INVESTOR RESPONSE TO AUDITORS GOING CONCERN OPINION

The collapse of well-established corporations around the world during period 2000 to 2002 reopened the debate about the auditors’ responsibility (Haron, et al., 2009; Herbohn, et al., 2007) and this increased tension led the auditors being subject to high level of scrutiny by the media, public and regulators (Careya, et al., 2012; Fargher & Jiang, 2008). Some argued that auditors have a duty to signal the external parties regarding the impending collapse of the business. Mostly regulators, politicians and the media have often criticized auditors for not flagging the users of the financial statements about the impending client failures (Carey, et al., 2008).

The limited access to the business’s accurate and unbiased information has increased the dependence on published general purpose financial statements for the decision making purposes by the interested parties. Accordingly, a considerable reliance is made on the independence auditor’s report for the truth and fair presentation of financial statements. Thus there is an argument that audit reports should provide an early warning signal of imminent failure of the corporate (Herbohn, et al., 2007). Other hand some argue that issuance of a going concern opinion can be a ‘self-fulfilling prophecy’, where that the going concern opinion itself triggers a bankruptcy, which could otherwise have been avoided if not for the auditors pinion.

Among the proponents against the auditor’s liability to predict the going concern ability argue that the auditors should not be held accountable for the business failures if the auditor has exercised his professional scepticism and followed the standards. The standard requires the auditor to evaluate whether there is “substantial doubt about the entity’s ability to continue as a going concern.” The term going concern is widely used in the profession, but, curiously, not defined authoritatively in accounting standards (Nogler & Jang, 2012). Accordingly, the absence of any reference to a material uncertainty about the entity’s ability to continue as a going concern in an auditor’s report cannot be viewed as a guarantee as to the entity’s ability to continue as a going concern ( Auditing and Assurance Standards Board, 2015).

The decision to modify a client’s report for going concern reasons is one of the most difficult decisions an auditor faces (Nogler & Jang, 2012). The studies show that auditors have a tendency to avoid issuing a going concern opinion, even when corporations depict liquidity issues (Haron, et al., 2009). The auditor faces a dilemma when disclosing the qualification on the audit report. If a financially distressed corporate collapse subsequent to an unqualified opinion, the auditor is at a risk of being charged as guilt of nondisclosure of the fact. On the other hand if the report is modified as to the validity of going concern assumption, it could hasten bankruptcy by making the alert on going concern a self-fulfilling prophecy (Nogler & Jang, 2012). Therefore the auditor must be sceptics of the work he performs.

Going concern

Under conceptual framework for accounting, the financial statements should be prepared on the going concern basis of accounting unless management either intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. The financial report is prepared on the assumption that the entity is a going concern and will continue its operations for the foreseeable future. General purpose financial reports are prepared using the going concern basis of accounting. Accounting Standard AASB 101 Presentation of Financial Statements requires directors when preparing the financial report to: make an assessment of a company’s ability to continue as a going concern disclose the uncertainties about which the directors were aware in making their assessment of going concern where those uncertainties may cast significant doubt on the company’s ability to continue as a going concern (Australian Institute of Company Directors, 2009)

According to Australian auditing standard ASA 570 - Going Concern issued by Auditing and Assurance Standards Board (AASB) in 2015 states that ‘the auditor’s responsibilities are to obtain sufficient appropriate audit evidence regarding, and conclude on, the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial report, and to conclude, based on the audit evidence obtained, whether a material uncertainty exists about the entity’s ability to continue as a going concern.’ It is the management responsibility to assess the going concern ability of the business. The standard further states that there is an inherent limitations on the auditor’s ability to detect material misstatements are greater for future events or conditions that may cause an entity to cease to continue as a going concern. The auditor cannot predict such future events or conditions. This could be further strengthened by referring to the landmark case on the auditor’s liability where the pronouncement of Lord Justice Lopes in the late nineteenth century stated that an auditor was a watchdog and not a bloodhound (Baxt, 1986).

Auditor’s evaluation on going concern

The auditor’s consideration of its client organization ability to continue as a going concern, has been in effect since 1989 (Nogler & Jang, 2012). The tension has ignited again in the following the corporate collapses and audit scandals in early 2000 where the much of the criticism were directed at the auditors for not signalling the users of the financial statements of the corporate financial distress (Fargher & Jiang, 2008). Some argue that auditors are to blame for not being able to issue the appropriate going concern opinion report. They insist that the collapses of these companies may have been avoided if appropriate reports were issued (Haron, et al., 2009).

Evidence from Indonesia suggest that, in 1997, 14 companies had been issued a clean audit report in the previous year, but collapsed in the subsequent year. Similarly, in 1998, 15 companies previously issued a clean report collapsed in the next year (Haron, et al., 2009). Many stressed the auditors’ incompetence to identify the upcoming bankruptcy the corporates during the most recent audits (Meredith & Giacomino, 2003). Judging whether a going-concern qualification is required is a difficult and unstructured task (Nogler & Jang, 2012) which presents the auditor with a dilemma, and may actually accelerate a corporate collapse.

