Carcello, J.v. and T. L. Neal

8/6/2019 Carcello, J.v. and T. L. Neal

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AUDIT COMMITTEE COMPOSITION AND AUDITOR REPORTING

Joseph V. Carcello

Associate Professor

Department of Accounting and Business Law

College of Business Administration

University of Tennessee

Knoxville, TN 37996-0560

Phone: (865) 974-1757Fax: (865) 974-4631

E-mail: [email protected]

Terry L. Neal

Assistant Professor

University of Kentucky

E-mail: [email protected]

ACKNOWLEGEMENTS: We thank Mark Beasley, Bruce Behn, Dana Hermanson, Jim

McKeown, Jane Mutchler, Zoe-Vonna Palmrose, Sean Peffer, Bob Ramsay, Dick Riley,

Dan Simunic, participants at a Boston College Accounting Research Workshop, two

anonymous referees, and Jerry Salamon (the former editor) for many helpful comments

and suggestions. We also thank Chris Daugherty and Michelle Keasler for research

assistance.

DATA AVAILABILITY: The data are available from public sources. A list of sample

firms is available from the second author.

This paper can be downloaded from theSocial Science Research Network Electronic Paper Collection:

http://papers.ssrn.com/paper.taf?abstract_id=229835


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ABSTRACT: This study examines the relation between the composition of financially

distressed firms audit committees and the likelihood of receiving going-concern reports.

For firms experiencing financial distress during 1994, we find that the greater the

percentage of affiliated directors on the audit committee, the lower the probability the

auditor will issue a going-concern report. These results support regulators concern about

financial reporting quality and the recent calls for more independent audit committees.

Key Words: Audit committee composition, Affiliated directors, Auditor reporting

behavior, Going-concern reports

Data Availability: The data are available from public sources. A list of sample firms is

available from the second author.


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I. INTRODUCTION

The role of audit committees continues to be of importance to regulators, the

accounting profession, and the business community. The New York Stock Exchange

(NYSE) and the National Association of Securities Dealers (NASD) recently co-

sponsored a Blue Ribbon Committee to make recommendations for improving the

effectiveness of audit committees (BRC 1999). The NYSE- and NASD-sponsored Blue

Ribbon Committees first recommendation addresses the composition of audit

committees and calls for audit committee members to be independent of management.

In this study, we examine the relation between audit committee independence and

auditor reporting behavior. More specifically, we consider the relation between: (1) the

percentage of audit committee members affiliated with a company (i.e., directors who lack

independence) experiencing financial distress, and (2) the likelihood that the auditor will

issue a going-concern report. Affiliated directors include current or former officers or

employees of the company or of a related entity, relatives of management, professional

advisors to the company (e.g., consultants, bank officers, legal counsel), officers of

significant suppliers or customers of the company, and interlocking directors.1

The BRC (1999) and the National Association of Corporate Directors (NACD

1999) both suggest that audit committees are likely to be more effective in protecting the

credibility of the firms financial reporting if committee members are independent of

management. Therefore, we expect that the greater the proportion of the audit committee

comprised of affiliated directors, the less the committee will support the auditor in


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negotiations over the type of audit report to issue for a company experiencing financial

distress.

Our results support this expectation. We find an inverse relation between the

likelihood of receiving a going-concern report and the percentage of affiliated directors on

the audit committee. This result is robust across numerous model specifications and

sensitivity tests. This study provides initial evidence of a relation between one corporate

governance mechanism (audit committee composition) and an audit outcome of broad

interest, going-concern reporting. Our findings are consistent with the BRCs recent

recommendations for completely independent audit committees.

The remainder of this paper is organized as follows. Section II provides further

background and develops the prediction that we test. The research design appears in

Section III, and Section IV discusses sample selection and data. The results follow in

Section V. Section VI contains a summary and presents the implications and limitations of

our findings.

II. BACKGROUND AND EMPIRICAL PREDICTION

Regulators often view independent auditors as public watchdogs over Corporate

America (Levitt 1998, 5). However, according to Arthur Levitt, chairman of the Securities

and Exchange Commission, even these watchdogs need help in performing their vital

role, and that responsibility belongs to the audit committee (1998, 5). Birketts (1986)

historical analysis suggests that audit committees were established primarily to safeguard

the independence of the external auditor, and prior research suggests that audit

committees strengthen the auditors position in disputes with management (e.g., Knapp


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1987). More recently, Levitt (2000) has indicated that safeguarding the independence of

the accounting profession has never been more important.

