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  1. 1. 1GOING CONCERN? GOING WHERE?byHoward TuretskyAccounting Doctoral StudentVirginia Commonwealth University1015 Floyd AvenueP.O. Box 844000Richmond, VA 23284-4000(804) 330-4321E-mail acc3hft@cabell.vcu.edu
  2. 2. 2AbstractLegislators continue to question whether auditors assumesufficient responsibility in evaluating an entity’s abilityto "continue" as a "going concern." Invariably the finger ispointed at the auditor when a company fails shortly afterreceiving an unqualified opinion. The major criticism isthat the accounting profession is not providing the publicwith early warnings of corporate financial distress. With aproactive view towards conservatism, providing early warningsignals, and delimiting litigation risk, the purpose of thispaper is to propose new auditing standard guidelines forconsidering "An Entity’s Ability to Continue as a GoingConcern." The proposal is founded on a critical perspectiveof the historical background and salient criticism of thegoing-concern "assumption" and applicable auditing standards.
  3. 3. 3GOING CONCERN? GOING WHERE?Legislators, in reaction to a higher incidence ofbusiness failure, continue to question whether auditorsassume sufficient responsibility in evaluating an entity’sability to "continue" as a "going-concern." The issue ofaudit reporting for companies in financial distress is ofparticular public interest.1Invariably, the finger ispointed at the auditor when a company fails shortly afterreceiving an unqualified opinion2- defined by some as "auditfailure."3Throughout the 1980s and 1990s, creditors,investors and government regulators have brought suitsagainst accountants for corporate failures.4Warranted ornot, the public press is unforgiving when investors andcreditors are out hundreds of millions of dollars.The major criticism, as noted by Congressmen Dingell andWyden, is that the accounting profession is not providing thepublic with early warnings of corporate financial distress.5Carmichael and Pany (1993) argue that the ability of anaudit to provide adequate warning of impending failure1Per Raghunandan & Rama (1995), the House of Representatives held aseries of hearings (1985, 1990, 1993) regarding the accountingprofession, in particular the issue of reporting for distressedcompanies.2Ellingson, Pany & Fagan (1989).3Carmichael, Messier, Mutchler, Pany & Sullivan (1995).4Abbott (1994).5Carmichael et al. (1995), Raghunandan & Rama (1995).
  4. 4. 4reflects directly on the validity of the report.The problem, in conveying a timely financial distressmessage, is that auditing standards have not succeeded inmitigating the "expectation gap"--"the difference betweenwhat the public and financial statement users believeauditors are responsible for and what auditors themselvesbelieve their responsibilities are."6According to McKeown,Mutchler, and Hopwood (1991b), users expect the auditor toissue a financial distress warning, regardless of auditingstandards, and might thus consider absence of any warningsignal to be an audit error. However, controversy persistswithin the profession itself as to the auditor’sresponsibility for reporting on an entity’s "going-concern"status.7Fundamental to the issue are the conflicting viewsas to the meaning of "going-concern"; or more pertinent, whenis an audit report modification expressing doubt aboutcontinuity appropriate?In 1978, the Cohen Commission on Auditors’Resposibilities concluded that an audit report going-concernmodification is superfluous and unnecessary. Asare (1990)cites several studies that support this "irrelevancy" stance.Consistent with the "efficient market hypothesis",8proponents argue that a report modification does not provide6Guy & Winters (1993), p. iii.7Abbott (1994).8According to theory, the securities market quickly reflects allpublicly available information in share prices.
  5. 5. 5additional information beyond that already disclosed in thefinancial statements and accompanying notes.9In contrast to the lack of theoretical support forreport modification provided by market-reaction studies,there is a very real-world "relevancy" argument for "red-flagging" a going-concern uncertainty. According toRaghunandan and Rama (1995), research consistently indicatesthat more than half the companies filing bankruptcy do notreceive a prior going-concern report modification. This TypeII auditor error10invites public scrutiny and maintains theauditor’s litigious position. St. Pierre and Anderson (1984)document that a more rigid application of the "conservatism"doctrine, which includes "red-flag" audit report signals, canreduce auditor litigation risk.With a proactive view towards conservatism, providingearly warning signals, delimiting litigation risk, andminimizing the going-concern controversy, the purpose of thispaper is to propose new auditing standard guidelines forconsidering An Entity’s Ability to Continue as a GoingConcern. The proposal is founded on a critical perspectiveof the historical background and salient criticism of thegoing-concern "assumption" and applicable auditing standards.9Carmichael et al. (1995).10Type II error in that auditors accept the "null" = "no" distresssignal, when in fact there is distress.
