The Auditor's Going Concern Opinion as a Communication Risk

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Auditing: A Journal of Practice & Theory American Accounting AssociationVol. 30, No. 2 DOI: 10.2308/ajpt-50002May 2011pp. 77102

The Auditors Going-Concern Opinion as aCommunication of Risk

Allen D. Blay, Marshall A. Geiger, and David S. North

SUMMARY: In this study, we examine the proposition that the auditors going-concern

modified opinion is a valuable risk communication to the equity market that results in

a shift of the markets perception of financially distressed firms. Specifically, our analyses

reveal that the market valuation is significantly altered from a focus on both the incomestatement and balance sheet to a balance sheet-only focus in the year a company

receives a first-time going-concern modified opinion. These results hold even after

controlling for several common measures of financial distress and when examining a

larger control sample of distressed firms. We also document that the market devalues a

companys inventory and places increased weight on cash, receivables, and long-term

assets and liabilities as a result of the auditors modification. This indicates that the

going-concern modification provides incremental information specifically related to

abandonment or adaptation risk. Our results provide evidence that the market inter-

prets the going-concern modified audit opinion as an important communication of risk

that results in a substantial shift in the structure of the market valuation for distressed

firms.

Keywords: auditors opinion; going-concern; value-relevance; financial distress.

Data Availability: All data are available from public sources.

JEL Classifications: M41; M42.

INTRODUCTION

The only public communication mechanism available to external auditors is their audit

report. While the efficacy of the audit report, with its standardized wording, has long beenan issue of debate (Mautz and Sharaf 1961; American Institute of Certified Public

Accountants [AICPA] 1978; Ellingsen et al. 1989), it remains the sole communication mechanism

Allen D. Blay is an Assistant Professor at Florida State University. Marshall A. Geiger is a Professor, and

David S. North is an Associate Professor, both at the University of Richmond.

We gratefully acknowledge helpful comments from W. Robert Knechel (associate editor), the reviewers, Wendy Bailey,Nathan Stuart, and workshop participants at the University of Florida, the University of California, Riverside, theAmerican Accounting Association Annual Meeting, and the AAA Auditing Section Midyear Meeting.

Editors note: Accepted by Robert Knechel.Submitted: April 2009

Accepted: September 2010


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between the audit firm charged with rendering a final cumulative professional opinion and all

interested outside parties. In fact, professional standards in the U.S. expressly prohibit external

auditors from disclosing any additional information regarding the audited company to anyone

outside the organization (AICPA 2010).

The communication conveyed in the auditors report is part of the information made publiclyavailable when the company releases its annual report. As part of this information, the auditors

report expresses a professional opinion regarding the accuracy and completeness of the clients

financial information and disclosures. In addition, if deemed warranted, professional standards in

SAS No. 59 (AICPA 1988) require the auditor to add language to his or her report identifying cases

where, in the auditors judgment, there exists substantial doubtabout the continued viability of

the client over the next reporting year. While professional standards are clear that the responsibility

of the external auditor does not extend to predicting the future viability of the audit client, they do

require that auditors actively assess the continued viability of every audit client in every

engagement. This additional communication regarding the auditors judgment with respect to the

future viability of the client goes beyond providing a professional attestation on the accuracy andcompleteness of the firms reporting and disclosure, and provides additional information to the

financial markets concerning the auditors professional assessment as to the risk that the company

may not continue in business in the foreseeable future. Thus, a going-concern modified audit

opinion is the only way an external auditor can indicate his or her perceived risk regarding the

continued viability of a client.

Prior literature has documented a general shift in the markets valuation of a company from an

income statement focus to a balance sheet focus as financial stress increases and the company

approaches bankruptcy (e.g., Barth et al. 1998; Black 1998; Burgstahler and Dichev 1997; Hayn

1995; Subramanyam and Wild 1996; Joseph and Lipka 2006). However, prior research has been

unable to properly distinguish whether the documented shift in valuation is gradual or rapid, orwhether it coincides with discrete informational events. In addition, prior literature has not

addressed whether the shift in valuation has predictable effects on individual balance sheet

components (e.g., cash, inventory). Specifically pertaining to our study, no prior research has

adequately assessed whether the issuance of a going-concern modified opinion from the firms

external auditor, or any other informative disclosure regarding the risk of company failure, is

viewed by the market as a specific informational event that results in a shift in the valuation of a

firms financial statement components. Finding a valuation shift that coincides with the issuance of

a going-concern modified opinion would provide evidence that the modified opinion is a priced risk

factor relating to the possible abandonment of the companys operations.1,2

We contribute to the literature by testing the hypothesis that for similar firms facing financialdistress, the communication of a first-time going-concern modification by the firms auditors,

indicating what they perceive as a heightened risk of business failure (i.e., the abandonment

option), alters the structure of the valuation mechanism adopted by the market beyond any available

financial distress measure (Berger et al. 1996). Accordingly, we also examine the shift in market

pricing of individual balance sheet components and predict how a going-concern opinion may shift

1 An alternative possibility is that market valuation gradually shifts from a focus on the income statement to thebalance sheet as negative financial news is released. We control for this explanation by comparing the firmsreceiving a going-concern opinion to a similarly distressed control sample of non-going-concern modified firms.

2 The auditors going-concern opinion is certainly not the only informational event that could potentially causesuch a shift. Other examples include indications of debt default, credit ratings cuts, and dividend reductions,among others. However, the external auditors going-concern opinion is often the first public notification ofextreme financial distress (Kida 1980) In addition we control for debt default in our robustness tests and the

78 Blay, Geiger, and North


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the markets perception of the future uses of different classes of assets and liabilities, including

abandonment or adaptation.3

Evidence from a sample of 431 going-concern modified companies and 431 matched companies

in financial distress that did not receive a going-concern modified audit report indicates that market

valuation shifted significantly in the year the firm received a first-time going-concern modified audit

report compared to the firms previous three years and compared to the other stressed firms over the

same period. We find strong and consistent support for the proposition that the issuance of a

going-concern modification in the U.S. communicates substantial value-relevant information about

the abandonment risk of a firm. This information is priced by the market beyond traditional measures

of financial stress, resulting in a shift from an income statement valuation focus to a balance sheet

focus. Further, we document an increase in the valuation coefficient of assets and liabilities that are

directly related to abandonment value, and a decrease in the valuation coefficients of assets that

would generally possess more value if the firm continued in existence and were not liquidated.

Our study extends earlier research on the general market reaction to unanticipated

going-concern report modifications (Dopuch et al. 1986; Fleak and Wilson 1992; Chen and Church

1996; Blay and Geiger 2001; Menon and Williams 2010) and research on changes in earnings

response coefficients that have been unable to detect a shift in the valuation mechanism for

going-concern modified audit report recipients (Choi and Jeter 1992). Lo and Lys (2001) argue that

value relevance studies detect substantially different constructs than information content studies.

Whereas information content studies combine the effects of both recognized items and unrecognized

items, value-relevance studies isolate the effect of a variable of interest on market valuation of

recognized financial statement components. Thus, our study extends prior literature by concurrently

examining both income statement and balance sheet components in assessing share price valuation.

In addition, by including stressed non-going-concern modified companies in our control sample, and

by including companies that report negative income or book value of equity, we extend the existing

literature on the value relevance of book value and net income to include the most highly distressedfirms. We also provide the first test of shifts in specific asset and liability account valuations with

respect to companies exhibiting the most extreme levels of financial distress. The results of our

analyses present consistent evidence that communication of the auditors first-time going-concern

modification coincides with a shift in the structure of the valuation of financial statement components

from a combination of book value and net income to a function of recorded net asset values.

The remainder of the paper is organized as follows. The next section provides a background for

the paper, discusses the relevant prior literature, and presents the hypothesis examined in the paper.

Next, the Research Method section discusses our sample selection procedures and the statistical

models used in our analyses. We then present the results of our main analyses in the Results section,

and discuss additional tests in the Further Tests section. The Conclusion section summarizes ourresults and discusses the implications of our findings.

