The Going Concern Assumption Accounting Essay

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Dynamic economic environment has causes the increase of bankruptcy filing of companies. Similar to the failing of the entity is the inability of the entity to going concern. Normally, financial statements are prepared under assumption that the entity will not liquidate or scale down the operation size. ISA 570 stated that when an entity receives a going concern opinion from the auditor, the entity is viewed as continuing business for the foreseeable future. ISA 570 has provided guidelines for auditors in Malaysia to issue opinion on the going concern assumption. The entity will be able to realize its assets and discharge its liability in the normal course of business if the entity is said to be going concern. In the ISA 570, if there is characteristics of the listed indicators exist, auditors should assume that the entity will not be going concern. Some of the indicators are recurring losses of the operation, internal matters such as loss of key personnel, external matters such as pending litigation, inability to pay loan and significant changes in the market which affects competitiveness of the company.

The going concern evaluation will be based on the information obtained from the audit procedures which the auditor normally performs test on the audit assertions of the company (Auditing Standard No.13). Auditor will need to evaluate the client's ability to going concern and provide a going concern opinion when they have doubt on the client's future viability (Stanley, Todd De Zoort & Taylor, 2009). Separate procedures will need to be done if auditors believe that there is substantial doubt on the ability of going concern of the company.

According to ISA 570, the evaluation of going concern is a task that involves professional judgments from the auditors. Auditors have the responsibility to inform the stakeholders when there is a doubt of reasonableness of the going concern of the company exists. They are responsible to obtain sufficient audit evidence about the appropriateness on the use of going concern assumption in the preparation and presentation of the financial statement. However this standard is quite general and lacks of technical guidance and it gives rise to different verdicts among the auditors when dealing with client with going concern problem (Atef, Suhaimi & Zakimi, 2002).

Going concern assumption will have effects on the financial statements and the audit report (IAASB, 2009). According to the IAASB (2009), the going concern assumption is a fundamental principle in preparing financial statements and the assessment of an entity's ability to continue as a going concern is the responsibility of the management. When auditors have doubt on the ability of the client to go concern, they will evaluate the adequacy of the financial statement being audited and discuss with the management of the client. More disclosures will need to be reported in the auditors report on the conditions causing the doubt on going concern, management's plans to overcome the issue and information about the effect on the assets and liabilities (ISA 570). Explanatory paragraph should be added to the auditor's report when auditor has doubt on the going concern of the client. It is not necessary to issue a disclaimer but the paragraph will need to include the description on the management financial problems and its plan to mitigate it. If there is insufficient disclosure from the client, auditor normally will issue the qualified audit report. The audit report is the medium that the stakeholders use to make decisions and value the company. Therefore, the report must reflect the performance and situation of the entity. The importance of the auditor's report takes greater meaning when the client faces financial distress that could threaten its going concern status.

However, there are phenomena shows that auditors' accuracy is lower than what has expected (McKweon, Mutchler and Hopwood, 1991). Auditors pay lesser attention on some of the factors that are important on the issuance of audit opinion, such as financial indicators, evidence and disclosure (Haron, Hartadi, Ansari and Ismail, 2009). There are some potential reasons for the inaccuracy, that is, auditors lack of experiences, auditors feel that those factors are not important, and they are not agree on criteria to be evaluate in deciding a company has a going concern problem (Bazerman, Loewenstein, Tanlu, and Moore, 2002).

1.1.2 Financial distress

When a firm's business deteriorates to the point where it cannot meet its financial obligation, the firm is said to have entered the state of financial distress (Baldwin and Scott, 1983). Whitaker (1999) defines the entry into financial distress as the first year in which cash flows are less than the current maturity of long-term debt. The prediction of financial distress is an important and challenging issue that has served as the impetus for many academic studies over the past three decades (Beaver, 1966). Financial performance of the company is one of the elements that need to be tested by the auditor when they issue the auditor report (ISA 570).

Ferri et al, (1998) reported that the problems of corporate financial structure in East Asian Corporation, which including Malaysia, have been an important factor in contributing to the East Asian Financial Crisis and leading many firms to bankruptcy filings. The increasing number of failure for the companies in Malaysia, including those public listed companies, has increased the worries of public. Bursa Malaysia had come out with Practice Note to facilitate those public listed companies on their financial performance and give time to companies which face financial distress to solve their financial problem before being delisted from the Bursa Malaysia.