  6. 6. 6Historical BackgroundGoing-Concern has its roots as a basic assumption uponwhich accounting valuation is based. Paton (1922), in hispioneering Accounting Theory, lists "going concern" as thesecond postulate - assumption of expediency - without whichthe accountant is unable to proceed. After the existence ofthe entity is assumed, the accountant, as a corollary, takesfor granted the "continuity of this entity." The implicationis that the firm will continue "indefinitely." Wolk,Francis, and Tearney (1992) note that "going concern" becomesindefinite because the time period is presumed to be longenough to conclude the firm’s present contractualarrangements; however, by the time these are concluded thereare new arrangements, and the firm becomes "ongoing."Although the going-concern continued to be cited as apostulate-assumption-convention,11the AICPA issued "Statementon Auditing Procedure" (SAP) No.15 in 1942 as an initialformal attempt to consider the effect of "uncertainties."Going concern, while not a distinct audit consideration, wasincluded in the uncertainties to be considered in issuing theaudit report. The Statement suggested that when thecumulative effect of uncertainties was great, the auditorsmight report an exception or possibly not render an opinion.11Gilman (1939); American Accounting Association (1957); Sanders,Hatfield & Moore (1959); Moonitz (1961); Sprouse & Moonitz (1962).
  7. 7. 7Subsequently, the SEC, in Accounting Series Release (ASR)No.90 (1962), and the AICPA, in SAP No.33 (1963), requiredthe audit opinion to be "qualified" by the phrase "subjectto" when uncertainties were opined to materially affect thefinancial statements.The first formal segregate attention given to the-going-concern uncertainty was "Statement on Auditing Standards"(SAS) No.2 (1974),12which concluded that an uncertaintyconcerning an entity’s ability to continue should be reportedin the same manner as other uncertainties. Subsequently, in1981, the Auditing Standards Board issued SAS No.34, "TheAuditor’s Considerations When a Question Arises About anEntity’s Continued Existence," to provide operationalguidance to auditors when questions arose about a firm’scontinued existence. In accordance with the premise thatreports be modified for going-concern uncertainties (andcontrary to the Cohen Commission’s 1978 recommendation toeliminate report modifications due to uncertainties), SASNo.34 maintained the "subject to" qualification. However,under SAS 34, auditors were required to consider the going-concern issue only when the results of other audit proceduresbrought forth information that was contrary to continuedexistence. SAS No.34 was thus "passive" in that the auditorwas not required to "search" for evidential matter relating12Issued by the AICPA’s "Auditing Standards Executive Committee," thepredecessor of the "Auditing Standards Board."
  8. 8. 8to an entity’s continuity. Going concern was still"assumed."After considerable deliberations, the Auditing StandardsBoard, in 1988, issued SAS No.59, "The Auditor’sConsideration of an Entity’s Ability to Continue as a GoingConcern," as one of nine SASs addressing the "expectationgap." SAS 59 replaced the "subject to" qualified opinionwith an explanatory paragraph that follows (modifies) the"opinion."13However, the major impact of SAS No.59 is thatauditors are required to take a more proactive approach tothe consideration of going-concern. The auditor now has aresponsibility to evaluate whether there is "substantialdoubt" about an entity’s ability to continue for a reasonableperiod of time, "not to exceed one year" beyond the financialstatement date.14Thus, the auditor has an affirmative dutyto consider carefully conditions and events (i.e. negativetrends & possible financial difficulties) that could impactgoing-concern status. Continuity is no longer an assumption.The significance of the historical background is a trendthat is clearly depicted. Going concern was initially viewedas a postulate-assumption-convention that was customarilyunquestioned by the accounting profession. It wassubsequently addressed by auditing standards in aggregate13This directly tracks to the requirement of the FASBs SFAS No.5.14In 1990, SAS No. 64 was issued to require that the terms"substantial doubt" & "going-concern" be included in the paragraphdiscussing a going-concern uncertainty.
