Accounting and Finance 52 (2012) 10411059

Auditors going-concern-modied opinions after 2001: measuring reporting accuracy

Peter Careya, Stuart Kortumb, Robyn Moroneyc
a

School of Accounting, Economics and Finance, Deakin University, Melbourne, Vic., Australia b Deloitte Touche Tohmatsu, Melbourne, Vic., Australia c Department of Accounting and Finance, Monash University, Vic., Australia

Abstract An important change in auditors reporting behaviour in the period after the high-prole corporate collapses in 2001 is that auditors were more likely to issue going-concern (GC)-modied audit opinions. Comparing company failure rates subsequent to receiving a rst-time going-concern (FTGC)-modied audit opinion in the pre- and post-2001 periods, we nd a consistent type 1 error (misclassication) rate (the rate of survival among companies issued an FTGC opinion). Results are indicative of auditors maintaining GC reporting accuracy when comparing the 19951996 and 20042005 periods. This conclusion is supported after considering the impact of mitigating circumstances surrounding companies that received an FTGC-modied audit report and survived. Key words: Going concern; Audit reports; Bankruptcy JEL classication: M42 doi: 10.1111/j.1467-629X.2011.00436.x

1. Introduction The auditing profession was subjected to increased levels of scrutiny from the media, public and regulators following the corporate collapses in 2001. The public outcry following the collapse of HIH in March 2001 and the bankruptcy of

The authors would like to gratefully acknowledge the helpful comments of participants at the International Symposium on Auditing Research, the Accounting and Finance Association of Australia and New Zealand Annual Conference, the ANCAAR Forum at the Australian National University and workshop participants at Monash University. Received 23 August 2010; accepted 2 June 2011 by Robert Fa (Editor). 2011 The Authors Accounting and Finance 2011 AFAANZ

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Enron 8 months later saw a regulatory response that prescribed more explicitly auditors responsibilities and reporting requirements.1 In this environment, it is likely that auditors reporting habits and procedures changed. There is evidence that auditors issued more going-concern (GC)-modied audit reports post-2001 (in Australia (Xu et al., 2011; Carson et al., 2006),2 the United States (Willekens and Bauwhede, 2004; Geiger et al., 2005) and Belgium (Carcello et al., 2009)). This change in reporting behaviour is consistent with auditors responding to increased scrutiny by issuing more GC-modied audit reports. However, it is unclear whether auditors have achieved sustained accuracy in their GC reporting behaviour. There are two types of errors or misclassications associated with the GCmodied audit reports which research has linked to auditors GC reporting quality.3 A type 1 error occurs when the auditor issues a GC-modied report to a company which survives, and a type 2 error occurs when the auditor does not issue a GC-modied report to a company which subsequently fails (Hopwood et al., 1994). Analysis of variation in these misclassications over time has provided insight into the quality of auditors going concern reporting decisions. Studies from the United States (Geiger et al., 2005) and Belgium (Carcello et al., 2009) nd fewer type 2 errors were made immediately after 2001 than before, consistent with improved GC reporting accuracy. These authors suggest their ndings are indicative of increased auditor conservatism through the

Regulatory changes directed at improving auditor independence included the Australian Corporations Law reform in 2004 (CLERP 9) which following the recommendations of the HIH Royal commission (20012003) and in the US the SarbanesOxley Act 2002.

In Australia, the proportion of GC-modied audit reports (rst time and continuing) increased from around from 8 per cent during the 19962000 period to 15 per cent in 2003 (Carson et al., 2006) and then levelled out to around 11 per cent in 2005 (Xu et al., 2011). The increases in GC-modied opinions were predominantly unqualied opinions with emphasis of matter.
3

Drawing on custom from statistics, researchers have traditionally used the term error when referring to type I and type II errors. These errors are perhaps more accurately described as misclassications because they are not necessarily errors in the true sense of the word (i.e., see the discussion on page 4 concerning the inherent limitation of using type 1 errors as a measure of GC reporting accuracy). While we acknowledge potential misunderstandings which may arise from choice of terminology, we continue to use the description error because current research also continues to use this terminology (See for example, Carcello et al. 2009; and Feldmann and Read, 2010).

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issuance of a greater number of GC-modied opinions.4 However, Feldmann and Read (2010) found that in the United States, the type 2 error rate returned to pre-2001 levels by 20062007, and Fargher and Jiang (2008) similarly report that Australia auditors GC reporting behaviour had returned to normal or pre-2001 levels in 2004 and 2005. While the aforementioned studies have focussed on type 2 errors, the purpose of this study is to compare type 1 error rates pre- and post-2001, to measure GC reporting accuracy over time. The only study to have investigated whether there has been a change in the type 1 error rate after 2001 is the study of Carcello et al. (2009) who nd a decrease in the type 2 error rate and a concomitant increase in the type 1 error rate in a sample of private Belgium companies during the period immediately after the Enron collapse (2001/2002). The Carcello et al. nding is consistent with the trend to greater conservatism through the issuance of more GC opinions post-2001, and a corresponding increase in the type 1 error rate represents a technical reduction in GC reporting accuracy. However, by focussing on a time period immediately post-2001 when the audit market was in its greatest turmoil, generalising this nding to latter time periods is problematic. This study contributes to the literature by providing evidence from the Australian market as to whether auditors have maintained GC reporting accuracy after 2001 using the type 1 error rate to proxy GC reporting quality. Specically, this study compares the type 1 error rate for companies receiving a FTGC-modied opinion in 1995/1996 and 2004/2005, two comparatively stable periods.5 While the type 1 error rate increased among private rms in Belgium immediately postEnron (i.e. 20012002) (Carcello et al., 2009), prior research has not investigated whether the higher type 1 error rate continued after 2002. Drawing on research that suggests auditors GC reporting behaviour had returned to pre-crisis levels
4

