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.
The 2007 credit crisis and the economic downturn revealed high-embedded financial risks of many entities that eventually led to significant bankruptcies. The high-embedded financial risks affected many entities ability to continue as going concerns because of the lack of liquidity and the availability of credit. So financial institutions such as Bear Sterns, Lehman Brothers, American International Group, and Washington Mutual all failed. With the inclusion of Fannie Mae, Freddie Mac, Citigroup and Bank of America, the U.S. government had to shore up the capital of systemically important institutions (“too big to fail”) with direct investments due to the high-embedded risks in the balance sheets of these institutions (Bair, 2010). What happened to the going concern assumptions by Auditors prior to the crisis? Nothing! Should not the risks of the valuation assertions of an entity’s balance sheet be measured and access for going concern issues if such risk can lead the entity into the “zone of insolvency”?
Using the going concern assumption is a fundamental principle in the preparation of financial statements by auditors. The assessment of an audit client’s ability to operate, as a going concern, is the responsibility of the client’s management, coupled with the appropriate applicable financial disclosure framework. The auditors must consider the appropriateness of the use of the going concern assumptions. The International Standard of Audit (ISA) No. 570, “Going Concern,” institutes the relevant requirements and guidance as to auditor’s consideration of the going concern assumption in the attestation report. According to IAASB (2011), “Auditors must remain alert throughout the audit for evidence of events or conditions that may cast significant doubt on an entity’s ability to continue as a going concern. We cannot stress enough the importance of professional skepticism and judgment in evaluating financial statement disclosures and the implications for the auditor’s report when a material uncertainty exists relating to events or conditions that, individually or collectively, may cast doubt on the entity’s ability to continue as a going concern.”
Consideration of the need for a going concern emphasis paragraph is a difficult matter of judgment. With the huge losses incurred by shareholders from impacted institutions, it creates a need for a heightened risk concern disclosure that would enhance the financial usefulness of the financial statements, especially after another high embedded risk bankruptcy, MF Global Holding, became insolvent in the fourth quarter 2011. Ironically in December 2011 (IFA, 2011), Professor Arnold Schilder, Chairman of the International Auditing and Assurance Standards Board (IAASB) sent a membership alert regarding going concern reporting, “… an entity may be experiencing a decline in its financial health, or may have material uncertainties arising from direct or indirect exposures to sovereign debt of distressed countries. Auditors are therefore encouraged to review the Alert and, importantly, the relevant requirements in the ISAs.” This alert came out after the MF Global holdings filing with its exposure to sovereign debt holdings.
Statement of Auditing Standards (SAS) No. 59 “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern” requires auditors to evaluate conditions or events discovered during audit fieldwork that raise the validity of entities’ going-concern assumptions. For those auditors who are not satisfied with managements’ going-concern mitigation plans they are required to issue modified (unqualified) opinions. Unfortunately, auditors are not required to design audit procedures specifically to identify questions about the validity of an entity’s going concern assumptions unless issues were discovered contradicting the representation (Venuti, 2009).
Unfortunately the “expectations gap” of auditing standards concerning the level of what a user envisions from audited financial statements and the anticipated performance by auditors of the financial statements continues to widen. SAS No. 59 superseded SAS No. 34 because of the perceived ineffectiveness of the old codification as to providing an effective warning of impending bankruptcies (Ojo, 2007). However the efficacy of even SAS No. 34 is questioned as none of the top ten 2011 bankruptcies received a going concern paragraph.
The fear that a going concern opinion can hasten the demise of a distressed company, which can lessen the chances that the client can receive fresh capital, is at the center of a moral and ethical dilemma. Should the auditor increase the pain of the troubled company or provide an unbiased opinion to stakeholders so that they can make informed decisions? This is an open question.
According to IAS 570, a detailed going concern analysis need not be required for an entity that has a history of profitability and access to financial resources. However with the most recent economic environment (the credit crisis and economic downturn) the landscape has changed. The validity of longstanding approaches no longer hold and undermines previous assumptions. Current economic uncertainties, issues around liquidity and credit risk create new assumptions. Therefore, auditors must approach an entity’s assumptions with the current market environment in mind. The solution is for auditors to supplement prior years reviews with robust analysis that deals with the current economic conditions.
Critical to this assessment, IAS 1 requires management to take, “into account all available information about the future, which is at least, but is not limited to, twelve months from the balance sheet date.” IAS 570 requires auditors to consider the same timeframe. But if the auditors feel that managements review time period is less than twelve months, the auditor is required to ask management to increase its review period up to one year after the balance sheet date. If management is unwilling to comply, the auditor is required to consider modifying the audit report as to a limitation to the audit scope period.
The auditor is required to assess management’s knowledge of event or conditions and related enterprise risks beyond the period of assessment as the significant doubt on the enterprise’s ability to remain as a going concern.
Bair, S. (2010). Speeches and Testimony Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation on Systemically Important Institutions and the Issue of “Too Big to Fail” before the Financial Crisis Inquiry Commission, Room 538 Dirksen Senate Office Building.
IAASB (2009). Staff Audit Practice Alert- Audit Consideration in Respect of Going Concern in the Current Economic Environment. International Auditing and Assurance Standards Board.
IFAC (2011). Economic Conditions Continue to Challenge Preparers and Auditors Alike; Focus Must Include Going Concern Assumption and Adequacy of Disclosures. Retrieved on February 5, 2012 from http://www.ifac.org/news-events/2011-12/economic-conditions-continue-challenge-preparers-and-auditors-alike-focus-must-i
Ojo, M. (2007). Eliminating the audit expectations Gap: Reality of Myth? Retrieved on February 6, 2012 from http://mpra.ub.uni-muenchen.de/232/MPRA Paper No. 232, posted 07. November 2007 / 00:53
Vanuti, E.K. (2009). The Going-Concern Assumption Revised: Assessing a Company’s Future Viability. Retrieved on February 5, 2012 from http://www.nysscpa.org/cpajournal/2004/504/essentials/p40.htm
 The “expectations gap” is the difference between what users of financial statements, the general public perceives an attestation to be and what the auditor claims is expected of them in conducting an audit.
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.
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.