BACKGROUND, PRIOR LITURATURE, AND HYPOTHESIS

The going-concern assumption in financial reporting presumes that an entity will generally

continue largely in its present form for an indefinite future and allows for the financial statements to

be prepared using valuations other than liquidation value (Altman 1982; AICPA 1988;

Subramanyam and Wild 1996). In this context, and based on relatively privileged information,

the external audit firms ability to modify their audit report for what they perceive as a heightened

3 Abandonment refers to the option to exchange the continuing business for the exit value of the assets-in-place(Berger et al 1996) Adaptation in this setting refers to the ability to derive hidden value from recorded assets

The Auditors Going-Concern Opinion as a Communication of Risk 79


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threat to the going-concern assumption enables auditors to communicate what is often the first

substantial nonfinancial public statement about a stressed companys ability to continue in business

(Kida 1980; Mutchler 1985; Ellingsen et al. 1989). Thus, the communication of a first-time

going-concern modified audit opinion from the external auditor reflects the auditors current

assessment of the increased risk of business failure on the part of their client, and the potentialabandonment or adaptation of their extant assets and liabilities.

There has been a considerable amount of research over the years with respect to the markets

identification and security price incorporation of a companys business risk (cf. Altman 1982; Barth

et al. 1998; Baginski and Wahlen 2003; Nekrasov and Shroff 2009). In addition, researchers have

examined audit firms issuance or nonissuance of going-concern modified opinions to financially

stressed firms (cf. Kida 1980; Mutchler 1985; McKeown et al. 1991; Carcello and Palmrose 1994;

Hopwood et al. 1994; Carcello et al. 1995; Mutchler et al. 1997; DeFond et al. 2002; Geiger et al.

2005), and the impact of the going-concern modification to the recipient companies (cf. Loudder et

al. 1992; Louwers et al. 1999; Pryor and Terza 2001; Carcello and Neal 2003; Carey et al. 2008), as

well as their audit firms (cf. Kida 1980; Mutchler 1984; Geiger et al. 1998; Carcello and Neal2003). Further, prior research has also examined the information content of a going-concern

modified audit report and has, in general, concluded that an unexpected going-concern

modification, as measured by event study abnormal returns, results in a negative market reaction

for the recipient company (Dopuch et al. 1986; Fleak and Wilson 1992; Chen and Church 1996;

Blay and Geiger 2001; Menon and Williams 2010).

Accordingly, we argue that while financial statements and disclosures contain other

information that provides evidence regarding financial distress and the probability of continued

viability, the communication of a going-concern modified report from the companys external

auditor provides considerable additional credible evidence that, in the auditors professional

judgment, there exists a substantial amount of doubt about the future viability of the company and,

thus, the realization of any future income and continued use of existing assets and liabilities.

Conversely, financial distress not accompanied by an auditors going-concern modified opinion

may provide evidence to the markets that the firm is going through financial stress, but that the

auditor believes that the risk of business failure is not severe and that the firm may not need to resort

to liquidation. Accordingly, financial statement readers may more readily assume that the company

may still derive value from income in the future, albeit at possibly reduced levels (Hayn 1995;

Subramanyam and Wild 1996), and may continue to use their assets-in-place. More specifically,

continuance in business into the foreseeable future, as implied by the going-concern assumption,

and if not explicitly questioned by the auditor, creates the possibility of unrecognized net assets,

which can occur as a result of accounting returns in the future. However, violation of the

going-concern assumption eliminates, or significantly reduces, the probability that any accounting

returns will be generated in the future, and increases focus on the abandonment or adaptation value

of the recognized net assets on the balance sheet.

Prior researchers provide evidence that as firms approach bankruptcy, or show increasing signs

of financial distress, the market valuation mechanism places a higher weight on recognized net

assets, as reflected on the balance sheet, and less (or no) weight on unrecognized net assets, as

reflected in current net income. For example, Subramanyam and Wild (1996) find that the greater the

level of reported financial stress, the less informative was the companys net income to the market for

equity valuation purposes. Barth et al. (1998) provide additional evidence that market valuation is

more significantly positively influenced by book value for firms facing high levels of financial stress.

Although both of these studies document a differential market valuation for distressed firms

compared to nonstressed firms, they are unable to answer the question of when such a valuation shift



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Choi and Jeter (1992) examined the effect of all types of qualified audit reports (including

subject to qualified reports for going-concern uncertainty issues) on the value relevance of reported

net income by assessing changes in earnings response coefficients after a firm receives a qualified audit

report. Of particular relevance to this study is their examination of a subsample of 11 first-time

going-concern qualified report firms. In contrast to expectations, they find no significant shift in theweight of earnings response coefficients for these going-concern modified firms from three quarters

prior to the annual report release (containing the audit report) to three quarters subsequent to its release

(p 0.13, one-tailed). However, the authors suggest that their nonsignificant results may be partiallyattributed to their small sample size (only 56 quarterly observations for the 11 firms) and the fact that

the earnings response coefficients for these going-concern firms were positive but not significant even

in the pre-qualification period (p 0.09, one-tailed). Further, Berger et al. (1996) provide evidencethat the market values the abandonment option for firms that discontinue operations. However, it is

unclear when this abandonment option is first seriously considered by the market.

The communication of a going-concern modified audit opinion from the firms auditor

provides us with a significant discrete event to test whether the valuation shift from assets-in-placeto abandonment value noted in prior research for distressed firms is gradual or whether it coincides

with this specific informational event from the auditor concerning their perception of the increased

risk of discontinuation of the firm (Subramanyam and Wild 1996; Berger et al. 1996; Burgstahler

and Dichev 1997; Barth et al. 1998; Black 1998). Accordingly, the hypothesis (stated in alternative

form) examined in this study is:

H1:There is a shift in the valuation of financial statement components of distressed firms after

the receipt of a first-time going-concern modified report compared with similarly

distressed firms not receiving a going-concern modified report.

RESEARCH METHOD

Sample Selection

To identify financially stressed firms that may likely receive a going-concern modified audit

opinion, we first adopt Mutchlers (1984) four criteria for financial distress: operating loss, bottom

line loss, negative working capital, or negative retained earnings in the last three years. We then

identify firms during the period 19892006 that met one of the distress criteria. Because of

previously documented differences in market valuation between industries (Barth et al. 1998), we

limit our study to durable manufacturing firms (SIC codes 27002899 or 30003999). All publicly

traded durable manufacturing firms receiving a first-time going-concern audit report modification

were then identified using Compustat and 10-K filings in the SEC EDGAR database. Of thedistressed manufacturing firms that met all data requirements during our examination time period

(including stock price data on CRSP), 431 received a first-time going-concern modification.4

These 431 first-time going-concern modified firms were then matched by year, three-digit SIC

code, and size decile (based on book value of total assets), with one of the 3,070 distressed firms

that did not receive a modified report.5 For a firm with no exact match, a firm in a nearby size decile

was used or two-digit SIC code was used. We then collect financial and market data for the year the

company received the first-time going-concern modified report (t 0), or for the control firms, the

4 We required firms to have complete data for the year in which they received their first-time going-concern

modification and at least one of the preceding three years.5 Firms were first matched in yeart. This controlled for any differences in time-series valuation differences related

to either the market or auditor tendencies over time to issue a going-concern opinion (Francis and Krishnan 2002;



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year it was matched to a going-concern modified company (t0), along with available financialand market data for the preceding three years (i.e., t1, t2, t3).6

Summary statistics for theGCandNONGCsample firms are provided in Panel A of Table 1. As

indicated in Panel A, firms receiving the going-concern modification were generally smaller in terms

of book value of equity (BVE

), and showed a higher level of financial distress (ZSCORE

) as measured

by Altmans Z-score, using Begley et al.s (1996) coefficients, and had a lower market capitalization

(MVE).7 This is consistent with prior literature indicating that firms receiving a going-concern

modification are generally smaller and in greater financial distress than other financially distressed

firms (Mutchler et al. 1997). Accordingly, along with our matching procedure, we include additional

controls for level of financial distress and size in our statistical analyses discussed in the next section.

