Exchange Commission
Time Listed
Total Liabilities/Total Assets
Prior Year Audit Report
Restricted Sample of Companies with Clean Opinions
Restricted Sample of Companies with Going Concern Opinions
Weighted Exogenous Sample Maximum Likelihood
XI
CHAPTER I
INTRODUCTION AND THEORETICAL PERSPECTIVES
Introduction
In 1988, the auditor's responsibility for evaluating
and reporting on material uncertainties, including going
concern, was changed by several of the "expectation gap"
Statements on Auditing Standards (SAS). These SASs,
summarized in Appendix A, were intended to close the gap
between public expectations of the auditor's responsibility
and the auditor's service level in providing assurance that
financial reporting was in accordance with generally
accepted accounting principles.
SAS No. 59, "The Auditor's Consideration of an Entity's
Ability to Continue as a Going Concern," [AICPA, 1988f]
addresses the auditor's procedural responsibility regarding
the assessment of going concern. SAS No. 59 supersedes SAS
No. 34, "The Auditor's Consideration When a Question Arises
About an Entity's Continued Existence," [AICPA, 1981]. One
important procedural change in SAS No. 59 is the affirmative
responsibility imposed upon the auditor to evaluate, in
every audit, the assumption that the auditee can continue as
a going concern. In contrast, SAS No. 34 required the
auditor to assess going concern only when contrary
information came to the auditor's attention. Thus, SAS No.
59 increased the auditor's responsibility for detecting
firms displaying characteristics that raise substantial
doubt about the firm's ability to continue in its existing
form for at least one year from the financial statement
date.
The auditor's responsibility for assessing an entity's
ability to continue as a going concern is shown in Figure
1.1 for the guidance of SAS No. 34 (pre-expectation gap) and
in Figure 1.2 for the guidance of SAS No. 59 (post-
expectation gap). In addition to the affirmative
responsibility for assessing going concern imposed by SAS
No. 59, three differences exist between the pre- and post-
expectation gap requirements. First, the amount of required
audit evidence available for the assessment of going concern
has been increased (because of SAS No. 53, SAS No. 54, SAS
No. 56, and SAS No. 57). Second, the type of report issued
when going concern is questionable was changed (because of
SAS No. 59 and SAS No. 58). Third, the time frame for the
auditor's assessment of a company's ability to continue as a
going concern is specified as not exceeding one year from
the date of the financial statements being audited.
Subsequent to the issuance of the expectation gap SASs,
the AICPA issued SAS No. 64, "Omnibus Statement on Auditing
Standards-1990" [AICPA, 1991]. One purpose of this SAS was
to clarify the wording suggested in SAS No. 59 regarding the
explanatory paragraph added to the auditor's opinion when
substantial doubt exists about the auditee's ability to
continue as a going concern. SAS No. 64 requires that the
explanatory paragraph added to the audit report about going
concern must include the phrase "substantial doubt about its
(the auditee's) ability to continue as a going concern"
[AICPA, 1991]. The fact that the AICPA issued a SAS
requiring the terminology "substantial doubt" and "going
concern" may indicate that audit reports were issued with
the additional explanatory paragraph but with unclear
meaning or variation in the language used.
The Role of Auditing
This section provides a theoretical professional
responsibility perspective for the role of auditing. Two
important documents that provide a framework for auditing
are Mautz and Sharaf's The Philosophy of Auditing [1961] and
A Statement of Basic Auditing Concepts (ASOBAC) [1973],
which was written by the Committee on Basic Auditing
Concepts (the Committee).
The purpose of auditing is typically expressed as
lending credibility to financial information or statements
prepared by managers. Mautz and Sharaf [1961] state that
the task of auditing is "to review the measurements and
communications of accounting for propriety" [p. 14]. Their
first "tentative postulate of auditing" is that "financial
statements and financial data are verifiable" [p. 42]. In
their opinion, "unless financial data are verifiable,
auditing has no reason for existence" [p. 43].
Similar concepts are found in ASOBAC. The Committee
stated that:
the application of the auditing process to the communication of accounting information enhances the value of accounting information and that the primary beneficiary of the audit process is the user of the accounting information. [ASOBAC, 1973, p. 8]
The Committee indicated that after receiving the
information, the user had to interpret the information
content and evaluate the quality of the information [ASOBAC,
1973]. The Committee further recognized that there are four
conditions that make it difficult for the user to assess the
quality of information. These conditions are: (1) conflict
of interest between user and preparer; (2) significance of
the consequences; (3) complexity of the information; and (4)
remoteness or separation between the user and the preparer
[ASOBAC, 1973]. The combination of these four conditions
results in the user's reliance on an independent third-party
to evaluate the quality of the information communicated by
the preparer [ASOBAC, 1973]. The auditor acts as that
independent third-party by attesting to the quality of the
information [ASOBAC, 1973].
The auditor's role as a third-party is to provide
independent attestation to financial statements users and is
made more difficult when going concern issues are present.
For example, Palmrose [1987] found that almost 50 percent of
litigation against auditors involved clients who experienced
financial failure or severe financial difficulties.
Auditors' decisions regarding the disclosure of going
concern problems involve numerous considerations, including
a trade-off between the economic costs and benefits. From
the auditor's perspective, the potential loss of the auditee
as a client represents an economic cost of disclosure.
However, an economic benefit to the auditor of disclosure
could be the avoidance of possible legal liability should
they disclose going concern issues and the client suffers
financial distress.
This section has discussed the role of auditing from a
professional responsibility viewpoint. The next section
will review theoretical perspectives about the auditor's
reporting decision.
Theoretical Perspectives About The Auditor's Reporting Decision
There are several considerations that could impact the
auditor's reporting decision. These include professional
judgment considerations, the power struggle theory, agency
theory, the information and insurance hypotheses, and
ethical judgments. The question of interest in this study—
regardless of the factors impacting the auditor's reporting
decision—is the aggregate effect that the expectation gap
SASs had on auditors' decisions regarding the reporting of
going concern. Therefore, this study is not based upon any
one of the above mentioned theories or concepts. However,
the individual components of the auditor's reporting
decision provide potential reasons for why each theory may
impact going concern audit reports. Therefore, each of them
will be reviewed.
Professional Judgment Considerations
Considerations about professional judgment that may
affect the auditor's reporting decision will be reviewed in
this section. Summaries of this research are provided by
Joyce and Libby [1982], Libby [1981], Waller and Felix
[1984], and Solomon [1987].
Gibbins [1984] developed a series of propositions,
corollaries, and hypotheses from prior research regarding
the psychological modeling of professional judgment in
public accounting and interviews with public accountants.
He described routine audit judgment as a continuous,
incremental process that is conditional on information that
arrives sequentially. This process results in a cycle of
actions, choices, and feedback that promotes learning by the
practitioner. Gibbins [1984] described non-routine audit
judgment as a response to the circumstances, guided by
conscious judgment, and infrequently occurring (because the
practitioner's experience provides an updated, efficient
basis on which to exercise routine judgment).
One important aspect of the professional judgment
literature is the effect that the order in which information
is received has on judgement. Hogarth and Einhorn [1992]
propose an anchoring-and-adjustment model for updating
beliefs. Their model indicates that order effects arise
from the interaction of information-processing strategies
(whether the information is processed in a step-by-step or
end-of-sequence manner) and task characteristics (such as
the complexity of the stimuli and length of the series of
evidence items) [Hogarth and Einhorn, 1992].
Ashton and Ashton [1988] used five experiments based on
simplified auditing contexts to examine the auditor's
sequential belief revision based on an earlier version of
the model proposed by Hogarth and Einhorn [1992].
Consistent with the model, they determined that the
auditor's belief revisions depend on both the order in which
mixed evidence is received and the manner in which that
evidence is presented. Furthermore, in contrast to general
judgment theory, auditors revised their beliefs when new
evidence or disconfirming evidence was received.
Tubbs, Messier, and Knechel [1990] extended Ashton and
Ashton's [1988] research by using more realistic audit
contexts. Consistent with Ashton and Ashton, Tubbs et al.
[1990] found the order of evidence was not significant when
the evidence was consistently positive or negative.
8
However, when the evidence was mixed, the order of evidence
was significant [Tubbs et al., 1990].
Chow, McNamee, and Plumlee [1987] surveyed a national
sample of auditors regarding their perceptions of the
difficult and critical steps in an audit. The auditors
indicated that the aggregation of results and opinion
formulation phase of an audit was the most difficult overall
phase. Furthermore, within that phase, the most difficult
element was the assessment of the validity of the going
concern assumption [Chow et al., 1987].
This research suggests that some of the difficulty
regarding the assessment of going concern considerations
could be because of an ordering effect of information
reviewed by the auditor. Given that most decisions about
audit reporting (and especially going concern) contain mixed
information, the model posited by Hogarth and Einhorn [1992]
suggests that the order of information reviewed would
influence the auditor's reporting decision. Thus, the
ordering of information could be another factor affecting
the reporting of going concern considerations. Ricchiute
[1992] tested whether the presentation order of evidence
(causal order versus working-paper order) affected the
outcome of audit partner's going concern decisions. He
found that the order in which the evidence was presented did
affect the partner's going concern decision but not the
level of confidence in their decisions.
Power Struggle Theory
The power struggle theory posits that managers (the
preparers of financial statements) can affect the auditor's
reporting decision. Managers are theorized to have power,
in relation to auditors, because they can impose costs on
auditors if they do not give in to pressure from managers.
However, the relative strength of the manager compared to
the auditor varies.
DeAngelo [1981] hypothesized that managers impose costs
on auditors by changing (or threatening to change) auditors.
By changing auditors, the manager is hypothesized to deprive
the auditor of a stream of quasi-rents. Quasi-rents are
defined as the excess of revenues over avoidable costs,
including the opportunity cost of auditing the next-best
alternative client. Quasi-rents arise because the auditor
invests in the current period while expecting to earn a
return in future periods.
Goldman and Barlev [1974] theorized that the
relationship between the auditee (represented by management)
and the auditor is represented by an asymmetrical power
relationship that favors the auditee in a conflict
situation. Goldman and Barlev indicated that the auditor's
service is considered to be routine and to primarily benefit
third parties, such as investors or creditors. Because the
auditor's service is routine (and therefore easy to replace)
and the auditee is not the primary beneficiary of the
10
auditor's service, the auditor is in a less powerful
position than the auditee.
Subsequently, Nichols and Price [1976] expanded the
Goldman and Barlev analysis to consider the differing
pattern of dependencies that exist between the auditor and
the auditee. Nichols and Price also theorized that an
asymmetrical pattern of dependency exists between the
auditor and the auditee, but the asymmetry is due to the
greater number of alternatives available to the auditee (for
obtaining an audit) combined with a difference in how the
auditee and the auditor value the rewards of an audit. The
difference between how the firm and the auditor value the
rewards of an audit exists because it is probably easier and
less costly for the auditee to replace its auditors than it
is for an auditor to obtain alternative sources of revenue
[Nichols and Price, 1976].
Knapp [1985] studied how bank loan officers perceived
the ability of an audit firm to maintain its position when
there was a significant conflict with a client. He found
that management is perceived as more likely to obtain their
preferred outcome if the dispute between the auditor and the
client was not precisely dealt with by technical standards,
and if the client is in a healthy financial position.
The reporting of going concern considerations could be
considered an area where the technical standards have not
been precise (evidenced by the issuance of SAS No. 64
11
[AICPA, 1991]). SAS No. 59 [1988f] requires that if an
auditor has substantial doubt about the auditee's ability to
continue as a going concern, the auditor should obtain and
assess the likelihood of management's plans. This could
provide the auditee's management an opportunity to enter
into a dispute with the auditor prior to the auditor's final
decision regarding the type of opinion to be issued. This
would suggest that management might have some bargaining
power with the auditors (contingent upon the company's
financial position) regarding the inclusion of, or wording
in, the explanatory paragraph.
Agency Theory
An agency relationship exists when one party (the
principal) hires another party (its agent) to perform some
service on the principal's behalf, the performance of which
will require that the principal delegate some decision
making authority to the agent [Jensen and Meckling, 1976].
Because both the principal and agent are assumed to be
rational wealth-maximizing individuals, their interests may
diverge. Therefore, it is theorized that the principal will
incur expenditures (monitoring costs) to monitor whether or
at what level the agent performs its contractual duties or
reduce their payments (compensation) to the agent.
Auditing can be viewed as a means of monitoring that
will lead to an overall reduction of agency costs [Benston,
12
1985; Jensen and Meckling, 1976; Ng, 1978; and Watts and
Zimmerman, 1983]. The principal will anticipate the
divergence of interests that leads to the monitoring
expenditures; consequently, the principal will reduce the
agent's wages by the amount of the monitoring expenditures.
To minimize this wage reduction, the agent provides audited
financial statements to the principal as one component of
monitoring [Wallace, 1985].
DeJong and Smith [1984] theorize that the auditor's
decision (as an agent) about whether to qualify an audit
report represents a trade-off between: (a) the short-run
benefit of keeping a client (which is enhanced if the
auditor's report is not qualified or "red-flagged"); and (b)
long-run costs such as loss of reputation or potential
litigation if the audit report is not qualified or "red-
flagged" and financial difficulty is subsequently
actualized.
In an empirical test of the auditor's trade-off, Kida
[1980] found that auditors may be influenced by the
perceived consequences of issuing or not issuing an audit
report qualified for going concern considerations. Kida
found that the auditors who qualified the least number of
reports had stronger beliefs that they would lose the
client, the client would sue, the accounting firm's
reputation with potential clients would be negatively
affected, and relations with the current client would
13
deteriorate if the opinion were erroneously qualified.
Alternatively, auditors who qualified more reports had
stronger beliefs that if the opinion were not qualified for
a firm with going concern problems, the consequences would
be severe. Examples of outcomes anticipated by this second
group of auditors included that a client's creditors would
sue, grounds for alleging negligence would be provided, the
accounting firm's reputation with other clients would
experience a negative impact, and the accountant's
responsibilities would not be fulfilled if the opinion were
not qualified.
The effect of the expectation gap SASs on the auditor's
decision of whether to "red-flag" audit reports for going
concern considerations is partially contingent upon the
impact of these SASs on the balance between the short-run
benefit and the long-run cost of the reporting decision.
Because SAS No. 59 requires that auditor's obtain and
evaluate management's plans intended to mitigate the event
or condition leading to the auditor's doubt about the
client's ability to continue as a going concern, management
may have an opportunity to influence the auditor's reporting
decision. Through the required discussion of management's
plans, management could have an opportunity to influence the
auditor's perception of the trade-off short-run benefits of
keeping the client and the long-run costs to the auditor of
an incorrect report decision hypothesized to exist in the
14
agency framework. Specifically, because of the required
discussion of management's plans, management could emphasize
the auditor's perception of short-run benefit of maintaining
the auditee as a client.
Alternatively, the expectation gap SASs could have
shifted the auditor's economic trade-off toward increased
disclosure of going concern (i.e., greater emphasis on
serving the public) because of the expanded responsibility
placed on auditors for the assessment of going concern and
the additional information available for that assessment.
If the auditors' economic trade-off has shifted toward
increased reporting of going concern, auditors might have a
greater propensity to "red-flag" reports. Therefore,
auditors could be issuing reports that indicate going
concern problems for clients who are in less severe
financial situations, as compared with decisions made under
the previous guidance of SAS No. 34. Comparing the
characteristics of companies that receive a going concern
report before and after the issuance of the expectation gap
SASs will help assess whether the auditors' economic trade
off has shifted toward the public.
The purpose of this section has been to assess the
auditor's reporting decision based on agency theory, which
is a business risk perspective that explicitly considers the
dilemma that the auditor faces when attempting to serve both
the public and concurrently maintain the client. However,
15
the agency theory only partially explains the auditor's
reporting decision. Other perspectives that augment the
agency theory are the information and insurance hypotheses.
Information Hypothesis
Financial statement users face business risk and
information risk [DeJong and Smith, 1984]. Business risk
refers to the success or failure of a particular business.
Financial statement users can mitigate the influence of a
single firm's business risk by forming a diversified
portfolio. In contrast, information risk, the probability
that the financial statement information used is inadequate
and unreliable, is not mitigated by diversification. This
is because the diversification decision may be based on
financial statement information that is unreliable or
inadequate if it is not verified. Thus, financial statement
users can reduce their information risk by requiring audited
financial statements [DeJong and Smith, 1984]. The audit
adds value to the financial statements because it is assumed
to improve the quality of the financial information
[Wallace, 1985].
The information hypothesis formalizes the general
concept that the role of auditing is to lend credibility to
financial statements and posits that the demand for the
audit comes from financial statement users. The primary
purpose of the expectation gap SASs was to improve
16
communication between auditors and financial statement users
[Roussey, Ten Eyck, and Bianco-Best, 1988; Guy and Sullivan,
1988]. This communication had been particularly problematic
regarding going concern issues; therefore, SAS No. 59
[1988f] expanded the auditor's responsibility for evaluating
going concern considerations. To the extent that the
expectation gap SASs have improved auditors' communication
of going concern considerations, financial statements users'
information risk could be reduced.
A comparison of agency theory and the information
hypothesis indicates that similar auditor motivations could
be deduced from each. Some of the same information that
would be used in the monitoring process hypothesized in
agency theory would also be used by financial statement
users under the information hypothesis [Wallace, 1985].
However, the two theories differ in who is hypothesized to
provide the demand for audited financial statements. Based
on agency theory, the manager would contract with the
principal to provide audited financial statements in order
to minimize the manager's wage reduction resulting from the
principal's monitoring expenditures. In contrast, the
information hypothesis posits that financial statement users
(investors, creditors and managers) demand audited financial
statements for making rational investment decisions
[Wallace, 1985].
17
Insurance Hypothesis
Another hypothesis regarding audit motivation is based
on the auditors' liability when audited financial statements
are subsequently determined to be in error. The ability of
users of audited financial statements to collect from the
"deep pockets" of audit firms provides the basis for the
insurance hypothesis. The breadth of the auditor's legal
liability is substantial, and has been particularly
problematic when going concern issues are present. For
example, Palmrose [1987] found that almost 50 percent of
litigation against auditors involved clients who experienced
financial failure or severe financial difficulties.
Based on the securities acts of 1933 and 1934, the
auditor and the auditee are jointly and severally liable to
third parties for losses attributable to defective financial
statements [Wallace, 1985]. The premise of the insurance
hypothesis is that the demand for an audit is to provide
managers and investors with insurance against losses
[Wallace, 1985]. As Benston [1985, p. 52] states:
the services provided by public accountants include an element of insurance—that is, the auditors may be sued for failing to prevent some frauds and for having permitted the owners or managers to make "incorrect" reports of the enterprises activities.