1.2 Problem statement

There is a growing concern of the financial distress condition of the listed company in Malaysia. Bursa Malaysia has been updating the company list that has the financial health problem that grouped under PN17. There are different audit reports received by the company under PN17 in the Bursa Malaysia. Some of them are still using the assumption that they are able to go concern (which means that they able to continue their operation in foreseeable future) even though they have financial distress issue. Financial distress companies should have problem to continue their operation in future because of their liquidity and financial problems (Baldwin and Scott, 1983). It casts doubt on whether the audit report issued by the auditor is reflecting the exact financial condition of the company. This has raised the research question for this study on the financial distress level and the issuance of the going concern report by the auditors. Therefore, the main research question is whether there is a relationship between the financial distress level of the company and issuance of going concern opinion.

1.3 Research objectives

According to the problem statement as discussed above, the purpose of this study is to examine the relationship of the company's financial distress level and issuance of going concern opinion. It investigates whether financial distress level will affect auditor decision to issue going concern opinion to the company in Malaysia. It studies about the likelihood of issuing of going concern opinion when there is difference financial distress level facing by the company and explores the ability of going concern opinion by the auditors in Malaysia to serve as a warning sign for bankruptcy to the users.

1.4 Contribution of study

The finding of the study will enhance knowledge on one of the factor of issuance of going concern opinion. Findings of this study also shows whether level of financial distress level affect the issuance of going concern opinion from the auditor. This paper makes significant contribution in terms of valuating the effectiveness of the going concern opinion to reflect the severity of the financial distress facing by the company.

The finding of the study allows users of audit report more understand the indicator of the issuance of non-going concern opinion. The findings of the study will give sightings for the users on when will the auditor assumes that the company is not going concern when it reach a certain level of the financial distress that is severe. The users will be aware in the making decision such as investment in the stock market, when the indicators exist in the business operation. The user of the audit report will understands that when a non-going concern opinion is issued, the company is in what stage of the distress level and hence improve their understanding of financial performance of the company involved.

Besides that, finding of the study will show the effectiveness of audit opinion to reflect financial performance of companies in Malaysia. The finding also indirectly shows the ability of auditors to issue a true and fair assumption on the going concern ability of the clients' financial statements; and possibility of type 2 audit error, which is failure of auditor to issue accurate going concern opinion on the companies. It provides evidence to the accounting standard bodies on the quality of audit which enable them to improve on the standards on auditing which can ensure the quality of audit profession in Malaysia in the future.

1.5 Conclusion

This chapter briefly discuss about the study that is going to be conducted. The parts that have been discussed are the background of the study, the problem statement that leads to the study, the objective of the study and lastly the contribution of the study. The following chapter will discuss on the prior studies that had done on issues that related to the study that is going to be conducted.

Chapter 2

Literature Review

2. Introduction

This chapter will briefly review some prior studies on going concern assumption, financial distress, and the relationship between financial distress and issuance of going concern opinion.

2.1 Going Concern Assumption

International Standard on Auditing (ISA) is the standards that deal with the auditors' responsibility in the process of audit of financial statement. Under ISA 570 which is "going concern" standard, under the going concern assumption, an entity is viewed as able to continue in business for the foreseeable future. There are examples of events or condition stated in the mentioned standard that may cast doubt on the going concern assumption on the company. They are divided into three aspects, which are, the financial aspect, operating aspect and others such as management of the company and regulatory proceedings against the entity. Auditors will need to assess to all these three aspect to assume that the audited entity will be going concern.

There are many variables that proposed by different researches that affect the issuance of going concern from auditors. Mutcher (1985) had selected explanatory variables based on the provision of SAS no. 34 (AICPA, 1981). The variables were the relative degree of financial distress, presence of good news and bad news items, auditor characteristics and company size. The models tested in the study exhibit high degree of predictive accuracy on the variables to the opinion decision.