Models

Barth et al. (1998) provide evidence that as firms approach bankruptcy or show more signs of

financial distress, the market valuation mechanism places a higher weight on recorded net assets as

reflected on the balance sheet (BVE), and less, or no, weight on unrecognized net assets as reflectedin current net income (NI). These findings are predicated on the assumption that the market uses

financial information to predict the future viability of a firm. Barth et al. (1998) assume that there is

some association between stock market equity value and financial statement components, and

estimate the following equation:

MVEi a0a1BVEa2BVE LOa3NIa4NI LOei 1

where:

MVEmarket value of equity;BVEbook value of equity;

NInet income before extraordinary items; andLOBVEorNI 1 if the firm is of lower financial soundness, 0 otherwise.

Barth et al. (1998) find evidence in support of their predictions thatBVE_LO is positive and

NI_LO is negative, indicating that book value is more relevant and net income is less relevant for

firms facing higher financial distress. Using this basic approach, we extend the Barth et al. (1998)

method to also include firms with negative BVEand negativeNIand examine the change in market

valuation in the year a financially distressed firm receives a first-time going-concern modified report

from their auditor.

In order to demonstrate that the going-concern firms in the study have a marked shift in market

valuation structure upon receipt of the first-time going-concern opinion, we not only include a

control sample of financially distressed non-going-concern modified firms, we also include a

control sample of prior years for all the sample firms (going-concern modified and non-going-

6 Using a matched pair sample produces a sample selection bias if the base occurrence rate of the studied event issignificantly smaller than half the firms in the population. We use a matched pair sample to be consistent withprior studies on market reaction to going-concern opinions. More importantly, we are not studying going-concernreport recipients compared to the entire population of firms, but compared to similarly financially distressed firmsthat did not receive a modified report. Thus, including a larger sample with less-distressed firms would bias thestudy toward finding results, even if going-concern recipients were no different from similarly distressed firms.Nonetheless, as described in the Further Tests section, including a larger sample of financially distressedNONGCfirms produces substantively similar results.

7 Because the going-concern recipient firms have a higher level of financial distress, as discussed in a subsequentsection, we include financial distress control variables in the regression analysis to control for any remainingeffects of financial distress Further in sensitivity testing we limit our sample to observations with negative net



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TA

BLE1

DescriptiveSummary

anelA:MeansandStandardDevia

tionsbyClassification

Yeart

0

Yeart1

Yeart2

Yeart3

GC

NONG

C

GC

NONGC

GC

NONGC

GC

NONGC

Mean

S.D.

Mean

S.D.

Mean

S.D.

Mean

S.D.

Mean

S.D.

Mean

S.D.

Mean

S.D.

Mean

S.D.

ofobs.

431

431

391

399

355

394

346

3

88

VE

156.091784.09208.281735.15

143.97861.72177.25

1293.69

196.75

977.15

216.161473.94

330.002899.412

86.473140.52

VE

36.10

383.11

61.53

415.20

55.78285.31

69.22

347.65

77.50

347.20

95.09

641.35

149.961568.891

19.741359.90

ofobs,

0

81

21

31

11

19

26

33

18

33.37

169.19

2.38

134.8616.82112.26

1.24

105.2075.581304.0632.81

723.5811.04

168.88

5.01

107.58

ofobs,

0

410

312

307

215

241

192

231

1

99

CORE

5.19

15.74

3.88

8.86

3.48

17.69

5.61

5.61

6.58

15.55

6.13

8.55

4.09

25.81

6.57

10.22

anelB:StockReturnsforWindowsSurroundingReportAnnou

ncementDate(t

0)

GC

N

ONGC

Mean

S.D

.

Mean

S.D.

Difference

nnounce

mentDate

0.011

0.102

0.004

0.075

0.015*

DayWindow(1,1)

0.030

0.165

0.001

0.122

0.031**

DayWindow(2,2)

0.048

0.163

0.005

0.132

0.053**

-DayW

indow(1,10)

0.057

0.222

0.002

0.174

0.055**

**Significantlydifferentatthe0.05,and0.0

1levels,respectively.

riableD

efinitions:

C

samplefirmreceivedafirst-timegoingconcernmodificationinyeart

0;

ONGC

samplefirmreceivedanunmodified

auditopinioninyeart

0;

VEma

rketvalueofcommonequitytenday

ssubsequenttothe10-Kfilingdate;

VE

boo

kvalueofcommonequity;

netin

comebeforeextraordinaryitemsavailabletocommonshareholders;and

CORE

financialdistressscorecalculatedas

perAltman(1968)usingBegleyetal.(1996)coefficients.



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concern modified). If the receipt of the going-concern opinion produced the switch in the market

valuation methodology, including the years t1 through t3 enables us to demonstrate that thereemerges a difference in valuation in yeart 0 for recipients of a going-concern opinion comparedto firms earlier years and to other distressed firms. A finding that the coefficients for the going-

concern modification are the same in year t 0 after controlling for firm-specific effects wouldindicate that firm risk factors and not the going-concern opinion are driving differences in the

structure of the market valuation mechanism.

Since the going-concern modified opinion is correlated with level of financial distress, and

increasing levels of stress are associated with greater likelihood of bankruptcy, it is important that

we also control for level of financial stress communicated by other information in the financial

statements. Thus, in our analyses we incorporate a model of financial distress presented by Altman

(1968) to estimate the likelihood of bankruptcy for each firm for each of the four years (i.e., from

time t3 to t 0). We choose to use Altmans (1968) model updated with Begley et al. (1996)coefficients because it is generally robust and contains mostly financial accounting variables. While

other models have been developed that incorporate the use of many market variables such as

relative MVE, price, orMVE/BVE ratios (e.g., Campbell et al. 2008; Shumway 2001), our goal isnot to accurately predict bankruptcy, but to control for the effect of other financial distress

information issued concurrently with the going-concern opinion.

Using Altmans (1968) model and applying Begley et al.s (1996) updated coefficients, we

estimate:

ZSCOREi 10:4X1;i1:0X2;i10:6X3;i0:3X4;i0:17X5;i 2

where:

X1,i (current assets current liabilities)/total assets;X2,i retained earnings/total assets;

X3,iearnings before interest and taxes/total assets;X4,imarket value of preferred and common equity/book value of total liabilities; andX5,isales/total assets.

In this model, the ZSCORE score represents the firms financial strength. The higher the

ZSCOREscore, the less likely that a firm will terminate and the less likely they would receive a

going-concern modified opinion from their auditor. We use Altmans (1982) viability cutoff score

of 1.81, and consider a firm as a predicted going-concern modification recipient (PRED) if their

ZSCOREi , 1.81, and a predicted viable firm without a modification if their score exceeds 1.81,

after applying Begley et al.s (1996) adjustment factor.8 Including this additional control provides a

more robust assessment of the incremental effect of the going-concern modification beyond the

level of stress exhibited in the firms financial statements.9

Cross-Sectional Time-series Analyses

In order to assess the change in the markets valuation of financial statement components for

individual distressed firms across our four year examination period (i.e., from timet3 tot 0), weuse a firm and year fixed-effects approach when analyzing our sample companies. Specifically, for

this time-series analysis we include all four years of data observations for each of the GC and

8 Varying the cutoff slightly in either direction does not change the results. In addition, in the Further Tests sectionwe report that when we replace the indicator variable with the continuous measure we obtain results consistent

with those presented.9 As noted in the Further Tests section, we replace the predicted going-concern modification as our indicator of

financial stress with a going-concern opinion prediction indicator based on Mutchlers (1983) F-score and with a



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NONGCfirms and treat each company as its own control over the four separate observations. This

firm fixed-effects analysis technique allows us to examine the differential effect of the markets

change in valuation of the GC firms compared to that of the NONGC firms at t0. In addition,because of documented changes in value relevance coefficients over time (Lo and Lys 2001), and to

control for possible differences in auditors going-concern reporting thresholds over time (Francisand Krishnan 2002; Geiger et al. 2005), we also include a year fixed-effect in our analysis. This

approach allows us to isolate the change in market valuation for the year the GC firm receives their

first-time going-concern opinion compared to the firm itself in the prior three years, as well as to the

matched distressedNONGCfirms att 0. Accordingly, in our full analysis we estimate coefficientsfor the following model:

MVEi;ta0a1GCYEARi;t a2GCi;t a3BVEi;ta4NIi;ta5BVE NEGi;ta6BVE GCYEARi;t a7NI NEGi;ta8NI GCYEARi;t a9PREDi;ta10PRED BVEi;t a11PRED NIi;t a12GC BVEi;t a13GC NIi;ta14GCYEAR GCi;t a15GCYEAR GC BVEi;t a16GCYEAR GC NIi;t

ei;

t

3

where:

MVE market value of common equity for firm i, ten days subsequent to the date of the 10-Krelease in time t;

GCYEAR1 if t is 0, 0 otherwise;

GC1 if the company received a going-concern modification in time t, 0 otherwise;

BVEbook value of common equity for firm i, as reported in 10-K in time t;

NI net income before extraordinary items available to common shareholders for firm i intime t;

BVE_NEGBVEmultiplied by 1 ifBVE for firm i is negative in time t, 0 otherwise;BVE_GCYEARBVEmultiplied by 1 ifGCYEAR for firm i is 1 in time t, 0 otherwise;

NI_NEGNImultiplied 1 ifNIfor firm i is negative in time t, 0 otherwise;

NI_GCYEARNImultiplied by GCYEAR for firm i at time t;

PRED1 if predict a bankruptcy for firm i at time tper Altmans model, 0 otherwise;

PRED_BVEPRED multiplied by BVEfor firm i at time t;

PRED_NIPRED multiplied by NIfor firm i at time t;

GC_BVEBVEmultiplied by 1 if a going-concern firm, 0 otherwise;

GC_NINImultiplied by 1 if a going-concern firm, 0 otherwise;

GCYEAR_GCGCYEAR multiplied by GCfor firm i at time t;

GCYEAR_GC_BVEGCYEARmultiplied by GCmultiplied by BVEfor firm i at time t; andGCYEAR_GC_NIGCYEAR multiplied by GCmultiplied by NIfor firm i at time t.

To appropriately isolate the valuation effects ofBVEandNIon the market valuation structure

for our GC firms in the year they receive the first-time modification, we include several control

variables. First, we include partitions for negative book value (BVE_NEG) and negative net income

(NI_NEG) to control for firms with negative capital and negative net income. Hayn (1995) has

shown that the information content of negative net income is lower than that of positive net income

because of the general lack of persistence of negative net income. Thus, allowing the valuation

coefficient for net income to differ for positive and negative values of income will allow us to

separate the effect of the going-concern modification from the effect of negative net income.

Because market capitalization cannot be negative, the effect of negative book value is

indeterminate. However, it is essential to allow the coefficients to vary because of the likelihood



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To control for other firm-specific risk and valuation factors, we include an additional intercept

variable,GC, set to 1 for all years in our sample for firms receiving the going-concern modification.

We also include variables for book value (GC_BVE) and net income (GC_NI) for all firm-years to

control for firm-specific factors affecting the coefficients on BVEandNI. The coefficient for firms

with positive book value of equity receiving a going-concern modification is the sum of GCBVE_GC. Likewise, the coefficient for firms with negative book value but no going-concern

modification is BVEBVE_NEG, and firms with both negative book value and a going-concernmodification would be GC BVE BVE_NEG. A similar structure also exists for net income.Further, because BVE and NI are generally expected to be accretive to MVE, we expect their

coefficients to be positive. Since negative net income cannot persist, we expect thatNI_NEGwill be

negative, but do not make any predictions on BVE_NEG.

Because our financially distressed sample was matched in time 0, we also control for time-

specific risk factors by including a variable, GCYEAR, equal to 1 in time 0, as well as similarly

defined variables for book value (BVE_GCYEAR) and net income (NI_GCYEAR). Because net

income for firms likely to fail within the next year is not expected to persist, and therefore should

not provide relevant information about the future value of the firm, we expect that the sum of the

coefficients forNI(i.e., NINI_NEGGC_NIGCYEAR_GC_NI) will be essentially zero forgoing-concern opinion recipients.10

Additionally, if the market devalues firms receiving a going-concern modified opinion

unrelated to recognized financial statement items, we also predict that GCYEAR_GC, the

incremental valuation effect on going-concern firms in the year they receive the going-concern

modification, will be negative.

If the going-concern modification causes the market to employ a substantively altered valuation

methodology for the GC firms in t0 compared to the financially distressed NONGC firms andcompared to the GC firms themselves in years prior to receiving the going-concern modification,

we expectGCYEAR_GC_BVEwill be positive, indicating the higher relevance of book value forthe GCfirms in the year they receive the modified report. Similarly, we expectGCYEAR_GC_NI,

the coefficient on net income for the GCfirms to be negative; indicating that it is less relevant to

market valuation for the GC firms in the year the firm receives a going-concern modification

relative to their earlier years and to the distressed NONGC firms.

Pricing of Balance Sheet Components

If the market uses the auditors going-concern modification as a specific communication of the

increased risk of financial failure, we would also anticipate that differences in the perceived

abandonment or adaptation values of the firms assets and liabilities would result in a shift in the

market pricing of these balance sheet components upon receipt of a going-concern modification.11

Berger et al. (1996) document that investors use information in the balance sheet to value the option

to abandon the continuing business of a distressed firm in exchange for the assets exit values.

Similarly, Darrough and Ye (2007) document that investors value the hidden valueof adaptation

demonstrated by the presence of intangible assets that may enable a distressed firm to avoid

10 This assumes that firms receiving a going-concern modification all have negative net income. In practice, this isessentially true. In fact, for firms receiving first-time going-concern modifications during the period of this study,95.1 percent (410 out of 431) had negative net income. However, it is important to note that the converse is nottrue72.4 percent (312 out of 431) of control firms without a going-concern modification also experienced

negative net income at time 0 (see Table 1).11 We would not expect specific pricing differences for individual income statement components. If the auditors

communication increases the markets assessment of the risk of financial failure all components of income



11/27

bankruptcy costs. To test for these possible valuation shifts, we estimate the following fixed effects

model, controlling for predicted bankruptcy, and allowing the coefficients for net income and the

different components of book value to vary based on PRED, GC, GCYEAR, and GCYEAR_GC:

MVEi;ta0a1GCYEARi;t a2GCi;t a3NIi;t a4NI NEGi;ta5NET CASHi;t

a6RECi;t a7INVi

;ta8PPEi;t a9INTANi

;t a10OAi;t a11LTLi

;ta12PREDi;t a13PRED NIi;t a14GC NIi;ta15GCYEAR NIi;ta1622GCi;ta2329GCYEARi;t a3036PREDi;t a37GCYEAR GCi;ta38GCYEAR GC NIi;ta3945GCYEAR GCi;tei;t

4

where previously undefined variables are defined as:

NET_CASHcash less current liabilities for firm i in time t;RECtotal receivables for firm i in time t;INVinventory for firm i in time t;PPEproperty and equipment for firm i in time t;

INTANintangible assets for firm i in time t;OAall other assets for firm i in time t;LTLlong-term liabilities for firm i in time t;GC_* each individual asset or liability defined above multiplied by 1 if a going-concern firm,

0 otherwise;

PRED_* each individual asset or liability defined above multiplied by 1 if predictedbankruptcy for firm i at time tper Altmans model, 0 otherwise;

GCYEAR_* GCYEARmultiplied by each individual asset or liability defined above for firmiat time t; and

GCYEAR_GC_* GCYEARmultiplied byGCmultiplied by each individual asset and liabilitydefined above for firm i at time t.

Substantial amounts of cash (NET_CASH) and receivables (REC) enable the firm to weather

short-term financial difficulties and proxy for the firms ability to survive despite the modified audit

opinion (Altman 1968). If the modified audit opinion is a signal that there is an increase in the risk of a

firm incurring the high costs of bankruptcy (Altman 1984), the market is likely to interpret higher

levels of net current assets as indicative of a lower likelihood of bankruptcy. Thus, we would expect an

increase in the valuation coefficients ofNET_CASHand RECfor firms receiving a going-concern

modification from their auditors relative to firms not receiving a going-concern modification

(GCYEAR_GC_NET_CASH. 0 andGCYEAR_GC_REC . 0). Holding inventory (INV), however,

is likely to have the opposite relation. Inventory for a distressed firm is less likely to realize a profit (and

thus represent a higher firm value) and may even be liquidated at substantially less than book value ifthe firm exercises its abandonment option (Berger et al. 1996). Thus, if the auditors report

modification provides a signal about the increased risk of abandonment, we predict that inventory will

have a lower pricing multiple upon receipt of a going-concern modification (GCYEAR_GC_INV, 0).

