The Auditor's Going Concern Decision

Journal of Accounting and Public Policy 23 (2004) 415–440

www.elsevier.com/locate/jaccpubpol

The auditor�s going concern decisionand Types I and II errors: The

Coase Theorem, transaction costs,bargaining power and attempts to mislead

Paul Barnes *

Nottingham Business School, Burton Street, Nottingham NG1 4BU, UK

Abstract

It is shown that, in the absence of transaction costs and in line with the Coase The-

orem, the going concern decision is efficient in the sense that bias arising from either

Type I or II errors is not expected. However, when transaction costs in the form of legal

costs, are introduced, bias is expected. The direction of the error depends upon the audi-

tor�s relative bargaining power. It is also shown that its relative bargaining power pro-

vides an incentive for the client company to mislead. Finally, certain empirical

observations pertinent to this analysis are discussed together with the regulatory

implications.

� 2004 Elsevier Inc. All rights reserved.

Keywords: Audit; Going concern; Bargaining power; Misinformation

0278-4254/$ - see front matter � 2004 Elsevier Inc. All rights reserved.

doi:10.1016/j.jaccpubpol.2004.10.003

* Tel.: +44 115 848 2824; fax: +44 115 848 6175.

E-mail address: [email protected]

mailto:[email protected]

416 P. Barnes / Journal of Accounting and Public Policy 23 (2004) 415–440

1. Introduction

An investor needs to know whether a company in which he is interested is in

immanent danger of failure. The easiest way to do this is to examine the audit

report and whether in the auditor�s opinion there is substantial doubt about the

company�s �ability to continue as a going concern for a reasonable period oftime� (SAS # 59). As the auditor is a trained professional with inside informa-

tion into the commercial future of his client, the investor should be confident in

the inferences he makes from the auditor�s report. Normally, the report would

be unqualified but contain a paragraph expressing such uncertainty. Also, if the

auditor concludes that the financial statements inadequately indicate the com-

pany�s inability to continue, the auditor should express either a qualified or ad-

verse opinion in his report. A similar requirement and set of procedures exist in

the UK. See ICAEW (1994). It will probably matter little to the investor as towhat form such a conclusion may take in the auditor�s report and for the

remainder of this paper the term �adverse report� will be used to cover them all.

The going concern decision has been the focus of a considerable amount of

academic research over many years, primarily because it is an excellent example

in which its independence may be tested. See Antle (1984), Asare (1990), Bartlett

(1997), Chow and Rice (1982), Johnson et al. (1989), Jones (1996), Kida (1980),

Knapp (1985), Krishnan and Stevens (1995), Lavin (1976), Lee and Stone

(1995) and Pearson (1987) which are just a few paper to appear in academicjournals. More recently, the decision may be seen to involve even greater stakes,

given the concerns, particularly in the USA, about limited liability and the pro-

vision by audit firms of non-audit consultancy services (Davis et al., 1993).

Early research on the going concern decision focussed on audit quality involv-

ing (a) the possibility of incompetence (due to a lack of practical appreciation

and understanding of the industry in which the client company operates) and

(b) lack of independence (due to economic considerations, such as audit switch-

ing, affecting the audit firm that may arise from an adverse report). Researchstrongly supports the hypothesis that auditors are competent at making the

going concern decision (the competence hypothesis). However sometimes, they

do not issue an adverse report when they should, perhaps because of the fear

of loss of the audit and the financial consequences to the audit firm (the indepen-

dence hypothesis). For evidence to support both the competence and indepen-

dence hypotheses see Mutchler (1984, 1985), Campisi and Trotman (1985),

Menon and Schwartz (1987), Barnes and Huan (1993), Krishnan and Krishnan

(1996), Matsumura et al. (1997) and Lennox (1999a) but for evidence to reject theindependence hypothesis, see Louwers (1998). The relationship between the size

of the auditing firm and independence has also been raised as well as the in-

creased difficulty the auditor faces in maintaining his objectivity in the face of

the potential loss of a large client paying substantial audit and consultancy fees,

i.e. there is greater economic dependence (DeAngello, 1981c; McKeown et al.,

P. Barnes / Journal of Accounting and Public Policy 23 (2004) 415–440 417

1991; Carcello et al., 2000; Lennox, 1999b). 1 More recent studies have recogni-

sed the importance to the audit firm of its reputation and the importance of audi-

tor independence as a means of protecting it. See DeFond et al. (2002) who also

cite a large body of research that shows it is in the auditor�s interest to remain

independent. 2 Further, Reynolds and Francis (2000) show how very large audit

firms may act conservatively for larger clients (for example, by making an ad-verse report), suggesting that reputation–protection and fear of litigation dom-

inate audit considerations. But, of course, all these studies were prior to Enron.

The Reynolds and Francis (2000) findings also contrast with other empirical

evidence, particularly in the UK, which indicate that

(A) In a number of major firm collapses (for example the Robert Maxwell

Group and Mirror Group Newspapers) the auditors had not made an

adverse report (Type II errors), suggesting that for, perhaps economic rea-sons other than reputation effects, they were reluctant to do so. 3 Of

course, all these examples are surpassed by the Enron case. 4

(B) In many cases where an adverse report was made, the client companies did

not fail (Type I errors). See Peel (1989), Citron and Taffler (1992), Barnes

and Huan (1993) and Lennox (1999a) for UK evidence. What is also

remarkable is that there are no cases of the surviving firms suing their

auditors for damages arising from the adverse report. 5

1 The comment by DeAngello (1981c), although old, is typical: ‘‘consumers view auditors with

established reputations as having �more to lose� from misrepresentation’’. Therefore, we expect

auditor reputation to be positively associated with the size of the audit firm. Empirically, this has

been shown to affect its going concern decision (Krishnan and Krishnan, 1996).2 The reader is also referred to Chaney and Philipich (2002) who show by means of an event

study how the Enron scandal affected the credibility of the annual reports of other Andersen clients,

providing an interesting case study of the impact and fragility of auditor reputation.3 For a discussion of these and some evidence concerning audit quality in which large audit firms

are perceived to have a higher reputation for better quality audits see Lennox (1999b). Some of the

audit firms involved in these company failures subsequently suffered considerably.4 Although the principal auditing and accounting issues in the Enron case related to departures

from GAAP, there was no adverse report. Probably the most useful early summary of the issues

involved is Benston and Hartgraves (2002).5 The best evidence for this is an M.A. dissertation supervised by the author (Kandasamy,

1998). This shows that after a considerable search of UK accountancy and law magazines and

reports, discussions with practitioners etc., not a single case could be found.