Citron and Taffler (1992) also had done a research that tested the variables consist of the likelihood of company failure, auditor switch rates, self-fulfilling prophecy argument and company size. A positive relationship is found between the likelihood of company failure and the probability of a going concern qualification (GCQ). The results also exhibit significant relationship between auditor switching and GCQ. For the variables of self-fulfilling prophecy and firms' size, they are not significantly attributed to the issuance of GCQ.

Atef, Suhaimi and Zakimi (2002) from Malaysia had done a study on relationship between the characteristics of board of directors and audit committee of financially distress clients and the likelihood of receiving going concern audit reports. They found evidence to support their hypothesis, which is going concern opinion is associated with the proportion of outside directors to total directors, outside directors with substantial shareholdings and audit committee with only outside directors.

In the study conducted by Blay, Geiger, and North (2011), they have provided evidence on the auditors' communication of business risk through the issuance of the going concern modified audit report. It shows the relevance of the report to the securities market in adjusting the share price valuation. The communication resulted in the shift of market perception on the financially distress firms. The study indicated that the going concern opinion provides information towards the abandonment or adaptation risk. It shows the importance of the going concern report towards the equity market.

Mentioned in the study by Goodman, Braunstein, Reinstein and Gregory (2011), the issuance of going concern opinion by auditors is based on the judgement by the auditor himself. However, auditor needs to communicate with the management capability. The study done has investigated the ability of non-financial variables to help in the explanation of auditor's decision in going concern opinion decision. The results indicate that the non-financial variables as a class aid in explaining the going concern opinion decision from the auditors.

2.2 Financial Distress in Malaysia

In Malaysia, financial distress often associated with the PN17 status of companies (Noor and Iskandar, 2012). Listed companies that experienced financial distress will not be filed for bankruptcy straightaway but they will be temporarily suspended and given chance to restructure by Bursa Malaysia and Securities Commission (SC) Malaysia (Zeni and Ameer, 2010). Zeni and Ameer (2010) had done study on the turnaround prediction of distressed in companies which obtain evidence from Malaysia. In the study, they mentioned that Bursa Securities came out with the Practice note No. 17/2005 (PN17) which aimed at expediting the time taken by listed companies with unsatisfactory financial condition and level of operations to regularize the companies' condition.

PN17 had set out criteria to identify companies in financial distress. The criteria includes deficit in the consolidated adjusted shareholders' equity, receivers or managers have been appointed over the property of the company or property of the major subsidiaries or major associated company whose property is at least 70% of the total assets employed of the company on consolidated basis; auditors had express adverse opinion on latest account; and the company ceased or suspended the major operations. PN17 declared that listed companies that have unsatisfactory financial condition and operations will have eight months to submit their regularization plans to relevant authorities for approval. If they failed to do so, the securities will be suspended on the fifth market day after the eight months and de-listing procedures will be started.

There are other studies done on the financial distress company in Malaysia. Noor and Iskandar (2012) have tested the relationship of the managerial ownership and financial variables with the survival likelihood of financially distress companies. They targeted on the PN17 companies population. The results imply that higher managerial ownership helps reduce the failing of the company while larger companies contribute to higher risk of failing.

2.2.1 Measurement of financial distress

There are models that studies used to test the financial healthiness of a company. Based on prior research, financial distress is measured using the following alternative variables: Altman's Z-Score (Altman, 1968), Altman Z" Score (Altman and Hotchkiss, 2006),, the Hopwood et al. (1994) bankruptcy probability score, and the Zmijewski et al. (1984) bankruptcy probability score (Sun L. 2007). Hopwood et al. (1994) had introduced a stress indicator that defines a company into distressed category. The company need to exhibit signals such as negative working capital, loss from operations, deficit retained earnings, and a bottom line loss.

Salehi and Abedini (2009) have proposed the ability of financial ratio to predict the financial distress of the listed companies in Tehran Stock Exchange (TES). The model was according to ratios that indicate liquidity, profitability, managing of debt and managing of property. The results of the study indicate that the model had presented correct prediction about the financial distress. Study done by Bakar and Hamid (2012) also indicate that Naïve Bayesian Network Model also valid to predict the bankruptcy of the company.