Berger et al. (1996) document that the market prices the value to abandon a firm at the sales price

expected for the firms net assets in dissolution, and that this exit value may exceed the firms aggregate

value in use. Specifically, they find that firm value increases in exit value for distressed firms that

discontinue operations. Therefore, it is likely that the book value of property and equipment for a

continuing operation is not as closely related to market value as it is for a firm with a higher risk of

abandonment. If the auditors going-concern modification increases the markets expectations of

abandonment, we would expect an increase in the pricing of property, plant, and equipment (PPE) for

these distressed firms upon receipt of a modified audit opinion (GCYEAR_GC_PPE. 0).

Intangible assets (INTAN) may indicate the presence of hidden assets (Darrough and Ye



12/27

costs for distressed firms (Darrough and Ye 2007). However, in liquidation, intangible assets are

likely to have a value of zero (Holthausen and Watts 2001). Thus, the direction of the effect of a

modified audit opinion on the valuation of recognized intangible assets is unclear. We also do not

make any directional predictions regarding Other Assets (OA).

Bankruptcy can also be triggered if firm value is less than the value promised to borrowers

(Merton 1974). In addition, there are limits to the amount of leverage a company can acquire

(Leland and Toft 1996; Faulkender and Peterson 2006). The higher the risk level of a firm, the

greater the probability of default on any debt claims, and the less capital a firm should optimally

borrow (Myers 1984). Thus, higher levels of long-term liabilities (LTL) for a more risky distressed

firm indicate less available financing and higher risk of incurring costs of default. Based on these

arguments, if the going-concern modification signals increased risk, we expect that greater levels of

LTLshould have a higher negative effect on market value than LTL for financially distressed firms

that do not receive an auditors modification (GCYEAR_GC_LTL ,0).

RESULTS

Correlation

Table 2 presents the Spearman correlation coefficients for most variables used in the study.12,13

As would be expected, there are high degrees of correlation between many of the variables used in

the models presented in this paper. Panel A presents correlations among all observations in our

sample; Panel B presents correlations among observations in time 0, the year of the going-concern

modification. Predicted bankruptcy is highly correlated with the issuance of the going-concern

opinion (p , 0.01). In addition, net income is highly negatively correlated with the issuance of a

going-concern opinion (p , 0.01). Most notably, these relations are stronger during the going-

concern year, as expected.

Because of the high degree of correlation, one concern is the effect of possible multicollinearity

in the multiple regression models. High correlation among the independent variables can result in a

nearly singular regressor matrix. To provide partial assurance that multicollinearity is not driving

the results of the study, we performed two tests. First, we obtained condition numbers for all

regressions. In none of the models reported did the condition number exceed commonly used

thresholds for potential multicollinearity problems. In addition, as suggested by Greene (1993), we

singularly removed observations from all estimations to determine if large swings in the parameter

estimates occurred. In no cases did any substantive changes occur to the parameter estimates upon

random removal of observations. Thus, it does not appear that multicollinearity is a significant

problem with the interpretability of the results.14

Time-Series Results

Table 3 presents the results for the multivariate time-series cross-sectional fixed-effects

regression models including all firm-year observations. In order to first assess whether the market

values the firms in our study similarly to those examined in prior research (e.g., Barth et al. 1998),

we initially regress BVE, NI, BVE_NEG, and NI_NEG on MVE. The results of this base model

12 We use Spearman rank-order correlation coefficients because of the high variances in our sample. Spearmancoefficients provide as much information as Pearson coefficients and are of wider validity (Altman 1991).

13 We do not present correlation coefficients for the separated asset and liability accounts.14 Multicollinearity does not bias the parameter estimates, nor does it make significance levels higher. In fact, high

correlation increases the standard errors and decreases the likelihood of obtaining significant parameter



13/27

TA

BLE2

CorrelationTable

anelA:AllYears

PRED

BVE

BVE_

NEG

GCYEAR_

GC_BVE

NI

NI_NEG

GCYEAR_

GC_

NI

BVE_

PRED

NI_PRED

C

0.25**

0.13**

0.13**

0.25**

0.27**

0.28**

0.37**

0.13**

0.27**

ED

0.29**

0.29**

0.16**

0.43**

0.43**

0.36**

0.62**

0.81**

VE

0.45**

0.06**

0.11**

0.05*

0.20**

0.16**

0.23**

VE

_NEG

0.33**

0.20**

0.20**

0.19**

0.47**

0.29**

CYEAR_

GC

_BVE

0.14**

0.15**

0.52**

0.41**

0.17**

0.98**

0.35**

0.25**

0.59**

_NEG

0.36**

0.25**

0.60**

CYEAR_

GC

_NI

0.16**

0.42**

VE

_PRE

D

0.47**

anelB:GCYearOnly

PRED

BVE

BVE_

NEG

GCYEAR_

GC_BVE

NI

NI_NEG

GCYEAR_

GC_

NI

BVE_

PRED

NI_PRED

C

0.49**

0.31**

0.21**

0.58**

0.37**

0.37**

0.84**

0.21**

0.49**

ED

0.32**

0.29**

0.19**

0.46**

0.46**

0.54**

0.53**

0.88**

VE

0.56**

0.30**

0.00

0.02

0.25**

0.34**

0.23**

VE

_NEG

0.53**

0.25**

0.26**

0.27**

0.57**

0.32**

CYEAR_

GC

_BVE

0.17**

0.17**

0.43**

0.64**

0.19**

0.99**

0.62**

0.24**

0.68**

_NEG

0.62**

0.24**

0.68**

CYEAR_

GC

_NI

0.23**

0.66**

VE

_PRE

D

0.46**

(continued

onnextpage)



14/27

TABLE

2(continued)

**SpearmansRhosignificantatthe0.05an

d0.01level,respectively.

riableD

efinitions:

C

1ifthecompanyreceivedagoing-concernmodification,0otherwise;

E

boo

kvalueofcommonequity;

netin

comebeforeextraordinaryitemsavailabletocommonshareholders;

E_

NEG

BVEmultipliedby1ifBVEisnegative,0otherwise;

CYEAR_GC

_BVE

BVEmultipliedby1intheyeargoing-concernmodificationisreceived,0otherwise;

_NEG

NImultipliedby1ifNIisnegative,0otherwise;

CYEAR_GC

_NI

NImultipliedby1intheyearagoing-concernmodificationisreceived,0otherwise;

EDpredictedgoing-concernmodification,

1ifZSCORE,

1.81,0otherwise;

ED

_BVE

BVEmultipliedby1ifthereisa

predictedgoing-concernmodification,0otherwise;and

ED

_NI

NImultipliedby1ifthereisapredictedgoing-concernmodification,0

otherwise.



15/27

TA

BLE3

FirmandYearFixed-E

ffectsRegressionAnalyses

odel:

MVEi;

t

a0

a1

GCYEAR

i;t

a2

GCi;t

a3

BVE

i;t

a4

NIi

;

t

a5

BVE

NEG

i;t

a6

BVEGCYEAR

i;t

a7N

INEG

i;t

a8

NIGCYEAR

i;t

a9

PRED

i;t

a10

PREDBVE

i;t

a11

PR

EDNIi

;

t

a12

GCYEARGC

i;t

a13

GCYEARGCBVE

i;t

a14

GCYEARGCNIi

;

t

ei;

t

PredictedSign

a

PanelA

PanelB

PanelC

PanelDa

Coeff.

Std.

Error

Coeff.

Std.

Error

Coeff.

Std.

Error

Coeff.

Std.

Error

ercept

0.14

1.60

8.79

7.74

16.95

7.04

5.31

4.02

CYEAR

?

28.75*

8.05

18.98*

6.93

16.55*

5.38

C

?

16.57*

3.53

22.02*

3.35

3.48

3.02

VE

1.84*

0.01

2.00*

0.01

2.03*

0.01

0.51*

0.05

5.86*

0.11

4.52*

0.16

4.24*

0.015

2.81*

0.13

VE_

NEG

?