The "deep pockets" version of this theory is that
auditors are often held responsible for investor losses
because they are perceived to have the ability to pay. This
18
is particularly true when the auditee goes bankrupt or has
going concern problems [Jaenicke, 1977].
The insurance hypothesis is consistent with both agency
theory and the information hypothesis. Based on agency
theory, monitoring costs are hypothesized to exist because
of the anticipated divergence between the interests of the
manager (the agent) and the owner (principal). If the
owners or financial statement users perceive that monitoring
costs include a means of settling for the costs of actions
taken by the agent that were divergent from the owners'
interests, then the auditor's legal liability ("deep
pockets") provides a means of settlement [Wallace, 1985].
In addition, investors may value the information in audited
financial statements (more than unaudited financial
statements) because of the auditor's legal liability if the
statements are proven to be misleading [Wallace, 1985].
Based on the insurance hypothesis, if auditors perceive
themselves as providing insurance against losses incurred by
financial statement users and that their responsibility to
users has been increased because of the expectation gap
SASs, they might be more cautious about the form and content
of their opinion. The effect of SAS No. 59 was to expand
the auditor's responsibility regarding the assessment of
going concern considerations. Thus, auditors may issue more
going concern opinions or issue those opinions for companies
19
in less severe financial distress (than under the guidance
of SAS No. 34) in order to avoid potential litigation.
Ethical Considerations
Ethical considerations are the final factor that will
be reviewed regarding the auditor's reporting decision.
Ethical training has been found to affect the professional
decision making of students [Hiltebeitel and Jones, 1991].
In addition, auditors face a unique professional ethical
dilemma because of the conflicts involved in serving two
masters—the client and the public [Westra, 1986]. This
concept is also expressed by the Anderson Committee in their
report which led to the revision of the AICPA Code of
Professional Conduct in 1988.
Client, employers, and the public at large all benefit from the services of certified public accountants. In discharging their professional responsibilities, members may encounter conflicting pressures from among each of these groups. In resolving these conflicts, members should act with integrity, guided by the precept that when members observe their responsibility to the public, clients' and employers' interests are best served. [Anderson and Ellyson, 1986, p. 96]
Noreen [1988] examined ethical issues in relation to
agency theory. Agency theory literature indicates that the
agent will act with unconstrained opportunism and, when in a
professional service context, without being readily
observable. Noreen [1988] shows that in ex ante terms, both
the principal and the agent would be better off economically
if it were possible to restrain the opportunistic behavior
20
of the parties by using an ethical code or agreement.
However, because violations of an ethical code or agreement
would not be observable, sanctions would not be effective in
inducing ethical behavior [Noreen, 1988].
Shaub [1989] examined whether the ethical orientation
and organizational and professional commitment of auditors
(from one Big Eight public accounting firm) affected their
sensitivity to ethical situations. He found strong
relationships between auditors' ethical orientations, and
their levels of professional and organizational commitment.
However, those factors had no effect on ethical sensitivity.
In addition, Shaub [1989] found that the auditors in his
study varied in ethical orientation, ability to recognize
ethical issues, and in their level of cognitive moral
development. Each of these ethical factors could influence
auditors' decision making, including areas such as
reporting.
Ponemon [1991] examined the influence of accounting
firm socialization on accountants' level of ethical
reasoning. His results corroborated the existence of
ethical socialization within public accounting firms and a
convergence of ethical reasoning below comparable norms for
college educated adults. Further, Ponemon found that
promotion decisions made by managers are biased in favor of
accountants who possess ethical reasoning that is comparable
with their own level of ethical reasoning. This leads to
21
his conclusion that the accountants who remain with the firm
and are promoted to manager and partner positions have lower
and more homogenous levels of ethical reasoning than
accountants who either chose to leave or were not promoted
and consequently left the firm.
Lampe and Finn [1992] studied the ethical decision
making of accountants and auditors by comparing a "code (of
ethics) implied" model with a "five-element" model that was
developed based upon prior cognitive-developmental models.
The "code-implied" model indicates that when an auditor is
faced with an ethical dilemma, he or she would compare the
situation with the code and make a decision that would avoid
any possible violation. Their "five-element" model is as
follows: gain understanding; recognize impact; judge
alternatives; assess other values; and make a final
decision. They determined that the "five-element" model
reflected the decisions made and the reasons for the
decisions better than the "code-implied" model. However,
the code-based reasons were the most significant influence
of auditors' ethical decision making. The "five-element"
model indicated the degree to which other non-code based
factors such as self-interest and concern for others
influenced auditors' ethical decision making. In addition,
Lampe and Finn [1991] determined that the level of moral
development attained by the individual auditor affected how
the alternatives were judged.
22
The implications of Lampe and Finn's findings regarding
decision-making by auditors, particularly regarding audit
reporting, are that factors other than strictly professional
standards may influence the auditors' decisions. This could
be particularly important regarding the reporting of going
concern considerations because the financial ramifications
of this decision and the expectations of the conflicting
parties are extensive. One additional factor that could
influence the auditor's reporting decision about going
concern considerations is that the issuance of a going
concern opinion may serve as a self-fulfilling prophecy for
failure of a firm [Elliott and Jacobson, 1987].
Additionally, the concept of substantial doubt is not well
defined in the accounting or auditing literature [Ellingsen,
Pany, and Fagan, 1989].
Synopsis
The purpose of this section was to review the
theoretical perspectives that impact auditors' reporting
decisions. The perspectives include professional judgment,
power struggle, agency, information and insurance
hypotheses, and ethical considerations. Each of these
theories, some of which are overlapping, is an important
component of the auditor's reporting decision. However, the
expectation gap SASs were intended to increase the auditor's
overall responsibility for the assessment and reporting of
23
going concern. Thus, the research question addressed here
is what the aggregate impact of the expectation gap SASs has
been on the reporting of going concern.
Research Objectives
One of the stated purposes of the expectation gap SASs
was to improve communication between auditors and financial
statement users [Roussey, Ten Eyck and Bianco-Best, 1988;
Guy and Sullivan, 1988]. This communication has been
particularly problematic when going concern issues are
present. Two of the expectation gap SASs, Nos. 58 and 59,
addressed this by expanding the auditor's responsibility for
evaluating going concern considerations and by eliminating
the qualified opinion requirement, while retaining the "red-
flag" concept [Ellingsen, Pany, and Fagan, 1989].
The purpose of this research is to study the effect, if
any, that the procedural and reporting changes instituted by
the expectation gap SASs have had on the financial reporting
of entities. Determination of the possible effect will be
analyzed by comparing financial and market characteristics
of companies with audit reports that indicated going concern
uncertainties with random samples of companies receiving
audit reports that did not indicate going concern
uncertainties. Companies included in the going concern
groups were both those receiving an explanatory paragraph in
their audit opinion related to going concern uncertainty as
24
required by SAS No. 59 and modified by SAS No. 64 and those
that had previously received a qualified "subject-to"
opinion. The results of this comparison indicate whether
the post-expectation gap reporting of going concern provides
an improved early-warning signal for financial statement
users.
The going concern and "clean" firms included in this
study have been selected from the Compact Disclosure
database. The Compact Disclosure database contains
financial and management information on over 12,000 publicly
held companies that provide goods or services to the public.
Management investment companies, real estate limited
partnerships, and oil and gas drilling funds are excluded
from the database. The financial statement information
necessary for the computation of the financial ratios used
in both the financial and synthesized models were also
obtained from Compact Disclosure. Thus, the companies
selected from Compact Disclosure comprised the "full sample"
and were used for comparisons based on the financial model.
Because the synthesized model proposed in this study
includes market variables, the full sample of companies has
been restricted to those with market data available on the
Center for Research in Security Prices (CRSP) tapes. This
sample is referred to as the "restricted sample" and has
been used for comparisons based on the synthesized model.
Companies included on the CRSP tapes are relatively large
25
companies whose stocks are traded on the American or New
York Stock Exchanges. The restricted sample includes a much
smaller subset of the larger companies in the full sample.
The use of the restricted sample is recognized to contain
some selection bias because of the exclusion of smaller
companies that are traded on over-the-counter (OTC)
exchanges.
The financial model used in this research as the basis
for comparisons related to the full sample of companies
selected from Compact Disclosure, is based on prior research
by Mutchler [1985]. Mutchler [1985] used discriminant
analysis to examine the relationship between the going
concern opinion and publicly available information. She
constructed and compared several models, determining that
the model with the highest classification accuracy (89.9%)
was one that included six financial ratios and the prior
year audit opinion. These six variables also comprise the
financial model used for this study.
The synthesized model, used for comparisons related to
the restricted sample of companies, is a combination of the
six financial variables with additional market variables
from the Dopuch, Holthausen, and Leftwich [1987] study.
Dopuch et al. [1987] predicted initial going concern
qualifications using a probit model that included both
financial and stock market variables. They hypothesized
that the market variables would capture information beyond
26
that reported in the financial statements, and that the
variability in the market measures would reflect the risk of
lawsuits against auditors.
Both the financial (full sample) and synthesized models
(restricted sample) are used to compare characteristics of
companies from three time periods: the pre-expectation gap
SAS period of 1986 and 1987 (when SAS No. 34 applied); the
transition period from February 1988 through December 31,
1988 (when auditors could choose whether to follow SAS No.
34 or SAS No. 59); and the post-expectation gap SAS period
of 1989 and 1990 (when SAS No. 59 was implemented and
subsequently clarified by SAS No. 64).
Two types of statistical analyses have been made to
determine whether the financial or market characteristics of
companies receiving a going concern report have changed
between the pre-, transition, or the post-expectation gap
SAS periods. First, multivariate comparisons of the
difference in variable means are made between the going
concern and "clean" companies. Second, dummy variables are
added to the models and the variables standardized to test
the effect of the three different reporting requirements on
the odds of a company receiving a going concern report. In
addition, summary statistics on the number and percentage of
firms receiving a going concern report are provided for each
of the years in the sample.
27
Organization of the Study
The remainder of the study is organized as follows.
Chapter II provides a historical summary of professional
guidance regarding going concern reporting and a discussion
of the relevant literature related to modelling and
predicting going concern opinions. Implications for the
current study based upon this literature are examined. The
research hypotheses of interest, sample selection, and data
collection are presented in Chapter III. Chapter IV reports
on the research results. Finally, Chapter V provides a
summary and discussion of the implications of the results.
28
Audit Evidence
^x^ContraryS y^ Information
^"V.^^ Indicating GC ^^" '
No
Yes
Yes
1 ' Qualified
"Subject to" Opinion
Issue Unqualified
Opinion
Consider Mitigating
Factors
\
Consider Management
Plans
^^^T)oes\. Substantial
Doubt About GC Still .
^ ^ s t j / ' ^
^ No
\
Unqualified Opinion
Figure 1.1
The Auditor's Responsibility for Assessing and Reporting on Going Concern (GC) Under
SAS No. 34 (Pre-Expectation Gap)
29
Additional Procedures to Meet
Guidance in SAS No. 53,54,56,57
Yes
1 ^
Yes
i ^ Consider
Management's Plans
> / ' ^ o e s \ . y^^ Substantial ^ v ^
Issue Unqualified
Opinion (with Explanatory
Paragraph)
GCStiU \ B d s t ^ /
F i
Audit Evidence
\
Assess Evidence forOC
v^^DocsX.^ y^ Substantial ^^ s .
Doubt About " ^ ^ ^ GCErist ^ ^
No
' r
Issue Unqualified
Opinion
g u r e 1 . 2
No
' 1 Issue
Unqualified Opinion
The Auditor's Responsibility for Assessing and Reporting on Going Concern (GC) Under SAS No. 59 (Transition and Post-Expectation Gap)
CHAPTER II
LITERATURE REVIEW AND ANALYSIS
Introduction
This chapter is organized into four sections. First, a
historical summary of reporting on going concern is
provided. Second, empirical research that has focused on
creating models regarding the auditor's decision to issue a
going concern audit report is described.^ Third, the more
recent empirical literature related to predicting going
concern opinions is reviewed. Fourth, the implications of
the prior research for the current research, focusing on
variables for the models and research method, is described.
Summary of Professional Guidance regarding Going Concern Reporting
The going concern assumption is one of the basic
assumptions underlying financial accounting and the
preparation of financial statements. Accounting Principle
Board Statement No. 4 [1970] has called it a "basic feature
of financial accounting." The going concern assumption
means that a company can be expected to continue in business
for a reasonable period of time or at least not be
liquidated in the near future. This means that the carrying
This review does not include studies of bankruptcy prediction models. Zavgren [1983] and Jones [1987] provide reviews of these studies.
30
31
value of assets will be realized and liabilities will be
liquidated in the ordinary course of continuing business
activity. The going concern assumption provides the basis
for the definition of assets (probable future economic
benefits to a firm), conventional balance sheet
classification, historical cost measurement, and interperiod
allocation procedures such as depreciation, amortization,
and income tax allocation [Williams, Stanga, and Holder,
1989].
The auditor also has direct professional
responsibilities for the going concern assumption. When
financial statement values are questionable because of doubt
about the entity's ability to continue in existence, the
auditor must decide if the situation requires a going
concern audit report.^ Theoretically, a going concern
audit report would signal financial statement users that the
auditor has substantial doubt regarding the entity's ability
to continue in existence.
The first formal guidelines for auditors related to
going concern opinions were presented in Accounting Series
Release (ASR) No. 90, "Certification of Income Statements,"
[SEC, 1962] issued by the Securities and Exchange Commission
(SEC) [Rappaport, 1972]. ASR No. 90 specified that the
^Throughout this paper, the term going concern report includes both the qualified "subject-to" opinion required by SAS No. 34 and the unqualified (or clean) opinion with the additional explanatory or "red flag" paragraph required by SAS No. 58 and SAS No. 59.
32
"subject to" qualification was appropriate when there was a
reference to a material matter, transaction or event whose
status could not be resolved at the financial statement
date. The auditing profession responded to ASR No. 90 with
the issuance of Statement on Auditing Procedures (SAP) No.
33 [AICPA, 1963]. SAP No. 33 advised auditors that their
audit reports should specifically call attention to unusual
uncertainties when the probable effects were not reasonably
determinable at the time the financial statements were
released.
SAS No. 2, "Reports on Audited Financial Statements,"
[AICPA, 1974] contained the first formal references to
specific financial statement characteristics that were
associated with the going concern report decision (e.g.,
recoverability and classification of recorded assets,
amounts and classification of liabilities, recurring
operating losses, etc.). Auditors were advised that when
material uncertainties exist, they should consider either
qualifying their reports or disclaiming an opinion.
In 1977, the American Institute of Certified Public
Accountants (AICPA) Auditing Standards Executive Committee
(AudSEC) recommended elimination of all subject-to opinions
including the going concern opinion [Campbell and Mutchler,
1988]. However, this recommendation was opposed by the
Securities and Exchange Commission (SEC) and was never
issued in final form [Robertson, 1988].
33
AudSEC's recommendation was based on the tentative
conclusions of the Cohen Commission [Campbell and Mutchler,
1988]. In their final report, the Cohen Commission [AICPA,
1978] formally recommended that the subject-to opinion
qualification be eliminated. This recommendation was made
because the Commission indicated that "from the perspective
of both users of financial statements and independent
auditors, the present requirements for reporting
uncertainties are deficient" [Commission on Auditor's
Responsibility (CAR), 1978, p. 25]. Specifically, the
Commission indicated that the qualified opinion placed
contradictory audit requirements on the auditor, caused
confusion for users, and created false expectations for
users [CAR, 1978].
In 1982, the Auditing Standards Board (ASB) agreed in
principle to eliminate the use of the subject-to opinion
because it was "unnecessary if the client has reasonably
estimated and disclosed a significant uncertainty" [AICPA,
1982a]. However, when the ASB held public meetings to
elicit the public's viewpoint, strong opposition to the
proposal was expressed by representatives from the SEC,
bankers, and investment analysts [AICPA, 1982b]. They
argued that the subject-to qualification was useful as a
"red-flag in their decision-making procedures" [AICPA,
1982b]. In addition, some of the representatives indicated
that they viewed the auditor as having access to inside
34
information for use as the basis of opinion decisions
[AICPA, 1982b]. Because of the strong opposition expressed
at the public meeting regarding this proposal to eliminate
the subject-to opinion, it was sent back to the ASB for
further study, where it was indefinitely postponed [Campbell
and Mutchler, 1988].
Debate about the auditing profession and audit reports
continued, partially because of several well-publicized
business failures such as Wedtech Corp. [Berton, 1987a,
1987b] and Vernon Savings & Loan Association [Taylor, 1987].
Public concern regarding these companies that failed soon
after receiving an unqualified opinion from their auditors,
resulted in increased public scrutiny of the accounting
profession's ability to provide an early-warning signal
about the possibility of business failure. These and other
events prompted Congressional hearings by the House
Subcommittee on Oversight and Investigations (the Dingell
Committee) and the organization of the National Commission
on Fraudulent Financial Reporting (NCFFR, also referred to
as the Treadway Commission after Chairman James C.
Treadway).
The Dingell Committee equated business failure, shortly
after having received an unqualified opinion, with audit
failure. The Dingell Committee began to hold hearings in
February 1985, to review the process for preparing and
auditing reports that are filed with the SEC [Beckman,
35
Byington, and Munter, 1989]. Ultimately, the Dingell
Committee decided to rely on the accounting profession's
attempts at self-regulation instead of pursuing legislative
solutions [AICPA, July 1987].
In October 1985, the Treadway Commission began a study
of the financial reporting system in the United States to
find more effective ways to prevent fraudulent financial
reporting. The Commission issued its final report in
October 1987. In the recommendations for improving the
communication between auditors and the public regarding the
auditor's role, the Treadway Commission noted that:
Auditors can and should do a better job of communicating their role and responsibilities to those who rely on their work. Users of audited financial statements need to understand better the nature and the scope of an audit and the limitation of the audit process. [NCFFR, 1987, p. 57]
Specifically, the Treadway Commission suggested that the
auditor's standard report be modified to communicate the
auditor's responsibility more clearly and explicitly to
report readers [NCFFR, 1987].
Expectation Gap SASs
While the accounting profession has vacillated about
the reporting of going concern, the public has been
consistent in its expectations [Campbell and Mutchler,
1988]. The public expects that the auditor's access to
inside information will provide an early-warning signal or
36
"red-flag" about the auditee's financial viability and
probability of continued existence when going concern is
questionable. However, the professional guidance in SAS No.
34 had restricted going concern issues to the classification
and recoverability of assets and liabilities.
