Audit Risk: Surprise Bankruptcy Despite Financial Risks

Audit Risk: Surprise Bankruptcy Despite Financial Risks

The problem is the lack of issuing a going-concern uncertainty opinion prior to bankruptcy announcement to offset the “surprise” of signs of financial trouble. Generally publicly accessible negative information that acts as a signal of financial trouble mitigates the negative announcement effect of subsequent bankruptcy filings. Unfortunately, as in the case of the 2011 top 10 U.S. bankruptcies none of the audit reports accompanied a going concern opinion prior to filing. In particularly with public scrutiny of the audit profession in the light of high-profiled, alleged audit failures such as, Enron, Lehman Brothers, and now Olympus (Nakamoto, 2011), the problem questions the value-add of the audit function to society at large. Some would say, “the informational content of the going-concern opinion is not homogenous across the industry prior to bankruptcy filing.” Coupled with the fact that non-obvious distress signs of financial trouble prior to a filing (e.g., as firms being in default or showing deviated accounting ratios) those companies with embedded risks received clean opinions.

In a paper by Sengupta and Shum (2007), the researchers investigated whether auditors’ decisions can be explained by accrual quality[i]. Based on prior research, it was determined that a firm with prior accrual quality has associated higher fees, a heighten likelihood of receipt of a going concern opinion and greater chance of an auditor turnover based on using alternative measures of accrual quality. The study found that accrual quality is a proxy for a company’s information risk that is a basis for explaining decisions by auditors. Coupled with the fact that earnings management was found in the audits. accrual quality measures have also been suggested as a means of identifying earnings management using discretionary accrual and providing conflicting results. Evidence was gathered of the likelihood of earnings management affects auditors’ decisions adversely.

Since the collapse of Enron, auditors are now likely to issue a modified going-concern paragraph opinion according to a study by (Carey, Kortun, & Moroney, 2008). In the study, it found that comparing company failure rates subsequent to receiving a going concern modified audit opinion (type-1 error[ii] rate) in the pre- and post-2001 periods, the paper found a consistent type-1 error rate notwithstanding auditors issuing a greater number of going concern modified opinions. The outcomes provided an indication that auditors maintaining going concern reporting accuracy. Additionally, firms with large offices provide higher audit quality than small offices and there is a correlation to greater in-house experience due to more expertise in managing the audit (Yu, 2007).

In 2004 Sarbanes-Oxley Section-104 required PCAOB auditing firms to ‘‘to assess compliance with the Act, the rules of the Board, the rules of the Securities and Exchange Commission, and professional standards, in connection with the firm’s performance of audits, issuance of audit reports, and related matters involving issuers.’’ Gramling, Krishnan, and Zhang (2011) conducted a study as to whether following Section 104 identified audit deficiencies associated with a change in triennially inspected audit firms’ going-concern reporting decisions of financially distressed companies. Reviewing PCAOB inspection reports, the study indicated no audit deficiencies and provided only limited evidence of a change in the likelihood of issuing a going concern opinion.

The solution, short of promulgation by the accounting rules bodies, is drilling deeper into the value-at risk[iii] composition of the assets and liabilities of those companies’ balance sheets. Based on various potential scenarios i.e., a market decline of securities and the mark to market value of assets relative to liabilities, a going concern opinion should be issued and information provided if such risk appear plausible.  Such solution would have warmed stakeholders of Lehman Brothers, Beard Stearns, and AIG that the composition of these companies’ value at-risk financial positions posed high levels of risk, if the market went against them. The 2011 bankruptcy of MF Global may not have happened if management knew that the audit report would have informed shareholders of the company’s increased risk strategy to gain higher earnings. Externally, MF Global looked fine, however its composition of Greek sovereign debt relative to liabilities, posed high risk. When news of a possible Greek debt default, MF Global could not meet its cash collateral calls by its counterparties forcing it into bankruptcy.

References

Carey, P, J., Kortum, S. & Moroney, R. A., (2008). Auditors’ Going Concern Modified Opinions Post 2001: Increased Conservatism or Improved Accuracy. Retrieved on January 7, 2012 from http://ssrn.com/abstract=1309943

Gramling, A.A., Krishnan, J., & Zhang, Y. (2011).  Are PCAOB-Identified Audit Deficiencies Associated with Change in Reporting Decisions of Triennially Inspected Audit Firms? American Accounting Association, Pg 57-79

Nakamoto, M. (2011). Olympus Disclosure Shakes Auditors’ Reputations, Financial Times. Retrieved on January 11, 2012 from http://www.ft.com/intl/cms/s/0/b8aaffe0-0b8c-11e1-9861-00144feabdc0.html#axzz1jeGdZ5TH

Sengupta, P. & Shum, M. (2007). Can Accrual Quality Explain Auditors’ Decision Making? The Impact of Accrual Quality on Audit Fees, Going Concern Opinions and Auditor Change. Abstract retrieved on January 12, 2012 from http://ssrn.com/abstract=1178282

Yu, M.D. (2007). The Effect of Big Four Office Size on Audit Quality. Dissertation Abstracts International,  (UMI Number 3322756)


[i] Accruals quality measures the quality of the reported earnings and expenses.

[ii] Type I Error connotes a wrong decision that is made when a sample reject a true null hypothesis (H0) or called a false positive.

[iii] Value-at Risk is the loss in value that will not exceed some specified confidence level.

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