There are many possible reasons for this: as these companies survived, there may have been

little demonstrable damage suffered; the low priority of suing for negligence when the company is

continuing, e.g. the opportunity costs involved; and, of course, the possibility of the company still

being in danger of failing. It should also be remembered that the companies suffering are also,

almost by definition, short of funds to mount a legal action and are, of course, relatively small.

Nevertheless, there is a likelihood of such an action which has a real cost to the auditor which needs

to be taken into account. In the US, the UK and many other countries, often legal actions do not

come to Court but are settled outside. Given the reasons for the difficulties of bringing the case to

Court mentioned here, it is very likely that they would be settled in this way.


It is the purpose of this paper to examine the inter-relationships of these and

their effects. It is arranged as follows. First, these costs will be examined in the

context of a simple rational economic decision-making model excluding trans-

action costs. It is shown how the Coase Theorem applies if �efficiency� is ex-tended to include the effects of unbiased information. That is, in the absence

of transaction costs, the going concern decision is unlikely to be biased. Trans-

action costs are then introduced in the form of legal costs. It is shown that

either a Type I or II error may occur, simply depending upon the bargaining

power of the auditor/client. The paper then moves on to consider the situation

where there is information asymmetry offering scope for the client company to

mislead and the auditor�s skills in handling this are a factor. This is followed by

a short discussion of the conclusions and their regulatory implications.The approach of this paper is along similar lines to that originally developed

by Antle (1984) who examined auditors� incentives and possible actions using a

rational economic model. It also follows (although it does not focus on auditor

effort levels and extended procedures) Antle and Nalebuff (1991), Krishnan and

Krishnan (1996), Boritz and Zhang (1999) and Lennox (1999a) by examining

the risk of Types I and II errors and the economic trade-offs by placing the

auditor�s decision in a bargaining model. Its origins are a paper by Zhang

(1999) who used a bargaining model to examine the effects of auditor and clientincentives. He showed that an auditor�s independence will be preserved if the

firm-specific quasi-rents from an audit (the value arising from the difference be-

tween expected audit fees and costs in future engagements with the client) are

zero. It is compromised if they are positive. Unfortunately, Zhang (1999) did

not examine the possibility of the client company providing misleading infor-

mation and the effect that this may have.

For this we may use the insights provided by Coase (1960). Coase showed

that, in the absence of transaction costs, the parties to an economic transactionwill continue to negotiate until there is a Pareto efficient outcome as there is no

incentive to bargain further. He showed that inefficiency can arise either

through explicit transaction costs or imperfect information about the gains

from bargaining. The critical assumption, therefore, is that bargaining costs

are zero and information is perfect. 6 Saraydar (1983) has shown that where

information is not perfect and there is asymmetry of information, then there

is an incentive for participants to provide misleading information (or as Saray-

dar calls it �dissimulation�).

6 Coase stresses the importance of transaction costs for explaining real world phenomena. In the

presence of transaction costs, agents will cease bargaining if these costs exceed efficiency gains:

�Such a rearrangement of rights will only be undertaken when the increase in the value of

production consequent upon the rearrangement is greater than the costs which would be involved

in bringing it about . . .In these conditions the initial delimitation of legal rights does not have an

effect on the efficiency with which the economic system works�.


Bargaining power has been examined in the context of private information

(for a review see Kennan and Wilson, 1993; Aumann and Heifetz, 2002)

although the theoretical relationship between bargaining power and dissimula-

tion has not been extended. 7 The Saraydar proposition has been applied in the

study of business mergers and the determination of the terms of a bid. (The

information disclosed at the time of a bid is likely to affect negotiations be-tween the directors of the companies involved, the determination of the final

offer price and its outcome, Barnes et al., 1990). 8 It has also been examined

empirically as an explanation of the hubris hypothesis and why bidding com-

panies typically overpay (Barnes, 1998).

In any game model, the outcome is affected by the procedures involved

(Kennan and Wilson, 1993, emphasize this point). Here the bargaining model

is defined so as to reflect the institutional setting of auditing and follows Zhang

(1999). The bargaining process is as follows. During negotiations, both theauditor and the client can propose the content of the financial statements. If

they agree, the auditor will issue a clean report. If they do not, either the client

can report what the auditor requires, in which case there will be a clean audit

report, or the client reports what he wants, in which case, there will be an ad-

verse audit report. 9 The only other institutional assumptions to be made are

that if the audit firm and client company disagree to such an extent as to threa-

ten an adverse report, they will attempt to negotiate with one another, either

implicitly or explicitly, in an attempt to resolve the matter. It is also assumedthat, whilst there may be no immediate limit to the length of the negotiating

process, the period is finite and within the constraints imposed by law on the

period within which the financial statements and an auditor�s report must be

7 Research on bargaining with private information usually involves a price of a good or service

and not, as here, a �yes–no� decision. Emphasis has not been on dissimulation or misinformation

but on signaling and how best (or how most advantageously) to communicate private information.

The typical context (certainly the area of most empirical research) is in the area of wage negotiation

where, for example, an employer knows more about the value of labor�s product than do the

workers and its acceptance of a strike may be seen as a way in which this may be communicated

(Kennan, 2001).

A model applying roughly similar principles and arguments to that of Saraydar (1983) is Farmer

and Pecorino (2003).

A more prescriptive and applied approach to procedures, strategies and tactics has emerged and

is known as ‘‘negotiation analysis’’. It de-emphasizes the game-theoretic approach and incorporates

the findings of behavioral scientists and economists. For a useful survey as it relates to management

see Sebenius (1992).8 This is an area ripe for the application of game theory and some of the most famous scholars

of economic game theory have applied their skills to it; for instance, Grossman and Hart (1980).9 It is interesting that Zhang notes after a disagreement, the client may impose a penalty on the

auditor by changing the auditor�s working conditions or terms of engagement or dismissing the

auditor. He cites the evidence provided by Chow and Rice (1982) who identify a positive

association between a firm�s propensity to switch auditors and an adverse opinion in the year before

the switch.


presented to shareholders. This is in line with Saraydar who also adds a con-

dition to those of Coase: that of a finite period for the negotiation process.

The other assumptions used by Coase are negligible: simply, that the parties

are rational, self-interested, and, more crucially, they may negotiate freely.

It is assumed here that, in the same way that other actors negotiate when it is

in their interests to do so, it is axiomatic that the audit firm and the client com-pany will attempt to negotiate the outcome; especially, if they disagree to such

an extent as to threaten an adverse audit report. 10 In fact, it has been recog-

nised that negotiation plays an important part of auditing practice. 11 This pa-

per makes certain other assumptions. Given their competence to make such a

decision and the same data and other information being available to them

(including management�s plan for addressing the problem), a different auditing

firm, if required to act as the client company�s auditor, would come to a similar

conclusion about the probability of the company failing. It is also assumed forsimplicity that the costs and benefits relating to the audit, in particular those

relating to an action for negligence, would be similar for the same audit across

other audit firms. It should be noted, however, that when the concept of bar-

gaining power is introduced later in the paper, this does not mean that all audit

firms will make a similar decision about whether to issue an adverse report. The

assumption relating to the homogeneity of auditors when interpreting data and

deciding on the probability of failure is relaxed towards the end of the paper.