In 1985, the ASB began a series of studies, which were
an attempt at closing the gap between public expectations
and the auditor's professional guidance. Eventually, these
studies were combined into the "expectations gap" project
and resulted in the issuance of nine new SASs (summarized in
Appendix A). These SASs addressed the general areas of
detecting of fraud and illegal acts, audit effectiveness,
and improved external and internal communication [Guy and
Sullivan, 1988].
There are four primary differences between the pre-
expectation gap guidance (Figure 1.1) and the transition and
post-expectation gap guidance (Figure 1.2) with respect to
auditors' responsibilities for assessing and reporting
doubts about ability to continue as a going concern. First,
the amount of required audit evidence available for the
assessment of going concern has been increased (because of
SAS No. 53, SAS No. 54, SAS No. 56, and SAS No. 57).
Second, the auditor is now required to assess the auditee's
ability to continue as a going concern in every audit (per
SAS No. 59). Third, the type of report issued when going
concern is questionable has been changed (because of SAS No.
37
59 and SAS No. 58). Fourth, the time frame for the
auditor's assessment of going concern is specified as not
exceeding one year from the date of the financial statements
being audited (SAS No. 59). Each of these four differences
is reviewed in greater detail.
Audit Evidence
SAS No. 59 does not require that auditors perform
additional audit procedures in order to assess going
concern. This is because the results of audit procedures
designed and performed to achieve other audit objectives
should provide the auditor with sufficient evidence to
assess going concern [AICPA, 1988b]. However, as indicated
in Figure 1.2 (post-expectation gap assessment of going
concern), the amount of audit evidence available for the
assessment of going concern has been increased due to four
of the other expectation gap SASs. Appendix B provides a
detailed comparison of the pre- and post-expectation gap
SASs regarding audit evidence.
SASs No. 53 and 54 deal with the detection of fraud and
illegal acts. SAS No. 53, "The Auditor's Responsibility to
Detect and Report Errors and Irregularities" [AICPA, 1988a]
supersedes SAS No. 16, "The Independent Auditor's
Responsibility for the Detection of Errors or
Irregularities" [AICPA, 1977a]. SAS No. 53 expresses the
auditors' responsibilities for the detection of material
38
errors and irregularities in a much more affirmative manner
than did SAS No. 17 [Carmichael, 1988], In addition, SAS
No. 53 imposes several new audit requirements including the
responsibility to assess the likelihood of both material
misstatement at the entity level and management
misrepresentation [Carmichael, 1988].
SAS No. 54, "Illegal Acts by Clients" [AICPA, 1988b]
supersedes SAS No. 17 [AICPA, 1977b], which had the same
title as the new SAS. In contrast to SAS No. 17, SAS No. 54
establishes an affirmative responsibility that an audit
should be designed to provide reasonable assurance that
illegal acts that have a direct and material effect on the
financial statements will be detected and reported [Neebes,
Guy, and Whittington, 1991]. In addition, both SAS No. 53
and SAS No. 54 requires that the auditor notify the audit
committee (or its equivalent) about errors, irregularities,
or illegal acts unless they are inconsequential [Guy and
Sullivan, 1988]. These requirements should heighten the
auditors' awareness regarding the need to assess these
issues and provide additional audit evidence for the
assessment of going concern.
The other two SASs that expanded the minimum level of
audit performance are No. 56 and 57. These SASs deal with
both audit effectiveness and audit efficiency. For this
research, emphasis is placed on increased effectiveness in
detecting conditions that raise doubt about an auditee's
39
ability to continue as a going concern. SAS No. 56,
"Analytical Procedures" [AICPA, 1988c] supersedes SAS No.
23, "Analytical Review Procedures" [AICPA, 1978]. SAS No.
2 3 did not require the use of analytical procedures,
although it emphasized analysis to investigate significant
fluctuations. In contrast, SAS No. 56 requires the use of
analytical procedures in both the planning and final review
stages of all audits and encourages their use as substantive
tests [AICPA, 1988c]. The importance of analytical
procedures, such as trend and ratio analysis, is noted in
SAS No. 59 as an example of audit procedures that provide
indicators of an entity's ability to continue as a going
concern [AICPA, 1988f].
SAS No. 57, "Auditing Accounting Estimates" [AICPA,
1988d], requires that auditors provide reasonable assurance
that all estimates that could be material to the financial
statements have been developed, are reasonable, conform with
applicable accounting principles, and are properly
disclosed. The importance of accounting estimates in
detecting errors and irregularities has also been emphasized
by the Treadway Commission [NCFFR, 1987]. SAS No. 57 is an
important component of the expectation gap SASs' attempt at
preventing misleading financial reporting [Callahan,
Jaenicke, and Neebes, 1988].
40
Assessment of Going Concern
The procedural requirements regarding the assessment of
going concern have been directly modified by SAS No. 59.
Pre-expectation gap guidance was provided in SAS No. 34,
which was in effect from 1981 through 1988, and is
summarized in Figure 1.1. SAS No. 34 specified that the
auditor was not responsible to actively search for evidence
regarding an entity's ability to continue as a going
concern. However, the auditor was to remain "aware" that
other auditing procedures might generate evidence that could
result in the questioning of the going concern assumption.
Situations specified in SAS No. 34 as possibly causing the
auditor to question the going concern assumption included:
solvency problems (operating losses, negative cash flow from
operations, default on loan agreements); internal matters
(labor difficulties, substantial dependence on the success
of a particular product); and external matters (legal
proceedings or legislation that might impair the ability to
operate).
After situations such as those listed above came to the
auditor's attention, indicating a potential inability to
continue as a going concern, factors that could mitigate the
adverse effects of that information on the entity would be
considered. Examples of mitigating factors suggested in SAS
No. 34 included plans to dispose of assets, borrow money or
restructure debt, reduce or delay expenditures, or increase
41
ownership equity. The auditors would evaluate both the
mitigating factors they had identified and any plans that
management had in response to the conditions that resulted
in the contrary information. If the auditor concluded that
there was substantial doubt (ultimately a matter of
professional judgment under the guidance of both SAS No. 34
and No. 59) regarding an entity's ability to continue as a
going concern, the opinion paragraph of the audit report
would be modified by a subject-to qualification and an
explanatory paragraph added preceding the opinion paragraph.
SAS No. 59 does not require additional audit procedures
for the sole purpose of identification of conditions and
events that might indicate substantial doubt about the
entity's ability to continue as a going concern. However,
four of the other expectation gap SASs (No 53, 54, 56, and
57) expand the minimum level of audit performance and would
provide additional evidence for the auditor's assessment of
going concern. Thus, SAS No. 59's requirement that auditors
evaluate going concern based on evidence from other audit
procedures is more proactive than the SAS No. 34
requirements. Specific audit procedures that SAS No. 59
indicates might identify conditions and events leading to
doubt about an entity's ability to continue as a going
concern include: analytical procedures; review of
subsequent events; review of debt covenants; reading of
42
minutes; inquiry of legal counsel; and confirmation with
third parties [AICPA, 1988f].
Next, the auditor would consider whether management's
plans for dealing with the conditions and events causing the
auditor to doubt the client's ability to continue as a going
concern could be effectively implemented, and whether they
would improve the client's ability to continue as a going
concern. The management plans identified in SAS No. 59 are
plans to dispose of assets, borrow money or restructure
debt, reduce or delay expenditures, and increase ownership
equity [AICPA, 1988f]. These factors are similar to those
identified in SAS No. 34 as mitigating factors that would
have been identified and evaluated by the auditor when
substantial doubt existed about the client's ability to
continue as a going concern. However, SAS No. 59 does not
address mitigating factors because they are considered to be
inseparable from management's plans, and the responsibility
for identifying them rests with management [Ellingsen, Pany,
and Fagan, 1989].
The requirement that the auditor obtain and assess the
likelihood of management's plans could provide the auditee's
management with an opportunity to influence the auditor's
final decision regarding the type of opinion to be issued.
This potential opportunity to influence the auditors'
reporting decision has implications based on both the power
struggle and agency theories. The power struggle theory
43
posits that management might have some bargaining power with
the auditors (contingent upon the company's financial
position) regarding the inclusion of, or wording in, the
explanatory paragraph. Managers are theorized to have
power, in relation to auditors, because they can impose
costs on auditors if they do not give into pressure from
managers. Thus, during the required discussion of
management's plans, management could be theorized to have
the opportunity to influence the auditor's reporting
decision. The emphasis of agency theory is on the auditor's
perception of the trade-off between the short-run benefits
of keeping a client and the long-run costs to the auditor of
an incorrect reporting decision regarding that client. Due
to the required discussion of management's plans, management
could have an opportunity to influence the auditor's
perception of the trade-off between short-run benefit and
long-run cost.
In summary, the two main procedural changes in the
auditor's assessment of going concern required by SAS No. 59
(summarized in Appendix C) are the auditor's pro-active
responsibility to evaluate every auditee's ability to
continue as a going concern and the elimination of the
auditor's responsibility for identifying and evaluating
mitigating factors. The purpose of these changes was to
reduce the gap between user expectations and actual audit
service by providing an earlier warning signal to financial
44
statement users about companies with going concern problems.
The primary research question in this study is whether
auditors are providing an earlier warning signal of a
company's potential inability to continue as a going concern
following implementation of the expectation gap SASs. If
auditors are providing an earlier warning signal, there
could be an increased number of going concern reports issued
or the characteristics of companies receiving going concern
reports should be more similar to (or less different than)
those of unqualified companies (than what they were under
the guidance of the pre-expectation gap SASs).
If the auditor still has substantial doubt about the
client's ability to continue as a going concern after
assessing the audit evidence and obtaining and evaluating
management's plans, then the auditor would issue an opinion
indicating that uncertainty. However, the requirement that
the auditor assess management's plans may provide management
with an opportunity to influence the auditor's decision
about the type or content of report to be issued. If the
expectation gap related to the reporting of going concern is
caused more by the auditor's reporting decision than the
initial identification of companies with going concern
problems, then the procedural requirements may have minimal
effect on the reporting of going concern.
45
The type of audit opinion issued was also changed by
SAS No. 59 and SAS No. 58. The effect of these changes on
the audit report is discussed in the next section.
Audit Reporting
SAS No. 58 "Reports on Audited Financial Statements"
[AICPA, 1988e], summarized in Appendix D, modifies the
standard audit report to clarify the descriptions of the
auditor's responsibility, work performed, and assurance
provided [Guy and Sullivan, 1988]. Another significant
change from SAS No. 34 to SAS No. 59, which is of particular
importance to this research, is the change in how material
uncertainties such as going concern are reported. SAS No.
34 required a qualified subject-to opinion to be issued when
an auditor had substantial doubt about an entity's ability
to continue as a going concern. In contrast, SAS No. 59
stipulates that when the auditor has substantial doubt
regarding going concern, an unqualified opinion should be
issued with the going concern uncertainty discussed in an
explanatory paragraph following the opinion paragraph. This
explanatory paragraph would act as a "red-flag" to financial
statement users describing the uncertainty, indicating that
its outcome cannot presently be determined, and stating that
the financial statements do not contain an adjustment for
the uncertainty [AICPA, 1988f].
46
Subsequently, SAS No. 64, "Omnibus Statement on
Auditing Standards-1990" [AICPA, 1991], has been issued with
clarification of the wording to be contained in the
explanatory paragraph. SAS No. 64 requires that the
explanatory paragraph added to the audit report about going
concern include the phrase "substantial doubt about its (the
auditee's) ability to continue as a going concern" [AICPA,
1991]. The issuance of a SAS requiring the terminology
"substantial doubt" and "going concern" indicates that audit
reports were being issued with an additional explanatory
paragraph but with unclear meaning or extensive variation in
the language used.
Research questions raised by these reporting changes
address their effects on the financial statement users and
on the preparers of the financial statements. The financial
statement users are the primary focus of the expectation gap
SASs. The desired impact is that the new report form will
still convey the "red-flag" or signal that financial
statement users want and expect from auditors with improved
overall communication of the situation and the auditors'
knowledge of it. However, the issuance of SAS No. 64
suggests that some reports based upon SAS No. 59 contained
weakened wording or unclear explanatory paragraphs. The
effect of the report change on the preparers of financial
statements is associated with the change in the type of
opinion issued when substantial doubt exists about an
47
entity's ability to continue as a going concern. SAS No. 59
requires that an unqualified report be issued, whereas
previously based on SAS No. 34 a qualified subject-to
opinion would have been issued. It is possible that because
the form of the report is now considered unqualified,
management may be less concerned about receiving an audit
report that indicates going concern problems. Another
alternative is that management, who have prepared the
financial statements, may be equally or even more opposed to
the addition of a descriptive explanation than the
previously issued "subject-to" opinion.
Time Frame
SAS No. 59 specifies that the auditor is responsible
for the assessment of the auditee's 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" [AICPA, 1988f]. In addition, SAS No. 59
states that the auditor is not responsible for predicting
future conditions or events, and that the absence of
reference to substantial doubt in the auditor's report
should not be interpreted as providing assurance that the
auditee will continue in existence [AICPA, 1988f].
In contrast to the explicit time period indicated in
SAS No. 59, the prior guidance of SAS No. 34 did not specify
the applicable time frame. The only time reference in SAS
48
No. 34 was in relation to the auditor's consideration of
management's plans. The SAS indicated that the auditor
would place particular emphasis on plans that might have a
significant effect on the auditee's solvency "within a
period of one year following the date of the financial
statements on which the auditor is currently reporting"
[AICPA, 1981]. SAS No. 34 emphasized considering whether
the auditee could continue as a going concern during the
next year, but did not limit the auditor's consideration of
going concern ability to one year. Similar to SAS No. 59,
SAS No. 34 also indicated that the auditor is not
responsible for predicting future events, and that the
absence of a going concern opinion should not be interpreted
as a guarantee or assurance that the entity will continue as
a going concern [AICPA, 1981].
Models Regarding the Auditor's Decision to Issue a Going Concern Report
Empirical research has focused on creating a model for
the auditor's decision to issue a going concern report and
comparing the auditor's accuracy rate to that of other
prediction models. Table 2.1 contains a summary of the
studies reviewed in this section.
Altman and McGough [1974] were the first to model the
auditor's decision to issue a going concern audit report.
They used Altman's [1968] bankruptcy prediction model in
which five financial ratios were used as the predictor
49
variables. Altman and McGough compared the classifications
based on the bankruptcy prediction model with the auditors'
actual report decisions for a sample of 34 bankrupt firms.
They found that the discriminant model correctly classified
82% of the bankrupt companies using data from the latest
financial statements issued prior to bankruptcy. In
contrast, auditors had issued going concern audit reports to
only 44% of the companies that were bankrupt.
Altman and McGough discussed the differing functions of
the bankruptcy model and the auditor's report. The model
attempts to predict bankruptcy, whereas the auditor's report
is concerned with whether the financial statements are
fairly presented. They note that the financial statements
could have been fairly stated (not requiring a going concern
audit report given the professional guidance applicable at
the time of their study) if the carrying value of the assets
represented their realizable value. However, Altman and
McGough did not examine whether this issue contributed to
the presumed misclassification of firms by the auditors.
In a similar study, Deakin [1977] compared the
predictive accuracy of his bankruptcy prediction model with
the auditor's opinions issued for a sample of 47 companies
that had declared bankruptcy and a random sample of 116
nonbankrupt firms. His model correctly identified 83% of
the bankrupt companies as failures two years prior to
failure, whereas auditors had issued going concern reports
50
for only 15% of the firms. The auditors had issued clean
opinions to 115 (99%) of the 116 nonbankrupt firms.
Deakin's examination of the classification accuracy two
years prior to failure could have contributed to differences
between the results of his study and others, and to the low
reporting rate of auditors in his study. If auditors
interpreted the professional standards as indicating that a
going concern opinion should be issued when the auditor had
substantial doubt about the company's ability to continue
within the upcoming business year, then issuing a going
concern opinion two years prior to failure would be
incorrect. Based on that interpretation of the professional
standards, the auditors had issued the correct opinion in
85% of the cases. Thus, the model correctly predicted that
bankruptcy would occur within two years and the auditors
correctly predicted that the company would continue as a
going concern in the next period.
Levitan and Knoblett [1985] constructed and then
compared two discriminant functions to determine whether
auditors use the same variables in assessing going concern
decisions as are used in bankruptcy prediction models. They
found some overlap in the variables used by both the
auditors and the bankruptcy models; however, the variable
with the most importance for auditors (ratio of total debt
to total assets) was not used in the bankruptcy model.
51
Levitan and Knoblett's bankruptcy prediction model
accurately classified 90% of the companies in their sample.
In addition, the auditor reporting rate in their study was
84%, which is substantially higher than the prior two
studies had found. In their analysis of the report
classifications, they concluded that a going concern
exception was a clear signal of financial distress.
However, the absence of a going concern qualification was
not necessarily a signal of the absence of financial
distress.
Kida [1980] suggested that comparisons between
prediction model accuracy and the auditor's report decision
may be confounded by extraneous variables such as the
auditor's perceptions of the consequences of issuing a going
concern audit report. Kida's study is the first to model
the auditor's reporting decision as a two-stage process
where the auditor must first identify potential going
concern companies, and second make a reporting decision
based on audit evidence, the evaluation of management plans,
and interactions with management. Because the auditor's
reporting decision is a two-stage process, studies that
compare prediction model accuracy to the auditor's report
decisions may understate the auditor's ability to recognize
problems. Kida does not refer to this situation as the
effect of type I (incorrectly issuing an unqualified opinion
on a failed firm) or type II errors (incorrectly issuing a
52
qualified opinion on a non-failed firm). However, the
auditor's trade-off between the cost of these two types of
errors could be a component of the "extraneous variables"
referred to by Kida.
Kida used a two-stage process to first investigate the
auditors' abilities to identify companies with going concern
problems, and then the auditors' decisions to issue a going
concern report for companies previously identified as having
going concern problems. Brunswik's lens model was used to
model the auditors' assessments of whether companies had
going concern problems because it allowed both behavioral
and environmental factors to be explicitly considered.
Kida used a sample of 20 problem and 20 non-problem
companies selected from the Disclosure Journal Cumulative
Index entries from May 1974 to April 1975. Kida found that
a discriminant model using five financial ratios could
accurately classify 90% of the companies.
Auditors were first asked to discriminate problem from
non-problem firms by the use of the five financial ratios
from the discriminant model. On average, the auditors'
correctly classified 33 of the 40 companies, resulting in an
83% accuracy rate. Kida determined that all but two of the
auditor subjects classified the companies with an accuracy
rate greater than chance accuracy (an accurate
classification by the auditors of 28 or more companies had
less than a 1% chance of occurring at random). The number
53
of correct auditor responses ranged from 24 to 37. The
auditors' 83% accuracy rate is substantially higher than
what was found in either Altman and McGough [1974] or Deakin
[1977], and is comparable to the 90% accuracy rate that Kida
found when using the five ratios as a discriminant model.
