Legislators continue to question auditors' responsibility in evaluating companies' ability to continue as a going concern. The document discusses the historical background of the going concern assumption in accounting and auditing standards. It outlines criticism of the assumption for implying indefinite life and lack of conservatism. It also criticizes prior auditing standards for inconsistently identifying companies in financial distress, allowing auditor flexibility and bias. The author proposes new guidelines in SAS 59 to more proactively evaluate going concern and limit litigation risks.

1. 1
GOING CONCERN? GOING WHERE?
by
Howard Turetsky
Accounting Doctoral Student
Virginia Commonwealth University
1015 Floyd Avenue
P.O. Box 844000
Richmond, VA 23284-4000
(804) 330-4321
E-mail acc3hft@cabell.vcu.edu

2. 2
Abstract
Legislators continue to question whether auditors assume
sufficient responsibility in evaluating an entity’s ability
to "continue" as a "going concern." Invariably the finger is
pointed at the auditor when a company fails shortly after
receiving an unqualified opinion. The major criticism is
that the accounting profession is not providing the public
with early warnings of corporate financial distress. With a
proactive view towards conservatism, providing early warning
signals, and delimiting litigation risk, the purpose of this
paper is to propose new auditing standard guidelines for
considering "An Entity’s Ability to Continue as a Going
Concern." The proposal is founded on a critical perspective
of the historical background and salient criticism of the
going-concern "assumption" and applicable auditing standards.

3. 3
GOING CONCERN? GOING WHERE?
Legislators, in reaction to a higher incidence of
business failure, continue to question whether auditors
assume sufficient responsibility in evaluating an entity’s
ability to "continue" as a "going-concern." The issue of
audit reporting for companies in financial distress is of
particular public interest.
1
Invariably, the finger is
pointed at the auditor when a company fails shortly after
receiving an unqualified opinion2
- defined by some as "audit
failure."
3
Throughout the 1980s and 1990s, creditors,
investors and government regulators have brought suits
against accountants for corporate failures.
4
Warranted or
not, the public press is unforgiving when investors and
creditors are out hundreds of millions of dollars.
The major criticism, as noted by Congressmen Dingell and
Wyden, is that the accounting profession is not providing the
public with early warnings of corporate financial distress.
5
Carmichael and Pany (1993) argue that the ability of an
audit to provide adequate warning of impending failure
1
Per Raghunandan & Rama (1995), the House of Representatives held a
series of hearings (1985, 1990, 1993) regarding the accounting
profession, in particular the issue of reporting for distressed
companies.
2
Ellingson, Pany & Fagan (1989).
3
Carmichael, Messier, Mutchler, Pany & Sullivan (1995).
4
Abbott (1994).
5
Carmichael et al. (1995), Raghunandan & Rama (1995).

4. 4
reflects directly on the validity of the report.
The problem, in conveying a timely financial distress
message, is that auditing standards have not succeeded in
mitigating the "expectation gap"--"the difference between
what the public and financial statement users believe
auditors are responsible for and what auditors themselves
believe their responsibilities are."
6
According to McKeown,
Mutchler, and Hopwood (1991b), users expect the auditor to
issue a financial distress warning, regardless of auditing
standards, and might thus consider absence of any warning
signal to be an audit error. However, controversy persists
within the profession itself as to the auditor’s
responsibility for reporting on an entity’s "going-concern"
status.7
Fundamental to the issue are the conflicting views
as to the meaning of "going-concern"; or more pertinent, when
is an audit report modification expressing doubt about
continuity appropriate?
In 1978, the Cohen Commission on Auditors’
Resposibilities concluded that an audit report going-concern
modification is superfluous and unnecessary. Asare (1990)
cites several studies that support this "irrelevancy" stance.
Consistent with the "efficient market hypothesis",
8
proponents argue that a report modification does not provide
6
Guy & Winters (1993), p. iii.
7
Abbott (1994).
8
According to theory, the securities market quickly reflects all
publicly available information in share prices.

5. 5
additional information beyond that already disclosed in the
financial statements and accompanying notes.
9
In contrast to the lack of theoretical support for
report modification provided by market-reaction studies,
there is a very real-world "relevancy" argument for "red-
flagging" a going-concern uncertainty. According to
Raghunandan and Rama (1995), research consistently indicates
that more than half the companies filing bankruptcy do not
receive a prior going-concern report modification. This Type
II auditor error
10
invites public scrutiny and maintains the
auditor’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, can
reduce auditor litigation risk.
With a proactive view towards conservatism, providing
early warning signals, delimiting litigation risk, and
minimizing the going-concern controversy, the purpose of this
paper is to propose new auditing standard guidelines for
considering An Entity’s Ability to Continue as a Going
Concern. The proposal is founded on a critical perspective
of the historical background and salient criticism of the
going-concern "assumption" and applicable auditing standards.
9
Carmichael et al. (1995).
10
Type II error in that auditors accept the "null" = "no" distress
signal, when in fact there is distress.