There the possibility of the client intentionally misleading the auditor is intro-duced, together with the concept of audit quality which here relates to the abil-

ity of the auditor to see through these attempts.

2. Economic model excluding transaction costs

Although it is not reported in probabilistic form, the auditor�s going concern

judgement effectively relates to the probability of the firm continuing and theinvestor is correct in attempting to make probabilistic inferences. In only the

most extreme cases can the auditor be absolutely certain. 12 In all other cases

10 Zhang (1999) also does this.11 Negotiation is assumed to play a part in the choice of accounting method. Watts and

Zimmerman (1990) suggest that accounting methods may be classified as an acceptable set and an

unacceptable set. The role of the auditor is to prevent the client company from adopting the

unacceptable set.

For research on the negotiating process in the auditor–client relationship see for example

Demski and Frimor (1999), Gibbins et al. (2001) in Canada who conclude that negotiation is

�normal� in auditor–client relations, and in the UK, Beattie et al. (2001).12 The professional literature provides guidance on what information to use, e.g. management

reports and plans, but it does not say how. This is left to the auditor�s �professional judgment� based

on his experience concerning the client company, the industry and the economy generally.


there must be a cut-off or threshold to represent �reasonable belief�. That is, if

there is an adverse report, the investor may infer that p(D) > p(P)* where p(D)

represents the probability of failure in the judgement of the auditor and p(P)*

represents the probability level threshold above which an auditor is profession-

ally expected to issue an adverse report. Similarly, the investor may infer

p(D) < p(P)*, if there is no adverse report. Unfortunately for the investor,p(P)* is not expressed in probabilistic terms. If he were to consult the auditing

standard he would find it vague and open to different interpretations. Cer-

tainly, he would be unable to infer a probability value from it.

On the other hand, the investor should feel satisfied that the situation is not

completely unregulated. If a firm fails and there had been no adverse report,

the investor could sue the auditor for damages arising from negligence. 13

The basis of the judgement would be the best practice of the auditor�s peers

as determined by the Court, i.e. p(P)*.Why should the auditor decide otherwise? There may be factors other than

the fear of being sued for negligence. 14 These include: lost revenue arising

from the loss of the audit (an audit switch) in the event of an adverse report

but no resulting failure by the client company, 15 and lost revenue arising from

lost reputation in the event of no adverse report but failure by the client com-

pany. An alternative point to p(P)* may be identified, therefore: p(Z)*, where

the costs or lost revenues arising from issuing an adverse report or not are min-

imized. The distinction between p(Z)* and p(P)* which are both thresholds(hence the superscript *) should be noted. p(P)* is the threshold above which

the auditor should issue an adverse report according to externally-determined

professional standards, whereas p(Z)* is the threshold above which the auditor

should issue an adverse report determined by his own costs and benefits and

self-interested objectives.

We may examine the alternative outcomes in the following way. An adverse

report will occur if:

pðP Þ� < pðZÞ� < pðDÞ; ð1Þ

13 Krishnan and Krishnan (1996) argue that the magnitude of the auditor�s payment is likely to

be related to the size of damages incurred by investors and, therefore, the size of their investment.14 Carcello and Palmrose (1994) report that bankruptcy is one of the most frequent sources of

litigation against auditors and that the issuance of an adverse report reduces the likelihood of

litigation.15 For empirical evidence to support this see Chow and Rice (1982), McKeown et al. (1991) and

Krishnan and Stevens (1995). Krishnan and Krishnan (1996) identify the expected loss of losing a

client as the loss of quasi-rents associated with that client. The relative importance of the client in

the audit firm�s portfolio determines the ease with which it can replace the quasi-rents. Second,

assuming that audit fees are proportional to client size, the client company�s importance depends on

its size relative to the audit firm�s other clients. This approach forms the basis of the paper by

Zhang (1999).


pðZÞ� < pðP Þ� < pðDÞ: ð2ÞSimilarly, there will be no adverse report if

pðDÞ < pðZÞ� < pðPÞ�; ð3Þ

pðDÞ < pðPÞ� < pðZÞ�: ð4ÞTwo situations remain, the outcomes of which depend on the objective func-

tion of the audit firm. These are

pðP Þ� < pðDÞ < pðZÞ� ð5Þand

pðZÞ� < pðDÞ < pðPÞ�: ð6ÞIn case (5), the auditor will not issue an adverse report as p(D) < p(Z)* if

rational economic decisions over-rule professional considerations, i.e. p(P)*is irrelevant. This causes a Type II error, as p(P)* < p(D) if, as expected, the

client company fails. On the other hand, if professional considerations over-

rule the profit-maximizing objective, p(Z)* will be irrelevant and the auditor

will issue an adverse report as p(P)* < p(D). In case (6), the auditor will issue

an adverse report as p(Z)* < p(D) if rational economic decisions over-rule pro-

fessional considerations, i.e. p(P)* is irrelevant. 16 This causes a Type I error as

p(D) < p(P)* if, as expected, the client company does not fail. On the other

hand, if professional considerations over-rule the profit-maximizing objective,p(Z)* will be irrelevant and the auditor will not issue an adverse report as

p(D) < p(P)*.

We may now define the nature of the economic costs and benefits. An ad-

verse report will occur if:

CNQ > CQ where CNQ = [CA + CB] and CQ = [CC + CD] and

CQ and CNQ are the costs of issuing an adverse report and not issuing one,

respectively,CA is the expected cost of a lawsuit from a shareholder, or third party, acting

on the belief that, because there was no adverse report, the firm was not going

to fail. This will be non-zero if there is no adverse report and the firm fails.

CB is the expected cost of loss of reputation from not issuing an adverse report

in the event of the firm going bankrupt,

CC is the expected cost of a lawsuit for negligence in the event of an adverse

report and the firm not failing,

CD is the expected cost of the loss of the client from audit switching arisingfrom issuing an adverse report and the firm not failing.

16 It is unlikely that p(Z) < p(P)*. This is discussed in the section on transaction costs and

bargaining power.


The expected costs are comprised of:

ðaÞ CA ¼ CM½pðDÞ � pðPÞ��½1 � pðPÞ�� ;

where CA > 0 if [p(D) � p(P)*] > 0, otherwise CA = 0, and CM is the cost of lit-

igation in terms of damages payable if the auditor did not issue an adverse re-

port but was certain [p(D) = 1] that the firm would fail. For simplicity, weassume a simple linear relationship in which CA increases relative to the differ-

ence between p(D) and p(P)*. The nature of the slope is not crucial to the anal-

ysis other than CA > 0 and increases to the right of p(P)*.