Next, Kida measured the correspondence between the
identification of a problem company and the subsequent
decision to issue a going concern report. Kida measured
this by comparing the number of times auditors would have
issued a going concern opinion to the number of times that
auditors had judged a company to have going concern
problems. In the auditors' judgment, the number of
companies with going concern problems indicated ranged from
4 to 28 companies. On average, the auditors indicated that
17.5 of the 40 sample companies had going concern problems.
However, the auditors in Kida's study would have issued, on
average, a going concern report to only 13.2 (75.4%) of the
17.5 companies that they had previously identified as
problem companies. The number of going concern reports
issued ranged from 0 to 24. Thus, the auditors would have
issued an unqualified opinion to 4.3 (24.6%) of the problem
companies identified. This finding supported Kida's
hypothesis that the identification of a problem company does
not necessarily correspond to the issuance of a going
concern report. Although not mentioned by Kida, one
possible explanation for the auditor's decision to issue an
54
unqualified opinion to a company identified as problematic
could be that auditor's weigh type II errors as relatively
more costly than type I errors. The auditor's perception of
the relative weights of type I and type II errors could have
an even greater influence on actual report decisions because
the cost of a type II error might include the immediate loss
of a client.
Kida divided the auditors into three groups and
compared the beliefs of the third of the auditors who had
issued the most going concern reports with the third who
issued the least. Kida found that auditors who issued the
least going concern reports had slightly stronger beliefs
that they would lose the client, the client would sue, the
accounting firm's reputation would be negatively affected,
and deteriorated relations with the client would occur, if
they incorrectly issued a going concern report to a non-
problem company. Auditors issuing the most going concern
reports had slightly stronger beliefs that: a client's
creditors would sue; grounds for alleging auditing
negligence would be provided; the accounting firm's
reputation would experience a negative impact; and the
accountant's responsibility would not be fulfilled if the
opinion were not qualified when a firm had problems. Kida's
results indicate that auditors' reporting decisions (related
to going concern problems) involve economic tradeoffs based
55
on the perceived consequences of issuing or not issuing a
going concern audit report.
Mutchler [1984] also concluded that the identification
of a problem company may be based on different factors than
the subsequent decision about issuing a going concern
report. She interviewed partners from eight large public
accounting firms and identified 14 variables that they
considered to be indicators that a firm had potential going
concern problems. The auditors indicated that after they
had identified a problem company, they considered cash flow
projections and management plans to determine whether to
issue a report indicating going concern problems. In
addition, some of the auditors indicated that they believed
there was inside information embedded in their decisions
(particularly related to forecast information and management
performance).
The studies reviewed found varying levels of model and
auditor classification accuracy. All of the models
exhibited relatively high classification accuracy, ranging
from 82% in Altman and McGough [1974] to 90% in Levitan and
Knoblett [1985]. In contrast, the auditor classification
accuracy was much more varied, ranging from Deakin's [1977]
15% (or Altman and McGough's [1974] 44%, if the correct
auditor classification accuracy for Deakin [1977] is assumed
to be 85%) to 84% in Levitan and Knoblett [1985].
56
Two possible reasons for the auditors' varied
classification accuracy compared to the prediction models
are that: (a) in the first-stage decision, the
identification of companies with going concern
characteristics, the models may be omitting variables that
are important to auditors, or (b) in the second-stage
decision, regarding the type of report to be issued, the
models may not be weighing the types of errors accurately or
even considering all of the variables that influence the
auditor's reporting decision. All of the studies reviewed
(except Mutchler [1984] who did not use classification
accuracy) have determined classification accuracy by using
the number of misclassifications without consideration of
second-stage decision variables such as the cost of type I
errors (a qualified opinion or failed firm classified as
"clean" or non-failed) or type II errors (a "clean" opinion
or non-failed firm classified as qualified or failed).
The number of misclassifications is probably not an
optimal criterion from the perspective of auditors because
it does not consider the expected cost of the different
types of errors or other factors that could influence the
auditors' report decision. For auditors, a type I error
could lead to third-party lawsuits and loss of reputation,
while a type II error could lead to the loss of the client.
These errors may have relatively different costs for the
auditor. Because Altman and McGough's [1974] sample only
57
included failed companies, they have omitted type II errors.
Deakin [1977], Kida [1980], and Levitan and Knoblett [1985]
used samples that contained both problem and non-problem
companies, which has allowed for the investigation of type I
and type II errors. However, they did not recognize that
the costs of these two types of errors could be different to
auditors, thereby leading the auditors to make decisions (a
second stage reporting decision using Kida's two-stage
process) that are optimal from their perspective but not in
agreement with the model used for comparison. The study by
Dopuch et al. [1987], reviewed in the next section, is the
first to allow for differing costs of type I and type II
errors to auditors.
Prediction of Going Concern Opinions
Two additional studies [Mutchler, 1985; Dopuch et al.,
1987] will be reviewed. These studies are summarized in
Table 2.2 and are important to this research because they
attempt to directly predict companies receiving going
concern opinions. In contrast, the previously reviewed
studies compared the opinion issued by the auditor to the
company's classification (of problem or non-problem) based
on models that predicted the company's condition without
consideration of second-stage variables such as management
plans (mitigating factors based on the guidance in SAS No.
34) . That approach does not recognize that although the
58
auditor may identify problem companies as well as a
statistical model (they may even use a statistical model to
identify problem companies) there may be valid reasons (such
as management's plans) why the auditor decides to not issue
a going concern opinion. However, these studies are
important to this research because of the prediction models
that were developed in them.
Mutchler [1985]
Mutchler [1985] attempted to discern the information
content of auditors' going concern opinions by examining the
relationship between the opinions and publicly available
information. She theorized that if the auditor's opinion
merely reflected what could be gleaned from publicly
available information, then the opinion was redundant.
Mutchler used a matched set of 119 manufacturing
companies that had received a going concern audit report
(GCAR) and 119 manufacturing firms that exhibited problem
company criteria but did not receive a going concern audit
report (NGCAR). The NGCAR set of companies were selected
based on 11 problem company criteria that Mutchler
determined through interviews with 16 auditors (two from
each of the then "Big Eight" firms). These criteria
included such factors as whether the company had negative
amounts of net worth, cash flow, or income from operations,
whether the company had entered receivership or
59
reorganization, and whether the company had received a going
concern audit report in the previous year.
Next, Mutchler used a three-stage modelling process to
construct a model of the information cues used by auditors
to determine whether a problem company would receive a going
concern audit report. In the first stage, Mutchler used a
model based on the six ratios that were ranked by the
auditors as being most important for the assessment of going
concern. These six ratios were:
CFTL = Cash Flow (working capital from operations)/
Total Liabilities
CACL = Current Assets/Current Liabilities
NWTL = Net Worth/Total Liabilities
LTDTA = Total Long-Term Liabilities/Total Assets
TLTA = Total Liabilities/Total Assets
NIBTS = Net Income Before Tax/Net Sales
In the second stage of the modelling process, Mutchler
added dummy variables indicating whether the company
exhibited any good news or bad news information. (This
analysis was based on the discussion in SAS No. 34 of
mitigating factors and contrary information.) Items that
indicated good news for the company included whether: a
line of credit was available; debt or stock had been sold;
and the company had restructured debt payments. Items that
indicated bad news for the company included whether the
60
company had: defaulted on debt; lost a major customer;
experienced employee strikes; or was in reorganization.
Finally, in the third stage of modelling, Mutchler
included additional variables that the auditors had
indicated were important to their decision of whether to
qualify a report for going concern considerations. These
two variables were whether the company's performance had
improved (IMPROVE) and the type of the prior year audit
report (PYAR). The improvement variable was added because
the auditors interviewed suggested that a company may look
bad on the surface, but—compared to the previous year—the
performance has improved and a report qualification may not
be necessary. Mutchler measured IMPROVE as the difference
between the current year and prior year ratio of net income
divided by total assets. PYAR was added to the model
because the auditors indicated that a company with a going
concern audit opinion in the prior year was likely to
receive the same qualification in the current year. PYAR
was a dummy variable that Mutchler set equal to one if the
company had received a going concern opinion in the prior
year, and zero otherwise.
Based on this three-stage analysis, Mutchler developed
four models to predict whether companies would receive going
concern reports. The four models were: the financial
ratios; the financial ratios plus the good news and bad news
variables; the ratios plus IMPROVE; and the ratios plus
61
PYAR. The model with only the financial ratios classified
approximately 83% of the opinions correctly. Interestingly,
the addition of the good news and bad news variables as well
as the IMPROVE variable to the financial ratios decreased
the predictive accuracy of the model (to 80.6% and 82.4%
respectively). The model with the best predictive ability
(89.9% accuracy) was the combination of the ratios and PYAR.
Mutchler speculated that the good news/bad news
variables did not add predictive accuracy because the means
of the two groups were about equally weighted for both the
GCAR and NGCAR groups; and secondly, no attempt was made at
weighing the good news/bad news factors for relative
importance. She indicated that it is possible that the
IMPROV variable (measured as the difference between the
current year and prior ratio of net income divided by total
assets) did not add predictive power because auditors are
more interested in what improvement the company will make
between the current year and the next.
Because the auditors' going concern opinion decisions
could be accurately predicted based upon publicly available
information, Mutchler concluded that the opinion did not
have additional information content for the majority of the
companies in her sample. She further concluded that there
were some specific cases in which the opinion had marginal
information content, but these cases were unique and
difficult to incorporate into a model. These companies
62
could have been examples of instances where there is inside
information embedded in the auditor opinion, as suggested by
the auditors participating in the study. Mutchler's
modelling of the auditors' going concern opinion decision
provides the basis for the financial variables used in this
study. In addition, this study will consider the relative
cost of type I and type II errors.
Dopuch et al. [1987]
Dopuch et al. [1987] developed a probit model that
utilized both financial and market variables to predict
companies receiving audit opinions indicating uncertainty
qualifications due to going concern, litigation, asset
realization, or a combination of two or three of these
problems. Their model is the first to include variables
based upon the company's performance in the stock market to
predict the type of audit opinion issued.
Financial Variables
The five financial variables used by Dopuch et al.
[1987] were:
DLEV = Change in ratio of total liabilities to total
assets (current year ratio less prior year),
DREC = Change in ratio of receivables to total
assets (current year ratio less prior year),
63
DINV = Change in ratio of inventory to total assets
(current year ratio less prior year),
BVTA = Natural logarithm of book value of total
assets at end of current fiscal year (FY) ,
CYL = 0/1 dummy variable equal to one if income
available to common stock is negative for the
current year.
Three of these variables (DLEV, BVTA, CYL) were
intended to be indicative of financial health and included
because of their success in prior models that predict
financial distress. Dopuch et al. [1987] hypothesized two
reasons why these variables would be important to their
prediction model. First, uncertainty qualifications
(particularly the going concern qualification) raised
questions about the firm's ability to finance ongoing
activities. Second, if a firm was performing poorly,
auditors would be more likely to decide that contingencies
of a given magnitude were material.
The other two financial variables included in the model
(DREC, DINV) attempted to measure changes in the composition
of total assets. Dopuch et al. [1987] posited a
relationship between these variables and the auditor's
opinion because of prior research on auditors' exposure to
lawsuits [Simunic, 1980; St. Pierre and Anderson, 1984].
They did not specify whether they mean lawsuits against the
auditors by third parties (i.e., shareholders and
64
creditors), by clients, or both. However, one study cited
[St. Pierre and Anderson, 1984] included lawsuits by both
third parties and clients. Dopuch et al. [1987] also cited
Simunic [1980], who concluded that audit fees are higher for
clients with relatively larger inventory and receivable
balances because these accounts are the subject of more
lawsuits against auditors. Therefore, Dopuch et al. [1987]
have presumably included lawsuits against the auditors from
both third parties and clients.
Market Variables
The model developed by Dopuch et al. [1987] was the
first to include market variables to predict audit opinions.
The following market variables were used: time listed (on
the New York or American Stock Exchange); change in beta
(measured as the slope coefficient from the market model
regression); change in residual standard deviation of
returns (from the market model regression); and company
returns less industry average returns.
The "time listed" variable was included because
"younger" firms are more likely to experience financial
distress. Therefore, they hypothesized that auditors would
be more likely to issue uncertainty opinions to "younger"
firms.
Dopuch et al. [1987] hypothesized that the variability
measures (the change in beta and the change in residual
65
standard deviation of returns) reflected the risk of
lawsuits against auditors. They did not specify such, but
they referred to lawsuits against auditors by third parties.
They stated that lawsuits against auditors usually occurred
after a company's stock price drops severely, because
plaintiffs had only to establish that they relied on
financial statements that did not disclose major
uncertainties. Therefore, they hypothesized that increased
variability in a company's stock market returns could
indicate an increased probability of a large decline in
stock price, and consequently, an increased probability that
the auditor would issue an uncertainty opinion.
The final market variable included in the Dopuch et al.
[1987] model was company returns less an industry average
return. They hypothesized that this variable would capture
information beyond that reported in the financial
statements.
Method and Sample
Dopuch et al. [1987] used a probit model with weighted
exogenous sample maximum likelihood (WESML) procedures used
to correct for the bias due to choice-based sampling. By
using choice-based sampling, the probability of an
observation being included in the sample depended on the
value (or type of observation) of the dependent variable
(here, the type of opinion received by a company). This
66
occurred because the sample was drawn based upon knowledge
about the value of the dependent variable. This method of
selecting a sample violated the assumption of random
sampling because the dependent variable group was
oversampled relative to the actual occurrence rate of the
event in the population. WESML was identified as one
technique available for estimating models with choice-based
samples [Zmijewski, 1984]. Dopuch et al. [1987] used WESML
to weight the probit log-likelihood function according to
the proportion of qualified opinions in the sample and in
the population.
Dopuch et al. [1987] used a sample of 275 initial
uncertainty qualifications and 441 "clean" opinions from the
eleven year period 1969-1980. The qualified sample was
comprised of 39 going concern qualifications, 121 litigation
qualifications, 84 asset realization qualifications, and 31
multiple qualifications. The sample was restricted to firms
with data available on the Compustat and CRSP tapes, a
requirement that biases the sample toward larger companies.
In addition, firms were excluded if they did not have
sufficient data to compute all nine of the model variables.
This requirement would have also induced sample selection
bias (as discussed in Zmijewski [1984]). The final sample
included fewer qualified then "clean" companies, although
they initially selected equal numbers of both types of
companies.
67
Estimated Probability Levels
For each firm in the sample, Dopuch et al. [1987]
calculated the probability of a qualified opinion based on
the financial and market variables included in their model.
As anticipated, they found that the mean and median
estimated probabilities were higher for the qualified firms
(mean = .202 and median = .070) than the "clean" firms (mean
= .040 and median = .027). This indicated that both the
amount of probability estimates and the range of variation
in estimates was greater for the qualified firms. The
difference between the clean and qualified firms estimated
probability level was statistically significant (at the .001
level) for both the mean and median.
However, the mean and median probabilities varied
greatly for the four types of qualifications. The going
concern firms had the highest mean and median probability
levels (.444 and .491, which indicated a distribution skewed
to the left). The firms that had qualifications due to a
combination of problems, including going concern, had the
second highest levels (.277 and .077). The sample firms
receiving a qualified opinion due to asset realization or
litigation uncertainties had considerably lower mean and
median probability levels. For firms with qualified
opinions due to uncertainty about asset realization, the
mean was .183 and the median was .077. The firms with
68
qualified opinions due to litigation uncertainties had a
mean and median of .127 and .045, respectively.
The difference between the mean and median
probabilities in both the "clean" and qualified samples of
firms was not addressed by Dopuch et al. [1987]. However,
the difference indicated that the distribution is skewed to
the right for both the qualified (except for the going
concern firms) and "clean" firms, although the skew is more
pronounced in the sample of qualified firms. The right
skewness is also evident in the summary statistics presented
for the independent variables. Dopuch et al. [1987] tested
whether the means and medians were different between the
qualified and "clean" samples. They found that the means
and medians were significantly different between the
qualified and "clean" samples for all of the independent
variables, except two of the financial variables (book value
of total assets and the change in the ratio of inventory to
total assets). Thus, the distribution of both the qualified
and "clean" samples appears to be skewed to the right,
although significant differences do exist between the two
groups.
Dopuch et al. [1987] found that 100% of the "clean"
opinions had estimated probabilities below 0.4, whereas only
76.6% of the sample of all qualified opinions had similar
probabilities. For estimated probabilities less than 0.1,
they found that 92.8% of the "clean" sample firms had
69
probabilities below that level compared to 56% of the
qualified sample. These results included all of the firms
in the qualified sample, regardless of the reason for the
qualification. However, the mean estimated probability of
firms receiving qualified opinions because of asset
realization, litigation, or a combination of uncertainties
was considerably lower than that of firms receiving a
qualified opinion due to going concern uncertainty.
Therefore, the model's overall ability to predict the
probability of receiving a qualified opinion was somewhat
limited.
Classification of Firms
Following the calculation of the probability of a
qualified opinion, each firm in the sample was classified as
either qualified or "clean." A cut-off score was selected
that would minimize the expected misclassification costs,
and firms with estimated probabilities above that score were
classified as qualified; firms with estimated probabilities
less than or equal to the cut-off score were classified as
"clean."
The expected cost of misclassification was estimated
based on the conditional probabilities and costs of type I
and II errors, and the prior probabilities of firms having
qualified or "clean" opinions. The cost of type I errors
and type II errors were not directly measured. Instead, the
70
relative cost of type I and type II errors was allowed to
range from 1:1 to 20:1.
The addition in the Dopuch et al. [1987] study of the
expected cost of misclassification is important because the
auditor would weigh the cost and probability of type I
errors (a qualified opinion classified as "clean" by the
model) against the cost and probability of type II errors (a
"clean" opinion classified as qualified by the model). From
the perspective of an auditor, legal liability to third
parties is greatest when a type I error occurs. From the
perspective of financial statement users, a type I error
results in a potential investment loss and is the component
of the expectation gap between the public and auditors
addressed by SAS No. 58 and SAS No. 59. However, auditors
also have to consider type II errors because such errors
could result in the loss of a client. Auditors would also
consider management's plans, the likelihood of their outcome
and other relevant factors during the second stage of their
reporting decision.
