The changing relationship between audit firm size and going concern reporting
Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت) Accounting, Organizations and Society, Volume 37, Issue 5, July 2012, Pages 322–341
مقالات حسابداری - نشریه حسابداری - جامعه و سازمان ها -
As a result of gradual shifts in the market for audit services, we expect financially stressed public companies to be increasingly audited by regional firms, who, in turn, will be increasingly likely to issue going concern reports to their financially stressed public companies. Our expectations challenge the view that larger audit firms, in order to avoid exposure to litigation, report more conservatively. To address these issues, we examine the 22 years between 1989 and 2010, which we classify into four ERAs (e.g., 1989–1994, 1995–2001, 2002–2005, and 2006–2010). We initially document that over time, financially stressed public companies are shifting to regional audit firms, partly due to the actions of larger audit firms shedding these clients, which represent ex-ante conservatism. In contrast, audit firm reporting represents ex-post conservatism. We next show that over time, for their financially stressed public clients, regional audit firms are increasingly more likely to issue going concern reports, and BigN audit firms are increasingly less likely to issue going concern reports. We also show that in more recent ERAs, regional audit firms have been more likely than BigN and national audit firms to issue a going concern report to their financially stressed pubic clients. Overall, our evidence suggests that more recently, larger audit firms, relative to regional audit firms, acted more proactively to lessen their litigation risks through increasing centralization of client selection and acceptance processes. However, our evidence suggests that more recently, to lessen their litigation risks, regional audit firms, relative to BigN and national audit firms, acted more conservatively by issuing more going concern reports to their financially stressed public clients.
Under Generally Accepted Auditing Standards (GAAS), audit firms have the responsibility to evaluate the going concern status of each of their clients and to include explanatory language in their report when they conclude that there is “substantial doubt” about a client’s ability to continue as a going concern (GC) over the next year. This responsibility has been controversial, as well as consequential. Generally, managers of public companies prefer not to receive a GC report (Geiger and Rama, 2006 and Mutchler, 1984), in part because equity markets react negatively when a GC report is issued (Blay and Geiger, 2001 and Menon and Williams, 2010). However, issuing a GC report presumably lessens the litigation risks audit firms face from investors seeking to recover their losses (Carcello & Palmrose, 1994). Audit researchers have a longstanding interest in understanding the extent to which firm size moderates the strength of the relation between litigation risks and GC reporting (DeFond and Francis, 2005 and Francis, 2004).
Audit researchers also have a longstanding interest in understanding the market for audit services and how it changes over time (Choi et al., 2004, Hogan and Martin, 2009, Jones and Raghunandan, 1998 and Landsman et al., 2009). Generally, the literature examines the extent to which the relative financial risks for the portfolio of public clients differ by audit firm size and changes to these financial risks over time, but links to going concern reporting are limited (Francis & Krishnan, 2002). Thus, further research is warranted on how changes in the market for audit services impact GC reporting decisions among differentially sized audit firms.
The purpose of the current study is to provide longitudinal evidence on the changing relationship between audit firm size and auditor going concern reporting. Our longitudinal analysis examines 22 years divided into four ERAs. The years 1989–1994 represent the first ERA preceding passage of the Private Securities Litigation Reform Act (PSLRA). The years 1995–2001 represent the second ERA, following the PSLRA, but preceding the Sarbanes–Oxley (SOX) legislation and the demise of Arthur Andersen. The years 2002–2005 represent the third ERA, which includes the immediate years after SOX while audit firms and public companies were responding to these dramatic changes. The years 2006–2010 represent the fourth ERA, which includes the time when audit firms and public companies largely adjusted to temporary shocks in the audit environment occurring in 2002.
Our study focuses on three classes of audit firms (e.g., BigN, national, and regional1) across four different ERAs. Over time, we expect that financially stressed public companies will increasingly be audited by regional audit firms, who in turn will increasingly report more conservatively as demonstrated by a higher propensity to issue a GC audit report. In addition, among financially stressed public companies still audited by BigN audit firms, we expect a decreasing likelihood of receiving a going concern report over time (e.g., less conservative GC reporting). Overall, at some point, regional audit firms are expected to be more likely to issue a going concern report compared to larger audit firms. Our findings generally support these predictions.
We document that across the ERAs, financially stressed public companies are increasingly audited by regional audit firms. Specifically, our evidence indicates that regional firms only audited approximately 16% of financially stressed public companies in the first two ERAs, but over 30% in the last two ERAs. While a variety of factors are involved, this change reflects, in part, a decreasing willingness by larger audit firms to audit financially stressed public companies. The BigN audit firms began using more formal firm-wide screening practices in the early 1990s (Arthur Andersen et al., 1992) and over time, placed more emphasis on formal firm-wide screening as a means to avoid associating with “risky” audit clients (Bell et al., 2002 and Winograd et al., 2000). These screening practices focus, in part, on financial stress, which is generally observable to the audit firm and also associated with audit litigation (Latham & Linville, 1998).
We also document that for their financially stressed public companies, regional audit firms were more likely to issue a GC report in the latter ERAs, whereas BigN and national audit firms were increasingly less likely to issue a GC report. Krishnan, Raghunandan, and Joon (2007) refer to the use of audit reporting to control their firm’s exposure to litigation risks as ex-post conservatism. Results are generally similar for an analysis of Type I accuracy (e.g., issuing a GC report to a client that becomes bankrupt in the subsequent year). In the case of regional firms, we believe this change reflects, in part, increases in regional firms’ exposure to catastrophic litigation costs (Francis & Krishnan, 2002). We also believe the change among BigN firms reflects, in part, increases in BigN firm reliance on client screening as a mechanism to control their firm’s exposure to litigation risks. Krishnan et al. (2007) refer to the use of client screening for this purpose as ex-ante conservatism.