ðbÞ CB ¼ CR½pðDÞ � pðP Þ��½1 � pðP Þ�� ;

where CB > 0 if [p(D) � p(P)*] > 0, otherwise CB = 0, and CR is the cost of loss

of reputation from not issuing an adverse report and was certain [p(D) = 1] that

the firm would fail. CB will be zero below p(P)* because the auditor is not ex-

pected to issue one at such low probability of failure levels. For simplicity, weassume a simple linear relationship 17 in which CB increases relative to the dif-

ference between p(D) and p(P)*. Again, the nature of the slope is not crucial to

the analysis other than CB > 0 and increases to the right of p(P)*.

ðcÞ CC ¼ CN½pðP Þ� � pðDÞ�

pðP Þ� ;

where CC > 0 if [p(P)* � p(D)] > 0, otherwise CC = 0, and CN is the cost of the

litigation in terms of damages payable in a successful action where there was an

adverse report yet the auditor was certain that the firm would not fail

[p(D) = 0]. Once more, it is assumed that there is a linear relationship between

costs, CC, and the difference between the auditor�s assessment of the probabil-ity of failure [p(D)] and the level above which professional opinion would re-

quire an adverse report [p(P)*]. Again, the nature of the slope is not crucial

to the analysis other than CC > 0 and increases, this time to the left of p(P)*.

ðdÞ CD where pðDÞ < pðPÞ�

and CD represents the cost of the audit switch in terms of lost profits by the

audit firm. The threat of an audit switch occurs where the client company seeks

to obtain a clean audit report from another audit firm because it is unable to

obtain one from its present auditing firm. Assuming that similar interpretations

17 For all costs, CA to CD, a linear relationship is assumed. This is because there is no reason to

assume otherwise and their relationship to p(D) clearly suggests constant proportionality. The

direction of the slope (i.e. upwards or downwards) and the point at which these costs become

positive are what are critical to the argument and conclusions. These would be the same if the

relationships were curvilinear.


would be made by other audit firms and as p(P)* is the same for them all, the

cost of an audit switch is zero because other firms would also not issue a clean

report where p(D) < p(P)*. Hence, for present purposes, CD is assumed to be

zero. When transaction costs are taken into account (Section 3), CD is found

to be non-zero and influential to the decision. A non-zero CD also has impor-

tant effects in Sections 4 and 5 where bargaining power and the possibility ofthe client company attempting to mislead the audit firm are introduced.

We may also assume that CN and CM are equal as they represent gross dam-

ages where p(D) = 1 or 0, if there was and was not an adverse report, respec-

tively. Damages in respect of CN would be based on the difference between

the value of the firm without the adverse report, VNQ, and with the adverse re-

port, VQ. That is, investors were led to believe that it was worth VNQ whereas it

was actually worth VQ. In the event of the failure of the firm, they may sue for

their losses, being the difference between what they thought the firm was worthon the basis of no adverse report and what they would have thought it was

worth had there been an adverse report, VQ. Thus, CN = VQ � VNQ. Damages

in respect of CM are based on a similar principle: (VQ � VNQ) as the plaintiffs

would claim that the adverse report had harmed the business by causing other

firms to be reluctant to do business with the firm, making the acquisition of

loans more difficult and so on. The firm�s value would have been reduced to

VQ when it should have been VNQ; that is (VNQ � VQ). Therefore, CN = CM

and their expected values are zero when p(D) = p(P)*. 18

It will be seen from (a) to (d) above that the costs CA, CB, CC and CD are

zero if p(D) = p(P)*. See Fig. 1. This shows costs becoming non-zero as p(D)

departs from p(P)*, hence p(Z)* = p(P)*. As p(Z)* = p(P)*, there is no expec-

tation of bias arising from Type I or II errors.

This analysis suggests that external effects are brought into the calculations

of the responsible parties in line with the Coase Theorem to achieve Pareto effi-

ciency assuming rational economic decision making by auditors (Coase, 1960).

As long as p(P)* is effectively enforced by auditors in their actions by realisingthe need to take into account the legal implications of their decisions, the rec-

ognition of the costs involved will lead them to a Pareto efficient outcome––in

this case, non-biased going concern decisions.

3. Transaction costs

It should not be thought that there are no transaction costs. These are in theform of legal costs associated with CM and CN. Regarding CA, FA,A represents

18 Empirically, of course, this may not be so. They may not be symmetrical. For instance, the

damages re CM may be more clearly measured than CN. However, the directions and origins of the

slopes are merely necessary for the argument.

Fig. 1. The auditor�s costs associated with the decision of whether or not to issue an adverse report

and their relationship with the probability of failure by the client company, p(D), where there are

no legal costs. Line CA represents the expected value of legal damages from a successful action

against the auditor if he did not issue an adverse report and the client company failed (this increases

with the probability of failure). Line CB represents the cost of the loss of reputation to the auditor if

he did not issue an adverse report and the client company failed. Line CC represents the expected

value of legal damages from a successful action against the auditor if he issued an adverse report

and the client company did not fail (this decreases with the probability of failure). Point p(Z)*

represents probability of failure threshold at which the costs or lost revenues arising from issuing

either an adverse report or not are minimized. Point p(P)* represents probability of failure

threshold above which the auditor should issue an adverse report according to externally-

determined professional standards.


the legal costs incurred by the audit firm and FA,C represents those incurred by

the client company, its shareholders or a third party. In which case

CA ¼ CA;L þ F A;A þ F A;C

and CA P 0. CA = 0 where CA,L = 0 as the client company, its shareholders or a

third party will not sue unless CA,L > 0. Here

CA;L ¼ CM½pðDÞ � pðP Þ��½1 � pðP Þ�� F A;C;

where CA,L P 0. 19

Similarly for CC, where FC,A represents the legal costs incurred by the audit

firm and FC,C represents those incurred by the client company, or its sharehold-

ers. In which case

CC ¼ CC;L þ F C;A þ F C;C

and CC P 0. CC = 0 where CC,L = 0 as the client company, or its shareholders

will not sue unless CC,L > 0. Here

19 FA,C is added back in CA as it is deducted in arriving at CA,L.



legal costs and the auditor�s bargaining power is zero. For definitions of CA, CB, CC, p(Z)* and

p(P)* see Fig. 1. Line CD represents the cost of an audit switch arising from the auditor issuing an

adverse report and the client company did not fail. Point p(B) represents the probability level of

client company failure above which, taking into account legal fees, there is a positive expected value

of legal damages and costs from a successful action against the auditor if he did not issue an adverse

report and the client company failed. Point p(C) represents the probability level of client company

failure below which, taking into account legal fees, there is a positive expected value of legal

damages and costs from a successful action against the auditor if he issued an adverse report and

the client company did not fail.