The study conducted by Alifiah, Salamudin, and Ahmad (2011) used the accrual-based or financial ratio such as debt ratio, total assets turnover ratio, current ratio, quick ratio, working capital ratio and net income to total income ratio. The findings found that the most useful and significant ratio for the prediction of financial distress companies in the development sector in Malaysia was only debt ratio. The findings also showed that the prediction model provided more than 50% chance that the model is accurate for five years before distress.

2.3 Linkage between financial distress and going concern opinion

Variables for describing going concern opinion decision should include the indicators of the firm's financial condition (Goodman, Braunstein, Reinstein and Gregory, 2011). Dopuch, Holthausen and Leftwich (1987) mentioned that auditors will more likely issue a qualified audit opinion when the company is experiencing financial condition deteriorates for two reasons, that is, going concern qualifications had raised questions on the firm's ability to finance its ongoing activities and the auditors are likely to decide that contingencies of a given magnitude are material. It showed the linkage between the financial distress and the going concern opinion. In the above mentioned study stated that the relationship between going concern and bankruptcy had been recognized in the auditing literature (Foster et al, 1998; Lotus and Miller, 2000; Kuruppu et al., 2003). The literature identifies the probability of bankruptcy as the main factor of a qualified going concern opinion (Foster et al., 1998; Kaminski et al., 2004).

In Hopwood, McKeown and Mutchler (1989) study, the result had showed that there is significant association between audit report qualifications and financial failure. The study had cited some of the result from previous studies that support the study done. Altman and McGough (1974) found that 46.4% of their samples of bankrupt companies had received going concern opinion prior year to the bankruptcy. Deakin (1977) study cases two years before the bankruptcy event and found out that 14.9% of the bankrupt company received going concern opinion. All these studies show that there is unlikely a company that received going concern opinion to be bankrupt. Hopwood, McKeown and Mutchler (1989) also mentioned that going concern opinion is useful as a warning sign of bankruptcy of a company.

Sun (2007) conducted study on the auditor's opinion versus statistical models in bankruptcy prediction. Sun (2007) mentioned that the most typical reason for a company to file bankruptcy is the company is facing financial distress. The more financially distressed a company, there is more likely it will go bankrupt. The analysis showed that there is incremental prediction ability of the going concern opinion. The ability is beyond the tradition financial ratio, composite measure of financial distress and non-financial-accounting information which include the market variables and industry failure rate). The study conducted actually showed us that the going concern opinion by the auditor supposed to have ability to show to the public on the prediction on the financial distress of the company.

Bryan, Tiras, and Wheatley (2005) have conducted study on whether the going concern opinions serve as early warnings of financial collapse of company. They have tested the variables of bankruptcy prediction, auditors switching and the use of income-increasing accounting methods for the financial statements issued. The study found out that the going concern opinions are positively associated with the bankruptcy emergence. The evidence suggested that auditors' going concern opinion has the ability as the early warning of financial collapse and supports the burden placed on auditors to evaluate the success or failure of management's business plans.

In Malaysia, Haron, Hartadi, Ansari and Ismail (2009) conducted study to test the factor that affects the issuance of going concern opinion. They tested the financial indicator; type of evidence on the company's going concern and adequacy of disclosure that relates to management effort to overcome going concern issue. They found out that financial indicator, evidence and disclosure have significant effect on auditor's judgement on the issuance of going concern opinion. The variable on the financial indicator was tested using Z-score by Altman. The result that they collected has showed that the financial strength of the company significantly affect the auditors' judgement to issue going concern opinion.

The studies done show that the going concern report issue by the auditors shall reflect the financial position of the related company (Haron et al., 2009; Hopwood, McKeown and Mutchler, 1989; Bryan, Tiras, and Wheatley, 2005). The relationship between financial distress level of company in Malaysia and the issuance of going concern opinion will be tested in this study. It will be able to show the reliability of the going concern opinion issued by auditors in Malaysia to reflect the financial distress facing by the company.

2.4 Conclusion

After discussing prior studies on the linkage between financial distress and going concern opinion, the following chapter will discuss about the variables and methodology used to test the relationship between the financial distress level and issuance going concern opinion.

