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The accuracy of auditor going concern opinion in predicting bankruptcy at different sectors companies

Background

SAS no.59 have been issued in 1988, the auditor's going concern report received much attention from the stakeholders such as legislators, the public and researchers. SAS no 59 enhanced the auditor cautious, attention, and responsibility for going concern evaluation by requiring the auditor to evaluate on substantial doubt exist about the client going concern ability.

However as time goes by the current economic condition and environment has made the significant change in issuance of the auditor going concern opinion. The Institute of Chartered Accountants In England and Wales stated that “higher proportions of 2008 year end annual reports are likely to contain disclosures relating to going concern and liquidating, together with an increase in the number of modified audit reports as compared to previous years” (ICAEW, 2008, p.1). The market reactions and the full market implications of a rise in these disclosures and modified audit opinions will be affected by the levels of understanding and awareness regarding of this likely rise.

The need of going concern opinion is urgently required these days to enhance the level of business confidence. Based on ICAEW 2008 Q4, business confidence monitor found that “UK business confidence had fallen for a sixth consecutive quarter to reach the lowest level since the monitor began” (ICAEW, 2008, p.2), therefore the needs to disclose that a material uncertainty exist, that will make decisions makers misleads in predicting the company ability to continue as going concern is urgently required. .

Meanwhile, even the auditor explain the ability of the continuity of the company business, it does not mean guaranteed that the business will continue until the date of next financial statements. Academic interest related to this topic has largely focused on the process of the decision making in the auditor going concern opinion, while the issue of going concern reporting accuracy has been the centre of debate for stakeholders.

The increasing number of bankruptcies occurring the past decade caused by the global economic condition is become one of the most frightening for the stakeholders, therefore many stakeholder is really rely on the auditor going concern opinion as their guidance. Although the auditor is not responsible for predicting bankruptcy and the issuance of going concern opinion is by no means a prediction of bankruptcy, investors appear to expect the auditor to provide them with a warning of approaching financial failure. Because the result of the prior studies indicate that going concern opinion are useful in predicting bankruptcy and provide some explanatory power in predicting bankruptcy resolution.

Research Problem and Objectives

Auditor going concern report is becoming more important these days. Because the report is explain about the ability of the company to continue their business therefore the stakeholder can rely on that statement for their guide in doing business or taking some action. However, not all company published the auditor report to the public.

This research is aimed to answer the following questions:

  1. Is there any relation about auditor going concern report and stakeholders interests?
  2. How accurate is auditor going concern opinion in predicting bankruptcy (US company, for period 2006-2008)
  3. Is Management plan influence the audit going concern opinion?
  4. What factors are influence the increasing rate in issuance the modifications of audit going concern report by the auditor?

Literature Review

Company's information is very important for shareholder in particular and stakeholder in whole. White (2003, p4) divided stakeholders (i.e external users) into three general groups, firstly are “Credit and Equity investors. Secondly are government (executive and legislative branches), regulatory bodies, and tax authorities. And last one is the general public and special interest groups, labor unions, and consumer groups”.

As stakeholders interests become more important these days, therefore management plans and auditor going concern opinion is needs to disclose. Statement on Auditing Standards (SAS) No.59 (AICPA 1988) requires that “auditors to asses the client's ability to continue as going concern. If auditor believes there is substantial doubt regarding the client's ability to continue as going concern, SAS No.59 requires auditors to asses management's plans and provides guidance as to what information to consider” (AICPA, 1988). However several independent pieces of research have been undertaken (Mutchler, 1985; Chen and Church, 1992) indicating that “there has been extensive research on factors that influence the issuance of a going concern opinion”. Ellingsen et al. (1989) said that “once an auditor has substantial doubt about a company's ability to continue as a going concern, the issuance of going concern audit report depends upon an assessment of management's plans”.

The importance of auditor going concern report for stakeholder interest is very substantial for nowadays. Previous studies report that “going concern opinions are useful in predicting the bankruptcy” (Hopwood et al., 1989), (Hopwood et al., 1994) and provide some explanatory power in predicting bankruptcy resolution (Kennedy and Shaw, 1991). Prior study Altman (1982, p7) suggest that “financial-statement users often perceive the issuance of going concern opinion as a prediction of bankruptcy”. Prior studies (Campbell and Mutchler, 1988) argued that “the issuance of a going concern opinion may increase investors' assessment of the firm's probability of financial failure”.

The high profile collapses during the period 2000 to 2002 resulted in increased litigation against auditors, higher insurance costs, increased media scrutiny, and increased regulatory review of the auditing profession. Over the years the auditing profession has repeatedly been criticized for not providing warning signals for impending client bankruptcy (Raghunandan and Rama, 1995; Geiger and Raghunandan, 2002). In response to these changes in the audit environment during this period auditors would be expected to increase audit effort (Bedard and Johnstone, 2005) and professional skepticism (Sercu et al., 2006). Prior research suggests that auditor's decisions were more conservative after this period. Prior research suggested that “auditor can compensate for changes in risk exposure by altering their threshold for issuing modified audit reports” (Francis and Krishnan 1999; Geiger and Raghunandan 2002; Geiger et al., 2005).