In general, the Dopuch et al. [1987] model predicted
going concern uncertainty qualifications most accurately,
followed by multiple qualifications, asset realizing, and
then litigation qualifications. However, the prediction
accuracy varied depending on the relative cost of type I and
type II errors. The model performed best when the relative
cost was estimated at 20:1. At that point, the model
71
estimated that the auditor considered the potential cost of
third-party lawsuits to be 20 times greater than the
potential cost of the loss of a client. Using the 20:1
relative cost estimate, the model accurately classified
83.3% of the going concern opinions, 80% of the multiple
qualifications, 53.8% of the asset realization
qualifications, and only 37% of the litigation
qualifications. Although the classification accuracy rates
for the going concern and multiple qualifications were
consistent with the results from prior studies, the accuracy
rates for asset realization and litigation qualifications
were fairly low, which indicated that the 20:1 ratio is not
realistic for these types of uncertainties.
Implications of Results
One implication of these results is that the model
developed by Dopuch et al. [1987] has omitted some of the
variables that auditors use in deciding whether to issue
uncertainty opinions (possibly auditors' inside information
about the company or management's plans). It is apparent,
however, that auditors' consideration of the second-stage
decision variables beyond the financial and market variables
included in the model have measurable impact when making
decisions with respect to issuing qualified opinions for
asset realization and litigation issues.
72
A second implication of these results is that the model
of Dopuch et al. [1987] is most accurate when auditors are
assumed to consider type I errors to be more than 20 times
more costly than type II errors. This weights the publicly
available information far more heavily than either the
auditors' insider information or concerns about losing the
client. When the relative cost estimate ratio was 10:1, the
accuracy rate for going concern and qualification for more
than one reason (such as litigation and going concern) were
classified with the same level of accuracy (83.3% and 80%,
respectively). However, only 22.2% of the litigation and
46.1% of the asset realization uncertainties were accurately
classified. When the relative cost estimate ratio was 1:1
(i.e., type I and type II errors were valued equally), the
model was not able to accurately classify any of the
litigation or qualifications for more than one reason. The
accuracy rate for going concern qualifications dropped to
32.3% and only 7.7% of the asset realization qualifications
were accurately classified. Overall, Dopuch et al.'s [1987]
results indicate that when auditors are reporting on going
concern uncertainties they weight type II errors relatively
higher than when reporting on litigation and asset
realization uncertainties, where type I errors are weighted
relatively higher. Thus, one overall weighting scheme for
type I and type II errors does not appear to accurately
73
reflect the differing weight that auditors would place on
these errors when making reporting decisions.
Implications for the Current Study
The empirical studies described above, and summarized
in Tables 2.1 and 2.2, have used a variety of variables and
statistical methods to predict which companies would receive
a going concern audit report. The importance of these
models to this study is that they can be used as a benchmark
to estimate whether a company would receive a going concern
audit opinion.
This study uses models based upon prior research to
compare differences between characteristics of companies
from three time periods: pre-expectation gap SAS (when SAS
No. 34 applied); a transition period (when auditors could
choose whether to follow SAS No. 34 or SAS No. 59) ; and
post-expectation gap SAS (when SAS No. 59 applied as later
clarified by SAS No. 64). Three types of comparisons were
made to determine whether the characteristics of companies
receiving a going concern report have changed between the
pre, transition, or post-expectation gap SAS periods.
First, summary statistics on the number and percentage of
firms receiving a going concern report are provided for each
of the years in the sample. Second, using a multivariate
approach, the clean and going concern companies were
compared by analyzing the difference in the means of the
74
financial and market variables. Third, the odds of
receiving a going concern report was compared for changes
across the three periods. These three types of comparisons
will help assess whether the implementation of the
expectation gap SAS guidance has resulted in any change in
the degree to which audit reports provide early warning
signals regarding companies with going concern problems.
In the next section, implications of the prior
empirical research regarding the models used in this study
are described. The focus is on the model variables and
research method used in this study.
Models
Because of the sample selection process, two models
were used in this study. The initial samples of both going
concern and clean companies, and the necessary financial
information, were identified from the Compact Disclosure
database. These companies comprise the full sample and the
model associated with them is the financial model, shown in
Figure 2.1, Financial Model Variables.
A review of the prior studies indicates that a wide
variety of financial ratios have been used to predict
whether a company will receive a going concern report. The
initial studies, those by Altman and McGough [1974] and
Deakin [1977], used variables from bankruptcy prediction
models. As this area of research developed, the variables
75
were determined with more of an emphasis on auditors and
their decision making process. For example, Mutchler [1985]
selected variables based on her interviews with auditors.
The financial variables used by Mutchler [1985] were
selected because they are comparable to the financial
variables used in other studies (including Dopuch et al.
[1987]), and more importantly, because they were the
variables that auditors had indicated they used to assess
whether a company has going concern problems. Ratio
analysis by auditors is now required by SAS No. 56 (in the
planning and final review stages of all audits), and
identified in SAS No. 59 as an audit procedure that could be
indicative of an entity's ability to continue as a going
concern. Thus, using the ratios that auditors have
previously identified as the most helpful for the assessment
of going concern should capture the financial information
that auditors consider most important in discerning whether
substantial doubt exists about an entity's ability to
continue as a going concern. However, in the two-stage
analysis of the auditors' reporting decision, the
identification of a company with going concern uncertainty
is not synonymous with the subsequent issuance of an audit
report for that company which indicates going concern
uncertainty. In this study, the auditors' ultimate decision
about reporting is the important consideration.
76
The second model that was used is shown in Figure 2.2,
Synthesized Model Variables. This model combined the
Financial Model Variables with the market variables from
Dopuch et al. [1987]. The resulting model is shown in
Figure 2.2, Synthesized Model Variables. The requirement
that the companies selected from Compact Disclosure also
have information available on the CRSP tapes for the
computation of the market variables, substantially reduced
the number of companies used with the synthesized model.
However, these variables are included in this research
because, as Dopuch et al. [1987] theorize, market variables
should capture information beyond what is reported in the
financial statements, and they reflect the risk of lawsuits
against auditors (see Berton [1992]; Berton and Lublin
[1992]; and Lochner [1992] for current discussion on
auditors legal liability). Indeed, Dopuch et al.'s [1987]
results confirmed that the market variables had explanatory
power beyond that contained in the financial variables.
Statistical Method
As indicated in Table 2.1, most of the prior studies
related to the prediction of going concern audit report
recipients used discriminant analysis as the statistical
method. Discriminant analysis is a multivariate technique
that assigns a score or value to each company in the sample
based on the independent variables selected. The
77
independent variables are weighted so that the between-group
variance is maximized relative to the within-group variance.
A cutoff score is selected, and the sample is categorized by
assuming that companies with a score below the cutoff will
receive going concern reports, and the companies with scores
above the cutoff will receive "clean" reports.
As shown in Table 2.1, several of these models have
performed well in terms of classification accuracy.
However, discriminant analysis is based on two restrictive
assumptions. These assumptions are that the independent
variables are jointly distributed as a multivariate normal,
and that the variance-covariance matrices of the predictor
variables are the same for both types of companies in the
sample.
The assumption that the independent variables have a
multivariate normal distribution is always violated when
dummy variables are used as predictor variables. In this
study, one of the independent market variables (time listed)
is a dummy variable and therefore would violate this
assumption.
The second assumption, that the variance-covariance
matrix of the predictor variables is equal, was violated in
this study. The companies that receive going concern
reports are usually experiencing financial difficulties
greater than other companies. This would indicate that the
risk, or variance, of these variables would be greater for
78
the going concern report recipients than that of the "clean"
companies. In addition, a priori expectations indicate that
the variance-covariance matrix related to the market
variables (added to reflect the risk of lawsuits against
auditors) should reflect the difference in risk between
these two groups.
The most recent study, that by Dopuch et al. [1987],
used probit analysis. Probit and logit analyses are two
types of conditional probability models. Similar to
discriminant analysis, both methods provide a score for each
company in the sample, indicating the conditional
probability of a company belonging to a certain class (going
concern or "clean" in this study). The coefficients of the
independent variables are weighted to maximize the
likelihood of companies known to have received a going
concern report being so classified and of companies known to
have received a "clean" report being accurately classified.
Both methods are based on cumulative probability functions
(probit assumes the normal cumulative probability function
and logit assumes the logistical cumulative function), but
do not make the restrictive assumptions of discriminant
analysis. However, logit analysis does not require the use
of a weighting procedure (such as WESML) with choice based
samples [Maddala, 1991]. This is because the coefficients
of the explanatory variables are unaffected by the different
sampling rates from the two choice based groups [Maddala,
79
1991]. Therefore, this study used logit regression
analysis.
Summary
In this chapter, the professional guidance about going
concern reporting and the empirical research related to the
prediction or modelling of both the auditor's decision to
issue a going concern report and actually predicting going
concern reports has been summarized. These models have
demonstrated a high accuracy rate for classifying companies
while using a variety of variables and statistical methods.
In contrast to the models, auditors' accuracy rates have
been quite varied. Based on the prior research, the two
models used in this research were developed. The Financial
Model, that was used with the full sample, is based on
research by Mutchler [1985]. Mutchler's model demonstrated
a high classification accuracy rate (89.9%) and was
preferred because the variables were based on interviews
with auditors. The Synthesized Model, that is used with the
restricted sample, combines the Financial Model Variables
with the market variables from Dopuch et al. [1987]. The
market variables from Dopuch et al. [1987] were added
because they were previously found to have explanatory power
beyond financial variables, and they were theorized to
reflect some of the risk of lawsuits against auditors.
Chapter III describes the research methodology used in this
80
research, including the sample selection and the hypotheses
that were tested via the sample companies using the model
described in this chapter as a benchmark.
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85
Financial Variables [Mutchler, 1985]:
1. CFTL
2. CACL
3. NWTL
4.
= Cash Flow (from operations) / Total Liabilities
= Current Assets / Current Liabilities
= Net Worth / Total Liabilities
LTDTA = Total Long-Term Liabilities / Total Assets
5. TLTA = Total Liabilities / Total Assets
6. NIBTS = Net Income Before Tax / Net Sales
7. PYAR = Type of Prior Year Audit Opinion
Figure 2.1
Financial Model Variables
86
Financial Variables [Mutchler, 1985]:
1. CFTL = Cash Flow (from operations) / Total
Liabilities
2. CACL = Current Assets / Current Liabilities
3. NWTL = Net Worth / Total Liabilities
4. LTDTA = Total Long-Term Liabilities / Total
Assets
5. TLTA = Total Liabilities / Total Assets
6. NIBTS = Net Income Before Tax / Net Sales
7. PYAR = Type of Prior Year Audit Opinion
Market Variables [Dopuch, et al., 1987]:
8. TLIST = Time Listed
9. DBETA = Change in Beta 10. DRSTD = Change in Residual Standard Deviation of
Returns
11. EXRTN = Company Returns Less Industry Average Returns
Figure 2.2
Synthesized Model Variables
CHAPTER III
RESEARCH METHODOLOGY
Introduction
The primary objective of this research was to study the
financial reporting impact of auditors' procedural and
reporting changes following the issuance of the expectation
gap SAS regarding going concern. These changes could have
resulted in auditors reporting a greater number of companies
with going concern considerations, and/or reporting those
companies earlier (i.e., before their condition is as
severe).
The purpose of this chapter is to describe how the
research objective was accomplished. To assess whether more
companies are receiving going concern audit reports
subsequent to the issuance of the expectation gap SASs,
summary statistics are presented regarding the number and
percentage of companies receiving going concern reports
throughout the sample period of FYs 1986-1990. In addition,
a logit model with dummy variables representing the
different reporting requirements was used to assess the
effect of these requirements on the odds that a company
would receive a going concern audit report.
To determine whether the post-SAS No. 59 companies
receive going concern audit reports earlier than similar
pre-SAS No. 59 companies, the differences between the
87
88
financial and market characteristics of going concern
companies were compared to corresponding clean companies.
The research cited in the previous chapter indicated that
these characteristics are measurably different for going
concern versus clean companies. If the measured differences
are narrowing—i.e., the differences are less—then the
auditors would be considered to be reporting earlier, before
the amount of deterioration in financial and market
characteristics became as great. Multivariate tests were
performed to determine whether the difference between the
means of the going concern and clean companies had changed.
The remainder of this chapter is organized as follows.
First, sample selection is described. The second part of
the chapter describes data collection. The third part of
the chapter details the research hypotheses and tests of
hypotheses. Finally, the limitations of the research are
addressed.
Sample Selection
Companies included in this research, both the going
concern companies (the test group) and the clean companies
(the control group), were identified via the Compact
Disclosure database. The companies in the going concern
sample were selected by searching the database for key-words
from the auditor's report for companies receiving modified
report language both prior to and subsequent to the issuance
89
of SAS No. 59. The clean companies were selected by
beginning with the population of companies with information
available on Compact Disclosure and eliminating companies
that received audit reports other than clean or that had
changed accounting principles. From this group, a random
sample of companies was selected so that the resulting
sample was equal in size to the number of going concern
companies.
Population of Companies
The Compact Disclosure database contains information
regarding more than 12,000 companies that are required to
file reports with the SEC. These companies comprised the
population from which the samples used in this study were
selected.
Selection of Going Concern Sample
The key-words used in the search process for companies
receiving going concern audit reports were contingent upon
the time periods in the sample. Figure 3.1 illustrates the
audit time line with the three time periods and the
applicable professional guidance.
Pre-Expectation Gap SAS Period
The first time period, when the applicable professional
guidance was SAS No. 34, is referred to as the
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pre-expectation gap SAS period. All of the audit reports
issued for FY 1986 financial statements are included in this
period. In addition, this period includes some of the
reports issued for FY 1987 and 1988 financial statements.
This is because SAS No. 59 was approved and distributed in
early 1988 and although it was required for audits of
financial statements for periods beginning on or after
January 1, 1989 (i.e., FY 1989 financial statements and
beyond), early adoption was permitted. In effect, auditors
could choose whether to follow SAS No. 34 or SAS No. 59 for
reports issued during most of calendar years 1988 and 1989
(for FYs 1987 and 1988).
Going concern audit reports issued during the pre-
expectation gap SAS period of this study (for FYs 1986-1988)
and based on the guidance of SAS No. 34, were qualified
subject-to opinions. Auditors' reports modified because of
going concern were required to contain the wording "subject-
to" in the opinion paragraph. The explanatory paragraph
associated with the subject-to qualification typically
included key-words such as "substantial doubt," and "going
concern". Thus, the key-word search on Compact Disclosure
of the auditor's reports for FYs 1986-1988 included
"subject-to," "substantial doubt," and "going concern."
91
Transition Periocj
The second time period is the transition period. It
included auditors' reports on FY 1987 and 1988 financial
statements that were issued in 1988-1989, the period of time
during which auditors could elect to follow the guidance in
either SAS No. 59 or SAS No. 34.
Based on the guidance of SAS No. 59, when an auditor has
substantial doubt about the company's ability to continue as
a going concern, the auditor issues an unqualified opinion
with an explanatory paragraph following the opinion that
describes the auditor's doubt. Thus, a key-word search for
"subject-to" was not applicable for reports based on SAS No.
59. The initial key-word search for this period used
"substantial doubt" and "going concern."
However, the subsecjuent issuance of SAS No. 64, in 1990,
recjuiring the terminology "substantial doubt" and "going
concern" may have indicated that some of the reports issued
during the transition period did not contain that
terminology. Therefore, to select companies with going
concern audit reports that are not included in the first
search, additional searches were made. These additional
searches included key-words indicative of the auditor's
doubt about an entity's ability to continue as a going
concern. Examples of words searched for include "inability"
(for example, inability to meet debt payments), and
"continuation" (as a going concern).
92
Post-Expectation Gap SAS Period
The final time period is the post-expectation gap SAS
period, which included all reports issued for FY 1989 and
1990 financial statements. The applicable professional
guidance was SAS No. 59 as later modified by SAS No. 64.
Thus, the key-word search for the post-expectation gap
period used "substantial doubt" and "going concern" because
these are recjuired by SAS No. 64.
Selection of Clean Companies
The sample of clean companies was selected by beginning
with the population of all companies included in the Compact
Disclosure database. The population was reduced by the
elimination of (a) audit reports other than unqualified and
(b) reports with additional explanatory paragraphs (based on
SAS No. 59) . This recjuirement eliminated all companies with
audit reports indicating material uncertainties (including
going concern). These companies were eliminated by
searching for key-words such as "subject to" (prior to SAS
No. 59), "going concern," "asset realization" and
"litigation." Companies with key-words such as "except
for," "disclaim," or "do not express" indicating that the
report was (qualified, were also eliminated from the clean
sample. In addition, companies with audit reports
93
indicating a change in accounting principles were
eliminated.
The companies remaining after these eliminations
constituted the population of clean companies from which
comparison samples were randomly selected. The number of
clean companies that were randomly selected for the
comparison samples was ecjuivalent to the number of companies
previously selected in the going concern samples.
After determining the population of clean companies,
summary statistics were collected for both the number and
percentage of firms (relative to the population of clean
companies) receiving going concern reports for each of the
years in the sample period. This provided an initial
indication of whether SAS No. 59 or SAS No. 64 affected the
reporting of going concern uncertainties. Additional
analyses tested for differences in the financial and market
characteristics of the respective company groupings and for
changes in the odds of a company receiving an audit report
that indicated going concern uncertainty.
Data Collection
The data necessary for the computation of the financial
variables were obtained from Compact Disclosure. As shown
in Figures 2.1 and 2.2, these included CFTL, CACL, NWTL,
LTDTA, TLTA, NIBTS, and PYAR. Specific financial amounts
needed included: current assets, total assets, current
94
liabilities, total long-term liabilities, total liabilities,
net sales, net income before tax, cash flow from operations,
and the type of prior year audit opinion received by a
company. The companies identified from Compact Disclosure
comprised the full sample of companies on which hypotheses
related to the financial model were tested (see Figure 2.1).
The restricted samples of going concern and clean
companies were those identified from the Compact Disclosure
search that also have market data available on the CRSP
tapes. The CRSP tapes provided stock returns for the
companies and the market and the date that the company was
first listed. These data were needed for the computation of
the market variables, including DBETA, DRSTD, EXRTN, and
TLIST (as shown in Figure 2.2, Synthesized Model).
Both the full and restricted samples of going concern
and clean companies were used to test the impact of the
expectation gap SASs on the financial reporting of companies
within the pre-, transition, and post-expectation gap SAS
time frames. The next section of the chapter describes the
specific hypotheses used to analyze the impact of the
expectation gap SASs on the financial reporting of the
companies included in the full and restricted samples.
Research Hypotheses
The purpose of this part of the chapter is to state the
hypotheses of interest. Each hypothesis is stated in the
95
null form. Two types of comparisons were made. First,
multivariate tests of differences between the means of the
going concern and clean companies are compared for each of
the relevant periods. Second, dummy variables were added to
the logit model to test the effect of the three different
reporting recjuirements. These comparisons assessed whether
the expectation gap SAS guidance led to an early warning
signal regarding companies with going concern problems.