Chapter 3


3. Introduction

This section will discuss about the method used to conduct this study. This study examines the relationship between the financial distress level of firms and the issuance of going concern opinion. Therefore, in this chapter, the method to test each of the variables will be discussed and also the formula that is going to be used to determine the relationship between the two variables.

3.1 Hypothesis

H0: there is relationship between financial distress level and the issuance of the going concern opinion

H1: there severe the financial distress, the higher the possibility of the company to receive non-going concern opinion from the auditors.

3.2 Data Collection

3.2.1 Source of data

Company's annual report will be used as the main sources for this study. The objective of the study is to study the relationship of financial distress level of company and the going concern report received. The information and data for the study can be gathered from the information stated in the annual report. The annual reports selected for the study are sourced from public listed companies which categorized as PN17 companies in the Bursa Malaysia. Therefore, the annual reports are publicly available and can be downloaded from the company website or Bursa Malaysia's website. The data used in this study is secondary data. There are advantages of using secondary data in the study as they are data which publish to the public and more reliable.

3.2.2 Population and sample selection

The population covered for this research covered public listed companies in the main market of Bursa Malaysia. The sample for the study will be the PN17 companies. Those companies are chosen because they are those companies that Bursa Malaysia listed as they experiencing financial distress but not yet delisted or bankrupt. From the samples, we can test the different level of the financial distress experience by each company and consequently see the audit report received by the company. The sample of this study only includes companies that have financial distress and may lead the auditors to doubt on their going concern ability. Dopuch, Holthausen and Leftwich (1987) mentioned that auditors will more likely issue a qualified audit opinion when the company is experiencing financial condition deteriorates.

3.3 Variables

The independent variable for this study is the financial distress level of company and the dependent variable is the issuance of going concern opinion by the auditor.

3.3.1 Independent variables

Financial Distress level

stress zone

grey zone

distress zone

Financial indicator used to test financial distress level in this study is Altman's Z-score. Altman's Z score is commonly used to assess financial distress. It is a weighted composite of financial indicators which relate to profitability, revenue, slack resources, and market return (Altman, 1968). Hayes, Hodge and Hughes (2010) showed the efficacy of Altman's Z' score in predicting financial distress firms in their study.

Odipo and Sitati (2011) concluded in their study that Altman model is a useful tool for the investors in Kenyan market to predict financial distress of the companies. They found out that the model indicates 80% successful prediction. Samarakoon and Hasan (2003) also investigate the ability of the three version of Altman's Z score model of distress prediction in the emerging market of Sri Lanka. The result shows overall success rate of 81% us observed using the Z score. Gerantomis, Vergos and Christopoulos (2009) also concluded that Altman model performs well in predicting failures of companies.

Z' Score Bankruptcy Model:

Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5

T1 = (Current Assets − Current Liabilities) / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings before Interest and Taxes / Total Assets

T4 = Book Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Analysis for Z-score:

Zones of Discrimination:

Z' > 2.9 -"Safe" Zone

1.23 < Z' < 2. 9 -"Grey" Zone

Z' < 1.23 -"Distress" Zone

3.3.2 Dependent variable

Going Concern Opinion

1= Going Concern opinion

0= otherwise

Data for this variable is collected by looking at the audit report issued by the audit firm. There are different opinion can be issued by the auditors, such as, unqualified opinion, qualified opinion, disclaimer, adverse, or emphasis of matter. There will be explanatory paragraph added to explain the qualification before the opinion of matter or emphasis on matter the matter paragraph. From reading the audit opinions and paragraph, the information on going concern assumption on the company can be detected.

3.4 Data analysis

Logistic regression will be used to interpret the data collected on the two variables. Logistic regression is a technique used to measure the relationship between a categorical depended variable and the independent variables by converting the dependent variable to probability score. It can be used when the predicted outcome is binary (on/off, pass/fail, infected/not infected and etc.). This technique resolve the inconsistencies associated with dichotomous dependent data and the assumptions on ordinary sum of squares regression methods (Healy, 2006). The independent variables that are used for the outcome prediction may be dichotomous, categorical or continuous.

The formula for the regression is


3.5 Conclusion

The study will be carried out using the methodology mentioned in this chapter. The findings will be discussed in the chapter four and conclusion will be made in chapter five.