Regarding the global economic crisis suffered during 2007, the accuracy of the auditor going concern opinion in terms of predicting bankruptcy is very important. Prior research has shown that “the proportion of bankrupt companies that received a going concern modified audit opinion in the year immediately preceding bankruptcy is generally lower than 50 percent” (Chen and Church, 1992; Raghunandan and Rama, 1995; Geiger and Raghunandan, 2002). In addition, a study by Nogler (1995) “following a total of 157 firms the resolution of their going concern opinion found that only 33 percent of the sample firms resolved their going concern opinions by entering into bankruptcy proceedings, whereas 35 percent of the companies received an unqualified opinion in the subsequent period and 32 percent resolved their going-concern opinion through dissolution, liquidation and merger”. The high frequency of audit reporting errors is indicative of the fact that the auditor's going concern decision is highly complicated and involves a high level of judgment. Prior research that investigated that “the causes of audit reporting errors focused on variety of auditor and client related factors such as auditor size, auditor tenure, the probability of bankruptcy, payments and covenant defaults, bankruptcy lag, industry sector etc”. (McKeown et al., 1991; Mutchler, Hopwood and Mckeown, 1997; Lennox 1999a and 1999b).

Methodology

Auditor going concern reporting is quite a sensitive and extensive topic. There is time constraint where I need to complete this dissertation in just five months. All of these confines make me decided to do my research based on secondary data. I will investigate various secondary sources that is relevant to my research topic, such as text-books, internet, company's websites, audit network's websites (for example: PWC, Ernest & young and KPMG), some organization's , academic journals, previous surveys or researches conduct by different authors that related in this topic, and other related documents or reports. This research is focused in US, This research will conduct by using “the bankruptcy prediction model” (Koh, 1991), but for this research I will renew the data such as numbers of sample and time periods. Basically the model was constructed with probit analysis using WESML (Weighted Exogenous Sample Maximum likelihood) procedure on matched sample of bankrupt and non bankrupt firms. This procedure incorporates the sample and population proportions of bankrupt and non bankrupt firms in the model construction process by weighting the log likelihood function. Secondary data source such as the Moody's industrial and OTC Manuals and 10-K reports will be needed to support this analysis.

Timeline

DATE

ACTION

20th November 2009

Submitting dissertation proposal

8th December 2008 - 10th January 2009

Collection of literature review

11th January 2010 - 11th February 2010

Data collection

12th February 2010 - 18th March 2010

Analysis data

19th March 2010 - 23rd April 2010

Writing the dissertation

24th April 2010 - 10th May 2010

Revision and editing the dissertation

11th May 2010

Submitting dissertation

Bibliographies

Altman, E., (1982) Accounting implications of failure prediction models, Journal of Accounting, Auditing,and Finance,6(Fall), 4-19

Chen, K. & Church, B.K., (1992) Default on debt obligations and the issuance of going-concem opinions, Auditing: A Journal of Practice & Theory,11 (Fall), 30-49.

Ellingsen, J.E., Pany, K. and Fargan, P., (1989) SAS No. 59: How to evaluate going concern,Journal of Accountancy,167 (January), 51-57

Francis, J.R. and J. Krishnan., (1999) Accounting accruals and auditor reporting

conservatism, Contemporary Accounting Research, 16(1), 135-165.

Geiger, M.A. and Rama, D.V., (2003) Audit Fees, Nonaudit Fees, and Auditor Reporting on Stressed Companies, Auditing: A Journal of Practice and Theory, 22(2), 53-69

Geiger, M.A. and Raghunandan, K., (2001) Bankruptcies, Audit Reports, and the Reform Act, Auditing: A Journal of Practice and Theory, 20(1), 187-197

Geiger,M.A. and Raghunandan, K., (2002). Auditor Tenure and Audit Reporting Failures, Auditing: A Journal of Practice and Theory, 21(1), 67-80

Geiger, M.A., Raghunandan, K. and Rama, D.V., (2005) Recent Changes in the Association between Bankruptcies and Prior Audit Opinions, Auditing: A Journal of Practice and Theory, 24(1), 21-35

Hopwood, W., McKeown, J. and Mutchler, J., (1989) A test ofthe incremental explanatory power of opinions qualified for consistency and uncertainty. The Accounting Review 64 (January), 28—48

Hopwood, W., McKeown, J. and Mutchler, J., (1994) A reexamination of auditor versus model accuracy within the context of the going-concem opinion decision Contemporary Accounting Research 10 (Spring), 409-432

Kennedy, D. and Shaw, W., (1991) Evaluating financial distress resolution using prior audit opinions, Contemporary Accounting Research 8 (Fall), 97-114

Koh, H., (1991), Model Predictions and Auditor Assessments of Going Concern

Status, Accounting and Business Research, Vol. 21, No. 84, pp. 331-38

Lennox, C., (1999a) The Accuracy and Incremental Information Content of Audit Reportsin Predicting Bankruptcy, Journal of Business Finance and Accounting, 26(5), 757-778.125

Lennox, C., (1999b) Are large auditors more accurate than small auditors?, Accounting and Business Research, 29(3), 217-227

McKeown, J.C., Mutchler, J.F., and Hopwood, W., (1991) Towards an explanation of auditor failure to modify the audit opinion of bankrupt companies, Auditing: A Journal of Practice and Theory, supplement, 1-13

Mutchler, J., (1984) Auditor's perception of the going concern opinion, Auditing: A Journal of Practice &Theory 5 (Spring), 17-30

White, G., Sondhi, A.C. & Fried, D., (2003) The Analysis and Use of Financial Statements, 3rd edition, John Wiley & Sons, Inc., (London)

Raghunandan, K. and Rama, D.V., (1995) Audit Reports for Companies in Financial Distress: Before and After SAS No. 59, Auditing: A Journal of Practice and Theory, 14 (1), 50-64

The Institute of Chartered Accountants in England and Wales, (2008) Policy Briefing Going Concern, (London)

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