Going-Concern opinions in the "new" legal environment.

SYNOPSIS: The Securities and Exchange Commission (SEC 2000) recently asserted that the litigation environment facing auditors has changed significantly since 1994, and that the reduced threat of litigation can influence auditor behavior. This study examines the potential impact of the "new"

legal environment described by the SEC by examining the audit reports on 1,871 companies under financial stress during the years 1992-93, 1996-97, and 1999-2000. We find that after controlling for financial stress, company size, and default status, going-concern audit reports were less likely (1) in 1996-97 than in 1992-93, and (2) in 1999-2000 than in 1996-97. Our results indicate that changes in the litigation environment are associated with the issuance of fewer going-concern-modified opinions to stressed companies in recent years. This finding is consistent with the SEC's claim that auditors' behavior in recent years has been influenced by reduced litigation pressures.

GOING-CONCERN OPINIONS IN THE "NEW" LEGAL ENVIRONMENT

The Securities and Exchange Commission asserts that the incentive structure facing auditors changed substantially in recent years (SEC 2000). Specifically, the Commission notes that since 1994 there has been a significant decrease in the threat of liability faced by accountants created by four legal developments that reduced the likelihood of success in private lawsuits against auditors:

1. The Central Bank of Denver case in 1994 eliminated liability in private litigation for aiding and abetting a securities fraud violation;

2. Passage of the Private Securities Litigation Reform Act of 1995 (Reform Act) affected pleading standards and substituted proportionate liability for joint and several liability;

3. Elimination of the threat of treble damage liability following amendment of the Racketeer Influenced and Corrupt Organization Act (as part of the Reform Act enactment); and

4. Passage of the Securities Litigation Uniform Standards Act of 1998 pre-empted certain state or common law claims in securities fraud actions against auditors in both state and federal court.

Consequently, the SEC (2000) notes, "It has become much more difficult, and less worthwhile, for private plaintiffs to assert civil claims against auditors." The SEC (2000) also asserts that "changes in incentives are likely to affect [the] behavior" of auditors. This study examines whether these recent shifts in legal incentives are associated with a changed propensity of auditors to issue going-concern-modified audit opinions to financially stressed companies. To do so we examine audit opinions for 1,871 financially stressed companies during three periods--1992-93, 1996-97, and 1999-2000--to empirically document changes in auditors' propensity to issue going-concern-modified audit opinions.

PRIOR RESEARCH AND RESEARCH QUESTION

The decision on what type of audit report to render to the client involves considerable professional judgment and negotiation with the client (AICPA 1988; Ellingsen et al. 1989). These negotiations are particularly sensitive in the case of a financially stressed client facing the possibility of receiving a going-concern-modified audit report, since clients do not like receiving any audit report other than a standard, unmodified report (Kida 1980; Mutchler 1984).

Audit reporting for financially stressed companies has been the subject of many congressional hearings over the years (U.S. House of Representatives 1985, 1990; Carmichael and Pany 1993). The most recent legislative interest in this area manifested itself in the form of the auditor's responsibility for going-concern reporting being elevated to the status of a law as a part of the Reform Act in 1995. (1)

Thus, two issues motivate the current study: (1) The SEC's assertion that the litigation environment facing public accounting firms changed in recent years, and (2) the ongoing interest of legislators and the public regarding going-concern reporting. Accordingly, for evidence of reduced going-concern modifications, we examine the audit reports on samples of financially stressed companies before and after the changes in litigation environment.

Audit Opinions and Stressed Companies

Previous studies note that there are two types of misclassiflcations, with associated costs, in the context of going-concern-modified audit opinions (e.g., Mutchler 1984; Hopwood et al. 1989; Geiger et al. 1998). A type I reporting "error" occurs when a company receives a going-concern-modified report but subsequently remains viable and does not fail. A type II reporting "error" occurs when a company that enters bankruptcy did not receive a prior going-concern-modified opinion. Both reporting outcomes are not technically reporting errors per the existing professional auditing standards, but are readily viewed as such by clients, financial statement users, and Congress (McKeown et al. 1991b; Geiger et al. 1998). Similarly, both types of reporting errors create costs for auditors, clients, and others.