Comparisons of the Difference in Means
The first tests discussed are whether the differences
between the means of the going concern and the clean
companies have decreased from the pre-expectation gap period
to the post-expectation gap period. If the auditors'
reporting based on the expectation gap SASs provides an
earlier warning of going concern problems, any differences
between the going concern and clean groups should have
decreased (i.e., the going concern companies should be more
similar to clean companies). This would provide an
indication that auditors' reporting of going concern based
on the expectation gap SAS occurred before the deterioration
of the company had become as great as it had been when
auditors were relying on the guidance of SAS No. 34 to
decide when similar going concern reports should be issued.
The multivariate tests are designed to detect whether the
difference between the going concern and clean companies has
96
decreased at the point that the auditor issues an audit
report indicating going concern uncertainties.
There were two changes in the professional guidance
related to auditors' reporting on going concern during the
period of FY 1986-1990 from which the sample was chosen.
These two changes resulted in three separate time periods:
the pre-expectation gap SAS period (when SAS No. 34
applied); the transition period (when auditors could choose
whether to follow SAS No. 34 or SAS No. 59); and the post-
expectation gap SAS period (when SAS No. 59 applied as later
clarified by SAS No. 64). Therefore, multivariate test of
differences between the means were assessed between (a) the
pre-expectation gap SAS and the transition period, (b) the
transition period and post-expectation gap SAS, and (c) the
pre- and post-expectation gap SAS guidance. The overall
test of the difference between the pre- and post-expectation
gap SAS period is considered the most important because it
would indicate the total effect of the expectation gap SASs
and SAS No. 64. However, testing the sub-periods will
indicate whether an overall change was due primarily to (a)
SAS No. 59, (b) SAS No. 64, (c) a combined effect of these
SASs, or if no significant change occurred.
97
Differences Between the Pre-Expectation Gap SAS and the Transition Period
SAS No. 59 increased the auditor's responsibility for
detecting firms displaying characteristics that raise
substantial doubt about the firm's ability to continue in
its existing form for up to one year from the financial
statement date. Therefore, SAS No. 59 could result in
companies receiving a going concern audit report when its
characteristics are relatively more similar to clean
companies.
The companies receiving going concern reports during the
transition period should have characteristics more similar
to (or less different from) clean companies. Because the
financial variables selected were the ones auditors had
indicated to Mutchler [1985] that they used to assess going
concern, it is expected that any change from SAS No. 59
would be most strongly reflected by differences in these
variables. It was anticipated (for all three of the sub-
period tests) that the results for the restricted sample
model (which includes market variables) would be less strong
because of the smaller number of companies included and
auditors may not consider the market^^ariables in their
assessment of going concern. Following, are the hypotheses
(in null form) for the changes from the pre- to the
transition period.
98
Hoi: Fc3r the full sample, there is no change in the difference between the means of the going concern and clean companies from the pre-expectation gap period to the transition period.
H02: For the restricted sample, there is no change in the difference between the means of the going concern and clean companies from the pre-expectation gap period to the transition period.
It was expected that these hypotheses would be
rejected. This would indicate that auditors are providing
an "earlier warning signal" regarding going concern. If the
hypotheses could not be rejected, then it would be inferred
that the reporting of going concern during the transition
period based on SAS No. 59 did not provide an improved early
warning signal.
Differences Between the Transition Period and the Post-Expectation Gap SAS Period
Subsequent to the issuance of SAS No. 59, the AICPA
issued SAS No. 64, "Omnibus Statement on Auditing Standards-
1990" [AICPA, 1991]. SAS No. 64 requires that the
explanatory paragraph added to the audit report about going
concern must include the phrase "substantial doubt about its
(the auditee's) ability to continue as a going concern"
[AICPA, 1991]. The fact that the AICPA issued a SAS
recjuiring the terminology "substantial doubt" and "going
concern" may indicate that a significant number of audit
reports were issued during the transition period with an
99
additional explanatory paragraph but with unclear meaning or
variation in the language used.
The following hypotheses test whether there was a
change in the difference between the mean values of the
going concern and clean companies from the transition period
to the post-expectation gap period.
H03: For the full sample, there is no change in the difference between the means of the going concern and clean companies from the transition period to the post-expectation gap period.
H04: For the restricted sample, there is no change in the difference between the means of the going concern and clean companies from the transition period to the post-expectation gap period.
Again, it was anticipated that these hypotheses would
be rejected. This would provide evidence that auditors are
providing an earlier warning signal regarding going concern
subsecjuent to the issuance of SAS No. 64. If the hypotheses
cannot be rejected, then it could be inferred that SAS No.
64 did not have a measurable impact on the reporting of
going concern.
Differences Between the Pre- and the Post-Expectation Gap SAS Period
The first four hypotheses evaluated the change from
pre- to post-expectation gap in two sub-periods. It is
possible that the changes tested by the prior hypotheses
would be non-significant, but that the overall change from
pre- to post-expectation gap would be significant. However,
100
it is also possible that the change from one of the sub-
periods could offset the other, resulting in the overall
test indicating that there was not a significant change in
the difference in the means.
The fifth and sixth hypotheses provide an overall test
of the change in the difference between the means of the
going concern and clean companies from the pre-expectation
gap SAS period to the post-expectation gap SAS period.
These hypotheses are considered the most important to this
study because they provide an overall test of the total
effect of the expectation gap SASs and 64.
H05: For the full sample, there is no change in the difference between the means of the going concern and clean companies from the pre- period to the post-expectation gap period.
Hog: For the restricted sample, there is no change in the difference between the means of the going concern and clean companies from the pre- period to the post-expectation gap period.
The purpose of these hypotheses was to test whether the
overall change in the difference between the means of the
going concern and clean companies from the pre- to the post-
expectation gap period was significant. It was anticipated
that these hypotheses would be rejected.
101
Test of Change in Report Odds
The previous hypotheses were intended to test whether
the expectation gap SASs resulted in earlier reporting of
going concern. If the implementation of the guidance in SAS
No. 59 or SAS No. 64 has resulted in companies receiving
going concern reports earlier, than their financial and
market characteristics might be more similar to companies
receiving clean audit reports. However, it is possible that
the expectation gap SASs increased the odds of a company
receiving a going concern report, even when the differences
in the mean values of the financial and market
characteristics were not substantially different from the
clean companies. The use of logit analysis and the addition
of the dummy variables representing the three time sub-
period tests whether was a change in the odds that a company
would receive a going concern audit opinion.
Six hypotheses (for 3 time sub-periods, each with both
the full and restricted samples) were tested. The first
four hypotheses (numbers 7-10) tested whether there were
changes in the odds ratio from the pre- to the transition
period and then the transition period to the post-
expectation gap period. The fifth and sixth hypotheses
(numbers 11 and 12) tested whether there was an overall
change from the pre- to the post-expectation gap period.
These hypotheses are necessary because the changes between
102
the three periods may be small and not significant, whereas
the overall change might be significant.
Ho7« For the full sample, there is no difference in the predicted odds ratio between the pre-expectation gap SAS period and the transition period.
Hos: For the restricted sample, there is no difference in the predicted odds ratio between the pre-expectation gap SAS period and the transition period.
H09: For the full sample, there is no difference in the predicted odds ratio between the transition period and the post-expectation gap period.
Hoio: For the restricted sample, there is no difference in the predicted odds ratio between the transition period and the post-expectation gap period.
Hoii: For the full sample, there is no difference in the predicted odds ratio between the pre- and the post-expectation gap periods.
H012: For the restricted sample, there is no difference in the predicted odds ratio between the pre- and the post-expectation gap periods.
It was expected that these null hypotheses would be
rejected. However, the hypotheses related to the overall
change from the pre- to the post- period (numbers 11 and 12)
were expected to show the highest level of increased odds.
In addition, hypotheses 7 and 8, related to the change from
the pre-expectation gap SAS period to the transition period
were expected to be show significant changes in the odds
ratio. Although the expectation gap SASs, which expanded
auditors' responsibility for the assessment of going
concern, were not recjuired guidance during the transition
103
period, it is anticipated that most auditors were aware of
the SASs and thus this may have led to increased odds of
companies receiving going concern opinions. These
hypotheses provided another measure of the effect of the
expectation gap SASs on the reporting of going concern
considerations.
Limitations of the Study
As is true of all empirical research, this study has
limitations that may affect the results obtained or the
generalizability of the results.
The initial two limitations to be addressed are because
of the sample selection process. First, the restricted
sample used in this study excludes non-publicly traded
companies and restricts publicly traded companies to those
with market data available on the CRSP tapes (firms traded
on the New York or American Stock Exchanges and traded OTC).
The resulting restricted sample included companies that are,
on average, larger than the population of all companies.
However, this limitation was partially offset by also using
the full sample of companies selected from the Compact
Disclosure database.
Second, the multivariate analysis of the difference in
means necessitated that companies used in the statistical
analyses have complete data for all variables. This
recjuirement resulted in the elimination of more going
104
concern than clean companies from the final samples used in
the analysis of the difference in mean values.
Another limitation of this study is that
misclassifications of firms may have occurred. This is
particularly problematic for the transition period because
some reports issued during that period had weakened wording
or variability in wording, making it difficult to accurately
classify these firms. This limitation was addressed by
expanding the key word search used for companies with going
concern opinions issued during the transition period.
The final limitation addressed is the confounding
effects of variables omitted from the model utilized in this
study. The model does not include variables such as the
auditor's insider information about management plans or the
influence of financial or market variables other than those
included in the model.
Although this research does have limitations, it
provides an initial assessment of whether the implementation
of the expectation gap SAS guidance provided an improved
early warning signal for financial statement users. In
addition, this study is the first to assess the overall
impact of the expectation gap SASs on the reporting of going
concern.
105
SAS 34 SAS 59 SAS 64
+ + + + FY86 FY87 FY88 FY89 FY90
Figure 3.1 Audit Time Line
CHAPTER IV
RESEARCH RESULTS
Introduction
The purpose of this chapter is to present the data
collected and discuss the results of the data analyses
performed. The first part of the chapter includes a
description of the number and percentage of companies
receiving audit reports that indicated going concern
uncertainties during the periods covered by this study (FY
1986-1990). In addition, descriptive statistics are
presented about the type of audit report issued during FY
1986-1990 when substantial doubt about going concern
existed. The second section of the chapter reports the
results of the multivariate tests for changes in the
differences of the variable means between the going concern
and clean companies selected for comparison. The third
section of the chapter focuses on whether changes occurred
in the odds of a company receiving an audit report flagged
for going concern uncertainty during the periods covered by
this study. Results from regression analyses using the full
and synthesized models to determine the likelihood of
significant changes are presented.
106
107
Number of Companies
The number and percentage of companies receiving audit
reports indicating going concern uncertainties are
summarized in Table 4.1. The total number of going concern
opinions includes all companies identified from searches of
Compact Disclosure that had received going concern audit
reports (both qualified and unqualified opinions) during the
FY 1986-1990. The number of going concern reports
identified has increased steadily from FY 1986 (665 reports)
to FY 1990 (978 reports).
The total number of going concern opinions identified
is reduced by eliminating those companies with adverse or
disclaimer opinions, accounting changes, multiple
uncertainties (such as litigation or asset realization in
addition to going concern), as well as those with both
accounting changes and multiple uncertainties. The reports
remaining after these restrictions represent the primary set
of research companies for this study. The number of going
concern reports remaining has then been added with the
number of companies with clean audit opinions (and no
accounting changes) and divided by the total in order to
determine the percentage of opinions issued with going
concern uncertainties indicated.
The results indicate that the percentage of going
concern report modifications increases every year, with a
minor exception in 1987. These numbers may indicate that
108
auditors were more likely to issue an audit report that
flags going concern uncertainties when the form of the
opinion issued is unqualified. The data also indicate that
the transition to the unqualified opinion for going concern
occurred during 1987 (see Table 4.2). Furthermore, the
additional responsibility placed on auditors for the
assessment of going concern by the expectation gap SASs
(particularly SAS No. 59) may have resulted in increased
numbers of companies receiving going concern opinions. The
number of opinions, however, does not justify a conclusion
of causality. The increased number and percentage of going
concern opinions could have been caused by difficult
economic conditions or other factors not controlled for in
this step of the analyses.
Additional data analyses have been performed to better
determine other factors associated with the change in number
of going concern audit reports. An immediate extension is
the type of audit report (qualified or unqualified) received
by the sample companies with audit reports indicating going
concern uncertainties. The "remaining going concern
opinions" from Table 4.1 are classified in Table 4.2 by the
type of audit opinion received. The data in Table 4.2
indicate that during 1987 most auditors made the transition
to the guidance in SAS Nos. 58 and 59 (regarding the type of
opinion to be issued when the auditor has substantial doubt
regarding the client's ability to continue as a going
109
concern). Approximately 18% of the companies that received
going concern opinions in 1987 received unqualified opinions
with the additional explanatory paragraph. One year later,
in 1988, over 95% of the companies with going concern
uncertainties received an unqualified opinion. These data
indicate that most auditors elected to issue the changed
format with an unqualified opinion in the transition period,
when compliance with the expectation gap SASs was not yet
required.
Multivariate Tests of Differences
in Means
The prior research cited in Chapter II indicated that
both the financial and market variables are measurably
different between the going concern and clean companies.
The purpose of the statistical tests described in this
section of the chapter are to determine if the difference
between the variable means of the going concern and
comparison companies decreased in the periods affected by
the issuance of the expectation gap SASs.
The variables selected for both the financial and the
synthesized model used in this research are based on prior
research by Mutchler [1985] and Dopuch et al. [1987]. Table
4.3 summarizes the variables selected for the financial and
synthesized models, their mean values per prior research
(either Mutchler [1985] or Dopuch et al. [1987]), and the
direction of the differences between clean and going concern
110
companies identified by the current research. The purpose
of Table 4.3 is to provide an initial basis for comparison
with the differences generated for the same variables for
the companies selected in this study. Anticipated changes
are not presented for the full and restricted samples
because, on an a priori basis, both groups are expected to
react similarly.
The means presented in Table 4.3 for the financial
variables are from Mutchler [1985] and provide a comparison
of her two samples.of problem companies. The GCAR sample
had received a going concern audit report, whereas the NGCAR
sample had received an unqualified audit opinion. The means
shown for the market variables (used in the synthesized
model with the restricted sample) are from Dopuch et al.'s
[1987] samples of companies with audit reports indicating
uncertainties (because of going concern, litigation, asset
realization, and multiple reasons) and their comparison
sample of companies with clean audit opinions.
Mean Values by Year
The sample sizes and variable mean values by year are
shown for both the full and restricted samples of companies
with going concern and clean audit opinions in Tables 4.4
and 4.5, respectively. A review of the tables yields three
overall observations. First, the individual variable means
have fairly consistent signs over the five years included in
Ill
the sample. For example, as shown in Table 4.4, all of the
variable means for the full sample of going concern
companies have the same sign throughout the five-year
period. For the restricted sample of companies, only three
(CFTL, DBETA, EXRTN) of the eleven variables show sign
changes over the five-year period. Similar results are
found in Table 4.5 regarding the companies with clean audit
opinions. For the full sample of companies, all of the
variables, except CFTL, have the same sign throughout the
five year period. CFTL switched from positive to negative
for 1989 and 1990. For the restricted sample, three
variables (DBETA, DRSTD, EXRTN) have sign changes. Two
(DBETA and EXRTN) of these three variables are the same ones
that had changed sign in the restricted sample of companies
with going concern opinions.
A second observation from Tables 4.4 and 4.5 is that
the full and restricted samples for either the companies
with going concern or clean opinions have different
financial variable means. This could be because of the
different composition of these samples. The restricted
sample is comprised of relatively larger, publicly traded
companies (whose stock return information is included on the
CRSP tapes). The full sample includes the companies from
the restricted sample and other relatively smaller
companies.
112
Third, the data in Tables 4.4 and 4.5 further indicate
that the means of the full sample financial variables vary
more in magnitude across years more than the comparable
restricted sample variable mean values.
Graphs of the variable means from Tables 4.4 and 4.5
are shown in Figures 4.1 through 4.11 for both the full and
restricted samples. It should be noted that the scale used
for the ratio differs from the full to the restricted
sample. In general, the variables computed for this
research are consistent with prior research. The financial
variables have been compared to Mutchler [1985] and the
market variables to Dopuch et al. [1987].
Liquidity Ratios
CFTL by Year, shown in Figure 4.1, indicates that the
companies with going concern opinions have lower values for
CFTL than their comparison clean companies, in both the full
and restricted samples. This indicates that the companies
with going concern opinions have smaller amounts of cash
flow available in comparison to their liabilities,
contributing to liquidity problems and possibly leading the
auditor to have substantial doubt about the company's
ability to continue as a going concern.
Similar results are found in Figure 4.2, for CACL by
Year. The going concern companies have lower ratio values
than the comparison clean companies, for both the full and
113
restricted samples. The fact that the going concern
companies have lower current ratios than the clean companies
is another indicator of potential going concern uncertainty.
Furthermore, the overall lower variability in the ratios for
the larger companies in the restricted sample set (both
going concern and clean), may suggest that larger companies
are less affected by year to year changes in conditions or
that the management of these companies are better able to
control their reported financial results.
Solvency
The next three financial ratios, NWTL, LTDTA, and TLTA
are indicators of solvency. Figure 4.3, NWTL by Year shows
that the clean companies, in both the full and reduced
samples, have relatively lower proportions of long term
liabilities in their capital structure (i.e., these
companies have larger NWTL ratios). The ratios graphed in
Figures 4.4 and 4.5, LTDTA by Year and TLTA by Year, are
consistent with this inference. Both of these graphs
indicate that the going concern companies have higher levels
of debt, measured both as long-term debt and total
liabilities, in relation to their level of assets, than the
clean companies.
Although the liability levels of the companies sampled
also influenced the liquidity ratios, the implication of the
liquidity measures (more debt relative to assets) in
114
conjunction with the solvency measures (less cash flow to
service that debt) provides a further indication of why the
going concern companies' ability to continue in the future
might be questioned by the auditor.
Profitability
As shown in Figure 4.6, NIBTS by Year, the full sample
of companies with going concern opinions have substantially
lower values than any of the other three groups. In
addition, the restricted sample of clean companies
consistently display the highest ratio values. This measure
provides another indication that significant differences
exist between the going concern and clean companies.
Prior Year Audit Report
PYAR, shown in Figure 4.7, is the last financial
variable. The difference between the going concern and
clean samples is pronounced, which is probably indicative of
why Mutchler [1985] found this variable to be important in
her model. It is interesting to note that both the full and
restricted samples of going concern companies have fairly
similar values for PYAR over the sample period. This
indicates that companies receiving a going concern report in
the prior period are more likely to receive another in the
current period.