However, audit committee members do not always perform their duties

adequately (POB 1993; Sommer 1991). For example, audit committees may perform

inadequately if their members are not independent of management. Members such as

affiliated directors may have personal and/or economic dependence on company

management (Baysinger and Butler 1985).

Audit Committee Composition and Going-Concern Reporting

Management may pressure the auditor against issuing a going-concern report.

Prior research associates modified reports with stock price declines (Jones 1996),

difficulty in raising debt capital (Firth 1980), and a perception by management that a

modified report may precipitate the companys failure (i.e., the self-fulfilling prophecy

effect) (Mutchler 1984). We therefore expect management to resist a modified report

(Mutchler 1984).

Consistent with the extant literature (e.g., Antle and Nalebuff 1991; Knapp 1985;

Teoh 1992), we view the issuance of a going-concern report as the outcome of an often

contentious negotiation among management, the auditor, and the audit committee.

Management may imply that issuing a going-concern report will adversely affect the

auditor. For example, clients receiving a going-concern report are more likely to switch

auditors (Chow and Rice 1982; Geiger et al. 1998; Mutchler 1984). Other adverse

consequences might include increased fee pressure, a reduction in the purchase of non-

audit services, and deterioration in the working relationship with incumbent management.


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Prior research suggests that the going-concern reporting decision is among the

most difficult and ambiguous audit tasks (Chow et. al. 1987, 129; Carmichael and Pany

1993, 49). Moreover, Salterio and Koonce (1997, 573) find that auditors facing an

ambiguous situation are likely to adopt the clients position. Levitt (2000, 5) argues that

it is in these gray areas where the temptation to see it the way your client does is

subtle, yet real.

The difficulty and ambiguity in the going-concern reporting decision may render

the auditor susceptible to management pressure. An independent audit committee could

help mitigate such pressure by supporting the auditor in disputes with management

(Parker 2000). That is, we expect that an audit committee independent of management is

more likely to mitigate any management pressure on auditors to issue a clean opinion

when a going-concern report is warranted (McMullen 1996). More specifically, we

expect that the greater the percentage of affiliated directors on the audit committee, the

lower the likelihood of going-concern reports for financially distressed companies.

III. RESEARCH DESIGN

We test the relation between audit committee composition and auditor reporting

using the following logistic regression model:

REPORT = b0 + b1 AFFILIATED + b2 DEFAULT + b3 PRIOROPN + b4 SIZE +

b5 ZFC + b6 DEVELOP + (1)

The variables are defined as follows:


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REPORT. The type of audit report issued on the entitys 1994 financial

statements (1 = going-concern-modified, 0 = unmodified or modified for a consistency

exception).

AFFILIATED. The percentage of audit committee members classified as affiliated

directors. We expect a negative relation between the percentage of affiliated directors on

the audit committee and the receipt of a going-concern report.

In addition to the independent variable of interest, we control for the effects of

other factors that are likely to affect the auditors propensity to issue a going-concern

report: debt default status, prior audit report, company size, level of financial distress,

and whether the company is classified as a development stage company.

DEFAULT. Chen and Church (1992) find that debt default increases the

likelihood the auditor will issue a going-concern report.2 Chen and Church (1992, 31)

argue that difficulty in complying with debt agreements, evidenced by missed payments

or covenant violations, clarify the companys going-concern problems. Since the auditor is

more likely to be blamed for failing to issue a going-concern report after events suggesting

that such an opinion may have been appropriate, the cost of failing to issue a going-

concern report when a company is in default is particularly high. We therefore expect

default to increase the likelihood the auditor will issue a going-concern report. We use a

dummy variable to measure whether the entity is in default before the issuance of the

audit report (1 = debt default, 0 = other).3

PRIOROPN. Mutchlers (1985, 675) interviews with practicing auditors suggest

that companies receiving a going-concern opinion in the prior year are more likely to


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receive the same opinion in the current year. Nogler (1995, 62) finds that after auditors

have issued a going-concern opinion a company must show significant financial

improvement to receive a clean opinion in a subsequent year. We expect a going-concern

report in the prior year to increase the auditors propensity to issue another going-

concern report in the current year. We use a dummy variable to measure whether the

entity received a going-concern report in the preceding year (1 = prior year going-concern

report, 0 = other).