6. 6
Historical Background
Going-Concern has its roots as a basic assumption upon
which accounting valuation is based. Paton (1922), in his
pioneering Accounting Theory, lists "going concern" as the
second postulate - assumption of expediency - without which
the accountant is unable to proceed. After the existence of
the entity is assumed, the accountant, as a corollary, takes
for granted the "continuity of this entity." The implication
is that the firm will continue "indefinitely." Wolk,
Francis, and Tearney (1992) note that "going concern" becomes
indefinite because the time period is presumed to be long
enough to conclude the firm’s present contractual
arrangements; however, by the time these are concluded there
are new arrangements, and the firm becomes "ongoing."
Although the going-concern continued to be cited as a
postulate-assumption-convention,
11
the AICPA issued "Statement
on Auditing Procedure" (SAP) No.15 in 1942 as an initial
formal attempt to consider the effect of "uncertainties."
Going concern, while not a distinct audit consideration, was
included in the uncertainties to be considered in issuing the
audit report. The Statement suggested that when the
cumulative effect of uncertainties was great, the auditors
might report an exception or possibly not render an opinion.
11
Gilman (1939); American Accounting Association (1957); Sanders,
Hatfield & Moore (1959); Moonitz (1961); Sprouse & Moonitz (1962).

7. 7
Subsequently, the SEC, in Accounting Series Release (ASR)
No.90 (1962), and the AICPA, in SAP No.33 (1963), required
the audit opinion to be "qualified" by the phrase "subject
to" when uncertainties were opined to materially affect the
financial statements.
The first formal segregate attention given to the-going-
concern uncertainty was "Statement on Auditing Standards"
(SAS) No.2 (1974),
12
which concluded that an uncertainty
concerning an entity’s ability to continue should be reported
in the same manner as other uncertainties. Subsequently, in
1981, the Auditing Standards Board issued SAS No.34, "The
Auditor’s Considerations When a Question Arises About an
Entity’s Continued Existence," to provide operational
guidance to auditors when questions arose about a firm’s
continued existence. In accordance with the premise that
reports be modified for going-concern uncertainties (and
contrary to the Cohen Commission’s 1978 recommendation to
eliminate report modifications due to uncertainties), SAS
No.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 procedures
brought forth information that was contrary to continued
existence. SAS No.34 was thus "passive" in that the auditor
was not required to "search" for evidential matter relating
12
Issued by the AICPA’s "Auditing Standards Executive Committee," the
predecessor of the "Auditing Standards Board."

8. 8
to an entity’s continuity. Going concern was still
"assumed."
After considerable deliberations, the Auditing Standards
Board, in 1988, issued SAS No.59, "The Auditor’s
Consideration of an Entity’s Ability to Continue as a Going
Concern," as one of nine SASs addressing the "expectation
gap." SAS 59 replaced the "subject to" qualified opinion
with an explanatory paragraph that follows (modifies) the
"opinion."
13
However, the major impact of SAS No.59 is that
auditors are required to take a more proactive approach to
the consideration of going-concern. The auditor now has a
responsibility to evaluate whether there is "substantial
doubt" about an entity’s ability to continue for a reasonable
period of time, "not to exceed one year" beyond the financial
statement date.14
Thus, the auditor has an affirmative duty
to consider carefully conditions and events (i.e. negative
trends & possible financial difficulties) that could impact
going-concern status. Continuity is no longer an assumption.
The significance of the historical background is a trend
that is clearly depicted. Going concern was initially viewed
as a postulate-assumption-convention that was customarily
unquestioned by the accounting profession. It was
subsequently addressed by auditing standards in aggregate
13
This directly tracks to the requirement of the FASBs SFAS No.5.
14
In 1990, SAS No. 64 was issued to require that the terms
"substantial doubt" & "going-concern" be included in the paragraph
discussing a going-concern uncertainty.