  9. 9. 9with other uncertainties. SAS No.34 did provide separateguidance to auditors in assessing a company’s continuedexistence; however, the approach was passive and going-concern was only to be addressed when contrary informationpresented itself. With the issuance of SAS No.59, theaccounting profession was acknowledging that there is anexpectation gap and that an entity’s continued existence canno longer be assumed. The auditor now has an affirmativeresponsibility to evaluate the entity as a going-concern.The issue is whether SAS No.59 objectively delimits theexpectation gap, especially given the prevalent legalconsequences being absorbed by the profession.CriticismCriticizing the AssumptionWhile Paton (1922) did note the speculative element ofthe going-concern postulate, he acknowledged that theassumption of continuity was a necessary convention withoutwhich the accountant could not proceed. The going-concernconvention was postured to be indispensable in precluding thereporting of liquidation (current) values, thus fixing"historical cost" as the prescribed valuation measure.Fremgen (1968) criticizes this view, citing that variouswriters have found the going-concern to be consistent withsignificantly different principles of asset valuation. He
  10. 10. 10questions even the relevancy of the going-concern concept toaccounting, noting that the formulation of accountingprinciples has not relied on this concept. Officialpronouncements have generally ignored the continuityassumption in arguments supporting the promulgation ofaccounting principles.Additionally, the assumption of continuity is by itsvery nature non-conservative. Fremgen warns that a potentialdangerous implication of the going-concern concept is that"it can quite logically be construed to mean continuedoperation at a profit,"15violating the intended"conservatism" in accounting. Sterling (1967) similarlypoints out that application of historical cost (per thegoing-concern) can result in an "unconservative" valuegreater than market for a distressed firm.Sterling (1968) further posits that the historical costrealization method is valid only when a firm is "stationary,"but a firm is engaged in a continuing process of change; andthere is "uncertainty" about what the future holds.According to Sterling, the major problem with the going-concern concept is its false inference of "indefinite life."In light of the evidence that companies have "limited life,"Sterling makes a case that "accounting reports ought to showsomething about the likelihood of the firms continuinginstead of the reports being prepared under the assumption
  11. 11. 11that it will continue."16Paton (1922), in spite of theinfrequency of corporate failure in his environment, had theforesight to remark that the balance sheet is provisional,with validity dependent on uncertain future events. Also,"if the trend of events points toward bankruptcy in aparticular case the financial reports should be soconstructed that all interested are apprised of the realsituation."17Sterling (1967) emphasizes that the courts do not assumefuture corporate activity when they seek to restore rights inthe event of damages to investors and creditors. In today’slitigious environment, the argument that "indefinite life"cannot be assumed has greater relevance. Continuity shouldbe more in the nature of a prediction than an underlyingassumption.18In light of the prevalence of financialdistress, the issue is whether auditing standardsappropriately address the "uncertain" nature of a "goingconcern." As Fremgen (1968) questions: Going Where?Criticizing the Auditing StandardDespite the early criticism regarding the going-concerninference of "indefinite life" and potential risk to auditorliability, the standard setters were relatively slow to15Fremgen (1968), p. 656.16Sterling (1968), p. 494.17Paton (1922), p. 480.18Wolk, Francis & Tearney (1992).
  12. 12. 12react. Only in 1988, with the issuance of SAS #59, did theAuditing Standards Board mandate a proactive responsibilityfor evaluating "going concern." The issue is whether thisstandard objectively guides the auditor and whether iteffectively delimits the expectation gap.Criticism of prior going-concern uncertainty auditingstandards is relevant to evaluating whether SAS #59 rectifiespre-existing problems. Prior to SAS #59 there weresignificant inconsistencies in the issuance of a going-concern qualification. As noted by Raghunandan and Rama(1995), research spanning a wide spectrum indicates thatauditors gave going-concern qualifications to less than 50%of the firms that actually went bankrupt in the subsequentaccounting period.19In addition to this Type II error,Altman and McGough (1974), Shindledecker (1980), and Altman(1982) found that auditors err, by as much as 75%, in issuinggoing-concern qualifications to firms that did not gobankrupt (i.e. Type I error). Other studies addressingfinancial distress (instead of specifically bankruptcy) alsofound significant discrepancies between recognition offinancial distress by auditors and actual qualification.20The predominant explanation for the incongruous going-concern opinions is that auditor opinion is confounded by an19Altman & McGough (1974); Altman (1982); Menon & Schwartz (1987);Hopwood et al. (1989); McKeown et al. (1991a); Koh (1991); Chen & Church(1992). {for dates subsequent to #59, the sample was still prior.}20Libby (1975b); Casey (1980); Kida (1980).
  13. 13. 13"agency" predicament based on the perceived consequences ofdisclosing a going-concern uncertainty.21There is theconcern that a going-concern warning of imminent financialdistress, taken seriously by creditors, investors, suppliersand customers, will in and of itself become a "self-fulfilling prophecy" and precipitate the client’s insolvency.Alternatively, not appropriately disclosing the uncertaintycan lead to litigation and a damaged reputation.A more rudimentary explanation for going-concern reportinconsistencies is the tacit sanctioning of auditor"flexibility." Under SAS #34, the auditor did not have anaffirmative duty for going-concern evaluation. This"passive" role allowed the auditor-client relationship andother external factors to influence/confound the auditoropinion. SAS #59 does establish an active responsibility toevaluate the going-concern. The question is whether theStandard is successful in restricting auditor flexibilitythat results in "bias."Raghunandan and Rama (1995) specifically address auditreports for companies in financial distress, before and afterSAS #59. Their results suggest that subsequent to SAS #59auditors are more likely to issue going-concern modifiedreports for both financially stressed non-bankrupt companiesand for companies that did go bankrupt in the subsequentperiod. A finding of 62%, in the post-SAS #59 period, for21Altman (1983).