SIZE. Prior studies find a negative relation between client size and going-concern

reports (e.g., Carcello et al. 1995; McKeown et al. 1991; Mutchler et al. 1997). Large

companies may be less likely to fail (Carcello et al. 1995, 136), and auditors may hesitate

to issue a going-concern report to a large client due to a concern about losing the

significant fees that large clients generate (McKeown et al. 1991, 11). We measure size as

the natural log of total sales (in thousands of dollars),4 and we expect a negative relation

between client size and receipt of a going-concern report.

ZFC. Prior studies find that the greater the clients financial distress, the greater

the probability of receiving a going-concern report (e.g., Carcello et al. 1995; McKeown et

al. 1991; Mutchler et al. 1997). We measure financial distress using Zmijewskis financial

condition score (ZFC). Specifically, we use Zmijewskis (1984) financial distress

prediction model based on: return on assets, financial leverage, and liquidity, and the

PROBIT coefficients from his 40 bankrupt / 800 non-bankrupt estimation sample. Higher

ZFC scores indicate greater financial distress, so we expect a positive relation between

ZFC and the receipt of a going-concern report. 5


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DEVELOP. Although we control for the clients financial condition (via ZFC

score), Rosman et al. (1999, 39) conclude that financial information may not truly

reflect current activities and may not be predictive of a start-up companys going-concern

status. Given the start-up nature of development stage entities, their financial statements

may indicate some degree of distress. The auditor is likely to view the financial distress

of a development stage entity as a function of the companys stage in its life cycle rather

than as an indication of impending failure. Therefore, after controlling for financial distress

level, we expect that development stage entities will be less likely to receive going-concern

reports than established entities.6 We identify development stage entities by examining

financial statement headings. PerStatement of Financial Accounting Standards No. 7

(FASB 1975), a development stage entity must be clearly identified as such in its financial

statement headings.

IV. SAMPLE SELECTION AND DATA

We use the Compact D/SECdatabase toidentify a sample of public companies

experiencing financial distress during 1994 (financial institutions are excluded).7 We focus

on distressed companies since prior research indicates that auditors virtually never issue

going-concern reports to companies that are not financially distressed (McKeown et al.

1991).8 However, because auditors reporting discretion declines when a company has

filed for bankruptcy, we exclude companies that filed for bankruptcy before the issuance

of the 1994 audit report (n = 14).9

Our sample includes only companies whose level of financial distress is high

enough to prompt auditors to question the entitys going-concern status. Prior research


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indicates that auditors are more likely to issue a going-concern report when the

probability of failure (calculated from Zmijewskis (1984) financial distress prediction

model) exceeds 28 percent (Davis and Ashton 2000; Krishnan and Krishnan 1996).10

Thus, our sample includes publicly held non-financial companies with a probability of

failure above 0.28 (based on 1994 financial data) that had not filed for bankruptcy before

the audit report, provided that appropriate proxy and financial statement data are

available from the Q-Data SEC files.

Table 1 presents the details of our sample selection procedure. Of the 383

companies in our initial sample, almost one-third (117) did not maintain an audit

committee and so are excluded from further analysis. Eleven companies are excluded

because they were subsidiaries of other sample companies. Since client size (measured in

sales) is a control variable, we excluded entities that did not report any sales (n = 10). We

excluded seven companies that received a modified report for non-going-concern

uncertainties and fifteen companies for miscellaneous other reasons [the prior audit

opinion was not available (n = 6); foreign companies (n = 4); outliers (n = 3);11 and no

audit opinion was issued in 1994 (n = 2)]. Our final sample includes 223 companies.

____________________

Insert Table 1 about here

____________________

To compute the percentage of affiliated directors, we read the following sections

of the proxy statements: (1) biographical background of directors and officers, and (2)

certain relationships and related transactions. Companies are required to disclose the


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backgrounds of their directors, including affiliations between the company and the

director, in these sections of the proxy statement. Reg. 229.401 of SEC Regulation S-K

requires board nominees and directors to disclose family relationships, prior business

experience (used to determine if a director was a former officer), and other directorships

held (used to determine the existence of an interlocking directorate). In addition, Reg.