9. 9
with other uncertainties. SAS No.34 did provide separate
guidance to auditors in assessing a company’s continued
existence; however, the approach was passive and going-
concern was only to be addressed when contrary information
presented itself. With the issuance of SAS No.59, the
accounting profession was acknowledging that there is an
expectation gap and that an entity’s continued existence can
no longer be assumed. The auditor now has an affirmative
responsibility to evaluate the entity as a going-concern.
The issue is whether SAS No.59 objectively delimits the
expectation gap, especially given the prevalent legal
consequences being absorbed by the profession.
Criticism
Criticizing the Assumption
While Paton (1922) did note the speculative element of
the going-concern postulate, he acknowledged that the
assumption of continuity was a necessary convention without
which the accountant could not proceed. The going-concern
convention was postured to be indispensable in precluding the
reporting of liquidation (current) values, thus fixing
"historical cost" as the prescribed valuation measure.
Fremgen (1968) criticizes this view, citing that various
writers have found the going-concern to be consistent with
significantly different principles of asset valuation. He

10. 10
questions even the relevancy of the going-concern concept to
accounting, noting that the formulation of accounting
principles has not relied on this concept. Official
pronouncements have generally ignored the continuity
assumption in arguments supporting the promulgation of
accounting principles.
Additionally, the assumption of continuity is by its
very nature non-conservative. Fremgen warns that a potential
dangerous implication of the going-concern concept is that
"it can quite logically be construed to mean continued
operation at a profit,"
15
violating the intended
"conservatism" in accounting. Sterling (1967) similarly
points out that application of historical cost (per the
going-concern) can result in an "unconservative" value
greater than market for a distressed firm.
Sterling (1968) further posits that the historical cost
realization method is valid only when a firm is "stationary,"
but a firm is engaged in a continuing process of change; and
there 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 show
something about the likelihood of the firms continuing
instead of the reports being prepared under the assumption

11. 11
that it will continue."
16
Paton (1922), in spite of the
infrequency of corporate failure in his environment, had the
foresight 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 a
particular case the financial reports should be so
constructed that all interested are apprised of the real
situation."
17
Sterling (1967) emphasizes that the courts do not assume
future corporate activity when they seek to restore rights in
the event of damages to investors and creditors. In today’s
litigious environment, the argument that "indefinite life"
cannot be assumed has greater relevance. Continuity should
be more in the nature of a prediction than an underlying
assumption.18
In light of the prevalence of financial
distress, the issue is whether auditing standards
appropriately address the "uncertain" nature of a "going
concern." As Fremgen (1968) questions: Going Where?
Criticizing the Auditing Standard
Despite the early criticism regarding the going-concern
inference of "indefinite life" and potential risk to auditor
liability, the standard setters were relatively slow to
15
Fremgen (1968), p. 656.
16
Sterling (1968), p. 494.
17
Paton (1922), p. 480.
18
Wolk, Francis & Tearney (1992).

12. 12
react. Only in 1988, with the issuance of SAS #59, did the
Auditing Standards Board mandate a proactive responsibility
for evaluating "going concern." The issue is whether this
standard objectively guides the auditor and whether it
effectively delimits the expectation gap.
Criticism of prior going-concern uncertainty auditing
standards is relevant to evaluating whether SAS #59 rectifies
pre-existing problems. Prior to SAS #59 there were
significant inconsistencies in the issuance of a going-
concern qualification. As noted by Raghunandan and Rama
(1995), research spanning a wide spectrum indicates that
auditors gave going-concern qualifications to less than 50%
of the firms that actually went bankrupt in the subsequent
accounting period.
19
In 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 issuing
going-concern qualifications to firms that did not go
bankrupt (i.e. Type I error). Other studies addressing
financial distress (instead of specifically bankruptcy) also
found significant discrepancies between recognition of
financial distress by auditors and actual qualification.
20
The predominant explanation for the incongruous going-
concern opinions is that auditor opinion is confounded by an
19
Altman & 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.}
20
Libby (1975b); Casey (1980); Kida (1980).

13. 13
"agency" predicament based on the perceived consequences of
disclosing a going-concern uncertainty.
21
There is the
concern that a going-concern warning of imminent financial
distress, taken seriously by creditors, investors, suppliers
and customers, will in and of itself become a "self-
fulfilling prophecy" and precipitate the client’s insolvency.
Alternatively, not appropriately disclosing the uncertainty
can lead to litigation and a damaged reputation.
A more rudimentary explanation for going-concern report
inconsistencies is the tacit sanctioning of auditor
"flexibility." Under SAS #34, the auditor did not have an
affirmative duty for going-concern evaluation. This
"passive" role allowed the auditor-client relationship and
other external factors to influence/confound the auditor
opinion. SAS #59 does establish an active responsibility to
evaluate the going-concern. The question is whether the
Standard is successful in restricting auditor flexibility
that results in "bias."
Raghunandan and Rama (1995) specifically address audit
reports for companies in financial distress, before and after
SAS #59. Their results suggest that subsequent to SAS #59
auditors are more likely to issue going-concern modified
reports for both financially stressed non-bankrupt companies
and for companies that did go bankrupt in the subsequent
period. A finding of 62%, in the post-SAS #59 period, for
21
Altman (1983).