Our study offers important contributions to the audit markets and to the GC reporting literatures. Specifically, the results of our study extend existing longitudinal auditing research on portfolios (e.g., Choi et al., 2004, Francis and Krishnan, 2002, Hogan and Martin, 2009 and Landsman et al., 2009). Our evidence considers a long time horizon, more current data, and three categories of audit firms, which allows us to assess the effects of gradual changes in the audit environment on both the market for audit services and GC reporting. Our evidence is particularly important because it shows that in more recent time periods, BigN audit firms did not issue GC reports more conservatively than smaller audit firms for financially stressed public companies. Instead, in more recent time periods our evidence shows that for financially stressed public companies, regional firms issued GC reports more conservatively than did BigN and national audit firms.
The remainder of this paper is organized as follows. The next section discusses the auditing environment and develops the hypotheses. The third section describes the research methods and presents our results. The last section provides a discussion of our results.
نتیجه گیری انگلیسی
Our research extends research on GC reporting by considering the strategic implications that result from gradual changes in differentially sized audit firms’ portfolios over time. We contend that over time BigN firms will be increasingly unwilling to audit financially stressed public clients, and that regional firms will increasingly audit financially stressed public clients. For financially stressed public clients, our research initially documents a gradual shift away from BigN audit firms to regional audit firms. Across the ERAs, increases in financial stress were significantly associated with a higher likelihood of being audited by a regional firm. Our evidence also indicates that the shift toward regional firms by financially stressed public clients is due, in part, to the actions of BigN firms. Thus, our evidence indicates that BigN firms were increasingly engaging in ex-ante conservatism (Krishnan et al., 2007) through their unwillingness to audit financially stressed public companies.
Based on these changes, we tested three hypotheses about audit firm reporting: regional audit firms will be increasingly more likely to issue a GC report; BigN audit firms will be increasingly less likely to issue a GC report; and in more recent time periods, regional audit firms will be more likely to issue a GC report compared to larger audit firms. Our results generally provide support for our three hypotheses. In testing H1 and H2, the results for the last three pooled samples indicate an increasing tendency for regional firms to issue GC reports, a decreasing tendency for BigN firms to issue GC reports, and limited changes in national firms propensity to issue a GC report. Our tests for H3 show that starting around ERA2, financially stressed public companies were significantly more likely to receive a GC report from a regional audit firm compared to either BigN or national audit firms. Additional analysis indicate that over time, Type I errors were generally increasing for regional firms, consistent with the notion that regional firms exhibited increasingly conservative GC reporting. Similar results were found when controlling for the potential effects of clients self-selecting an audit firm and a subset of financially stressed clients with the largest number of potential successor audit firms.
Our findings for the three hypotheses provide important contributions. Our research shows that for a key subset of the audit market, financially stressed public clients, regional audit firms appear to engage in audit behaviors that reflect greater conservatism with respect to going concern reporting compared to larger audit firms. Krishnan et al. (2007) refer to this activity as ex-post conservatism. In this regard, our findings indicate that in more recent ERAs, regional firms are more likely to issue a GC report to their financially stressed public clients compared to larger firms. Because the economic consequences for inferior audit quality in terms of a damaged reputation and litigation costs are tied to audit firm size, larger audit firms are believed to have the strongest incentives to report in a conservative fashion (DeFond & Francis, 2005). In recent ERAs, however, our results challenge this view. Specifically, our findings document significant changes occurring to the riskiness of differentially sized audit firms’ portfolios and relate these changes to differentially sized audit firms’ tendencies to issue GC reports more or less conservatively.
Several factors may motivate differentially sized audit firms to change the relative conservatism in their GC reporting in response to gradual changes in the riskiness of their portfolios. First, Francis and Krishnan (2002) speculate that regional firms are likely to report more conservatively (e.g., ex-post conservatism) as they audit more risky clients and as the riskiness of the firm’s portfolio increases. Regional audit firms, because they are smaller, are less able to withstand and survive large litigation-related damages. Second, Francis and Krishnan (2002) also speculate that BigN firms, increasingly relying on firm-wide decision aids and technologies to make acceptance and continuation decisions (e.g., ex-ante conservatism), may believe that client screening has effectively dealt with risks associated with financially stressed clients.
In comparing our results to previous GC research, our study is noteworthy, in part, as it provides longitudinal evidence across four discreet ERAs covering 22 years, which includes recent time periods. Also, our research considers three classes of audit firms. While considering three categories of audit firms is not novel, we believe that the growth of national audit firms over time makes it an increasingly important design choice. In this regard, our results indicate that for several ERAs, GC reporting differs between national and regional firms. For example, results shown in Table 6 and Table 7 indicate that national firms were significantly more likely to issue a GC report compared to regional firms in the last three ERAs. Also, the results from Table 5 generally indicate that there were no differences in GC reporting across ERAs for national firms, but regional firms were increasingly more likely to issue a GC report over ERAs. Thus, our results suggest that going forward, it may be increasingly important to use three classes of audit firms in GC research.
Lastly, our results raise an interesting policy issue related to the ability of financially stressed clients to hire an audit firm. While the results of our study indicate that financially stressed clients are still able to hire an audit firm, their options appear to be decreasing over time. To the extent that their audit firm options continue to shrink over time, some financially stressed public companies may be unable to hire an audit firm in the future. Evaluating the implications and potential consequences to these firms represents an important area for further research.