CC;L ¼ CN½pðP Þ� � pðDÞ�

pðP Þ� � F C;C;

where CC,L P 0. Here, the threshold p(Z)* rises from p(P)* to p(B), that point

above which CA ceases to be zero. That is: CA, CB, CC and CD are zero if

p(D) = p(B) where p(B) is defined as where

CA;L ¼ CM½pðBÞ � pðP Þ��½1 � pðP Þ�� F A;C ¼ 0:

See Fig. 2. 20

The variation of assumptions has an effect on CB. In the initial model, CB

became non-zero and positive to the right of p(P)* because of the increasing

possibility of adverse reputational effects. Under these new assumptions, CA

determines the point above which the costs are non-zero. Below p(B) (i.e. to

20 p(B) will be the auditor�s adverse report threshold unless he is able to negotiate it with the

client company without loss of audit at a lower probability of failure level, i.e. his bargaining ability

is zero. The concept of bargaining ability is introduced and discussed in the next section.


the left) there are no reputational costs as, because of legal costs, there is no

likelihood of legal action. Hence CB is redefined as

CR½pðDÞ � pðBÞ�½1 � pðBÞ� ;

where CB > 0 if [p(D) � p(B)] > 0, otherwise CB = 0. These changes have an ef-fect on the possibility of an audit switch. At expected failure probability levels

above p(B) all audit firms would issue an adverse report, but at points between

p(B) and p(C) there may be audit firms which would be prepared to issue a

clean report as shown in Fig. 2. Consider one such competing audit firm.

Assuming homogeneity of costs as before, it will have similar cost functions

and schedules CA and CC. It will therefore be prepared to offer a clean audit

report for probability levels up to p(B). 21 The existing auditor therefore faces

the risk of a switch if he issues an adverse report.As there is now the possibility of an audit switch below p(B), CD > 0 for val-

ues of p less than p(B). Where CD > 0, it is assumed to be constant as there is no

change in the probability of the available alternative auditor. 22 In either event,

the slope of CD is not critical to the subsequent analysis in this paper, merely

the point above which it becomes non-zero below p(B). Hence, where there are

transaction costs, self-interested auditors will use p(B) as their criterion for an

adverse report and not p(P)*. That is, p(Z)* = p(B). As p(B) > p(P)*, bias aris-

ing from Type II errors should, therefore, be expected to occur. This result isalso interesting as it relates to reputational costs. The shifting of the origin for

CB from p(P)* to p(B) has shifted the point above which there will be an ad-

verse report from p(P)* to p(B). Reputational costs and considerations between

these two points have been driven out as a result of competitive pressures (the

threat of a switch) which has been made possible by the existence of legal costs.

4. Bargaining power and audit switching

Bargaining power relates to the strength of a negotiator to obtain advanta-

geous terms or, more precisely, the ability to secure an opponent�s agreement

on one�s own terms. Here it relates to the ability of the auditor to withstand

the pressures placed on him by his client, notably the threat of audit switch,

and issue an adverse report nevertheless. At one extreme, the auditor is able

21 If the assumption of homogeneity of costs and interpretation by auditors is relaxed, the area

in which there is threat from an audit switch [between p(C) and p(B)] may be even wider. It is

possible that there may be significant differences across audit firms, especially between the

incumbent audit firm and its competitors, regarding fees charged (low balling, Jevons Lee and Gu,

1998) and set-up and continuing costs (Zhang, 1999).22 If it is assumed that the probability of an available auditor does increase below p(B), then the

line CD is upward sloping to the left of p(B) where it is zero.


to withstand all pressures, perhaps because he has such a high reputation and is

not prepared to risk this being threatened. Also, an audit switch may be seen to

be a signal to the outside world that the client company is unable to stand up to

such high standards of scrutiny. That is: there is no threat of an audit switch as

it would have a negative signal to the outside world about the client company.

Here the auditor�s bargaining power is high. At its extreme, Ba = 1, where B

indicates bargaining power and the subscript indicates the auditor. At the other

extreme is a situation in which the auditor is unable to withstand such pres-

sures and the threat of audit switch is very high. That is, Ba = 0. In which case

CD > 0 where p(D) < p(B) and p(Z)* = p(B). That is, CD > 0 for values of p(D)

below p(B). In which case, he will issue an adverse report only where

p(D) > p(B) as in Fig. 2. 23

In terms of the foregoing analysis, if Ba = 1, the auditor should be able to

negotiate an adverse report without loss of the audit for a probability of failureas low as p(C) if he is concerned about protecting his reputation, even though

there are no explicit expected costs for CB below p(B). Hence p(Z)* = p(C) as in

Fig. 3. That is: CA, CB, CC and CD are zero if p(D) = p(C) where p(C) is defined

as where:

CC ¼ CN½pðP Þ� � pðCÞ�

pðP Þ� � F C ¼ 0:

The important point is that the high value for Ba pushes back the point be-

low which CD > 0 from p(B) to p(C). In the case of auditors who perceive their

bargaining power as falling between these extremities of one and zero, then

CD > 0 from the point lying between p(B) and p(C), where Ba[p(B) � p(C)].Hence, bias may occur in either direction. If Ba > B0

a where B0a ¼

pðP Þ��pðCÞpðBÞ�pðCÞ , it

will be of the Type I form and if Ba < B0a, it will be of the Type II form. The

point should also be made that whilst it is true that Ba + Bf = 1, where Bf rep-

resents the bargaining power of the client company, it does not follow that each

knows each other�s bargaining strength. For instance, the auditor might think

Ba = 0.75, hence Bf = 0.25, yet the client company might believe that they are

opposite in value. 24

Hence, the addition of transaction costs has introduced the opportunity forbargaining by the auditor and the client company (in order to avoid an audit

switch) between the points p(C) and p(B). Whilst the Coase Theorem recog-

nises the effects of bargaining power, here there is no scope for it as p(P)* is

the only available point in the absence of transaction costs. With the addition

of transaction costs, this is now possible; the precise value for p(Z)*, the thresh-

23 Note that CD > CD at p(B). If it is less, then p(Z) will be determined by the intersection of CB

and CD.24 How this is decided is outside purpose of this paper. However, it has been shown by Nash

(1950) that it may be decided by the two parties depending upon their marginal utilities.



legal costs and the auditor�s bargaining power is at a maximum (unity). For definitions of CA, CB,

CC, p(Z)* and p(P)* see Fig. 1. For definitions of CD, p(B) and p(C) see Fig. 2.


old for issuing an adverse report by a self-interested auditor, is then determined

by the two parties according to their subjective relative bargaining strengths.