229.404 requires disclosure of nominees or directors who have been a member of, or

counsel to, law firms the registrant retained during the past year. Also, companies must

disclose nominees or directors who are executive officers of suppliers (customers) of the

registrant, if the amount of goods or services purchased (sold) exceeds five percent of

either partys consolidated gross revenues.

V. RESULTS

Descriptive Statistics

Table 2 presents descriptive statistics, by audit report type, for each of the

studys independent variables. Since we later split the percentage of affiliated directors on

the audit committee into two components (the percentage of inside directors and the

percentage of gray directors), Table 2 also includes descriptive statistics on the percentage

of inside directors and gray directors on the audit committee. Inside directors are current

officers or employees of the company or of a related entity. Gray directors include former

officers or employees of the company or of a related entity, relatives of management,

professional advisors to the company (e.g., consultants, bank officers, legal counsel),

officers of significant suppliers or customers of the company, and interlocking directors.


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Approximately 37 percent (83 out of 223) of the sample companies received a

going-concern report. As expected, companies that receive going-concern reports have on

average a smaller percentage of affiliated directors on the audit committee (p < 0.01). For

entities receiving a going-concern report, only 19 percent of audit committee members are

affiliated directors. By contrast, almost 40 percent of audit committee members are

affiliated directors for entities receiving an unmodified report.

Evidence on the relation between the percentage of inside directors on the audit

committee and the type of audit report (going-concern or clean) is mixed: parametric t-

tests are insignificant, but the Wilcoxon rank sum test is marginally significant (p < 0.10).

However, both tests indicate that companies receiving going-concern reports have on

average a smaller percentage of gray directors on the audit committee (p < 0.01).

As expected, companies that receive a going-concern report are more likely to be

distressed (measured by default status, prior audit report, and ZFC index) and smaller (p

< 0.01). There is no significant negative relation between receipt of a going-concern report

and development stage.

____________________


____________________

Although not reported in a table, we also examine audit committee size and

composition for going-concern and unmodified report recipients. Sixty-four percent of the

companies receiving a going-concern report have audit committees consisting solely of

independent directors, but only 31 percent of the companies receiving an unmodified


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report have fully independent audit committees. There are no noticeable differences in

audit committee size between companies receiving going-concern or unmodified reports.

Table 3 presents the correlations among the independent variables. The

correlations are quite low, generally below 0.3, except for AFFILIATED, INSIDE, and

GRAY, which are correlated by construction. As expected, larger firms are less likely to

receive prior going-concern audit reports and are less likely to be in development stage.

____________________


____________________

Primary Tests

Table 4 presents the results of the logistic regression model used to test the

relation between audit committee composition and auditor reporting behavior.12 The

overall model is highly significant (p < 0.0001), and the models pseudo-R2 is 51 percent.

As predicted, the greater the percentage of affiliated directors on the audit committee, the

less likely the auditor is to issue a going-concern audit report (p < 0.01).13

The relations between going-concern reports and the control variables are

consistent with prior studies. The likelihood of a going-concern report increases with debt

default (p < 0.01), a going-concern report in the prior year (p < 0.01), and financial

distress level (p < 0.05). The likelihood of a going-concern report declines with company

size (p < 0.01), and development stage status (p < 0.01).

____________________



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____________________

Sensitivity Analyses

Our main model (table 4), controls for key variables where prior literature has

documented a relation between the variable and the incidence of going-concern reports.

We also performed sensitivity tests controlling for other company and audit firm

characteristics that, although not explicitly documented in prior literature, mightbe

correlated with both audit committee composition and the incidence of going-concern

reports.

Client Industry

There may be a relation between industry and both audit committee composition

and the incidence of going-concern reports. Since our sample includes companies from all

non-financial industry groups, we control for industry by adding 2-digit SIC code dummy

variables to the model presented in table 4. In general, the industry dummy variables are

not significant (p > 0.10),14 but we continue to find that the greater the percentage of

affiliated directors on the audit committee, the lower the probability of receiving a going-

concern report (p < 0.01).

Stock Exchange

Since various stock exchanges have differing requirements regarding audit

committee composition, there may be a relation between stock exchange and the

percentage of affiliated directors on audit committees. The NYSE proscribes company

management or employees (a subset of affiliated directors) from serving on the audit

committee. NASDAQs National Market System proscribes members of company


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management or employees from constituting a majority of the audit committee. The

requirements as to audit committee composition for companies traded via AMEX,

NASDAQs Small Capitalization market, or over-the-counter were either less stringent or

non-existent.