3.23*

0.05

3.96*

0.06

3.85*

0.05

1.86*

0.11

VE_

GCY

EAR

?

0.78*

0.08

0.42*

0.07

0.04

0.09

_NEG

6.10*

0.11

4.66*

0.16

5.88*

0.24

_GCYEAR

?

4.41*

0.28

4.47*

0.22

1.64*

0.32

ED

?

12.71*

3.90

1.42

2.99

ED

_BV

E

?

1.03*

0.04

0.69*

0.04

ED

_NI

?

0.73*

0.16

0.98*

0.13

C_

BVE

?

0.20*

0.02

0.30*

0.02

1.19*

0.06

C_

NI

?

0.11*

0.03

0.46*

0.03

1.43*

0.05

CYEAR_

GC

47.23*

11.48

47.17*

1.03

2.91

7.07

CYEAR_

GC

_BVE

2.84*

0.11

3.05*

0.09

0.32*

0.10

CYEAR_

GC

_NI

3.61*

0.31

3.40*

0.25

2.33*

0.31

j.R2

0.94

0.97

0.98

0.99

3115

31

15

3100

2106

(continued

onnextpage)



16/27

TABLE

3(continued)

ignificantatthe0.01level.

redicted

ValuefornetincomecoefficientsareonlyapplicableforPanelsA,B,an

dC.PanelDincludesonlynegative

NIfirms,whichchangestheinterpre

tationofincome

tementcoefficients(andlikelyreversesthesignonmany).

riableD

efinitions:

VEma

rketvalueofcommonequityforfirm

i,ondateofthe10-Kreleaseintim

et;

CYEAR

1ift

0,0otherwise;

C

1ifthecompanyreceivedagoing-concernmodificationintimet,0otherwise

;

E

boo

kvalueofcommonequityforfirmi

intimet;

netin

comebeforeextraordinaryitemsavailabletocommonshareholdersforfirmiintimet;

E_

NEG

BVEmultipliedby1ifBVEforfirmiisnegativeintimet,0otherwise;

E_

GCYEAR

BVEmultipliedby1ifGCYE

ARforfirmiis1intimet,0otherw

ise;

_NEG

NImultipliedby1ifNIforfirmiisnegativeintimet,0otherwise;

_GCYEA

R

NImultipliedbyGCYEARforfi

rmiattimet;

ED1

ifpredictabankruptcyforfirmiattimetperAltmansmodel,0otherwise;

ED

_BVE

PREDmultipliedbyBVEforfirmiattimet;

ED

_NI

PREDmultipliedbyNIforfirmiattimet;

C_

BVE

BVEmultipliedby1ifagoing-concernfirm,0otherwise;

C_

NIN

Imultipliedby1ifagoing-concern

firm,0otherwise;

CYEAR_GC

GCYEARmultipliedbyGCforfirmiattimet;

CYEAR_GC

_BVE

GCYEARmultipliedbyG

CmultipliedbyBVEforfirmiattimet;and

CYEAR_GC

_NI

GCYEARmultipliedbyGC

multipliedbyNIforfirmiattimet.



17/27

regression are presented in Panel A of Table 3.15 As expected from prior literature and reported in

Panel A, the coefficients on BVEand NIfrom this initial regression are positive and significant at

the 0.01 level, indicating the incremental value relevance of both book value of equity and net

income in valuing the firm. In addition, the coefficient on NI_NEGis negative and significant at the

0.01 level, indicating, as expected, the lack of persistence in negative earnings. Thus, these model

results provide some baseline evidence that the sample of 862 firms in our study are valued

similarly to other samples of financially distressed firms examined in prior research. Further, the

model Adjusted R2 of 0.94 for this base regression model, and the subsequent regressions, is

relatively high and is substantially higher than what is presented in prior literature on the value

relevance ofBVEand NIfor financially distressed firms.16 These high Adjusted R2 results suggest

that our fixed-effects models are capturing a larger amount of the variation in MVEfor the stressed

firms in our samples.

In order to assess the effect of the going-concern modification to the markets valuation

mechanism, next we add the GC and GCYEAR and related variables to the regression model.

Results of this expanded model are presented in Panel B of Table 3. As seen in Panel B, the

coefficient onGCYEAR_GCis negative and significant at the 0.01 level, indicating that beyond thevaluation of financial statement components, overall, the market negatively valued theGC firms in

the year in which they received their first-time going-concern modification.

As hypothesized, the coefficient on GCYEAR_GC_BVEis positive and significant at the 0.01

level, and the coefficient on GCYEAR_GC_NI is negative and significant at the 0.01 level. The

results for theGCYEAR_GC_BVEvariable indicate that, after controlling for firm- and year-specific

factors, the market places increased relevance on book value of equity for firms receiving a first-

time going-concern modification compared to their market valuation in earlier years and to

financially distressed NONGCfirms. In contrast, the negative coefficient on the GCYEAR_GC_NI

variable indicates a lower relevance of net income for the going-concern modified firms in the year

the auditor renders their first-time going-concern modification. The valuation ofGCfirms exhibits aconsiderable shift from a balance sheet and net income focus to a focus only on the balance sheet in

the year these firms receive their first going-concern modified report from their external auditor.

Controlling for Bankruptcy Prediction

The results of our full model from Equation (3) incorporating the PRED, PRED_BVE, and

PRED_NIcontrol variables are reported in Panel C of Table 3.

Results of this model are very similar to the results reported in Panels A and B for the previous

models. Of specific interest, however, the coefficient on GCYEAR_GC_BVEremains positive and

significant at the 0.01 level, and the coefficient on GCYEAR_GC_NI remains negative andsignificant at the 0.01 level, and the other variables in the model typically retain the same signs and

significance levels obtained in the earlier regressions. These results indicate that even after

incorporating additional controls for probability of bankruptcy, the market places increased

relevance on book value and a decreased relevance on net income when firms receive a first-time

going-concern modification, compared to their earlier years and to financially distressed NONGC

firms.

In addition, as expected, we find that the sum of the coefficients on NI NI_NEG NI_GCYEAR GC_NI GCYEAR_GC_NIis substantially equal to zero (0.11; F-test 0.38, p .

15 In addition, intercepts were allowed to vary by calendar year to allow for time differences in valuation. Thesevariables are not tabulated for ease of exposition.

16 Barth et al (1998) find the R2 for their model to be between 0 53 and 0 80 for financially distressed firms that are



18/27

0.25) for our full model results, indicating that for firms receiving a going-concern opinion, net

income contains no detectable future importance as reflected in the firms market value.17 However,

for financially distressed firms not receiving going-concern modified opinions, net income

continues to be relevant in the going-concern year, as indicated by the significant positive sum for

the coefficients on NINI_GCYEAR (8.71; F-test1912.49, p,

0.0001) for firms with positivenet income, as well as the significant positive sum for the coefficients on NI NI_NEG NI_GCYEAR(2.83; F-test 109.85, p , 0.0001) for firms with negative net income. These resultsreinforce our earlier findings that for theNONGCfirms, net income continues to remain relevant to

the market in valuing the firm, even if net income is negative.

Cross-Sectional Results

The results presented in the prior section suggest that the auditors issuance of the going-

concern modification provides incremental information about the value relevance of book value of

equity and net income to the financial markets. An alternative explanation is that there is some other

underlying risk factor that distinguishes the firms in the sample that received a going-concernmodification. To examine this possibility, additional yearly cross-sectional comparison tests are

presented in Table 4. If the issuance of the going-concern opinion provides incremental information

about business continuity risk and has valuation implications for book value and net income, the

going-concern partition variables should demonstrate differences when compared to themselves

and the control firms using any of the three years prior to the report modification. However, if the

going-concern partition is proxying for an underlying difference in firm risk characteristics not

captured by financial distress and our control variables, it is likely that the going-concern

modification partition may no longer show significant differences when compared to only a single

prior year.