With respect to type I errors, prior research notes that only a small proportion of companies receiving going-concern-modified audit reports subsequently enter bankruptcy. (2) Further, Geiger et al. (1998) find that clients are more likely to switch to a new auditor following a type I reporting error. (3)

Prior studies also find that only approximately half of all companies filing for bankruptcy had a prior going-concern-modified audit opinion in the immediately preceding financial statements.(4) Carcello and Palmrose (1994,3) examine bankruptcy-related lawsuits against auditors, and find that auditors that issued modified reports prior to client bankruptcy had "the highest dismissal rate and the lowest payments (mean and median)."

Changes in Legal Standards and Audit Reports

During the 1990s, litigation reform was the primary public policy concern of the AICPA and audit firms (e.g., Cook et al. 1992; Chenok 1994; Berton 1995). The lobbying efforts of the profession resulted in the enactment of the Reform Act in 1995. The Reform Act offers litigation relief to auditors by both changing the pleading standards, and by providing for proportionate liability (instead of joint and several liability). However, since the Reform Act only covers suits filed in federal courts, critics assert that the Reform Act led to a "substitution effect" whereby the plaintiffs bar shifted its focus from the federal courts to state courts (Cloyd et al. 1998). Subsequent efforts by the public accounting profession led to passage of the Uniform Standards Act of 1998, which essentially closed the potential substitution loophole.

The SEC and others note that the four legal developments identified earlier provide significant litigation relief to auditors when type II "errors" occur (SEC 2000; Coffee 2000). This relief relates to reduced type II reporting error costs. Coupled with the continued risk of losing a disgruntled client due to a type I reporting error, lower type II costs are likely to be associated with auditors issuing fewer going-concern-modified audit reports. Coffee (2000) notes that "the expected costs facing the accountant who might be tempted to shirk his duties in order to please management have vastly declined in just the last five or six years."

Since the first and last of the four legal developments noted by the SEC above occurred in 1994 and 1998, respectively, our first research question in the null form is:

[RQ.sub.01]: Were auditors as likely to issue a going-concern-modified opinion after 1998 as they were before 1994?

Additionally, because the four legal developments noted above occurred over a period of years, this group of legislation could be construed as a continuous, rather than abrupt, shift in the legal environment faced by auditors. If there was a gradual change in the legal environment, then we would expect time periods in the midst of these events to reflect a partial effect not fully representative of the final cumulative effect. Accordingly, we test whether there was a cumulative effect of these events on auditor reporting behavior by examining audit reports in 1996-97, a time period occurring in the midst of these legal events. Thus, our second research question in the null form is:

[RQ.sub.02]: Were auditors as likely to issue a going-concern-modified opinion during 1996-97 as they were before 1994 and after 1998?

METHOD AND DATA

We examine audit reports for a sample of companies in financial stress at three different periods: 1992-93, 1996-97, and 1999-2000, from the 1993, 1997, and 2000 versions of Compact Disclosure-SEC, respectively. We chose 1992-93 and 1999-2000 because these two periods are before and after the four legal developments noted earlier had occurred. For [RQ.sub.02] we need to examine an intermediate period--1996-97--when auditors had obtained some, but not full, litigation relief. To jointly test our two research questions we examine whether financially stressed companies are less likely to have received a going-concern-modified report in (1) 1996-97 than in 1992-93, and (2) 1999-2000 than in 1996- 97. Following prior research, we use a multivariate logistic regression to control for variables associated with auditor reporting. (5)

The independent control factors used in the logistic regression, based on prior research (McKeown et al. 1991a; Raghunandan and Rama 1995; Carcello et al. 1995; Geiger et al. 1998), are company size (SIZE), financial stress (PROB), and default status (DFT). Prior research suggests a positive association between the likelihood of a going-concern-modified audit opinion and both financial stress and default on debt obligations, and a negative association between the likelihood of a going-concern-modified audit opinion and company size. Consistent with earlier studies, we measure client size (SIZE) using the natural log of sales (in thousands of dollars). (6) We then calculate our measure of financial stress (PROB) using the bankruptcy prediction model given in Hopwood et al. (1994). (7) We classify a company in default (DFT) if it is either behind in payments or in technical violation of loan covenants.