We add separate dummy variables to identify companies traded on the NYSE (1 =

NYSE-listed company, 0 = other) or traded via NASDAQs National Market System (1

= NASDAQ National Market, 0 = other) to the model presented in table 4. Neither the

NYSE nor the NASDAQ dummy variable is significant (p > 0.10), but we continue to

find that the greater the percentage of affiliated directors on the audit committee, the

lower the probability of receiving a going-concern report (p < 0.01).

Size of Audit Committee

Beasley (1996) finds that the likelihood of fraudulent financial reporting increases

with board size. Beasleys result suggests that smaller audit committees may be more

effective than larger committees. If smaller committees are more effective, audit committee

size might be associated with a higher incidence of going-concern reports for financially

distressed companies.

We add audit committee size to the model presented in table 4. While audit

committee size is not significant (p > 0.10), all our other inferences are unaffected.

Audit Firm Type

Prior research concludes that Big 6 (8) auditors provide higher quality audit

service (e.g., DeAngelo 1981; Palmrose 1988). Mutchler et al. (1997, 303) find univariate

evidence that Big 6 auditors are more likely than non-Big 6 auditors to issue going-concern


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reports to companies experiencing financial distress. Audit committee composition could

also affect the type of audit firm selected.

We add audit firm type (1 = Big 6 auditor, 0 = other) to the model presented in

table 4. Audit firm type is not significant (p > 0.10), but all our other inferences are

unaffected.

Audit Firm Industry Specialization

Large audit firms, in particular, increasingly emphasize industry specialization in

their audit practices (Hogan and Jeter 1999). If industry specialists provide higher quality

audits, specialists may be more likely to issue going-concern reports to companies

experiencing financial distress. In addition, if independent audit committees are more

concerned about audit quality, they may also be more likely to select an industry

specialist auditor.

We add to the model presented in table 4 audit firm industry specialization

measured as a continuous variable: the percentage of industry sales audited by that

accounting firm relative to the total industry sales in that same industry. Audit firm

industry specialization is not significant (p > 0.10), but we continue to find that the

greater the percentage of affiliated directors on the audit committee, the lower the

probability of receiving a going-concern report (p < 0.01).15

Audit Firm Tenure

Auditors who have long served a particular client may establish close relationships

with management that impair the auditors professional skepticism. A less independent


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audit committee may also be less likely to challenge or replace an audit firm for

diminished professional skepticism.

We add audit firm tenure (the number of consecutive years that the accounting

firm has served as the companys auditor) to the model presented in table 4.16 The

variable measuring audit firm tenure is not significant (p > 0.10), but we continue to find

that the greater the percentage of affiliated directors on the audit committee, the lower the

probability of receiving a going-concern report (p < 0.01).

Additional Analyses

Partitioning Affiliated Directors into Inside and Gray

Prior literature often distinguishes between insiders and gray affiliated directors

(e.g., Vicknair et al. 1993; Wright 1996). To this point, we have treated affiliated directors

as a single class, consistent with regulators current concern that neither inside directors

nor gray directors are independent of management. As additional analyses, we consider

the relation between auditor reporting behavior and the percentage of: (1) inside directors,

and (2) gray directors.

The NYSE has historically proscribed insiders from serving on audit committees,

and both the AMEX and NASDAQ have had similar, albeit weaker, requirements. Until

recently, none prohibited gray directors from serving on audit committees. However, the

major securities exchanges recently adopted the BRC (1999) recommendations that

generally proscribe gray directors from serving on audit committees. Therefore, regulators

currently view gray directors more like insiders than independent directors. Evidence on

the relation between auditor reporting and inside vis-a-vis gray directors may yield insight


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into whether gray directors are more like independent directors (consistent with previous

stock exchange treatment of gray directors) or more like insiders (consistent with the

BRCs recent recommendations).