115
The value of PYAR for 1988, for both the full and
restricted samples of going concern companies, is the lowest
of any year included in the sample. This may be reflective
of the large increase in the total number of going concern
opinions issued in 1988. As shown in Table 4.1, the total
number of going concern opinions issued in 1988 was 798,
whereas the 1987 total was 685, an increase of 107 (15.6%)
reports. This large increase in the number of going concern
opinions could decrease the PYAR variable because relatively
more of the companies would be receiving going concern
reports for the first time.
Market Variables
The market variables for the restricted samples are
graphed in Figures 4.8 to 4.11. Dopuch et al. [1987] found
that companies receiving going concern opinions were younger
(had lower values for TLIST) than the comparison companies.
The results shown in Figure 4.8, TLIST by Year, are
generally consistent with the findings of Dopuch et al.,
except for 1987, where the sample of companies that received
going concern opinions is relatively older.
Figure 4.9 shows DBETA by Year. The DBETA for the
going concern companies is very volatile and only the
results for 1987 and 1989, where DBETA is less for the going
concern than the clean companies, are consistent with the
results from Dopuch et al. [1987]. The volatility in DBETA,
116
which measures the change in beta (a regression of company
returns minus the return on an industry index), indicates
higher probability of large swings in stock prices and
lawsuits against auditors. This is particularly possible
when large declines in stock prices follow the issuance of
financial statements that fail to flag going concern
considerations. The values of DRSTD, shown in Figure 4.10,
are consistent with the results from Dopuch et al. [1987]
for every year in the sample.
Results related to the final market variable of EXRTN
are shown in Figure 4.11. These results are consistent with
those from Dopuch et al. [1987] for every year except 1986,
where the going concern companies had larger values for
EXRTN than the comparison clean companies. However, it
should be noted that the 1986 DBETA value for going concern
companies is a large positive value that indicates high
variability in returns and may be associated with the EXRTN
variable.
Summarv
There are substantial differences between the variable
means for both the going concern and clean companies
included in this sample. These differences are consistent
with the prior research findings of Mutchler [1985] and
Dopuch et al. [1987]. The next section discusses the data
117
after they are categorized into the three comparison sub-
periods.
Mean Values by Comparison Sub-Periods
The next analyses examine the going concern and
selected clean companies in the context of comparison sub-
periods (i.e., pre-, transition, or post-expectation gap
SAS) . The going concern companies included in the pre-
period are all those that received qualified audit opinions
in the FYs 1986 and 1987. As indicated in Table 4.2, this
group includes 1,114 companies—612 from 1986 and 502 from
1987. The transition period includes the FY 1987 and 1988
companies that received unqualified audit opinions with
indications of going concern uncertainties. This group
totals 745 companies, with 110 from FY 1987 and 635 from FY
1988. Finally, the post-expectation gap SAS period includes
the 1,507 companies from FY 1989 (657 companies) and FY 1990
(850 companies) with unqualified audit opinions that contain
language indicating substantial doubt about going concern
status. Table 4.6 contains the mean values for the
companies with going concern opinions grouped by comparison
periods.
The random sample of companies with clean audit
opinions has been selected based on the number of companies
with going concern report modifications for each year in the
sample. Thus, 612 clean companies have been selected for FY
118
1986 and 1987, 635 for FY 1988, 657 for FY 1989, and 850 for
FY 1990. Because it has not been possible to determine
whether the FY 1987 clean companies had received audit
opinions based on the pre- versus post-expectation gap SAS
guidance, it is not possible to allocate the 1987 companies
between pre- and transition periods. Therefore, the means
computed for the pre-period clean companies are based on all
FY 1986 and 1987 companies with clean audit opinions. The
mean values for the transition period include all FY 1987
and FY 1988 companies. The post-expectation gap SAS mean
values for the clean companies are based on the FY 1989 and
FY 1990 companies. Table 4.7 summarizes the mean values for
the companies with clean audit opinions by comparison
periods.
The three observations noted earlier about the mean
values compared year by year (in Tables 4.4 and 4.5) are
also applicable to the data in Tables 4.6 and 4.7. These
three observations were that (1) the data had consistent
signs, (2) the financial variable means varied greatly
between the full and restricted samples, and (3) that there
was more variance in the financial variables of companies in
the full sample compared with the restricted sample. It
would be expected that these observations would be the same
for Tables 4.6 and 4.7 because they are combinations of the
annual data.
119
The mean variable values from Tables 4.6 and 4.7 are
presented graphically in Figures 4.12 to 4.22. The mean
values shown in Figures 4.12 through 4.22 are similar to
those shown in Figures 4.1 to 4.11. An overall observation
of the graphical comparisons of financial and market
variables of going concern versus clean companies by sub-
periods begin to show that (for at least the full samples)
the differences generally widen from the pre- to transition
periods and narrow from the transition to post-expectation
gap SAS periods.
Difference in Mean Values
Table 4.8 presents the differences between the variable
mean values for the going concern and clean companies by
comparison periods. The differences presented in Table 4.8
are calculated by subtracting the mean value for the clean
company variables from the variable value for the going
concern companies. The data from Table 4.8 are graphed in
Figures 4.23 through 4.33.
These graphs in conjunction with Table 4.9, The MANOVA
Results for Differences Between Periods Using Differenced
Ratios, provide an indication of whether the differences
between the going concern and clean companies became more
narrow, as would be consistent with the hypotheses regarding
the implementation of the expectation gap SASs. Perusal of
Table 4.9 yields two general observations. First, for both
120
samples, the difference between the going concern and clean
companies widens from the pre- to transition period and then
narrows from the transition to post-period. Second, the
differences in NIBTS (DNIBTS) and PYAR (DPYAR) drive the
conclusions regarding overall changes in the differences for
the sub-period analyses, although they are less significant
in the overall MANOVA.
Based on the results presented in Table 4.9, the
following conclusions are reached on research hypotheses 1-6
presented in the previous chapter. Hypotheses one and two
are associated with measuring the change from the pre- to
the transition period for the full and restricted samples.
Both hypotheses are rejected based on the p-values presented
regarding the significance of the change in the model
between the pre- and transition period. Although the
hypotheses are rejected, it is interesting to note that the
outcome is that the variable means changed in the direction
of a widening of the difference between going concern and
clean companies. It was initially expected that the
differences would narrow if the expectation gap SASs
resulted in earlier reporting of potential going concern
problems.
Hypotheses three and four relate to measurement of the
change from the transition to the post-expectation gap SAS
period for the full and reduced samples and are also
rejected because the p-values presented indicate that there
121
was a significant change in that period. For both samples,
this change reflects a narrowing of the difference between
the going concern and clean companies.
Finally, hypothesis six (restricted sample, pre- to
post- periods) was also rejected. In contrast, hypothesis
five (full sample, pre- to post- periods) cannot be
rejected. These hypotheses are considered the most
important results of this research because the overall pre-
to post-expectation gap SAS change would be most indicative
of an overall reporting change. For the full sample, the
overall change is a non-significant narrowing of the
difference between the going concern and clean companies.
This may indicate that auditors are not reporting companies
with going concern problems until their financial condition
is as severe as it was in the pre-expectation gap SAS
period. However, the change in model variables for the
restricted sample of companies is a significant widening of
the difference between the going concern and clean
companies.
Loait Tests Regarding Change in Odds
Additional statistical analyses have been performed to
test whether the period (pre-, transition, or post-
expectation gap SAS) in which the report was issued affected
the odds of that report being flagged for going concern
considerations. The results of the logit analyses are
122
presented in Table 4.10, Logit Results for Changes Between
Periods.
Included in Table 4.10 are the estimated coefficient
for the model variables in both the full and restricted
samples, the p-value of the coefficient, and the odds ratio
for the coefficient. The estimated coefficient in logit
analysis is referred to as the log odds ratio. This
measures the effect of a unit increase in the independent
variable on the estimated odds being measured. However,
this measurement is contingent upon the initial or starting
point of the independent variable. The odds ratio is
computed as the antilog of the estimated coefficient and
gives a direct measure of the percentage change in the odds
being measured [Neter, Wasserman, Kutner, 1989].
A review of Table 4.10 yields three observations.
First, the estimated coefficients presented for the
intercept terms are affected by the choice-based sampling
used in this study [Maddala, 1991]. Because the intercept
terms are not particularly meaningful in this study, the
intercept terms were not adjusted for the effect of choice-
based sampling. Second, in the full sample, all of the
estimated coefficients are significant (p<.05) at
conventional levels except NWTL in the pre to transition
sub-period, and the PERIOD variable for the overall test of
the pre- to post- change. Third, in the restricted sample,
numerous variables had non-significant p-values. CFTL and
123
TLIST were non-significant in all of the tests related to
the restricted sample. These test results are consistent
with the general observation that differences in model
variables between clean and going concern companies were not
as great in the restricted sample.
Hypotheses 7-13 refer to the logit analyses. The first
two of these hypotheses (7 and 8) test whether the change in
the odds from the pre- to the transition period is
significant. Hypothesis seven, which tests the full sample,
is rejected because the coefficient for the period dummy
variable is significant (p<.0001). However, as indicated by
negative coefficient and the fact that the odds ratio is
less than one (.08), the odds of a company receiving a going
concern report actually decreases significantly from the
pre- to the transition period.
Hypothesis eight, for the restricted sample, is
similarly rejected because the period dummy variable is
significant (p<.0001) but the odds ratio (.018) indicates an
even larger decline in the odds of a company receiving a
going concern opinion in this sample. These results are
consistent with the multivariate analyses that indicated the
difference between the going concern and comparison
companies widens from the pre- to the transition period.
The next two hypotheses (9 and 10) address whether the
changes in the odds levels from the transition period to the
post-expectation gap SAS period are significant. The
124
sub-period variable indicating the change from the
transition to post-period in the full sample is significant
(p<.0001). Thus, hypothesis 9 is rejected. Based on the
positive sign of the coefficient and because the odds ratio
is greater than one (1.458), it is concluded that the odds
of companies in the full sample receiving an audit opinion
indicating going concern uncertainty increased from the
transition to the post-expectation gap SAS period. In
contrast, for the restricted sample, the period variable is
non-significant (p<.8233). Thus, hypothesis 10 cannot be
rejected.
Finally, hypotheses 11 and 12 test whether there has
been an overall change in the odds from the pre- to the
post-expectation gap period. These hypotheses are
considered the most important because they are interpreted
as an overall test of the change due to the expectation gap
SASs. For the full sample, the period dummy variable for
the pre- to the post-expectation gap SAS period was
marginally significant (p<.0917). Thus, hypothesis 11 is
rejected at the .10 level of significance. Furthermore, the
sign and magnitude of change indicate that the odds of
companies in the full sample receiving a going concern audit
report increased about 17.5% from the pre- to the post-
period. For the restricted sample, the change in reporting
from the pre- to the post-expectation gap SAS period is
significant at a lower level (p<.0017). Therefore,
125
hypothesis 12 is rejected. However, as indicated by the
negative coefficient and the odds ratio of .305, the change
indicated is a decrease in the odds of companies in the
restricted sample receiving a going concern audit report.
Summary
This chapter has presented the data collected and the
results of the data analyses performed. The first analysis
was of the number and percentage of companies receiving
audit reports indicating going concern uncertainties during
the periods covered by this study. It was determined that
the number of going concern reports issued steadily
increased over the five year sample period and that auditors
elected the reporting format in SAS No. 59 during 1987.
The second section of the chapter reported the results
of the multivariate tests for changes in the differences of
the model variable means between the going concern and clean
companies selected for comparison. These tests showed that
the amount of difference in financial and market variables
between going concern and clean companies actually widened
from the pre- to transition period, for both the full and
restricted samples. This difference narrowed from the
transition to the post-period sub-period for both samples.
The overall test of change in differences compared the pre-
period to the post-expectation gap SAS period and concluded
that for the full sample the differences narrowed by a
126
non-significant amount, but the difference had widened
significantly for the restricted sample.
The final section of the chapter focused on whether
changes occurred in the odds of companies receiving audit
reports flagged for going concern uncertainty during the
periods covered by this study. The logit results were
generally consistent with the multivariate analysis and
determined that from the pre- to transition period the odds
had decreased in both the full and restricted samples. The
odds increased for the full sample from the transition to
the post-period, but was non-significantly different for the
restricted sample. The overall test of the change from the
pre- to the post-period determined that for the full sample,
the odds of a company receiving a going concern opinion had
increased by 17.5%, but was only marginally significant with
a p-value of .0917. For the restricted sample of companies,
the overall test was significant and showed a decline in the
odds of a company receiving a going concern opinion.
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Year D r-GC + F-C
1989 1990
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Year
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1989 1990
Figure 4.1: CFTL by Year
138
i
1990
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.s
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3
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2.6
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2
1.8
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0.8 1986 1987 1988
Year
D R-GC H- R-C
b . R e s t r i c t e d Seimple
1989 1990
Figure 4 . 2 : CACL by Year
139
1986 1987 1988
Year D F-GC i- F-C
1989 1990
a. F u l l Seunple
A
1986 1987 1988 1989 1990
D R-GC •»• R-C
b. Restricted Sample
Figure 4.3; NWTL by Year
140
i
1986 1987 1988 1989 1990
a F—GC 1- F-C
a. Ful l Sample
0 IP
<8
1986 1987 1988
Year
D R-GC •»- R-C
b. Res tr i c ted Sample
1989 1990
Figure 4 . 4 : LTDTA by Year
1 4 1
0 IP
& -
4 -
3 -
2 -
1 -
1986 1987 1988
Year D F-GC + F-C
1989 1990
a. F u l l Sample
.0
i
0.5 1986 1987 1988 1989 1990
D R-GC -t- R-C
b. Restricted Sample
Figure 4.5: TLTA by Year
142
i
1986 1987 1988
Year
a F-GC + F - C
1989 1990
a. F u l l Sample
JO
I
0.1
0
- 0 . 1
- 0 . 2
- 0 . 3
- 0 . 4
-o.a
- 0 . 6
^ - ^ , - t - —^ '
/ \
/ \ r'~~-~~^ - / \ /
\ /
\ /
. 1 1 1 —
1986 1987 1988
Yeor
a R-GC •»• R-C
b. Restricted Sample
1989 1990
Figure 4.6: NIBTS by Year
143
9
o. /
0.6
0 .5
0 .4
O J
0 .2
0.1
5
-
-
• 1 1 1 1 1986 1987 1988
Year a F-GC 1- F-C
1989 1990
a. F u l l Seunple
.fi
i
0.6
0.5 -
0.4 -
0.3 -
0.2 -
0.1 -
1986 1987 1988
Year
a R-GC •»- R-C
b. Restricted Sample
1989 1990
Figure 4.7: PYAR by Year
144
.s
1986 1987 1988
Year • R-GC H- R-C
1989 1990
0
Figure 4.8: TLIST by Year
1986 1987 1988
Year
D R-GC -t- R-C
1989 1990
Figure 4.9: DBETA by Year
145
.s <8
1986 1987 1988
Year a R-GC H- R-C
1989 1990
Figure 4 . 1 0 : DRSTD by Year
jO
i
1990
Figure 4.11: EXRTN by Year
146
5 ««
i
Pre Transit a n
Period
a F-GC + F-C
Port
a . F u l l Sample
.0
I
b. Restricted Sample
Figure 4.12: CFTL By Period
147
.s
a. Ful l Sample
.0
Si
2.9 2.8 2.7 2.6 2.5 2.4 2.3 2.2 2.1
2 1.9 1.8 1.7 1.6 1.5 1.4 1 J h 1.2 -1.1 h
1
••-
Pre Past
b. Restricted Sample
Figure 4.13: CACL By Period
148
.2
.8
Pre Transitbn
Period
D F-GC i- F - C
Post
a. Ful l Sample
.0
i
Pre Transitbn Past
Period
D R-GC H- R-C
b. Restricted Sample
Figure 4.14: NWTL By Period
149
.fi
i
Post
a. F u l l Seunple
Pre Transition
Period
• R-GC -I- R-C
b . R e s t r i c t e d Scunple
F igure 4 . 1 5 : LTDTA By Per iod
Post
150
.8
Pre Transitbn
Period
O F-GC •»• F - C
a. F u l l Sample
Past
1 J
i
0 .7 -
0.6
0 .5
b. Restricted Sample
Figure 4.16: TLTA By Period
151
0
Pre Transitbn
Period
D F-GC + F - C
a. F u l l Sample
Post
0.1
JO
i
.1 -
- 0 . 2 -
- 0 - 3 -
- 0 . 4 -
- 0 . 5 -
Pre Transitbn Post
Period
D R-GC •»• R-C
b. Restricted Sample
Figure 4.17: NIBTS By Period
152
.fi
i
0.4
0.35 -
O J -
0.25 -
0.2 -
0.15 -
0.05 -
Pre
0.5
0.4 -
OJ -
0.2 -
0.1
Transitbn
Period
O F-GC -t- F - C
a. F u l l Sample
• R-GC •»- R-C
b . R e s t r i c t e d Scunple
Post
Figure 4.18: PYAR By Period
153
0
i
Pre Transitbn
Period
D R-OC + R-C
Post
Figure 4.19: TLIST by Period
&
O J S
O J
0Jt5
0 .2
0.15
0.1
0.05 -
-0.05 -
).1
Figure 4.20: DBETA by Period
154
5 <8
0.028
0.026
0.024
0.022
0.02
0.018
0.016
0.014
0.012
0.01
0.008
0.006
0.004
0.002 h
O
—0.002 Pre Transitbn
Period D R-GC 1- R-C
Post
Figure 4.21: DRSTD by Period
jO
Figure 4.22: EXRTN by Period
155
.fi
.0
I
Transitbn
Period
a FuH •*• Restricted
Figure 4.23: DCFTL by Period
Post
Pie Transitbn
Period
a Full H- Restricted
Post
Figure 4.24: DCACL by Period
156
Pre Transitbn
Period
D Full 1- Restricted
Past
Figure 4.25: DNWTL by Period
JO
i
Pre Transitbn
Period
D Full -t- Restricted
Post
Figure 4.26: DLDTA by Period
157
.fi
Pre Tra nsit b n
Period
a Full H- Restricted
Post
Figure 4.27: DTLTA by Period
&
Pre Transitbn
Po-iod
D Full ••• Restricted
Figure 4.28: DNIBTS by Period
158
0.5
0.45 -
0.4 -
0.35 -
0.3 -
0.25 -
OJl -
0.15 -
0.1 Pre Transitbn
Period
Q Fun i- Restrcted
Post
Figure 4 . 2 9 : DPYAR by Per iod
JO
i
Pre Transitbn
Period
Restrcted
Post
Figure 4.30: DTLIST by Period
159
.fi
i
Pre Transitbn
Period
Restricted
Post
Figure 4 . 3 1 : DDBETA by Per iod
(8
0.025
0.024 -
0 .023 -
0.Q22 -
0.021 -
0.02 -
0 .019 -
0 .018 -
0 .017 Pre Tra nsit a n
Period
• Restricted
Past
Figure 4.32: DDRSTD by Period
160
—4
JO
Pre Transitbn
Period
D Restricted
Post
Figure 4 . 3 3 : DEXRTN by Year
CHAPTER V
SUMMARY OF RESULTS, IMPLICATIONS, AND
FUTURE RESEARCH POSSIBILITIES
Summary of Results
The purpose of this research was to study what effect
the procedural and reporting changes instituted by the
expectation gap SASs had on the financial reporting of
entities. The results indicate that over the five FYs
included in this sample the total number and percentage of
companies receiving going concern opinions increased
substantially. The analysis of the type of audit report
issued when the auditor had substantial doubt about the
auditee's ability to continue as a going concern showed that
the switch from the pre-guidance of SAS No. 34 to SAS No. 59
occurred in 1987.