Data

The list of companies and relevant financial statement data were obtained from Compact Disclosure-SEC. Auditors do not generally issue going-concern-modified audit opinions for nonstressed companies (McKeown et al. 1991b). Hopwood et al. (1994, 412) suggest that "investigations of auditors' going-concern opinion decisions should be conducted on samples that have been partitioned into stressed and nonstressed categories" because "nonstressed, bankrupt companies are likely to have experienced management fraud leading to misstated financial statements." Consistent with the approach used in prior studies (McKeown et al. 199la; Mutchler et al. 1997; Geiger et al. 1998), we:

* restrict the analysis to financially stressed companies. We define a company as stressed if it exhibits at least one of the following features in the financial statements under audit: (1) negative working capital, (2) negative retained earnings, or (3) a bottom line loss; and

* delete companies in the financial, real estate, and utility sectors because these types of companies have unique financial characteristics not readily captured in our bankruptcy prediction model.

We also restrict the analysis to NYSE and AMEX companies because Compact Disclosure-SEC includes the full financial statement footnotes needed to gather the default data only for NYSE and AMEX companies. (8) We obtained relevant data for 1,871 companies--662,574, and 635 in the 1992-93,1996-97, and 1999-2000 periods, respectively.

RESULTS

Descriptive data about the sample of companies appear in Table 1. Table 1 also indicates that the sample companies are similar with respect to size and financial stress across the three periods examined in this study. The proportion of companies in default is higher in the 1992-93 sample than in the other two samples (p < .05, Chi-square test). Companies receiving a going-concern-modified report are smaller, are in greater financial stress, and are more likely to be in default.

In the 1999-2000 period only 22 of the 635 stressed companies (3.5 percent) received a going-concern-modified audit report. This proportion is down from the 1996-97 and 1992-93 sample proportions of 5.5 percent and 9.5 percent, respectively. A significant (p < .01) Chi-square test of association indicates a difference in going-concern modification propensities across the periods. The proportions of companies receiving a going-concern-modified audit opinion for each of these three time periods are graphically shown in Figure 1. However, a more comprehensive assessment requires a multivariate analysis that controls for other reporting-related factors.

Table 2 reports results from the multivariate logistic regression. The overall model is significant (Chi-square =370.2,5 d.f., p < .0001) and the coefficients for all the control factors are highly significant (p < .0001) and in the expected directions. Both time period variables of interest are negative and significant (p < .05), which indicates that goingconcern-modified opinions were less likely in 1996-97 than in 1992-93, and less likely in 1999-2000 than in 1996-97, after controlling for audit-reporting-related factors.

The logistic regression procedure also gives information about the changes in an event's probability given changes in values of the explanatory variables. (9) The results indicate that, ceteris paribus, auditors were about twice as likely to issue a going-concernmodified report in the 1992-93 period as in the

1996-97 period, and were again about twice as likely to issue a going-concern-modified report in the 1996-97 period as in the 1999-2000 period.

FURTHER ANALYSES AND DISCUSSION

Some might argue that (1-) large audit firms are more likely to issue a going-concernmodified opinion compared to smaller audit firms, (2) companies operating in inherently risky industries, such as the high-tech or pharmaceutical sectors, are more likely to receive a going-concern-modified report than other companies, or (3) audit firms with industry specialization are more likely to issue a going-concern-modified audit opinion. Accordingly, in order to test the robustness of our results, we performed additional analyses by including dummy variables in the logistic regression for the following factors:

(1) Auditor size (Big 6/5 audit firm or not)

(2) Risky-industry indicator variable (using the definition of Raghunandan and Rama [1999]).