When an auditor evaluates the going-concern assumption for a distressed client, it is required to evaluate all available information on the future (Bruynseels, et al., 2013). This is instructed and more complicated than evaluating past information on financial statements. Moreover, issuance of a going concern opinion can itself be a ‘self-fulfilling prophecy’ which triggers the bankruptcy. However, the results from an Australian settings in 2008 contradicts this idea stating that there no empirical evidence that there is a self-fulfilling prophecy of increased probability of company failure following the issuance of a going concern modified opinion (Carey, et al., 2008). On the other hand, if a financially distressed company is not qualified on the going concern basis and subsequently fails, the auditor could be seeming alleged for the professional negligence. Therefore, the auditor must be sceptical on the evidence they receive during their course of audit in order to protect themselves being charged for the noncompliance with relevant auditing standards (Bruynseels, et al., 2013).  

In this context there has been an evidence that the auditors were more inclined to issue modified going concern opinion (Fargher & Jiang, 2008; Careya, et al., 2012) during the global financial crisis. In this period there were number of corporate collapses in Australia (HIH, One.Tel, Pasminco, Ansett, and Harris Scarf Holdings), creating the tension among the society. According to an Australian study on auditors’ inclination to issue going concern modification pre and pose economic distressed period between 2000 to 2002 of publicly listed companies, Fargher & Jiang, (2008) fond that auditors were more likely to issue going concern opinions to financially stressed companies immediately after the crisis period however, these results were not in consistent with the period beyond 2003. Similarly, Careya, et al. (2012) also witness ed that there has been a change in auditor’s behaviour in the period after the high-profile corporate collapses in 2001 where the auditors were more likely to issue going concern modified opinion.

The decision matrix for going concern decision identifies two types of audit reporting misclassifications by the auditors as type I and type II errors. Type I error occurs when the auditor fail to render an unmodified opinion to a financially stressed company that does not file bankruptcy in the forthcoming year Type II error occurs when the auditor fail to render an qualified audit opinion to a financially distressed company that files bankruptcy in the upcoming year (Carcello, et al., 2007 ). Carey, et al. (2012) examined the failure rates of Australian companies following an issuance of a first time going concern modified audit opinion in their annual reports in the pre and post global distressed period of 2000-2001. They have noted that that there has been a number of occasions of making type I error during post crisis period and matched sample of financially distressed firms receiving an unmodified audit opinion. The results indicated that auditor switching is positively linked with the auditor’s issuance of a modified opinion going concern ability of the client.

The main stakeholder of a publically listed company is current and potential shareholders. These investors make decisions based on the published financial statements. Based on the information available in the market the investor will change their decisions as to buy, hold or sell that particular company’s shares. It was revealed that the auditor’s going concern modified opinion act as a risk communicator of the financial distress of the firm which change the perception of the equity market (Blay, et al., 2007). In contrast, Herbohn, et al. (2007) stated that there is no short term market reaction to the public announcement of a going concern modified opinion in the published financial statements of Australian firms. Further in the study they have witnessed a significant unfavourable medium term market response in the 12 months preceding to a first time going concern opinion modification. This could be due to the continuous disclosure regime of the ASX and the publically listed companies are now liable to publish their financial affairs more rigorously and a timely manner. These results concluded the notion that an audit opinion serves as an attestation and it has the ability to confirm the deteriorating financial state of a firm.

As per the auditing standards, the auditor should obtain sufficient appropriate audit evidence to evaluate the management assessment about the going concern opinion. Haron, et al., in 2009 studied auditor judgement on going concern opinio by using quasi experimental. The study revealed that there is three factors that caused the auditors' judgement on going concern evaluation, namely, financial indicators, evidence, and disclosure. Blay, et al. (2007) examined the relationship between the auditors’ preliminary assessments of going concern and fraud risk in the planning and performance of the audit. It was found that fraud risk and going-concern risk are significantly associated.

Most of the studies focused on auditors’ evaluation of going concern on single risk level. Young & Wang (2010) diviced five-level risk class based on Australian Auditing Standard pronouncements to observe the suitability of auditors’ going concern reporting. In this regard, they have used Altman Z-score bankruptcy prediction model and asses the going concern reporting of all Australian listed companies within the building industry in 1989 and to follow them through until 2007. This study was in conformity of the current literature view that auditors are not solely functioning as a monitoring mechanism but have agency features.

In the going concern literature the most researched area is the auditor’s audit procedure and how the auditor reach his conclusion as to whether the going concern opinion should be modified or not. In contrast, relatively little research has addressed whether auditors’ circumstances and surroundings influence their propensities to issue modified opinions (Blay, et al., 2016). During the planning and the performing stage of the audit, the auditors pay special consideration to management strategies of the turnaround the distressed firm. There is a strong association between operating turnaround initiatives are the higher likelihood of receiving a going concern opinion (Bruynseels, et al., 2013).

In review of the previous literature it was noted that investor self-reliance in the quality and truthfulness of freely accessible business financial information of  public companies and accompanied by independent auditor’s report is considered vital to the proper functioning of the capital markets (Robinson, 2008). In this regard most of the researchers paid their attention to the shareholders and assessed the auditor’s role in relation to shareholders reaction and perception on the audit report. However, there has been little research carried out understand how lenders in Australia perceive the modified going concern audit report and how they will react to an issuance of a going concern qualification. This study aims to contribute to the knowledge by bridging the existing knowledge gap.

Bibliography

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