  14. 14. 14the proportion of bankruptcies with prior going-concernmodified reports is significantly better than the norm ofless than 50% for the pre-SAS #59 period; however, a 35%frequency of financially stressed companies receiving agoing-concern modification in the post-SAS #59 period isstill relatively low22(i.e. 65% Type II error for financiallystressed companies). Also, Raghunandan and Rama (1995), inconcurrence with Carmichael et al. (1995), concede that themacroeconomic factors of the post-SAS 59 recessionary period,with systematically greater financial stress, may have causedauditors to issue more going-concern modifications, thusbiasing the results. In fact, in a broader study examiningbankruptcy-related opinions23from 1/1/72 to 12/31/92 (i.e. inorder to compare pre-SAS 34, SAS 34, and SAS 59 periods),Carcello, Hermanson, and Huss (1995) do not find evidence ofany temporal changes in bankruptcy-related reporting,24contrary to the results of Raghunandan and Rama.As Carcello et al. note, the number of years in the SAS59 period is quite small and empirical research addressingthe effects of SAS 59 is in the beginning stages and22For the pre-SAS #59 period, 22% of the financially stressedcompanies received a going-concern modified report.23Per Carcello, Hermanson, and Huss (1995), bankruptcy-relatedopinions refer to the last audit opinions given to clients before theirdeclaration of bankruptcy.24Note that analysis of a "full" sample that includes audit clientsdeclaring bankruptcy within 15 months of the last audit report (i.e.expanded from one-year time frame of SAS #59) did provide some supportfor an increase in the propensity to modify bankruptcy-related opinionsfrom the pre-34 to the SAS 34 period; however, there was no differencebetween SAS 34 & SAS 59 reporting, utilizing either sample.
  15. 15. 15inconclusive. While further research is necessary toevaluate whether SAS 59 has successfully responded to publicconcerns over auditors not providing early distress warningsignals, there is already considerable criticism directed atthe standard’s lack of objective guidance.Critics of SAS #59 posture that the standard does notprovide the objective, restrictive guidance necessary toeffectively delimit the expectation gap. The "substantialdoubt" criterion of SAS #59 is imprecise.25Boritz (1991)concludes that substantial doubt exists when there is a 50-70% likelihood of occurrence of events which will raise doubtregarding an entity’s continued existence. Asare’s (1992)mean probability value of 56.56% for substantial doubt has astandard deviation of 16.65%. Given the range ofprobabilities, the sizeable standard deviation, and thetraditionally subjective nature of assigning probabilities tothe occurrence of events, "substantial doubt" is inexact andnot apt to channel consistency in going-concernmodifications. Additionally, the criterion that going-concern be evaluated for a period not to exceed one yearbeyond the financial statement date severely limits theauditor’s horizon and precludes the issuance of the earlydistress signal that legislators regard as auditorresponsibility. Carmichael and Pany question whether the 12month period in SAS No. 59 "should ... be viewed as an
  16. 16. 16impenetrable barrier to consideration of a known financialdifficulty."26Carcello et al. (1995) warn that SAS No. 59may simply have codified current practice, manifesting theinconsistent going concern audit opinions. "If so, it didlittle to narrow the gap between users’ expectations andauditors’ reporting."27Message to Standard-SettersWithout a more definitive standard, the auditor is giventhe freedom to make either a Type I or Type II errorconcerning the going-concern evaluation. However, if thepotential effects of the trade-off between Type I and Type IIerror are considered, the message to the auditor and thestandard-setters is clear.Although the potential "self-fulfilling prophecy" cannegatively impact the auditor-client relationship (i.e. TypeI error effect), the more significant auditor risks arelitigation and reputational effects (i.e. Type II erroreffects). As Carcello et al. (1995) note, the costs imposedon society by issuing a modified opinion to a client thatdoes not declare bankruptcy are considerably less than thecosts of failing to modify a bankruptcy-related opinion.Carcello et al. cite studies (e.g. Altman (1977), andHopwood, McKeown, & Mutchler (1994)) that indicate25Ponemon & Raghunandan (1994).26Carmichael & Pany (1993), p. 46.
