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.
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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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.
Not since the Great Depression has the number of business bankruptcies been so prevalent. Bankruptcy is a dramatic experience. It is one thing reading about the recent large bankruptcies of AMR Corp., parent of American Airlines, Kodak, and MF Global Holdings. But for the business leader, understanding and planning a Chapter 11 bankruptcy to save their own company is a whole different “ball of wax.” Securing the professional advice from an accounting firm, not an individual practitioner is advisable. This is because several areas of specialization will be needed. A key question that will be asked is what the company will look like after all is said and done. After all the activities of debt restructuring and redistributing the ownership of the new company, accountants will use fresh start accounting, if it qualifies, to report the new balance sheet of the company. Because many business leaders are new to the process and never heard of fresh start accounting, and although the bankruptcy process and fresh-starting accounting are complex, a simplistic explanation of fresh-start accounting is attempted. Key expertise will be needed from the following areas that will effect the challenging bankruptcy process:
What is Fresh Start Accounting?
Fresh-start accounting means, “the financial statements of the emerged from bankruptcy entity obtains a fresh presentation of its financial position with newly valued assets after the liabilities have been cancelled and/or adjusted.” Under certain conditions, it is recognized that the new users of the financial statements will be better served by re-valuating the balance sheet on a “fair value” basis after the confirmation of the bankruptcy. Accountants are required to follow promulgations of ASC 852 (formerly SOP 90-7) in establishing an opening balance sheet of the successor company.
Fresh start accounting benefits the new shareholders by creating a “clean” balance sheet and favoring a step up in the value of the assets. Business leaders can eliminate losses of the bankrupt company, which enables the new company to come out of bankruptcy stronger. Use of fresh-start accounting is not a standalone process. It is an integral part of the Chapter 11 reorganization procedure designed to create a solvent, operationally viable entity. Certain debts of the bankrupt company are restructured and/or discharged. Then, if the new company qualifies for fresh start accounting treatment, the balance sheet of the new company is reset.
Complexity of Fresh-Start Accounting
The American Institute of Certified Public Accountants developed strict rules for restating and a timeline for implementing fresh start accounting reporting. Determining the fair value of both tangible and intangible assets, the start date for fresh-start reporting, and the best practices in “push down” fresh start adjustments to subsidiaries and underlying ledgers must be understood. Valuation is most critical to the overall process. This can be an enormous burden on the financial, operational and systems teams as well as management. Completing this process will enable management to move forward and focus on the operations of the newly reorganized business.
Many attorneys and accountants boast having bankruptcy experience, however regarding fresh-start reporting, the requirements are beyond most of them. Practitioners and firms with experience in fresh-start accounting, along with other advisers will be needed to support the individual asset valuations to the company’s external auditors. Know that stakes are high; the situation tends to be demanding; and delays will come with penalties, which requires expertise in this area.
Criteria to Qualify for Fresh-Start Accounting
To qualified for fresh-start accounting two requirements must be met:
These requirements were put into place to prevent solvent companies from filings and to prevent companies to exploiting the bankruptcy code to writing up the carrying value of the assets.
Pro Forma Fresh Start Reporting
The creation of a pro forma balance sheet using fresh start accounting includes two primary considerations:
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Sample of Fresh Start Reporting
The following provides an example of Fresh-Start in practice:
With the formation of Sarbanes-Oxley and the Public Company Accounting Oversight Board (PCAOB) to monitor the activities of accounting firms audit of publicly traded companies, and despite Lehman Brothers, Bear Stearns and AIG, time has shown us that despite additional save guards it has not lessen the “surprise” of companies that received clean audit opinions filed for bankruptcy. With no apparent signs of high risk, i.e., no mention of defaults or showing abnormal financial ratios, should those companies that have high level of embedded financial risks prompt auditors to issue a going concern opinion before the bankruptcy surprise? Hmmm…think of MF Global. This is a question that must be asked.
Generally publicly accessible negative information that acts as a signal of financial trouble mitigates the negative announcement effect of subsequent bankruptcy filings. But 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 Lehman Brothers, and now Olympus, 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) overall those companies with high-embedded risks received clean opinions.
2011 Corporate Bankruptcy Ranking as of December 1st, 2011
|MF Global Holdings, Oct. 31||
|AMR Corp, Nov. 29||
|Dynegy Holdings, Nov. 7||
|PMI Group, Nov. 23||
|NewPage Corp, Sept. 7||
|Integra Bank Corp, July 30||
|General Maritime Corp, Nov. 17||
|Borders Group, Feb. 16||
|TerreStar Corp, Feb. 16||
|Seahawk Drilling, Feb. 11||
In a paper by Sengupta and Shum (2007), the researchers investigated whether auditors’ decisions can be explained by accruals quality. Based on prior research, it was determined that a firm with prior accruals 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 accruals quality. The study found that accruals 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. Accruals quality measures have also been suggested as a means of identifying earnings management using discretionary accruals 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 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.
So what is the possible solution? One possible solution, short of promulgation by the accounting rules bodies, may be to drill deeper into the value-at risk 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.
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 Accruals Quality Explain Auditors’ Decision Making? The Impact of Accruals 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)
 Accruals quality measures the quality of the reported earnings and expenses.
 Type I Error connotes a wrong decision that is made when a sample reject a true null hypothesis (H0) or called a false positive.
 Value-at Risk is the loss in value that will not exceed some specified confidence level.