(3) Industry-specialization (using the classification in Hogan and Jeter [1999]).

None of the above factors is significant in the regression. However, in each of these additional analyses, the YR96 and YR99 variables continued to remain significant, providing support that the time period effect is robust to several different model specifications.

We also considered more stringent definitions of financial stress. First, we considered only those companies that had a cumulative negative Retained Earnings balance as being in financial stress. Next, we considered only those companies that had (1) negative Retained Earnings balance and (2) either a negative working capital position or a bottom line loss for the year, to be financially stressed. Regression results from each of these subsamples of companies are substantively similar to those reported in Table 2, and both the time-period variables continued to remain statistically significant.

Some might argue that the economic conditions in 1992-93 differed from the economic conditions in 1999-2000, and that is what accounts for the differences in reporting behavior. Specifically, in 1992-93 the economy was coming out of a recession that ended in the second quarter of 1991 and the economic expansion was still relatively young. This economic backdrop could account for the extra caution of auditors, leading to more going-concern-modified opinions. However, there are two counterarguments based on empirical data. First, Rama et al. (1997) provide evidence that when assessing auditors' propensity to issue a going-concern-modified report, an "economic condition variable was not significant in a multivariate regression, after controlling for client financial stress and other related factors." Second, we performed the same regression analysis presented in Table 2 by considering only the samples of companies from 1996-97 and 1999-2000. The economy had been growing for five years by 1996-97, so the economic conditions were substantively the same during the last two periods considered in the analysis. Again, this regression finds the time period variable to be statistically significant, similar to the results reported in Table 2, and auditors were twice as likely to issue a going-concern-modified report in 1996-97 as in 1999-2000.

These consistent additional results support the overall finding that auditor propensity to issue going-concern-modified audit reports changed over the time period 1992-93 to 1999-2000. Auditors were increasingly less likely to issue a going-concern-modified audit report to a financially stressed client over this period.

SUMMARY AND CONCLUSIONS

The SEC recently asserted that the litigation threat facing auditors declined significantly during the period from 1994 to 1998, and that changes in incentives could affect auditors' behavior. This study examines the potential impact of changes in the litigation environment on auditor reporting decisions. Our analysis of companies in financial stress during the years 1992-93, 1996-97, and 1999-2000 presents evidence that auditors were less likely to issue going-concern-modified audit opinions in 1996-97 compared to 1992- 93, and in 1999-2000 compared to 1996-97. These results support the SEC's argument that changes in the litigation environment provide significant relief to auditors, inducing them to issue fewer going-concern-modified reports to companies in financial stress.

The results also suggest some interesting avenues for additional research. While this study examines the issuance of going-concern-modified audit reports to stressed companies, it is also important to test whether the proportion of type I and type II reporting errors changed from the period before 1994 to the period after 1998. Such an analysis will indicate whether these modified or unmodified reports were justified based on subsequent viability. Another fruitful avenue for future research is to examine the effects of the changes in the litigation environment on other types of audit decisions, including those related to client acceptance and retention.

[Figure 1 omitted]

TABLE 1

Descriptive Statistics by Time Period and Type of Aduit Opinion


                                 Time Period
                     1992-93      1996-97     1999-2000
Variable            (n = 662)    (n = 574)    (n = 635)

LNSL                  12.39        12.23        12.25
PROB                   0.18         0.17         0.18
DFT (proportion)       0.30 (b)     0.24         0.24
GO modified            0.095        0.055 (b)    0.035 (c)

                          Audit Opinon
                  Going-Concern       Not
                     Modified      Modified
Variable            (n = 116)     (n = 1,755)

LNSL                  10.74        12.40 (a)
PROB                   0.54         0.15 (a)
DFT (proportion)       0.59         0.24 (a)
GO modified             --           --

(a)Significantly different from modified opinion sample, p < .01.

(b)Significantly different from the other time periods, p < .05.

