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SUMMARY: In this study, we examine the proposition that the auditor's going-concern modified opinion is a valuable risk communication to the equity market that results in a shift of the market's perception of financially distressed firms. Specifically, our analyses reveal that the market valuation is significantly altered from a focus on both the income statement 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 company's inventory and places increased weight on cash, receivables, and long-term assets and liabilities as a result of the auditor's 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 interprets 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: auditor's opinion; going-concern; value-relevance; financial distress.
Data Availability: All data are available from public sources.
JEL Classifications: M41; M42.
(ProQuest: ... denotes formulae omitted.)
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 been an 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 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 auditor's report is part of the information made publicly available when the company releases its annual report. As part of this information, the auditor's report expresses a professional opinion regarding the accuracy and completeness of the client's 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...