  17. 17. 17significant cost differentials for the misclassification ofbankrupt companies compared to misclassifying healthy firms.28The client and fee loss associated with Type I error ispredominantly client-specific, without broad ramifications.Additionally, there is scant empirical evidence thateven suggests the risk of a self-fulfilling prophecy effect.Citron and Taffler (1992), in a study of UK firms, foundthat the likelihood of failure was no greater following agoing concern qualification than it was subsequent to a non-qualified report. Similarly, Louwers, Messina, and Richard(1995), utilizing discrete-time survival analysis, find thatwhile 22% of the companies receiving an initial going concerndisclosure fail in the subsequent year, the firms, onaverage, survive over seven years. These findings, combinedwith the significant Type I error results of prior studies29provide evidence regarding the irrelevance, in a negativedirection, of a going-concern distress warning on an auditclient’s future operations; in other words, the going concerndisclosure does not appear to precipitate insolvency.Moreover, according to Carcello and Palmrose (1994), anincreased frequency of going-concern modifications willdelimit the litigation risks/costs to society.27Carcello et al. (1995), p. 141.28Altman (1977) estimates a 16.5 to 30 times greater cost ofmisclassifying bankrupt firms; Hopwood et al. (1994) indicate amisclassification cost ratio ranging from 1:1 to 100:1(i.e. misclassifying bankrupt co. cost/misclassifying healthy co. cost).29Altman & McGough (1974), Shindledecker (1980), and Altman (1982).
  18. 18. 18The message to auditors and standard-setters is that thecritical concern is avoidance of Type II error. In light ofthe going-concern opinion inconsistencies, standard-settersmust restrict auditor flexibility and formally incorporate amore conservative approach that is inclined toward Type Ierror.RecommendationNew auditing standard guidelines for considering "AnEntity’s Ability to Continue as a Going Concern" cannot allowthe subjectivity and inconsistent application of "substantialdoubt," or be constricted by a one-year time horizon. It isthe responsibility of the profession to objectively delimitthe expectation gap by providing early warnings of corporatefinancial distress. Continuity can no longer be an assumedconnection between the past and future, but must be evaluatedas a likelihood of continuation.A more conservative proactive approach requires that theprofession include recognition of the "financial distresscontinuum" in its guidelines for considering a going-concern.When appropriate, the auditor has an affirmative duty tocommunicate that a company experiencing an initial distresssignal has the potential to deteriorate financially along acontinuum, starting with milder states of liquidity squeezesand covenant violations and ending in the extreme states of
  19. 19. 19bankruptcy reorganizations and liquidations.30Theimplication for auditor responsibility is one of long-termprediction.Models exist and continue to be developed thatstatistically predict corporate financial distress as a statebetween financial health and bankruptcy.31Survival analysis,used extensively in the medical field, has recently beenutilized in accounting research to develop company riskprofiles.32This statistical technique has particular appealas an audit tool that can assign probabilities of survivalbased upon firm-specific attributes and succession along thedistress continuum.The proposal is for revised going-concern audit standardguidelines that require auditors to communicate theirassessment of firm survivability. Statistical analyses areto be combined with contextual qualitative factors andincluded in the audit report as part of an "Auditor’sDiscussion and Analysis" of a firm’s financial "condition."33Additional qualitative commentary is consistent with therecommendation of the AICPA Special Committee on FinancialReporting (AICPA, 1993) regarding future audit communication.Additionally, the revised going-concern AUDIT STANDARD30Giroux & Wiggins (1983), Foster (1986), & Aksu (1993) document the"financial distress continuum."31Wallace (1989); Cormier, Magnan & Morard (1995).32Louwers et al. (1995).33Price Waterhouse (1985), addressing concerns over business failuressubsequent to a clean opinion, advocated considering financial condition.
  20. 20. 20should require discussion addressing "financial flexibility"and "quality of earnings." Financial flexibility - a firm’sability to remedy cash flow squeezes - was included in aproposed AICPA Statement of Position (1993) entitled"Disclosure of Certain Significant Risks and Uncertaintiesand Financial Flexibility." Although "financial flexibility"was dropped in the official release of SOP 94-6, it reflectsa firm’s ability to survive moderate distress signals.Likewise, a "quality of earnings" analysis provides valuableinformation regarding sustainable earnings and their affecton prospective cash flows.The proposal for a proactive auditor responsibility toanalyze and discuss a firm’s likelihood of financialdistress, though a definite departure from a going-concernassumption, is necessary in light of the litigiousenvironment that surrounds audit reporting. The irrelevanceof Type I error, and the concern over Type II error34attestto the proposal’s validity.34Per Asare & Messier (1993), threat of lawsuit was the only factorassociated with auditor substantial doubt thresholds.
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