(c)Significantly different from the 1992-93 time period, p < .01.

LNSL = natural log of sales (in thousands of dollars);

PROB = probability of bankruptcy, calculated from Hopwood et al. (1994)
model; and

DFT = 1 if the company is in default, else 0.
TABLE 2

Logistic Regression Results for Analysis of Time-Period Effect

Model: GC = [b.sub.0] + [b.sub.1] [LNSL.sup.*] + [b.sub.2] [PROB.sup.*]
+ [b.sub.3] [DFT.sup.*] + [b.sub.4] [YR96.sup.*] + [b.sub.5]
[YR99.sup.*]

Variable  Coefficient Chi-square  p-value

INTERCPT     -1.38       6.25      .0124
LNSL         -0.19      19.01      .0001
PROB          2.41      77.58      .0001
DFT           1.54      46.82      .0001
YR96         -0.65       6.61      .0102
YR99         -0.63       4.12      .0424

Model Chi-square = 370.2, 5 d.f., p <.0001; Pseudo-[R.sup.2]= .30

LNSL, PROB, and DFT are as defined in Table 1.

GC = 1 if audit report was modified for going-concern, 0 otherwise;

YR96 = 1 if fiscal year end in 1996 or later, 0 otherwise; and

YR99 = 1 if fiscal year end in 1999 or 2000, 0 otherwise.

Submitted: March 2001

Accepted: June 2001

(1.) The Reform Act essentially codified existing generally accepted auditing standards requirements in SAS No. 59 (AICPA 1988) related to reporting on going-concern. See Boyle and Knopf (1996) and King and Schwartz (1997).

(2.) See, for example, Altman (1982), Mutchler and Williams (1990), Nogler (1995), and Geiger et al. (1998).

(3.) In addition, clients also incur costs in the form of increased cost of capital following a type I reporting error related to going concern (Geiger and Raghunandan 2001).

(4.) See, for example, Altman (1982), Hopwood et al. (1989), McKeown et al. (1991a), Raghunandan and Rama (1995), and Carcello et al. (1995).

(5.) Logistic regression is useful when the observed outcome is restricted to two values that represent the occurrence or nonoccurrence of some event-like receiving or not receiving a going-concern-modified report. The procedure produces a formula that predicts the probability of the occurrence as a function of the independent variables.

(6.) Using log of total assets as an alternative measure of firm size does not substantively alter the results presented in the paper.

(7.) Jones (1987) notes that the predictive accuracy of many bankruptcy prediction models is substantively the same. We use the model from Hopwood et al. (1994) for the sake of continuity with the established tradition in research related to going-concern-modified audit opinions. Geiger and Raghunandan (2001) note that the values of the intercepts given in Hopwood et al. (1994) are incorrect. We use the corrected intercept for the stressed sample (-7.322), as opposed to the incorrect value (5.565) reported in Table 3 of Hopwood et al. (1989), to estimate the probability of bankruptcy.

As part of sensitivity tests, we also used the model from Zmijewski (1984) to calculate the probability of bankruptcy. The results remain essentially the same when this alternative model is used.

(8.) Compact Disclosure-SEC also includes footnotes for the Fortune 1,000 companies but there are few Fortune 1,000 companies that are (1) financially stressed, and (2) not in NYSE or AMEX, and (3) in nonregulated industries.

(9.) Logistic regression produces what is referred to as an Odds Ratio (O.R.) associated with each predictor value. The odds of an event are defined as the probability of the outcome event occurring divided by the probability of the event not occurring. The Odds Ratio for a predictor tells the relative amount by which the odds of the outcome increase (O.R. greater than 1.0) or decrease (O.R. less than 1.0) when the value of the predictor value is increased by 1.0 unit.

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Mars hall A. Geiger is an Associate Professor at the University of Richmond, and K Raghunandan is a Professor at Texas A&M International University.

We thank the reviewers for their helpful suggestions on earlier drafts.

Corresponding author: Marshall A. Geiger

Email: mgeiger@richxnond.edu