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Abstract:
We test the predictions of the three main behavioral finance theories of market under- and overreaction using out-of-sample data conditional on the nature of the news using the going-concern audit opinion (bad news event) and its withdrawal (good news event). We find strong support for the Daniel, Hirshleifer and Subrahmanyam (1998) model for our bad news as well as the good news case suggesting that market underreaction to going-concern opinions is a consequence of prior market overreaction resulting from incorrect classification of going-concern firms by investors into trending regimes. In contrast, we find no support for the Barberis, Shleifer and Vishny (1998) or Hong and Stein (1999) models in our event-study setting in either the bad or good news cases. Our results have a number of implications relating to the value of such theoretical behavioral finance models in practice. We also highlight the central role of the limits-to-arbitrage assumption when testing such behavioral finance theories.

finance, under- and overreaction models, limits to arbitrage, going-concern

Abstract:
This study examines the comparative information content of the going-concern opinion in very similar auditing and capital market environments but divergent legal regimes. We hypothesize that, ceteris paribus, investors in a creditor-friendly bankruptcy regime (the U.K.) react more adversely to a first-time going-concern audit opinion indicating increased risk of loss associated with bankruptcy than do investors in a debtor-friendly bankruptcy regime (the U.S.). Our empirical results are consistent with this expectation. Our findings have clear implications for standard-setters and regulators who, in pursuing international harmonization of accounting and auditing standards, need to take into account how such standards interact with local legal regimes, and consequently their informativeness to capital market participants.

bankruptcy codes, going concern, international capital markets, international accounting standards

Abstract:
We explore the differential market reaction to the unambiguous bad news and good news signals provided by the going-concern audit opinion and its withdrawal for 845 firms from 1994 to 2002. Results show asymmetric market response to these news events. The market underreacts to such bad news disclosures, resulting in a downward drift of around -16% over the one-year period subsequent to the going-concern opinion, but treats good news consistent with theory. This post-going-concern announcement drift is also distinct from other established anomalies; however, we find no such evidence for going-concern cases with positive earnings surprise. Adjusting for transactions costs, the opportunity to earn profits by trading on this anomaly is limited and highly risky. Additional analyses of stockholder trading activities reveal that institutional investors reduce their holdings in such stocks on a timely basis in contrast to retail investors. Our results indicate that despite clear adverse signals about the firm's continuing financial viability being conveyed by the auditor to investors, this information is not being fully impounded by the market on a timely basis, in contrast to the good news conveyed by going-concern withdrawals. Our findings add to the existing literature calling into question the ability of the market to rationally price stocks in the case of acute public-domain bad news disclosures, as opposed to good news releases.

Market underreaction, going-concern, behavioral finance, limits to arbitrage

Abstract:
We explore the medium-term market reaction to going-concern modified audit opinions and their withdrawal for a large sample of firms from 1994 to 2002. Results show asymmetric market response to these accounting system disclosures. The market underreacts to going-concern opinions, resulting in a subsequent downward drift of around -16% over the one-year period subsequent to the going-concern opinion, but fully anticipates their withdrawal. This post-going-concern announcement drift is distinct from other established anomalies; however, it is limited to those going-concern cases with negative earnings surprise. Nonetheless, adjusting for transactions costs, the opportunity to earn profits by trading on this anomaly is limited and risky. Analysis of stockholder trading activities reveals that institutions reduce their holdings in such stocks on a timely basis in contrast to retail investors. Our results are original, and indicate that auditors are providing clear messages to financial statement users in the going-concern context but their information content is not being fully impounded by the market on a timely basis.

Market anomalies, Investor Biases, Limits to arbitrage, Going-concern

Abstract:
The joint provision of audit and non-audit services (NAS) may provide cost savings due to economies of scope but may also compromise audit quality. We examine whether companies assess the combined effect of such cost and quality spillovers as positive or negative. We find that a company's purchase of NAS is associated with an increased likelihood of voluntary audit, consistent with a positive spillover effect overall. However, the association eventually becomes negative when companies pay very high NAS fees, consistent with an impairment of audit quality when the threat to auditor independence is greatest.

Voluntary audit, non-audit services, spillovers

Abstract:
We investigate the stock price reaction to UK going-concern audit report disclosures in the calendar year subsequent to publication. Over this period our firm population underperforms by between 24% and 31% depending on the benchmark adopted. This market underreaction to such an unambiguous bad news release is not a post-earnings announcement drift phenomenon; it is also robust to other potentially confounding explanations. However, whatever the reasons for such stock mispricing, we find costly arbitrage prevents rational investors forcing prices back into line with fundamental value. Our results have implications for the market's ability to impound bad news appropriately and the incompleteness of arbitrage in such small "loser" firm situations.

Market anomalies, Investor biases, Behavioral finance, Limits to arbitrage