5. Asymmetry of information, misleading information and audit quality

It has often been asserted that there is a positive relationship between audi-

tor size and audit quality. 25 Probably the earliest was DeAngello (1981c) who

argued that the valuable reputations of large auditors act as an incentive to

provide accurate reports. More recent is the empirical evidence of Krishnan

and Schaur (2000) who found that organizational compliance with GAAP�sreporting requirements (a measure for quality) was related to the size of theauditing firm. One reason for this is their �deeper pockets� (see Dye, 1993).

Insights into the relative bargaining power of participants leading to incen-

tives to mislead have been developed by Saraydar (1983). Saraydar shows how

the relative bargaining power of the participants is manifested in a desire to

provide misleading information resulting in a Pareto inefficient outcome. We

may use these insights to extend the analysis of the going concern decision

25 Although this is an unclear concept and a largely unobservable phenomenon in which

different aspects may relate to different parties (for a discussion see Schroeder et al., 1986), here an

important aspect of audit quality relates to the skills and ability of the auditor to correctly assess

the commercial future of the client company when it may wish to mislead him.


where there is considerable information asymmetry. When making his decision,

the auditor is dependent upon the client company to a greater or less extent. He

may not be an expert in the commercial workings of the industry in which the

client company operates or even its financial records (Zimbelman and Waller,

1999). 26 His decision will involve judgement based on qualitative and subjec-

tive information provided, to some extent informally, by the client. The clientwill have the power to emphasize certain aspects and understate, or even hide,

other aspects, e.g. management�s plans and assessments. It is only with the

acquisition of experience and some considerable skill that the auditor may

overcome these shortcomings.

We can identify three possible probability estimates of client failure that the

auditor may make depending upon the quality of the audit. These are:

p(D1), where there is no attempt to mislead by the client company,p(D2), where there is an attempt by the client company to mislead and this is

not discovered because the quality of the audit is low,

p(D3), where there is an attempt to mislead by the client company but this is

discovered because the quality of the audit is high.

In each case p(D1) is the correct probability of failure that should be inferred

from the accounting data. However, the quality of audit may vary in its ability

to identify and adjust for the misleading information. The auditor may be ableto fully identify and adjust for it. In which case, p(D1) = p(D3). However, per-

haps more likely, p(D3) will fall somewhere between p(D2) and p(D1) depending

upon the quality of the audit, the magnitude of the misinformation and the

skill of the client company in its deception. Here p(D2) < p(D3) < p(D1).

It should not be presumed that p(D2) < p(D1) will always be the case. The

client company may decide to increase the adverse information so that

p(D1) < p(D2) if in its view this may be done without threatening an adverse re-

port; that is p(D1) < p(D2) < p(Z)*. 27 However, as the client company does notdesire an adverse report, misinformation which changes an audit decision only

occurs where p(D2) 6 p(D3) < p(Z)* < p(D1).

Misleading information and the impact of relative bargaining power may

act in the following way:

26 This contrasts with, for instance, the auditor�s ability to assess the client company�s internal

controls. Here, the auditor may be more expert at knowing whether they are satisfactory than the

company itself. For a discussion of the two parties� capabilities see Gibbins et al. (2001).27 There are many reasons why this may be done; for instance, to exaggerate the company�s

�turnaround� during the next year.


1. The client company will produce accounting data designed to suggest p(D2)

[based on the client company�s subjective view of its relative bargaining

power], although they should indicate p(D1), the correct probability. The

auditor will decide p(D3) which falls somewhere between the two depending

upon the quality of the audit.

2. The auditor will then determine p(Z)* which lies between p(C) and p(B)according to his perceived bargaining power relative to that of the client

company.

3. p(D3) will then be compared with p(Z)*. If p(D3) < p(Z)* then the auditor will

issue a clean audit report but if p(D3 ) > p(Z)* he will issue an adverse one.

As a result of this process, either a Type I or II error may occur. Consider the

situation where a bank has received information that some of its borrowers may

be unable to repay their loans. Its management think that the auditors are likelyto conclude that it is no longer a going concern [p(D1)]. Rather than make the

necessary provisions in full and provide the auditors with this information,

management decide to provide them with information suggesting that the loans

are safe [p(D2)]. When reviewing these loans, the auditors may conclude that (i)

they need providing for [p(D1)] in full, (ii) they do not need providing for [p(D2)],

(iii) only some of the loans need providing for [p(D3)], or (iv) all the suspect

loans need providing for, but not in full [p(D3)]. To use a simple illustration, as-

sume that there is a relationship between the total net value of the loans (L, theirface value less provision for bad debts) and the probability of failure, p(D),

which is determined by the function p(D) = 1.47 � 0.67L. For instance, if the re-

ported loans are $1.6bn and there are no provisions required, the probability of

failure, p(D1), is 0.4; but if there were a provision of $0.6bn (L = $1.0bn) then

p(D1) = 0.8. That is: 0.4 = 1.47 � 0.67(1.6) and 0.8 = 1.47 � 0.67(1.0).

See Case 1 in Fig. 4. Say the correct value of loans should be $1.254bn. In

which case there should be a provision of $0.346bn [i.e. $1.6bn � $1.254bn]

and the probability of failure, p(D1), should be 0.63 [i.e. 1.47 � 0.67(1.254)].However, say the client company makes a provision of $0.175 in order to imply

p(D2) = 0.52 [i.e. 1.47 � 0.67(1.425)] but the audit firm thinks there should be a

provision of $0.206bn which implies p(D3) = 0.54. Also say p(P)* is 0.6 and

p(Z)* is 0.62 based on the audit firm�s subjective estimate of its bargaining

power of 0.4 where p(C) and p(B) are 0.5 and 0.7, respectively [i.e.

0.4 = (0.7 � 0.62)/(0.7 � 0.5)]. Here there is a Type II error: there should have

been an adverse report [because p(D1) > p(P)*] but there was not [because

p(D3) < p(Z)*] and Ba < B0a [0.4 < 0.5, where B0

a ¼ 0:5, i.e. (0.6 � 0.5)/(0.7 � 0.5)]. Next, consider Case 2 in Fig. 4. Here, the correct value of loans

should be $1.334bn. In which case there should be a provision of 0.266

[$1.6bn � $1.334bn] and the probability of failure, p(D1), should be 0.58 [i.e.