Table 5 presents the results of our original model except that the percentage of

affiliated directors on the audit committee is split into two components: the percentage of

inside directors (INSIDE), and the percentage of gray directors (GRAY). As expected,

there is a significant negative relation between the percentage of inside directors on the

audit committee and the receipt of a going-concern report (p < 0.01). Table 5 also reveals

a significant negative relation between the percentage of gray directors and the receipt of a

going-concern report (p < 0.01), consistent with regulators concern that led the BRC to

recommend that all audit committee members be completely independent of management.

____________________


____________________

Interaction between Default Status and Affiliated Directors

The composition of the audit committee should be less important when there is

less ambiguity, less need for judgment, and so the going-concern decision is more

obvious.17 The more justification for issuing a going-concern report: (1) the less likely

management pressure can sway the auditor (i.e., the auditor has less need for the

independent audit committees support), and (2) the less likely affiliated directors are to

side with management.


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Prior literature suggests that default on debt is such an important predictor of

whether an auditor issues a going-concern report (e.g., Carcello et al. 1995; Chen and

Church 1992), that we expect audit committee composition to have less effect on the

auditors report if the company is already in default. To test this conjecture, we run the

model presented in table 4 after adding an interaction term between debt default status

and the percentage of affiliated directors on the audit committee. Since we expect affiliated

directors to have less influence when the company is in default, we expect a positive

relation between the interaction term and the incidence of going-concern reports.

Consistent with our conjecture that audit committee composition becomes less

important when the appropriateness of a going-concern report is more evident, we find

that the issuance of a going-concern report is positively associated with the interaction of

default status and the percentage of affiliated directors (p < 0.05). We also continue to

find that the greater the percentage of affiliated directors on the audit committee, the

lower the probability of receiving a going-concern report (p < 0.01).18

VI. SUMMARY, IMPLICATIONS, AND LIMITATIONS

This study presents evidence on the relation between a corporate governance

mechanism (audit committee composition) and auditor going-concern reporting behavior.

We find that the greater the percentage of affiliated directors on the audit committee, the

lower the likelihood of receiving a going-concern report.

Like all research, our study is subject to limitations. Although our results are

consistent with the audit committee affecting the audit reporting process, we document

association, not causation. While we run numerous sensitivity tests controlling for other


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variables that may be correlated with both audit committee composition and auditor

reporting behavior, we may not have successfully identified all potential correlated

omitted variables.

Notwithstanding these limitations, our results add to the growing body of

literature that documents the importance of various corporate governance mechanisms in

the financial reporting process (e.g., Beasley 1996). Our evidence supports regulators

concern that the audit committee should consist entirely of independent, outside

directors. Our results also add to the literature that documents adverse effects of certain

client characteristics on auditor reporting behavior. Specifically, our results suggest that

auditors are less likely to modify the reports of distressed companies that have a greater

percentage of affiliated directors on their audit committees.


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TABLE 2Descriptive Statistics

Mean (Median) [Standard Deviation]

Going-Concern CleanReport Report Difference

Variablea

(n = 83) (n = 140) (GC - Clean)b

AFFILIATED 0.19 0.39 -0.20 ***

(0.00) (0.33) (-0.33) ***[0.27] [0.33]

INSIDE 0.08 0.10 -0.02

(0.00) (0.00) (0.00) * c

[0.19] [0.20]

GRAY 0.11 0.29 -0.18 ***(0.00) (0.25) (-0.25) ***[0.20] [0.32]

DEFAULT 0.40 0.06 0.34 ***

(0.00) (0.00) (0.00) *** c

[0.49] [0.25]

PRIOROPN 0.61 0.09 0.52 ***(1.00) (0.00) (1.00) ***[0.49] [0.28]

SIZE 29.53 533.14 -503.61 ***(3.56) (54.94) (-51.38) ***

[70.93] [2,103.25]

ZFC 4.27 1.17 3.10 ***(2.09) (0.49) (1.60) ***[7.51] [2.11]

DEVELOP 0.13 0.05 0.08

(0.00) (0.00) (0.00)[0.34] [0.22]

* and *** indicate significance at p < 0.10 and p < 0.01, respectively, based on one-tailed tests.a Variable definitions:

AFFILIATED = percentage of affiliated directors on the audit committee. Affiliated directorsinclude both inside and gray directors as defined below.

INSIDE = percentage of inside directors on the audit committee. Inside directors includecurrent employees of the company or of a related party.

GRAY = percentage of gray directors on the audit committee. Gray directors include formeremployees of the company, relatives of management, and directors with other

business relationships.DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0.

