Audit Reports vs. the Zone of Insolvency: How Valuable is an Audit Report to Investors When It Does Not Have Predictive Value Of Possible Insolvency?

Audit Reports vs. the Zone of Insolvency: How Valuable is an Audit Report to Investors When It Does Not Have Predictive Value Of Possible Insolvency?

Many strongly believed that, in large part, the success of the U.S. capital markets is due to the quality of the financial statements and the disclosure standards used by U.S. public companies (Smith, 2012).  However, an “audit expectation gap” exists (Gray et al, 2011) between users of the financial statements and the auditors in providing informative disclosures during the financial crisis.

Audit Opinions without Predictive Value

Throughout the financial crisis of 2007 through 2009, many unqualified (clean) audit opinions were issued to entities without including the conservative informative going concern modification (GCM) paragraph prior to filing bankruptcy, or being placed into receivership in the case of a bank, although accounting promulgation requires notification by the auditors’ to users concerning of the material risk of insolvency.

Audited financial statements must provide users both predictive value and feedback value; two primary ingredients that supports the decision usefulness qualities of financial statements. When an auditor issues an unqualified (clean) opinion, however it is determines that the entity face material risk of insolvency within 12-months of the audit report issuance date, a GCM paragraph must be included in the opinion. Under Generally Accepted Auditing Standards—AU Section 341(PCAOB, 1989), states that when an auditor has substantial doubt whether an audit client’s likelihood of continuing as a going concern for one year from the date of the audit, a GCM opinion is required (Hahn, 2011).

Unfortunately, this has not been consistently followed, which lessens the predictive value of financial statements.  Andersen (2011) examined 565 companies from 2002-2004—the post Enron era and the passage of the Sarbanes-Oxley Act of 2002 compared to 2000-2001 noting that auditors provided more conservative opinions when the profession is in the news headlines, however such conservatism declined in the following periods. In a complimentary study, this trend remained the same through 2008 (Feldmann & Read, 2010).  Carson et al (2012) found that half of the bankrupt companies in the U.S. had not received a going-concern uncertainty opinion prior to filing bankruptcy.

The audit reports of financial institutions during the banking crisis provided little warning that the global financial system was at risk as to the financial statements’ narrowness of the attestation assurance (The House of Lords, 2011) and those institutions operating in the zone of insolvency. Little research both in the U.S. and abroad have been conducted on whether auditors are, or should be, reluctant to issue going concern reports to financial institutions as to the self fulfilling notion of precipitating the bank’s failure by issuing a going-concern opinion (Carson et al, 2012).

One belief is the danger that an auditor issuing a going concern may undermine the institution’s confidence that may trigger a “run on the bank” (Shin, 2009). Others may believe that that because of the implied assurance by the U.S. federal government mitigated the need for a going concern paragraph (Lastra, 2008). According to Hull (2010), regulators are concerned with the systemic risks associated with banks as “a default by one bank may create losses at other banks” (page 84), and the prospects of “moral hazard” (page 52) whereas banks are considered “to-big-to fail” requiring the government to bail out the institution to protect the financial system. Determining whether the assumption that a going concern opinion precipitates unanticipated consequences and how, if at all, moral hazard affect audit opinions will be studied. Unfortunately, accounting literature as to whether auditors were reluctant in issuing going-concern opinions to financial institutions during the financial crisis is limited (Carson et al., 2012).

The concept of Zone of Insolvency is often cited in director fiduciary duty litigation cases following bankruptcy filings (Kandestin, 2007) and derivative actions for breach of fiduciary duty (Rothman, 2012). The zone of insolvency is defined under the U.S. Bankruptcy Code by not operationally meeting one of three solvency tests (Stearn & Kandestin, 2011): (1) the Balance sheet Test, which determines insolvency when the sum of the entity’s adjusted liabilities is greater than the sum of the entity’s property, as determined by its fair value, and taking into account contingent assets and liabilities, (2) the Cash Flow Test under Section 548—Fraudulent Transfers, which requires taking a forward-look at an entity’s ability to pay its debts as they come due, which includes subjective knowledge that the company has insufficient liquidity to satisfy its obligations, and (3) the Unreasonably Small Capital Test, which is based on case-law that the entity is unable to generate sufficient profits to sustain operations and unable to raise credit.

The accounting profession is at a quandary. How will the profession follow the accounting quality concept of predictive value for shareholders to make informative decisions without lighting the “fire” to the “gasoline” when an entity is “swimming” in the zone of insolvency? The accounting rules making bodies must decide what is best for the shareholders, the capital markets, and the banking system.

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References

Anderson, K.L. (Sep 2011). The Effect of Hindsight Bias On Auditors’ Confidence In Going-Concern Judgments. Journal of Business & Economics Research 9.(9), pp. 1-11.

Carson, E., Fargher, N., Geiger, M., Lennox, C., Raghunandan, K. & Willekens, M. (2012) Auditor Reporting on Going-Concern Uncertainty: A Research Synthesis. Retrieved April 7, 2011, from Social Science Research Center http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2000496

Feet, J. (2012, Mar.). Turnaround Topics. American Bankruptcy Institute Journal. 16, pp. 70-71.

Feldmann, D.A. & Read, W.J. (2010, May), Auditor Conservatism after Enron. Auditing 29.(1), pp. 267-278.

Gray, G.L., Turner, J.L, Coram, P.J. & Mock, T.J. (2011, Dec.). Perceptions and Misperceptions Regarding the Unqualified Auditor’s Report by Financial Statements Preparers, Users, and Auditors.  Accounting Horizons 25.(4), pp. 659-684.

Harn, W. (2011). The Going Concern Assumption: Its Journey into GAAP. The CPA Journal, pp. 26-31.

House of Lords (2011). Auditors: Market concentration and their role. Select committee of economic affairs. 2nd Report of session 2010-2011. London: The Stationery Office Limited.

Hull, J.C. (2010). Risk Management and Financial Institutions, Boston, MA: Prentice Hall, (2nd Ed.), p. 52 and p. 84

Kandestin, C.D. (2007). The Duty to Creditors in Near-Insolvency Firms: Eliminating the “Near-Insolvency” Distinction. Vanderbilt Law Review 60.(4), pp. 1235-1272.

PCAOB (1989). The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern. Retrieved on March 28, 2012 from the Public Company Accounting Oversight Board from http://pcaobus.org/Standards/Auditing/Pages/AU341.aspx

Rothman, S.J. (2012). Lessons from General Growth Properties: The Future of the Special Purpose Entity. Fordham Journal of Corporate & Financial Law17.(1), pp. 227-260.

Shin, H.S. (2009, Winter). Reflections of Northern Rock: The Bank Run That Heralded the Global Financial Crisis. The Journal of Economic Perspectives 23.(1), pp. 101-119

Stearn, R.J. & Kandestin, C.D. (2011). Delaware’s Solvency Test: What Is It and Does It Make Sense? A Comparison of Solvency Tests Under the Bankruptcy Code and Delaware Law. Delaware Journal of Corporate Law 36.(1), pp. 165-187.

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