As shown in Table 4, we estimate Equation (3) separately, using data fort 0 and for each ofthe three years prior to t0. In all three estimations, the coefficients on GCYEAR_GC_BVEandGCYEAR_GC_NI obtain the predicted signs at 0.01 significance levels. These consistent results

provide additional evidence that communication of the going-concern modification provides

incremental value relevance to the market, regardless of which prior period the results are

compared. Moreover, these additional separate cross-sectional tests provide additional support that

the shift in valuation is not gradual, but that the auditors communication of the first-time going-

concern opinion is the event coinciding with the shift in market valuation related to book value of

equity and net income for these distressed firms.18

Pricing of Balance Sheet Components

To further support our conclusion that the going-concern opinion is providing additional

abandonment risk information to the market and is the driving force behind the valuation shift, we

17 As discussed previously, 95.1 percent of the firms in the sample receiving a going-concern opinion hadnegative net income; thus, all five coefficients apply to the going-concern recipients. Further, 72.4 percent ofthe matched control firms also had negative net income; thus, negative net income was common throughout thesample.

18 These tests, however, do not rule out the possibility that another risk factor not related to the going-concernopinion, but generally coinciding with its issuance, is actually driving the valuation implications found in Tables3 and 4. Nonetheless, our results provide additional support that the risk factor associated with the shift in marketvaluation occurs in the year the firm receives their first-time going-concern modification and does not occur inthe years immediately prior to the going-concern opinion, even for financially stressed firms. In the Further Testssection we attempt to control for some of these possibilities (e g debt default negative net income going-



19/27

TA

BLE4

FirmandYearFixed-E


ComparisontoPriorYears

odel:

MVE

i;t

a0

a1

GCYEAR

i;t

a2GC

i;t

a3

BVE

i;t

a4

NIi

;

t

a5BV

ENEG

i;t

a6

BVEGCYEAR

i;ta7

NINEG

i;t

a8

NIGCYEAR

i;t

a9

PRED

i;t

a10

PREDBVE

i;t

a11P

REDNIi

;

t

a12

GCYEARGCi;t

a13

GCYEARGCBVE

i;

t

a14

GCYEARGCNIi

;

t

ei;

t

PredictedSign

YearlyComparis

ons

Yeart

0,1

Std.Er

ror

Yeart

0,2

Std.

Error

Yeart

0,3

Std.

Error

ercept

1.12

4.22

3.97

4.45

3.01

5.05

CYEAR

?

13.27**

5.23

11.26*

5.12

11.19*

5.78

C

?

15.38**

5.11

10.24*

4.36

20.64**

5.10

VE

1.31**

0.05

0.49**

0.06

2.01**

0.02

7.94**

0.21

8.21**

0.26

4.78**

0.33

VE

_NEG

?

2.82**

0.76

2.91**

0.09

3.79**

0.07

VE

_GCY

EAR

?

0.29**

0.06

0.48**

0.07

0.51**

0.07

_NEG

11.00**

0.28

12.91**

0.34

7.92**

0.33

_GCYE

AR

?

2.30**

0.22

2.21**

0.24

4.27**

0.31

RED

?

9.10**

4.37

13.03**

4.18

6.96

4.99

RED

_BV

E

?

0.93**

0.06

0.92**

0.06

1.04**

0.06

RED

_NI

?

0.76**

0.20

2.68**

0.22

0.81**

0.26

C_

BVE

?

0.22**

0.07

0.10*

0.06

0.48**

0.03

C_

NI

?

1.71**

0.24

1.34**

0.05

0.01

0.32

CYEAR_

GC

29.05**

7.55

29.02**

7.62

33.74**

8.55

CYEAR_

GC

_BVE

2.08**

0.08

2.57**

0.10

2.99**

0.08

CYEAR_

GC

_NI

1.25**

0.25

1.06**

0.26

1.27**

0.42

dj.R2

0.95

0.95

0.95

1639

1597

1550

**Significantatthe0.05and0.01level,respectively.

variablesaredefinedinTable3.



20/27

test the marginal effect of the report modification on the valuation of specific balance sheet

components. Evidence that firms receiving a going-concern opinion are valued in a way that

represents a higher likelihood of abandonment or adaptation compared to similarly distressed firms

that did not receive an audit report modification would provide additional evidence that the going-

concern opinion communicated this specific risk to the market.Our results, tabulated in Table 5, provide support for this conclusion. As in our prior results,

the coefficients onGCYEAR_GCand GCYEAR_GC_NIare negative and significant at less than the

0.01 level in our expanded Model (4) regression. In addition, GCYEAR_GC_NET_CASH,

GCYEAR_GC_REC, and GCYEAR_GC_PPE are positive and significant at the 0.01 level, and

GCYEAR_GC_INV is negative and significant at the 0.01 level, as predicted. Further,

GCYEAR_GC_LTL is negative and significant at the 0.01 level, as predicted. Although we were

unable to predict signs,GCYEAR_GC_INTANis positive and significant at the 0.01 level, providing

some support that intangible assets proxy for opportunities to avoid failure (Darrough and Ye

2007). GCYEAR_GC_OA is also positive and significant. These findings are consistent with the

market assessing going-concern modified firms a higher risk of abandonment and provide

additional support for the proposition that the auditors going-concern opinion communicates firm-

specific information about increased continuance risk beyond what is communicated through other

information sources.

FURTHER TESTS

Negative Income Firms

Although we control for negative net income in our model, we cannot eliminate the possibility

that our results are driven by negative net income firms having a higher prevalence among going-

concern recipients (95 percent for GC firms and 72 percent for control firms). As an additional

analysis, we re-estimate our primary model including only firms with negative net income.19

Asshown in Table 3, Panel D, our model continues to be well specified and continues to indicate a

significant difference in the market valuation of the going-concern sample in year 0 in comparison

to the remainder of the sample. Specifically, for the remaining sample of 792 firms and 2,106 firm-

year observations, GCYEAR_GC_BVE is positive (0.31, F-test 9.52, p , 0.01) andGCYEAR_GC_NIremains significant (F-test57.09, p ,0.01).20,21

Alternate Financial Distress Control Variables

In order to ensure our results are robust with respect to using our specification of financial

distress as the predicted bankruptcy measure (PRED), we reran our models substitutingPREDwith:

(1) the continuousZSCOREmeasure used to calculate thePREDindicator, (2) an indicator variablebased on whether Mutchlers (1983) F-score predicts a going-concern opinion for the firm, or (3) an

indicator variable for whether the firm was in default (payment or technical) on their debt. Prior

research has found all of these measures to be associated with a going-concern modification and

with subsequent bankruptcy (Chen and Church 1992, 1996; Mutchler et al. 1997; Foster et al. 1998;

Geiger et al. 2005). Replacing the PRED variable, along with the interaction terms, with any of

19 After eliminating firms with negative net income, there is no longer a significant difference (p . 0.10) betweenthe means ofNI, MVE, orPRED for the sample and control firms, indicating closely matched distress levels.

20 We are unable to interpret the sign of the GCYEAR_GC_NIcoefficient because it is dependent on the value of

three other variables and related to negative net income. We can only infer that the valuation of this loss isdifferent for these firms in this year.

21 Our findings related to individual balance sheet components also continue to hold for the sample limited to



21/27

TABLE 5

Firm and Year Fixed Effects Regression Analysis

Balance Sheet Components

MVEi;ta0a1GCYEARi;ta2GCi;t a3NIi;t a4NI NEGi;t a5NET CASHi;ta6RECi;t a7INVi;t a8PPEi;ta9INTANi;t a10OAi;t a11LTLi;ta12PREDi;t a13PRED NIi;t a14GC NIi;ta15GCYEAR NIi;ta1622GCi;t a2329GCYEARi;t a3036PREDi;t a37GCYEAR GCi;t

a38GCYEAR GC NIi;ta3945GCYEAR GCi;tei;t

Variablesa

Pred Sign Coeff . Std. Error

Intercept ? 12.66 13.58GCYEAR ? 1.55 9.99GC ? 4.98 5.56

NI 11.23** 0.26

NI_NEG 13.05** 0.38NET_CASH 0.97** 0.14REC 0.77** 0.25INV 1.04** 0.22PPE 0.18** 0.10INTAN 1.89** 0.22OA 1.02** 0.22

LTL 0.90** 0.14GC_NI ? 1.87** 0.28GCYEAR_NI ? 0.03 0.41GCYEAR_GC ? 33.29** 13.79

GCYEAR_GC_NI 3.17** 0.28GCYEAR_GC_NET_CASH 1.53** 0.36GCYEAR_GC_REC 2.83** 0.77GCYEAR_GC_INV 2.37** 0.66GCYEAR_GC_PPE 1.79** 0.18GCYEAR_GC_INTAN ? 3.56** 0.44

GCYEAR_GC_OA ? 1.26* 0.42

GCYEAR_GC_LTL 2.07** 0.26Adj. R2 0.98

n 3115

*, ** Significant at the 0.05 and 0.01 level, respectively.

a We do not present coefficients forPRED,PRED_NI, nor theGC,PRED, andGC_YEARinteraction variables for easeof presentation and because we do not predict signs for these variables.

