Abstract
Corporate accounting failures and regulatory proceedings that led to the enactment of the Sarbanes–Oxley Act of 2002 increased the scrutiny of auditors. We investigate whether these events resulted in a change in auditor behavior with respect to going concern reporting. Generally speaking, we find that non-Big N auditors became more conservative while Big N auditors became more accurate. Specifically, non-Big N auditors issued more going concern opinions to both failing and non-failing clients post-2001, reducing their Type II misclassifications at the expense of increased Type I misclassifications. However, Big N auditors decreased their Type I misclassifications with no corresponding increase in Type II misclassifications. Thus, our findings suggest that increased auditor scrutiny resulted in performance improvements in the area of going concern reporting primarily for larger auditors. For smaller auditors, improved going concern accuracy for subsequently bankrupt clients came at the cost of more going concern opinions being issued to subsequently non-failing clients.
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Notes
While other proxies for auditor behavior exist, these are more difficult to evaluate ex post (e.g., accruals) or are unobservable without access to proprietary data (e.g., audit adjustments and substantive audit testing).
The Big N auditors during our sample period were Arthur Andersen, PricewaterhouseCoopers, Ernst and Young, Deloitte, and KPMG.
While an auditor’s decision to issue a GCO is likely to be affected by litigation exposure, Blacconiere and DeFond (1997) find that the issuance of GCOs did not protect auditors from litigation in the case of Savings and Loan client failures.
For example, prior research finds that clients of Big N auditors report more conservative accruals (Becker et al. 1998; Francis and Krishnan 1999; and Myers et al. 2003) and are less likely to commit fraud (Farber 2005), are more likely to comply with generally accepted accounting principles (Krishnan and Shauer 2000), are less likely to be sued (Palmrose 1988), have higher IPO market values (Firth and Smith 1995), and bear a lower cost of both debt and equity capital (Beatty 1989; Khurana and Raman 2004; Pittman and Fortin 2004; Cassell et al. 2011a; Kim et al. 2013). Prior research also finds that market reactions at earnings announcements are larger for Big N clients (Teoh and Wong 1993), suggesting that investors have more confidence in earnings numbers that are audited by Big N auditors. Hammersley et al. (2008) find that market reactions to the disclosure of internal control weaknesses are significantly less negative for Big 4 clients, and Krishnamurthy et al. (2006) find that investor reactions to auditor switches following the demise of Andersen were more positive when clients switched to Big 4 firms. Prior research also finds that Big N audit firms allocate audit hours more effectively, resulting in audits that are deemed to be of higher quality (Blokdijk et al. 2006).
Boone et al. (2010) do not investigate Type I and Type II misclassifications.
An example of additional work that could have resulted in higher quality Big N GC reporting decisions during our sample period is the addition of control attestations for accelerated filers (typically audited by Big N Auditors) under SOX Section 404. Just as Beck and Wu (2006) show that increases in non-audit services can, in some circumstances, create a learning effect that improves audit quality, we suggest that this additional work could have resulted in learning effects that resulted in improved GC reporting decisions.
Hopwood et al. (1994) note that because auditors generally do not issue GCOs to viable companies which fail, it is important to examine auditor GCO decisions for financially distressed companies separately from GCO decisions for viable companies.
To form the PrBANK measure, we apply the coefficients in the Hopwood et al. (1994) model to net income/total assets, current assets/sales, current assets/current liabilities, current assets/total assets, cash/total assets, long-term debt/total assets, and the natural log of sales. We then convert this bankruptcy index into a probability score.
Geiger et al. (2005) include technical default in their default measure but we limit our analyses to payment default (which is a more stringent default measure) because of data limitations.
Consistent with GRR, for clients that had already filed for bankruptcy at the time of the audit opinion, we use the prior year’s audit opinion data provided that the bankruptcy occurred within one year of the audit opinion. As a sensitivity test, we also use the prior year’s audit opinion data when the bankruptcy occurs within one year of the client’s fiscal year-end. Our results are qualitatively similar using this definition of bankruptcy.
These residuals are similar to the studentized residuals commonly used in ordinary least squares regression (Hamilton 1992, p. 236). Our results are robust to inclusion of all company-year observations and actually improve when we adopt more stringent outlier screens (i.e., when we remove observations with absolute value of studentized residuals less than 2.5 or 2, or when we exclude observations that yield a change in the χ2 Statistic greater than 3.99 [Hamilton 1992]). Our results are also robust to winsorizing client size (SIZE) to the 1st and 99th percentiles.
This result is significant even though there are only 21 bankrupt companies audited by non-Big N auditors in our 2000–2001 partition.
Jones and Raghunandan (1998) also find that Big N auditors are more likely to audit clients in risky industries. However, they find that this propensity declines in highly litigious time periods.
The only difference is that we find a significant coefficient on DEFAULT, indicating that subsequently non-failing clients in payment default are more likely to receive GCOs than are clients subsequently non-failing clients not in payment default. However, payment default does not increase the probability that a subsequently bankrupt client will receive a GCO.
We exclude any observation where auditor information is not available for all seven years in COMPUSTAT.
Our results are qualitatively unchanged when we include McGladrey as a third middle market auditor and when we include middle market firms with Big N firms.
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Acknowledgments
We thank Chris Hines, Janet McDonald, and Genevieve Scalan for helpful research assistance, and Tom Omer and workshop participants at Texas A&M University for helpful comments and suggestions. Linda Myers and Michael Wilkins gratefully acknowledge financial support from the Garrison/Wilson Chair at the University of Arkansas and from the Jesse H. Jones Chair at Trinity University, respectively.
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Myers, L.A., Schmidt, J. & Wilkins, M. An investigation of recent changes in going concern reporting decisions among Big N and non-Big N auditors. Rev Quant Finan Acc 43, 155–172 (2014). https://doi.org/10.1007/s11156-013-0368-6
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DOI: https://doi.org/10.1007/s11156-013-0368-6
Keywords
- Going concern
- Bankruptcy
- Type I and Type II misclassifications
- Audit quality
- Auditor size
- Auditor conservatism