14. 14
the proportion of bankruptcies with prior going-concern
modified reports is significantly better than the norm of
less than 50% for the pre-SAS #59 period; however, a 35%
frequency of financially stressed companies receiving a
going-concern modification in the post-SAS #59 period is
still relatively low
22
(i.e. 65% Type II error for financially
stressed companies). Also, Raghunandan and Rama (1995), in
concurrence with Carmichael et al. (1995), concede that the
macroeconomic factors of the post-SAS 59 recessionary period,
with systematically greater financial stress, may have caused
auditors to issue more going-concern modifications, thus
biasing the results. In fact, in a broader study examining
bankruptcy-related opinions
23
from 1/1/72 to 12/31/92 (i.e. in
order to compare pre-SAS 34, SAS 34, and SAS 59 periods),
Carcello, Hermanson, and Huss (1995) do not find evidence of
any temporal changes in bankruptcy-related reporting,
24
contrary to the results of Raghunandan and Rama.
As Carcello et al. note, the number of years in the SAS
59 period is quite small and empirical research addressing
the effects of SAS 59 is in the beginning stages and
22
For the pre-SAS #59 period, 22% of the financially stressed
companies received a going-concern modified report.
23
Per Carcello, Hermanson, and Huss (1995), bankruptcy-related
opinions refer to the last audit opinions given to clients before their
declaration of bankruptcy.
24
Note that analysis of a "full" sample that includes audit clients
declaring bankruptcy within 15 months of the last audit report (i.e.
expanded from one-year time frame of SAS #59) did provide some support
for an increase in the propensity to modify bankruptcy-related opinions
from the pre-34 to the SAS 34 period; however, there was no difference
between SAS 34 & SAS 59 reporting, utilizing either sample.

15. 15
inconclusive. While further research is necessary to
evaluate whether SAS 59 has successfully responded to public
concerns over auditors not providing early distress warning
signals, there is already considerable criticism directed at
the standard’s lack of objective guidance.
Critics of SAS #59 posture that the standard does not
provide the objective, restrictive guidance necessary to
effectively delimit the expectation gap. The "substantial
doubt" criterion of SAS #59 is imprecise.
25
Boritz (1991)
concludes that substantial doubt exists when there is a 50-
70% likelihood of occurrence of events which will raise doubt
regarding an entity’s continued existence. Asare’s (1992)
mean probability value of 56.56% for substantial doubt has a
standard deviation of 16.65%. Given the range of
probabilities, the sizeable standard deviation, and the
traditionally subjective nature of assigning probabilities to
the occurrence of events, "substantial doubt" is inexact and
not apt to channel consistency in going-concern
modifications. Additionally, the criterion that going-
concern be evaluated for a period not to exceed one year
beyond the financial statement date severely limits the
auditor’s horizon and precludes the issuance of the early
distress signal that legislators regard as auditor
responsibility. Carmichael and Pany question whether the 12
month period in SAS No. 59 "should ... be viewed as an

16. 16
impenetrable barrier to consideration of a known financial
difficulty."
26
Carcello et al. (1995) warn that SAS No. 59
may simply have codified current practice, manifesting the
inconsistent going concern audit opinions. "If so, it did
little to narrow the gap between users’ expectations and
auditors’ reporting."27
Message to Standard-Setters
Without a more definitive standard, the auditor is given
the freedom to make either a Type I or Type II error
concerning the going-concern evaluation. However, if the
potential effects of the trade-off between Type I and Type II
error are considered, the message to the auditor and the
standard-setters is clear.
Although the potential "self-fulfilling prophecy" can
negatively impact the auditor-client relationship (i.e. Type
I error effect), the more significant auditor risks are
litigation and reputational effects (i.e. Type II error
effects). As Carcello et al. (1995) note, the costs imposed
on society by issuing a modified opinion to a client that
does not declare bankruptcy are considerably less than the
costs of failing to modify a bankruptcy-related opinion.
Carcello et al. cite studies (e.g. Altman (1977), and
Hopwood, McKeown, & Mutchler (1994)) that indicate
25
Ponemon & Raghunandan (1994).
26
Carmichael & Pany (1993), p. 46.