1.47 � 0.67(1.334)]. However, the client company produces data designed to

imply p(D2), i.e. makes provisions of $0.175bn. However, the auditor decides

Fig. 4. Diagram to show how Types I and II errors may occur by reference to the probability levels

of the client company�s failure which determine the auditor�s decision to issue an adverse report

(not to scale). (The numbers in brackets and the data relating to net loans and provisions refer to

the numerical illustration in the text.) For definitions of p(B), p(C), p(P)* and P(Z)* see Figs. 1 and

2. p(D1) represents the probability of failure where there is no attempt to mislead by the client

company; p(D2) represents the probability of failure where there is an attempt by the client

company to mislead and this is not discovered because the quality of the audit is low; p(D3)

represents the probability of failure where there is an attempt to mislead by the client company but

this is (partly or otherwise) discovered because the quality of the audit is high. The values for p(Z)*

and p(P)* are assumed for illustration purposes. The values for p(D) are also derived from the

illustration where the relationship between it and reported net loans (L) is p(D) = 1.47 � 0.67(L)

and gross loans are $1.6bn.


that there should be provisions of $0.236bn, p(D3), which implies a probabilityof failure of 0.56 [i.e. 1.47 � 0.67(1.364)]. Assume that p(P)*, p(C) and p(B) are

the same as before but Ba is 0.75, making p(Z)* = 0.55 [i.e. (0.7 � 0.55)/

(0.7 � 0.5)]. Here there is a Type I error. There should not have been an ad-

verse report [because p(D1) < p(P)*] but there was [because p(D3) > p(Z)*]

and Ba > B0a [i.e. 0.75 > 0.5].

The important point is that increased bargaining power on the part of the

auditor also increases the incentive for, and the size of, misinformation. Say

Ba = 0, then p(Z)* = p(B). If p(D1) > p(Z)* then the auditor will issue an ad-verse report unless the client company provides sufficient misleading informa-

tion so that [p(D2) � mis0] 6 p(B), where mis0 represents the required effect of

the misinformation when Ba = 0. Now, say Ba = 1, then p(Z)* < p(B) and the

client company will need to provide sufficient misleading information to the ex-

Fig. 5. Diagram to show how the amount of required misinformation increases from mis0 to mis1

when the auditor�s bargaining power (Ba) changes from zero to unity. For a definition of p(Z)* see

Fig. 1. For definitions of p(B) and p(C) see Fig. 2. For a definition of p(D2) see Fig. 4. mis0

represents the required effect of the misinformation when Ba = 0; mis1 represents the required effect

of the misinformation when Ba = 1.


tent mis1, where mis1 represents the required effect of the misinformation when

Ba = 1, and [p(D2) � mis1] 6 p(Z)*. Here mis1 > mis0 and (mis1 � mis0)

increases with [p(B) � p(C)]. See Fig. 5. Thus, other things being equal, the

greater the bargaining power of the auditor, the greater the size of the required

misinformation. This is illustrated in Table 1. There the two extreme right hand

columns show in terms of the bank illustration how the amount of misleading

information (here a deliberate under-provision for bad debts) directly increases

with the auditor�s bargaining power. To put it another way, stronger auditingactually encourages the client firm to attempt to misinform (e.g. deliberately

misleading or fraudulent financial statements). It is only if Ba is directly related

to the quality of audit to combat it, that this tendency may be arrested. How-

ever, unless there are reasons to the contrary (and there may be empirically)

then these two variables (an auditor�s bargaining power and the quality of

audit required to handle dissimulation) should be regarded as independent.

This finding has implications for the regulation of the accountancy profession.

For instance, it suggests that, contrary to intuition, increasing the power of theauditor may not improve the efficient workings of the capital markets. Further,

the case for increased concentration of the auditing industry (or state control)

does not lie in improved financial reporting.

6. Inferences made by the investor

What may an investor infer from whether the audit report is adverse or not?Little, unless he makes certain necessary assumptions concerning the audit

Table 1

A numerical illustration from the text and Fig. 4 showing how the amount of required

misinformation (in terms of under-provision for bad debts) increases as the auditor�s bargaining

power, Ba, decreases from one to zero

Ba p(Z)*a Reported net loans,

Lb ($bn)

If p(D1) = 0.63

under-provision

requiredc ($bn)

If p(D1) = 0.58

under-provision

requiredd ($bn)

1.0 0.5 1.45 0.2 0.12

0.9 0.52 1.42 0.17 0.09

0.8 0.54 1.39 0.14 0.06

0.7 0.56 1.36 0.11 0.03

0.6 0.58 1.33 0.08 None

0.5 0.6 1.3 0.05 None

0.4 0.62 1.27 0.02 None

0.3 0.64 1.24 None None

0.2 0.66 1.21 None None

0.1 0.68 1.18 None None

0 0.7 1.15 None None

a For a definition of p(Z)* see Fig. 1. The values for p(Z)* in this table are derived from the

proportional relationship between p(Z)* and Ba, where Ba ranges from one to zero, and p(Z)*

ranges from 0.5 to 0.7, the assumed values for values for p(C) and p(B), respectively in the

illustration.b An increase in p(Z)* reduces the threshold of the minimum net loans, L, for a clean audit

report. This column computes L for a given value p(Z)* in column 2. L is determined by rear-

ranging the function D = 1.47 � 0.67L to L = (1.47 � D)/0.67 and substituting p(Z)* for D. For

instance, where p(Z)* = 0.5, L = (1.47 � 0.5)/0.67 = 1.45.c For a definition of D1 see Fig. 4. If p(D1) = 0.63 (as in Case 1 in Fig. 4), loans net of provisions

are $1.25bn [i.e. (1.47 � 0.63)/0.67]. Hence, if p(Z)* is 0.5, the under-provision is

$1.45bn � $1.25bn = $0.2bn.d If p(D1) = 0.58 (as in Case 2 in Fig. 4), loans net of provisions are $1.33bn [i.e. (1.47 � 0.58)/

0.67]. Hence, if p(Z) is 0.5, the under-provision is $1.45bn � $1.33bn = $0.12bn.


firm�s motivation and whether an opinion is determined by the audit firm�s at-

tempts to maximize profits when these conflict with independent professional

opinions, its bargaining power, and audit quality; matters which have been dis-

cussed here. Whether the firm is profit-maximizing or not determines whether

p(P)* or p(Z)* is used as the criterion. This was discussed in the Simple Ra-

tional Economic Model section concerning cases (5) and (6). We may now also

note that the auditor will issue an adverse report in (5) either if for some rea-

son, he is non-profit-maximizing and Ba < 1 or if he is profit-maximizing andBa = 1. If he is profit-maximizing and Ba = 0, he will not issue one. Regarding

(6), as noted in the previous section, this will only occur if Ba has a particularly

high value, that is Ba > B0a ¼ 0 in which case the auditor will issue an adverse

report, irrespective of whether or not he is profit-maximizing. It should also be

noted that the investor will have little idea of the cost functions involved and,

therefore, unable to estimate p(Z)*. He may find it easier to make inferences


based on the auditor�s reputation. For instance, because the audit firm is one of

the largest in the world with a good reputation, its bargaining power is high,

perhaps greater than B0a. The investor may decide that although the audit firm

is probably profit-maximizing, effectively p(Z)* = p(P)*. However, as noted

earlier, if Ba > B0a then p(Z)* < p(P)*. The situation in which p(Z)* < p(D) <

p(P)*, a Type I error, may, therefore, arise. Whilst at first glance the investormay be happy for the possibility of Type I errors arising (because he has been

warned about the possibility of a failure which may not occur) on closer inspec-

tion he may not. The effect of the adverse report would be to reduce the share

price and hence the market value of his investment. The astute investor may

even look for situations in which a Type I error may have occurred, in order

to make a gain. It should be noted that the market may only be efficient if there

are no expectations of bias arising from Type II errors.