PRIOROPN = 1 if going-concern-modified report in prior year, else 0.

SIZE = total sales (in millions of dollars).ZFC = Zmijewskis (1984) financial condition index.

DEVELOP = 1 if firm is a development stage company, else 0.b Tests for differences in the means are based on t-statistics (z-statistics) for continuous variables

(proportions). Nonparametric tests for differences in location are based on the Wilcoxon rank sum test.c The Wilcoxon rank sum test does not test whether the medians for the two groups are different. Instead,

the test identifies a difference in location, specifically, whether the observations in the two groups arefrom populations with different medians. Thus, the test indicates a significant difference even though themedians for the two groups are the same.


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TABLE 3

Correlations Among Independent Variables a,b

INSIDE GRAY DEFAULT PRIOROPN SIZE

ZFC DEVELOP

AFFILIATED 0.45*** 0.80*** -0.11 -0.15** 0.14** -0.09 -0.11*

INSIDE -0.16** 0.06 -0.02 0.02 0.01 -0.08

GRAY -0.16** -0.18*** 0.14** -0.11* -0.07

DEFAULT 0.26*** 0.00 0.16** -0.02

PRIOROPN -0.37*** 0.28*** 0.25***

SIZE -0.27*** -0.42***

ZFC 0.12*

*, **, and *** indicate significance at p < 0.10, p < 0.05, and p < 0.01, respectively.a We report Spearman-rank correlation coefficients for discrete variables (DEFAULT, PRIOROPN,

DEVELOP) and Pearson correlations otherwise.b Variable definitions:AFFILIATED = percentage of affiliated directors on the audit committee.

INSIDE = percentage of inside directors on the audit committee.GRAY = percentage of gray directors on the audit committee.

DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0.PRIOROPN = 1 if going-concern-modified report in prior year, else 0.

SIZE = natural log of sales (in thousands).ZFC = Zmijewskis (1984) financial condition index.

DEVELOP = 1 if firm is a development stage company, else 0.


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TABLE 4Logistic Regression of Going-Concern Modified Reports on the

Percentage of Affiliated Directors and Control Variables

REPORT = b0 + b1 AFFILIATED + b2 DEFAULT + b3 PRIOROPN + b4 SIZE + b5 ZFC +

b6DEVELOP +

Predicted Estimated Standard Wald

Variable a Relation Coefficients Errors Chi-Square

INTERCEPT none 4.458 1.231 13.119***

AFFILIATED - -3.040 0.789 14.825***

DEFAULT + 2.920 0.612 22.743***

PRIOROPN + 2.447 0.500 23.970***

SIZE - -0.601 0.131 21.185***

ZFC + 0.138 0.081 2.949**

DEVELOP - -1.836 0.767 5.733***

Number of Observations 223Chi-Square for Model

(6 degrees of freedom) 150.857p-value 0.0001

Pseudo R2 = 0.51Concordant Pairs 93.0%

** and *** indicate significance at p < 0.05 and p < 0.01, respectively, based on one-tailed tests.a Variable definitions:

AFFILIATED = percentage of affiliated directors on the audit committee.DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0.

PRIOROPN = 1 if going-concern-modified report in prior year, else 0.




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TABLE 5Logistic Regression of Going-Concern Modified Reports on thePercentage of Inside and Gray Directors and Control Variables

REPORT = b0 + b1 INSIDE + b2 GRAY + b3 DEFAULT + b4 PRIOROPN + b5 SIZE +

b6ZFC + b7DEVELOP +

Predicted Estimated Standard Wald

Variable a Relation Coefficients Errors Chi-Square

INTERCEPT none 4.469 1.234 13.124***

INSIDE - -2.899 1.196 5.879***

GRAY - -3.121 0.952 10.756***

DEFAULT + 2.913 0.613 22.598***

PRIOROPN + 2.447 0.500 23.957***

SIZE - -0.602 0.131 21.178***

ZFC + 0.137 0.081 2.840**

DEVELOP - -1.832 0.767 5.705***

Number of Observations 223Chi-Square for Model

(7 degrees of freedom) 150.880p-value 0.0001

Pseudo R2 = 0.51Concordant Pairs 93.0%

** and *** indicate significance at p < 0.05 and p < 0.01, respectively, based on one-tailed tests.a Variable definitions:

INSIDE = percentage of inside directors on the audit committee.GRAY = percentage of gray directors on the audit committee.

DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0.PRIOROPN = 1 if going-concern-modified report in prior year, else 0.




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ENDNOTES

1 Our definition of an affiliated director is consistent with prior studies (e.g., Beasley

1996; Vicknair et al. 1993; Wright 1996).

2 By adding default status to a going-concern prediction model that contained only

financial variables, Chen and Churchs (1992) achieved R2 increased from 38 percent to 93

percent.

3 Consistent with Chen and Church (1992, 35), we classify as in default a company that:

(1) has missed principal or interest payments, (2) has violated debt covenants, if the

covenant violation is not waived or if it is waived for a period of less than one year, or (3)

is in the process of restructuring debt.

4 Measuring client size using the natural log of total assets does not affect any of our

inferences, except that the DEVELOP variable is no longer significant (p > 0.10).

5 Prior research has used Zmijewskis (1984) weighted probit model to measure financial

distress (e.g., Bamber et al. 1993; Carcello et al. 1995).

6 Given the limited evidence of a relation between development stage status and going-

concern reports, we repeated the analysis excluding the development stage variable. Our

inferences are unaffected.

7 We exclude financial institutions (6000 SIC codes) because most financial distress

prediction models (including ZFC) are not designed to predict distress for financial

entities.


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8 None of the 96 nonstressed companies (16 of which subsequently filed for bankruptcy)

in McKeown et al. (1991, 7) received a going-concern report.

9

All 14 of these companies received a going-concern report.

10 We tested the sensitivity of our results to various cutoff probabilities (number of

observations): 0.35 (201), 0.50 (165), 0.60 (149), 0.70 (132), 0.80 (115), and 0.90 (92).

Our results are robust to the level of financial distress employed since we continue to find

that the greater the percentage of affiliated directors on the audit committee, the lower the

probability of receiving a going-concern report (p < 0.01).

11 We deleted three outliers with studentized residuals greater than 3.0 in absolute value.

If we include these outliers, we continue to find that the greater the percentage of

affiliated directors on the audit committee, the lower the probability of receiving a going-

concern report (p < 0.01).

12 Many of our variables, including AFFILIATED, are right-skewed. Although logistic

regression is robust to non-normality (Maddala 1983; Stone and Rasp 1991), we use an

approach similar to Chen and Church (1992, 38), by truncating observations such that the

skewness of the distribution is not greater than three. The only variable affected is ZFC.

Our inferences are unaffected by truncating (three) extreme values of ZFC (p < 0.01).

13 We also measure the independence of the audit committee using two alternative

dichotomous variables. Using the BRCs (1999) definition, we code the audit committee

as non-independent (1 = non-independent, 0 = independent) if at least one member of the

committee is an affiliated director. Using a much less conservative definition of audit


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committee independence, we code the audit committee as non-independent only if a

majority of audit committee members are affiliated directors. As expected, we find that

auditors are less likely to issue going-concern reports when the audit committee is non-

independent (p < 0.01 for both alternative definitions).

14 Companies in the following SIC codes are marginally more likely to receive going-

concern reports: SIC code 35 (industrial and commercial machinery; computer

equipment); SIC code 37 (transportation equipment); and SIC code 87 (engineering,

accounting, research, management, and public relations services) (p < 0.10).

15 We also measure audit-firm industry specialization using two dichotomous measures

(Palmrose 1986). We define a firm as an industry specialist if it audits 15 (or 20) percent

or more of total industry sales in a particular industry. Neither dichotomous measure of

industry specialization is significant, and all our other inferences are unaffected.

16 This sensitivity test is limited to companies that disclosed the length of auditor tenure

in the proxy statement (n = 111).

17 We are indebted to an anonymous referee for suggesting this reasoning.

18 We also examine the interaction between ZFC and the percentage of affiliated directors.

While the interaction is not significant (p > 0.10), we continue to find that the greater the

percentage of affiliated directors on the audit committee, the lower the probability of

receiving a going-concern report (p < 0.01). The interaction terms lack of significance

may reflect that auditors are reasonably likely to issue an unmodified report even for

companies experiencing high levels of distress. For example, of those companies with a


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Documents

Carcello, J.v. and T. L. Neal