17. 17
significant cost differentials for the misclassification of
bankrupt companies compared to misclassifying healthy firms.
28
The client and fee loss associated with Type I error is
predominantly client-specific, without broad ramifications.
Additionally, there is scant empirical evidence that
even suggests the risk of a self-fulfilling prophecy effect.
Citron and Taffler (1992), in a study of UK firms, found
that the likelihood of failure was no greater following a
going concern qualification than it was subsequent to a non-
qualified report. Similarly, Louwers, Messina, and Richard
(1995), utilizing discrete-time survival analysis, find that
while 22% of the companies receiving an initial going concern
disclosure fail in the subsequent year, the firms, on
average, survive over seven years. These findings, combined
with the significant Type I error results of prior studies
29
provide evidence regarding the irrelevance, in a negative
direction, of a going-concern distress warning on an audit
client’s future operations; in other words, the going concern
disclosure does not appear to precipitate insolvency.
Moreover, according to Carcello and Palmrose (1994), an
increased frequency of going-concern modifications will
delimit the litigation risks/costs to society.
27
Carcello et al. (1995), p. 141.
28
Altman (1977) estimates a 16.5 to 30 times greater cost of
misclassifying bankrupt firms; Hopwood et al. (1994) indicate a
misclassification cost ratio ranging from 1:1 to 100:1
(i.e. misclassifying bankrupt co. cost/misclassifying healthy co. cost).
29
Altman & McGough (1974), Shindledecker (1980), and Altman (1982).

18. 18
The message to auditors and standard-setters is that the
critical concern is avoidance of Type II error. In light of
the going-concern opinion inconsistencies, standard-setters
must restrict auditor flexibility and formally incorporate a
more conservative approach that is inclined toward Type I
error.
Recommendation
New auditing standard guidelines for considering "An
Entity’s Ability to Continue as a Going Concern" cannot allow
the subjectivity and inconsistent application of "substantial
doubt," or be constricted by a one-year time horizon. It is
the responsibility of the profession to objectively delimit
the expectation gap by providing early warnings of corporate
financial distress. Continuity can no longer be an assumed
connection between the past and future, but must be evaluated
as a likelihood of continuation.
A more conservative proactive approach requires that the
profession include recognition of the "financial distress
continuum" in its guidelines for considering a going-concern.
When appropriate, the auditor has an affirmative duty to
communicate that a company experiencing an initial distress
signal has the potential to deteriorate financially along a
continuum, starting with milder states of liquidity squeezes
and covenant violations and ending in the extreme states of

19. 19
bankruptcy reorganizations and liquidations.
30
The
implication for auditor responsibility is one of long-term
prediction.
Models exist and continue to be developed that
statistically predict corporate financial distress as a state
between financial health and bankruptcy.
31
Survival analysis,
used extensively in the medical field, has recently been
utilized in accounting research to develop company risk
profiles.
32
This statistical technique has particular appeal
as an audit tool that can assign probabilities of survival
based upon firm-specific attributes and succession along the
distress continuum.
The proposal is for revised going-concern audit standard
guidelines that require auditors to communicate their
assessment of firm survivability. Statistical analyses are
to be combined with contextual qualitative factors and
included in the audit report as part of an "Auditor’s
Discussion and Analysis" of a firm’s financial "condition."
33
Additional qualitative commentary is consistent with the
recommendation of the AICPA Special Committee on Financial
Reporting (AICPA, 1993) regarding future audit communication.
Additionally, the revised going-concern AUDIT STANDARD
30
Giroux & Wiggins (1983), Foster (1986), & Aksu (1993) document the
"financial distress continuum."
31
Wallace (1989); Cormier, Magnan & Morard (1995).
32
Louwers et al. (1995).
33
Price Waterhouse (1985), addressing concerns over business failures
subsequent to a clean opinion, advocated considering financial condition.

20. 20
should require discussion addressing "financial flexibility"
and "quality of earnings." Financial flexibility - a firm’s
ability to remedy cash flow squeezes - was included in a
proposed AICPA Statement of Position (1993) entitled
"Disclosure of Certain Significant Risks and Uncertainties
and Financial Flexibility." Although "financial flexibility"
was dropped in the official release of SOP 94-6, it reflects
a firm’s ability to survive moderate distress signals.
Likewise, a "quality of earnings" analysis provides valuable
information regarding sustainable earnings and their affect
on prospective cash flows.
The proposal for a proactive auditor responsibility to
analyze and discuss a firm’s likelihood of financial
distress, though a definite departure from a going-concern
assumption, is necessary in light of the litigious
environment that surrounds audit reporting. The irrelevance
of Type I error, and the concern over Type II error
34
attest
to the proposal’s validity.
34
Per Asare & Messier (1993), threat of lawsuit was the only factor
associated with auditor substantial doubt thresholds.

21. 21
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