Of course, the crucial question for the investor is whether the client com-pany has attempted to mislead the auditor and, if so, whether it has been suc-

cessful. If the investor assumes that there is no misinformation, then his

problems are restricted to what have so far been examined. However, if he

thinks that the auditor may be misled, this adds further complications. For in-

stance, if there is no adverse report, although the investor may infer that

p(D2) < p(Z)*, he does not know whether p(D1) < p(P)*. Here the important

point is that brought out in the previous section. That is, the magnitude of mis-

leading information is likely to increase with the auditor�s bargaining power,even though it would not be zero where Ba = 0.

7. Conclusions

It has been shown that, in the absence of transaction costs, the going con-

cern decision is efficient in the sense that bias arising from either Type I or

II errors is not expected. This is in line with the Coase Theorem, althoughthe situation here is not precisely the same. When transaction costs, in the form

of legal costs arising from a lawsuit against the auditor are considered, Types I

and II errors are expected. (Again, this is in line with the relaxation of the stan-

dard assumptions of the Coase Theorem.) Here, the auditor�s relative bargain-

ing power determines the direction of these errors: a Type I error where the

auditor�s bargaining power is relatively high (where Ba > B�a) and a Type II er-

ror when it is relatively low. An important aspect which has not been consid-

ered in the bargaining literature in auditing is the effect that this may have onthe incentive for misinformation. It is shown here how the relative bargaining

powers of the auditor and his client company produce an incentive for the lat-

ter to mislead and that this increases with the former�s perceived bargaining

power. This analysis helps to explain the empirical evidence in the UK (and

also, probably, the USA) where (a) there are many cases of lawsuits against


auditors who had not issued an adverse report prior to the failure of their client

company, and (b) a surprisingly large number of cases of companies having re-

ceived an adverse report have survived.

As yet, there is no new empirical evidence to support the principal proposi-

tion in the later sections of this paper, that increased bargaining power for the

auditor will encourage the client company to provide misleading information.Nevertheless, it does raise important regulatory issues and begs for empirical

evidence. For instance, the impact of mergers of large accountancy firms on

their relative bargaining power and the effects of developments in GAAP,

auditing processes and pricing on audit quality as they affect the degree and

nature of misleading information. Taken on its own, this analysis suggests that

increased auditor size per se may not be in the interests of investors generally

and the efficient working of the capital markets 28 and may lead directly to

earnings manipulation and the rest. It should be noted that there has been aconsiderable increase in concentration of the accountancy profession amongst

the very large firms over recent years both in the USA (Wolk et al., 2001) and

the UK (Pong, 1999). Although there is no direct evidence for this, the general

impression is that it has coincided with an increase in the manipulation of

accounting information by large corporations. This paper suggests a mecha-

nism by which these two phenomena may be related.

The implication is that it matters little in marginal cases whether the auditor

is weak or strong if the client company is determined to avoid an adverse auditreport. Regulatory efforts to increase the bargaining power of the auditor (e.g.

by protecting and enhancing audit firms� independence or encouraging mergers

between them in order to increase their size) may be self-defeating, if this

merely forces companies into greater efforts to mislead their auditors when they

cannot negotiate a favourable decision. Instead (and this is being done), regu-

latory efforts should focus on audit quality and the ability of the auditor to see

through the attempts to mislead him. Similarly, the development and strength-

ening of mechanisms, such as corporate governance procedures and audit com-mittees, will help to provide additional internal constraints on management�sundue influence on its external financial information.

At first glance, the Enron/Arthur Andersen case refutes the conclusions

here. (After all, much of the analysis in this paper was done before it occurred!)

How could the largest firm of auditors in the world––in terms of this paper,

therefore possessing huge bargaining power––be so damaged by apparently a

few weak decisions on one audit client company undermining its perceived

independence and the quality of its audits elsewhere? (Chaney and Philipich,2002). It should also be remembered that the bargaining power of the top four

28 As noted by Boritz and Zhang (1999) in a slightly different situation, biases arising from

Types I and II errors cannot be diversified away and therefore remain within equilibrium stock

market prices.


audit firm�s is boosted where the client company is so large that it is effectively

required to be audited by one of them. On the other hand, the impact of the

loss of one client company to a large audit firm will, typically, be much greater

than for a small or medium-sized firm because the client company will be much

larger. Also, both the likelihood of occurrence and the reputational costs and

effects for the audit firm of a negligence claim are much greater from a largeclient company than for a small one.

The relevant measure of auditor size as a proxy for bargaining power may

not necessarily be the total size of the firm but, especially if decisions are decen-

tralized and taken at local level, the size of the individual practice office as Rey-

nolds and Francis (2000) suggest. However, as Chaney and Philipich (2002)

illustrate in the Enron case, reputational effects and the need for its protection

extend, of course, to beyond the local branch level. In other words, some of the

costs and benefits in this analysis may occur at the local branch level, but oth-ers, notably the reputational effects, are likely to be at the firm level. The ra-

tional choice model which is developed here may be useful for the basis for

subsequent empirical work when identifying the costs and benefits involved

in independence-related decisions and their incidence. The model here specifi-

cally relates to the going concern decision but it may be widened considerably

to cover all similar types of decisions by the auditor where there is a conflict

between his interests and those of the client company.

8. Uncited references

American Institute of Certified Public Accountants (1988), Bierman and

Fernandez (1993), DeAngello (1981a), DeAngello (1981b), Hermanson et al.

(2003), Illing (1992)

Acknowledgments

The author would like to thank Den Hooi, Edward Barnes, Jill Lambell,

Shanti Chakravarty and Dhylan Kanddasamy for their help in various stages

of this research. He would also like to thank the two referees for their patience

and some very useful comments that have substantially improved the paper.

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The Auditor's Going Concern Decision