The full sample of going concern companies included all
those identified from the Compact Disclosure database as
having going concern report modifications. The full sample
of clean companies was randomly selected from the population
of all companies with clean audit opinions on Compact
Disclosure. Hypotheses related to the financial model were
tested using the full samples. The restricted samples of
going concern and clean companies were those identified from
the Compact Disclosure search that also had market data
available on the CRSP tapes.
161
162
Multivariate tests were used to assess the differences
in financial and market variables between the going concern
and clean companies for the two sub-periods (pre- to
transition and transition to post-) and the overall period
(pre- to post-). These tests showed that, for both the full
and restricted sample, the difference between the
characteristics of the companies widened from the pre- to
transition period. For both groups, the difference narrowed
during the transition to post sub-period. The overall test
of change in differences compared the pre-period to the
post-expectation gap SAS period and concluded that, for the
full samples, the difference had been non-significantly
narrowed but the difference had significantly widened for
the restricted sample.
The logit results generally complimented the
multivariate results and tested whether changes occurred in
the odds of companies' receiving audit reports indicating
going concern uncertainty during the periods covered by this
study. The logit results were consistent with the
multivariate analysis and determined that, from the pre- to
transition period, the odds decreased in both the full and
restricted samples. The odds increased for the full sample
from the transition to the post-period, but the change was
non-significant for the restricted sample. The overall test
of the change from the pre- to the post-period indicated
that for the full sample, the odds of a company receiving a
163
going concern opinion had increased by 17.5%, although this
finding was only marginally significant with a p-value of
.0917 (the multivariate analysis indicated a non-significant
narrowing). For the restricted sample of companies, the
overall test was significant (p<.0017) but showed a decline
in the odds of a company receiving a going concern opinion.
Implications of Results
One interesting aspect of this study's results is the
dichotomous effect of the expectation gap SASs on the
reporting of going concern uncertainty. Other studies
[Mutchler, 1986; McKeown, Mutchler, and Hopwood, 1991] have
found that auditors are more likely to issue going concern
opinions to smaller companies. For the restricted sample of
companies, the implementation of the expectation gap SASs
widened the difference between the financial and market
variables of the going concern and clean companies and
decreased the odds that companies would receive a going
concern opinion. Dissimilar results were obtained for the
full sample of companies. For this group, the overall
change in the difference between the going concern and clean
companies had narrowed. In addition, the odds of a company
receiving a going concern report increased.
This study was not designed to explicitly test any of
the various theoretical perspectives regarding the auditors'
164
reporting decisions. However, the results of the study are
consistent with power struggle theory and agency theory.
Power struggle theory posits that managers of larger
companies with larger audit fees can affect the auditor's
reporting decision because they have relatively more power
in relation to auditors. The theorized source of managers'
power is that they can impose costs on auditors by changing
(or threatening to change) auditors. The dichotomous nature
of this study's results are consistent with the power
struggle theory because the managers of the firms in the
restricted sample (larger, publicly traded companies) could
impose relatively more cost on the auditor than could the
managers of the smaller companies in the full sample could.
Another aspect of power struggle theory is the
perceived ability of auditors to resist management pressure.
Knapp [1985] found that management was perceived as more
likely to obtain their desired outcome if the dispute
between the auditor and client was not precisely dealt with
by technical standards and if the client is in a healthy
financial position. The findings of this study are
consistent with the perceptions reported by Knapp. The
initial change from the pre- to the transition period could
be considered to have decreased the precision of the
technical standards regarding going concern reporting
(because the expectation gap SASs did not require specific
wording) resulting in management obtaining their desired
165
outcome (i.e., an audit report that does not mention going
concern). The change from the transition to the post-period
could be considered to have increased the precision of the
technical standards because SAS No. 64 required specific
wording if going concern uncertainties were being reported.
For this period, the results for the full and restricted
samples of companies were distinctly different.
Furthermore, because the auditors' reporting decision
about going concern uncertainty includes both the initial
identification and the subsequent decision about the content
of the report to be issued, the requirement in SAS No. 59
that auditors inquire about and consider management's plans
may provide management with an opportunity to influence the
auditor's reporting decision.
The difference in findings between the full and
restricted samples are also consistent with Knapp's [1985]
conclusion that management is more likely to obtain their
desired outcome if their company is in a healthy financial
position. The variable mean values graphed in Figures 1-22
showed that the restricted sample (both going concern and
clean) had better financial and market position than the
full sample companies. Thus, the companies in the
restricted sample would be more likely to obtain their
desired reporting outcome in a dispute with their auditor.
The results are consistent with the hypothesized trade
off iri agency theory regarding the short-run benefit of
166
keeping the client and the long-run cost of issuing an
incorrect opinion. The auditors' reporting decision
regarding going concern uncertainty is twofold. The auditor
must first identify the companies with going concern
problems and then must decide on the content of the report
to be issued. Prior literature (see Chapter II) and the
data presented in this research suggest that financial and
market characteristics differ significantly between the
going concern and comparison companies. Thus, it is
probable that auditors, who are now required to perform
analytic procedures on such variables, accurately identify
going concern companies. However, the decision regarding
the type of report to be issued can be affected by the
interaction or relationship between the auditor and
management. The results presented for this study are
consistent with the agency framework, where auditors balance
short-run benefits from not reporting large companies with
marginal going concern characteristics against long-run
costs of failing to report to the public. If true, the
client's management may influence the auditor's perception
of the short-run benefit of maintaining the auditee as a
client.
Another possible explanation for the results in this
research is that auditors' view the larger, older, more
established companies included in the restricted sample as
less likely to fail within the one year criteria defined by
167
SAS No. 59. Although auditors may identify these companies
as having potential going concern problems, they may not
issue a going concern opinion because the risk of large and
long established compnaies failing to continue for at least
one year is very low unless financial variables are much
worse than smaller company counterparts.
Limitations
The limitations of this study were initially addressed
in Chapter III. Limitations recognized prior to data
collection were those due to the sample selection process
(i.e., the exclusion of non-publicly traded companies from
some analyses), the elimination in the multivariate analysis
of more going concern than clean companies due to incomplete
data, potential misclassification of firms (especially in
the transition period due to the weakened report wording),
and confounding effects of omitted variables.
Another limitation recognized during the data analysis,
was the extensive skewness and kurtosis of the data. For
the full samples of going concern companies (using all three
time periods), the skewness statistics ranged from -16 to 32
and the kurtosis statistics ranged from -2 to 1,076.
Similarly, for the full samples of clean companies, the
skewness statistics ranged from -29 to 38 and the kurtosis
statistics ranged from 40 to 1,074. The range of skewness
168
and kurtosis were similar in both the clean and going
concern samples.
The skew and kurtosis were greater in the full samples
(both clean and going concern) than in the restricted
samples. In the restricted samples of clean companies, the
skewness statistics ranged from -2 to 11 while the kurtosis
statistics ranged from -.1 to 131. For the restricted
sample of going concern companies, the skewness statistics
ranged from -4 to 9, while the kurtosis statistics ranged
from -2 to 77.
The severity of the skewness and kurtosis in the
samples could have affected the mean values computed and the
multivariate tests of differences in the mean values. The
effect on the mean values may be mitigated, however, because
both the going concern and clean samples had similar ranges
of skewness and kurtosis. It should also be noted that no
data points were eliminated to influence the skewness or
kurtosis.
Future Research Possibilities
This research was intended to provide an initial
indication of the effect of the expectation gap SASs on the
reporting of going concern considerations. Future research
could more specifically address the considerations raised
above about the impact of client size and power struggle
theory on the auditor's reporting decision. For example.
169
research quantifying auditors' perceptions of the relative
cost of type I and type II errors (which would be expected
to vary depending on the client's size) would provide
additional evidence about the impact of the power struggle
theory on reporting decisions.
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Zavgren, Christine V., "The Prediction of Corporate Failure: The State of the Art," Journal of Accounting Literature, Vol. 2, 1983, pp. 1-38.
Zmijewski, Mark E. , "Methodological Issues Related to the Estimation of Financial Distress Prediction Models," Journal of Accounting Research. Vol. 22, Supplement 1984, pp. 59-81.
APPENDIX A
THE EXPECTATION GAP STATEMENTS
ON AUDITING STANDARDS
Detection of Fraud and Illegal Acts: • SAS No. 53: The Auditor's Responsibility to Detect and
Report Errors and Irregularities
Effective Date: Reporting periods beginning on or after January 1, 1989 with earlier adoption permitted.
Synopsis: Explains the auditor's responsibility for material misstatements (including both errors and irregularities). Requires that the audit provide reasonable assurance of detecting material misstatements. Also requires that the auditor discuss all but inconsequential irregularities with management who are at least one level above those involved.
SAS No. 54: Illegal Acts by Clients
Effective Date: Reporting periods beginning on or after January 1, 1989 with earlier adoption permitted.
Synopsis: The auditor's responsibility for detecting and reporting misstatements resulting from illegal acts that have a direct and material effect on the financial statements is the same as that for errors and irregularities as described in SAS #53. Requires that the auditor consider both the quantitative and qualitative materiality of the act. The auditor is not responsible for detecting illegal acts that have an indirect effect on the financial statements.
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Audit Effectiveness:
SAS No. 55: Consideration of the Internal Control Structures in a Financial Statement Audit.
Effective Date: Audits of financial statements for periods beginning on or after January 1, 1990 with earlier adoption permitted.
Synopsis: Requires that in every audit, the auditor should obtain a sufficient understanding of each of the three aspects of internal control (the control environment, the accounting system, and control procedures) to plan the audit.
SAS No. 56: Analytical Procedures
Effective Date: Audits of financial statements for periods beginning on or after January 1, 1989 with earlier adoption permitted.
Synopsis: Requires the use of analytical procedures in the planning and overall review stages of all audits.
SAS No. 57: Auditing Accounting Estimates
Effective Date: Audits of financial statements for periods beginning on or after January 1, 1989 with early adoption permitted.
Synopsis: Provides guidance on obtaining and evaluating evidence to support accounting estimates included in financial statements. Indicates that the auditor's objective related to the evaluation of accounting estimates is to provide reasonable assurance that: all accounting estimates that could be material to the financial statements have been developed, those estimates are reasonable, and the estimates are presented in conformity with generally accepted accounting principles and are properly disclosed.
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Improved External Communications:
• SAS No. 58: Reports on Audited Financial Statements
Effective Date: Reports issued or reissued on or after January 1, 1989 with early adoption permitted.
Synopsis: This SAS substantially modified the standard report.
Changes include: 1. The addition of an introductory paragraph that
differentiates management's responsibilities for the financial statements from the auditor's role in expressing an opinion on the financial statements;
2. An explicit acknowledgment that the auditor's responsibility is to provide reasonable (but not absolute) assurance within the context of materiality that the financial statements are not materially misstated;
3. The addition, in the scope paragraph, of a brief explanation of what an audit entails;
4. The "subject to" opinion qualification for reporting on a material uncertainty is eliminated. However, the requirement to disclose the uncertainty in an explanatory paragraph is retained.
• SAS No. 59: The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern
Effective Date: Audits of financial statements for periods beginning on or after January 1, 1989 with early adoption permitted.
Synopsis: Establishes the auditor's responsibility to evaluate in every audit whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time, not more than one year beyond the date of the financial statements being audited.
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Improved Internal Communications:
SAS No. 60: Communication of Internal Control Structure Related Matters Noted in an Audit
Effective Date: Audits of financial statements for periods beginning on or after January 1, 1989 with early adoption permitted.
Synopsis: Requires that the auditor report items which, in their judgment, represent significant deficiencies in any of the following aspects of the internal control structure: the control environment, the accounting system, or control procedures. The wording of the report is also clarified by eliminating negative language.
SAS No. 61: Communication with Audit Committees
Effective Date: Audits of financial statements for periods beginning on or after January 1, 1989 with early adoption permitted.
Synopsis: Established the requirement that the auditor communicate certain matters to the audit committee.
These matters include: 1. The auditor's responsibility under generally
accepted auditing standards; 2. The initial selection of and changes in significant
accounting policies or their application; 3. Management's process of formulating significant
accounting estimates and the basis for the auditor's conclusions regarding the reasonableness of those estimates;
4. Audit adjustments (whether recorded or not) that either individually or in the aggregate, have a significant effect on the entity's financial reporting process;
5. The auditor's responsibility for other information contained in audited financial statement;
6. Any disagreements with management about matters that individually or in the aggregate, could be significant to the entity's financial statements or the audit report;
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7. The auditor's views regarding significant matters that were the subject of consultation with other accountants;
8. Any major issues that were discussed with management in connection with the initial or recurring retention of the auditor;
9. Any serious difficulties encountered in dealing with management regarding the performance of the audit.
APPENDIX B
COMPARISON of PRE- and POST-EXPECTATION
GAP SASs REGARDING AUDIT EVIDENCE
Issue Pre-
Errors anH
Irregularities
Post-
Applicable SAS
Audit Responsibility
SAS No. 16, The Independent Auditor's Responsibility for the Detection of Errors or Irregularities
The auditor should plan the audit to search for errors and irregularities that would have a material effect on the financial statements.
SAS No. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities
The auditor should assess the risk that errors and irregularities may cause the financial statements to contain a material misstatement. Based on that assessment, the auditor should design the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements.
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184
Issue
Audit Procedures
Pre-
The auditor's search for material errors and irregularities would be accomplished by the performance of procedures used to form an opinion on the financial statements. Extended auditing procedures would be required if those procedures indicated that material errors or irregularities may exist.
Post-
The auditor is required to review client characteristics that might increase the risk of material misstatements. Emphasis on red-flag client characteristics and internal control.
Management Integrity
The auditor The auditor neither should be aware assumes that of the importance management is of management's dishonest nor integrity and assumes consider whether unquestioned there are honesty. circumstances that might predispose management to misstate financial statements.
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Issue
Illegal Acts
Applicable SAS
Pre-
SAS No. 17, Illegal Acts by Clients
Post-
SAS No. 54, Illegal Acts by Clients
Illegal Acts having a direct and material effect on financial statements
This type of illegal acts were not distinguished, The auditor should be aware of the possibility that any type of illegal acts may have occurred.
The auditor should design the audit to provide reasonable assurance that this type of illegal acts are detected and reported.
Analytical Procedures
Applicable SAS SAS No. 23, Analytical Review Procedures
SAS No. 56, Analytical Procedures
Required Use of Analytical Procedures
None. Requires the use of analytical procedures in the planning and review stages of all audits.
Guidance Provided
Emphasis on nature of analytical review procedures and the investigation of significant fluctuations.
Provides expanded guidance on designing, applying and evaluating analytical procedures used as substantive tests.
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Issue Pre- Post-
Acconntinq Estimatf^a
Applicable SAS None, SAS No. 57, Auditing Accounting Estimates
Requirement None. Auditors should obtain sufficient competent evidence to provide reasonable assurance that all accounting estimates: • which could be material to the financial statements have been developed,
• are reasonable, • conform with applicable accounting principles and are properly disclosed.
APPENDIX C
COMPARISON of PRE- and POST-EXPECTATION
GAP SASs REGARDING the ASSESSMENT
of GOING CONCERN
Issue
Applicable SAS
Pre-
SAS No. 34, The Auditor's Considerations When a Question Arises About an Entity's Continued Existence
Post-
SAS No. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern
Auditor's Responsibility
The auditor should be aware that audit procedures may uncover information contrary to the assumption of going concern. However, the auditor does not search for evidence related to going concern because, in the absence of information to the contrary, an entity's continuation is usually assumed.
In every audit, the auditor has a responsibility to evaluate whether there is substantial doubt about the entity's ability to continue as a going concern.
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188
Issue Cause of Report Modification
Pre-If the auditor has substantial doubt about continued existence, they would evaluate the recoverability of assets and the classification of liabilities. Uncertainty about assets or liabilities would cause the audit report to be qualified.
Post-If the auditor has substantial doubt about the entity's ability to continue in existence an explanatory paragraph in the audit opinion would be required (regardless of the recoverability of assets or classification of liabilities) .
Mitigating Factors
The auditor was responsible for the identification and evaluation of factors which could mitigate the effect of contrary information about going concern.
Mitigating factors are not mentioned because they are considered inseparable from management's plans and thus, the responsibility for identifying them is management's.
APPENDIX D
COMPARISON of PRE- and POST-EXPECTATION
GAP SASs REGARDING REPORTING
Issue Pre- Post-
Applicable SAS SAS No. 2, SAS No. 58, Reports Reports on on Audited Audited Financial Financial Statements Statements
Introductory Paragraph
Not Applicable The introductory paragraph indicates which financial statements were audited and differentiates management's responsibilities for those statements from the auditor's responsbility for expressing an opinion on the financial statements.
Level of Assurance
Not mentioned. Indicates that the auditor provides reasonable assurance that the financial statements are free of material errors and irregularities.
Audit Description
Not Included. The scope opinion provides a brief descrption of an audit.
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190
Issue Pre- Post-
Consistency Reference
The opinion paragraph indicated that generally accepted accounting principles were applied on a consistent bases with the prior year.
The reference to consistent applicabition of GAAP is deleted. An inconsistent application of GAAP would be disclosed by the addition of an explanantory paragraph describing the inconsistency.
Reporting on Material Uncertainties
The auditor would issue a qualified "subject-to" opinion.
The subject-to opinion qualification is eliminated. The auditor would issue an unqualified opinion which describes the uncertainty in an explanantory paragraph.
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