Variable Definitions:NET_CASHcash less current liabilities for firm i in time t;RECtotal receivables for firm i in time t;INVinventory for firm i in time t;PPEproperty and equipment for firm i in time t;INTANintangible assets for firm i in time t;OAall other assets for firm i in time t;LTLlong-term liabilities for firm i in time t;GC_*each individual asset or liability defined above multiplied by 1 if a going-concern firm, 0 otherwise;PRED_* each individual asset or liability defined above multiplied by 1 if predicted bankruptcy for firm i at timetper

Altmans model, 0 otherwise;GCYEAR_*GCYEAR multiplied by each individual asset or liability defined above for firm i at time t; andGCYEAR_GC_* GCYEAR multiplied byGC multiplied by each individual asset and liability defined above for firm i

t ti t



22/27

these alternative indicators of financial stress and going-concern modification expectation in any

combination did not substantively change our results.22

Larger Control Sample

As an additional sensitivity test, we examined a larger control sample of all financiallydistressed firms not receiving a going-concern opinion, as measured by Mutchlers (1984) criteria.

This resulted in an expanded control sample of 2,011 financially distressed companies not receiving

a going-concern opinion. Using our 431 GC firms and this expanded sample of distressed, non-GC

firms, we re-estimate our models. Results of these expanded sample regressions are very similar to

the results presented in Table 3, and in particular, the re-estimate of Equation (3) produces a

coefficient onGCYEAR_GC_BVEthat continues to be positive and significant at the 0.01 level, and

a coefficient on GCYEAR_GC_NIthat continues to be negative and significant at the 0.01 level.

Based on these additional tests, our main results appear robust to financial stress indicator selection,

as well as control sample selection used in our analyses.

Time Period and Size Partitions

Because our sample spans an 18-year period, it is possible that regulatory changes or specific

time periods could influence our results. To test for this possibility, we partitioned the sample into

several regimes: pre/post-Private Securities Litigation Reform Act of 1995 (PSLRA) and pre/post-

Sarbanes-Oxley Act of 2002 (SOX). We present the coefficients of interest in Table 6 for the pre-

and post-SOX periods, as well as pre- and post-PSLRA. Re-estimating our models in these sub-

periods indicates that our results are generally robust to these time partitions. Our two main

variables of interest (GCYEAR_GC_BVEand GCYEAR_GC_NI) both retain their expected signs

and remain significant (p , 0.01) in each of the sub-period analyses. Thus, we find no indication

that our results differ substantively in the pre/post-PSLRA or the pre/post-SOX periods. Overall, wefind no substantive evidence that our findings are time-period sensitive.

We also partition our sample by median MVEfor ourGCsample ($23MM) and find that our

results are similar for the larger half of our sample; however, they become only marginally sig-

nificant (p , 0.10) for our main variables of interest (GCYEAR_GC_BVEandGCYEAR_GC_NI) in

the smaller half of our sample. To further test for a size effect, we partition into quartiles and find

that our main variables of interest retain their expected signs and remain significant (p , 0.01) for

the upper three quartiles, but not for the lowest quartile ofMVEfirms. Thus, although our results do

not appear to be overly size-dependent, there is some indication that the GC opinion does not

communicate the same information for the smallest firms in our study.

CONCLUSION

This study provides evidence regarding the auditors communication of business risk through

the issuance of a first-time going-concern modified audit report and the relevance of this

communication to the securities market in adjusting share price valuations. Subramanyam and Wild

(1996) and Barth et al. (1998) demonstrate that for distressed firms the market shifts from using

both book value and net income in valuing firms to using only book values. In this study we present

22 An additional test examined ex postsurvival and removal of the audit report modification. We identified caseswhere theGCfirm survived and received an unmodified opinion in the subsequent year and the matched controlfirm also survived and received an unmodified opinion. The results (not presented) indicate that the going-concern partition no longer provides any explanatory power upon removal of the report modification, providingfurther evidence that the initial audit report modification was the driving factor behind the valuation differences



23/27

TA

BLE6

FirmandYearFixed-E


ByTimePeriod

odel:

MVE

i;t

a0

a1

GCYEAR

i;t

a2

GCi

;

t

a3

BVE

i;t

a4

NIi

;

t

a5

BVE

NEG

i;t

a6

BVEGCYEAR

i;t

a7NI

NEG

i;t

a8

NIGCYEAR

i;ta

9PRED

i;t

a10

PREDBVE

i;t

a11

PRE

DNIi

;

t

a12

GCYEARGC

i;t

a13

GCYEARGCBVE

i;t

a14

GCYEARGCNIi

;

t

ei;

t

PredictedSign

a

Pre-SOX

Post-SOX

Pre-PSLRA

Post-PSLRAa

Coeff.

Std.

Error

Coeff.

Std.

Error

Coeff.

Std.

Error

Coeff.

Std.

Error

VE

1.28**

0.05

1.97**

0.01

0.99**

0.08

2.06**

0.01

4.27**

0.32

5.28**

0.18

7.82**

0.64

3.84**

0.15

_NEG

4.89**

0.36

8.89**

0.53

8.16**

0.79

5.12**

0.25

CYEAR_

GC

13.63*

8.55

1

91.22**

49.90

11.71*

9.34

71.82**

15.66

CYEAR_

GC

_BVE

1.30**

0.12

4.01**

0.28

4.12**

0.63

3.19**

0.09

CYEAR_

GC

_NI

1.03**

0.26

5.13**

0.74

1.60**

0.22

4.01**

0.27

2175

9

25

528

2572

**Significantatthe0.10and0.01level,respectively.

oreaseofpresentation,weonlypresentvariab

leswithpredicteddirectionsinthetim

eperiodpartitions.Pre-SOXisdefinedasfiscalyearsendingpriortoAugust29,2002.Pre-

SLRAisdefinedasfiscalyearsendingprior

toDecember31,1996.

variablesaredefinedinTable3.



24/27

the first evidence that this shift coincides with the external auditors communication of a first-time

going-concern report on the financially stressed firm. Specifically, we find that book value of equity

has a greater valuation weight for firms receiving a first-time going-concern modified audit report

compared to their earlier years and to similar financially distressed firms not receiving a

going-concern modification. In addition, we document that the market prices the risk communicated

by the auditor through the going-concern modified opinion at the individual balance sheet

component level, supporting the contention that the risk factor communicated by the going-concern

opinion provides relevant information specifically about the potential abandonment or adaptation of

firm assets (Berger et al. 1996). Thus, this crucial auditor communication results in the markets

increased assessment of the relevance of net cash, receivables, long-term assets, and long-term

liabilities, and a decreased valuation of inventory, all consistent with an increased risk of

abandonment.

We also demonstrate that the results hold even after controlling for several other measures of

financial distress, expanding our control sample of distressed firms, and examining sub-periods

within our 18-year examination period. In sum, our results provide consistent support that the

equity markets consider the auditors business risk evaluation of the company, as communicated ina first-time going-concern modified report, as incrementally value-relevant even in conjunction with

other financial distress measures found in the financial statements.

Our results provide additional insight regarding the relevance of specific nonfinancial

information communicated by external auditors to the valuation of financially stressed firms and

provide impetus for future research in several areas. For example, are there specific financial

reporting situations, economic conditions, or industries in which these going-concern communi-

cations from the auditor are more or less impactful to the securities markets? In addition, are there

other types of modified audit opinions (e.g., other uncertainty or except forqualifications) that are

used in the markets valuation of firm risk, and what, if any, are the financial statement components

affected?

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Documents

The Auditor's Going Concern Opinion as a Communication Risk