Are Going Concern Opinions Associated with the Reversal of Financial Distress for Bankrupt Firms?

Abstract:     
We examine a set of bankrupt firms and test the relation between going concern opinions [GCs] and the emergence from bankruptcy. If the role of GCs is to alert stakeholders to the potential of financial failure, as prescribed by the auditing standards, then those investors and creditors who receive such a signal should be able to take actions to reduce their potential losses. Our results indicate that GCs are positively associated with bankruptcy emergence under both SAS No. 59 and the predecessor standard SAS No. 34, indicative of GCs being an effective warning of financial distress. The prior literature suggests, however, that managers may take steps that delay or avoid GCs, and thus reducing the likelihood of a favorable resolution, such as manipulating earnings or switching auditors. In the first case, managers may manipulate their accruals over many years in an ongoing attempt to cover up the deteriorating financial condition of the firm, such that by the time these signs are observable (i.e., low liquidity ratios or high debt-to-equity ratios), stressed firms would have fully exhausted the leeway in their accruals, leaving these firms to report using income-increasing accounting methods. In the second case, managers may switch auditors when their current auditor can no longer ignore negative information about the firm’s future prospects. We find that the use of income-increasing accounting methods at the time of the bankruptcy filing, and/or switching auditors shortly before the filing are negatively associated with bankruptcy emergence, but only during the SAS No. 59 period. This suggests that under SAS No. 59, managers may have more flexibility to take actions that would delay or avoid GCs than they had under the predecessor standard. We expect this finding to be of great interest to the PCAOB as the board revisits the existing set of auditing guidelines.

Number of Pages in PDF File: 42

Keywords: Bankruptcy Emergence, Auditor Switch, Going Concern Opinion, Income- Increasing Accounting Methods

JEL Classification: M41, G33

working papers series