Analysing data from the present study, it is noteworthy that Australian companies that went bankrupt in the 2004/2005 period were signicantly more likely to have been issued a GC-modied opinion prior to failure than bankrupt companies in the 1995/1996 period (p < 0.01), indicating a lower type 2 error rate post 2001. Further, our data also indicate a higher number of rst-time going concern (FTGC)-modied opinions issued in the 2004/2005 period compared with the 1995/1996 period. A test of proportions reveals that FTGC opinions (56) as a percentage of the total number of companies listed on the ASX issued during the 1995/1996 period are lower than FTGC opinions (108) as a percentage of the total number of companies listed on the ASX issued during the period 2004/2005, though the dierence is only marginally signicant (p < 0.10). There was no dierence in the proportion of public companies in the population that went bankrupt in 2004/2005 compared to 1995/1996. In the present study, bankruptcies are dened as companies that entered external administration within 12 months of scal year-end and details were drawn from a custom report ordered from the Australian Securities and Investments Commission (ASIC). According to this report, in the two-year period 1995/1996, 21 companies went bankrupt, and in the 2-year period, 2004/2005, 40 companies went bankrupt. The population of listed public companies was 1158 in 1996 and 1667 in 2005, so the proportion of companies that went bankrupt comparing these periods are similar (i.e. 0.018 and 0.024 per cent). 2011 The Authors Accounting and Finance 2011 AFAANZ

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after 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010), we accordingly predict that there will be no change in the bankruptcy rate among companies receiving FTGC-modied opinions (type 1 error rate) between the 1995/1996 and 2004/2005 consistent with auditors maintaining GC reporting accuracy. A further contribution of this study is to provide a richer analysis of surviving companies (the type 1 error subsample) through the identication of mitigating events, which may explain why rms receiving a rst-time GC opinion survive. This analysis is conducted in response to the inherent limitation of using type 1 errors as a measure of GC reporting accuracy. Some companies survive because of an event, such as a large injection of cash, which the auditor could not foresee or conrm when signing the audit report. A mitigating event is dened in the present study as a large (comprising 10 per cent or more of the base amount) injection of debt or equity capital in the year following the issuance of an FTGC audit opinion. A large injection of cash is one explanation as to why a company may survive after receiving a GC opinion which is not indicative of audit failure. The type 1 error subsample is divided into two groups: those that disclose a mitigating event and those that do not. In view of the increase in the proportion of GC opinions issued post-2001 compared to pre-2001 (Carson et al., 2006; Xu et al., 2011), a nding that there is a stable proportion of surviving companies that did not disclose mitigating circumstances pre- and post-2001 would provide support for the argument that auditors have maintained GC reporting accuracy. We nd that the type 1 error rate was static comparing pre- and post-2001 in spite of increased GC reporting after 2001, which suggests that GC reporting accuracy has not deteriorated. The proportion of surviving companies disclosing mitigating circumstances also remained unchanged over the same period. These results conrm the overall maintenance of accuracy in FTGC reporting decisions in Australia when comparing the 1995/1996 and 2004/2005 periods. The next section of this paper contains the background and hypothesis development, followed by the methodology and results. The nal section contains concluding remarks. 2. Background and hypothesis development Financial statements are prepared under the assumption that the entity will continue as a going concern. Where there is signicant uncertainty regarding the appropriateness of the going concern assumption, the auditor will issue a GCmodied audit opinion. A GC-modied opinion may be an emphasis of matter to an unqualied audit report, where the client adequately discloses the GC issue in the notes to the nancial statements, or a qualication, where the issue is not disclosed or the auditor believes the issue is so serious as to warrant a qualication. The two types of errors or misclassications in the context of a GC-modied audit opinion are depicted in Table 1. A type 1 error occurs when the auditor issues a GC-modied opinion to a company which survives. A type 2 error occurs when the auditor does not issue a GC modication to a company
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Table 1 Type 1 and type 2 errors GC-modied opinion Bankrupt Not bankrupt GC, going-concern. No error Type 1 error

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Not GC-modied opinion Type 2 error No error

which subsequently fails. As noted earlier, these errors are perhaps more accurately described as misclassications in the current context as they are not necessarily errors in the true sense of the word. For example, some companies survive following a GC-modied opinion (type 1 error) because of a mitigating event, such as a large injection of cash, which the auditor could not foresee or conrm when signing the audit report. Similarly, while the failure to issue a GC-modied opinion to a company that subsequently fails is indicative of audit failure (type 2 error), there will be situations where the auditor had not failed i.e. a client going bankrupt after receiving an unmodied audit report in circumstances that were not apparent at the time the audit report was signed. With each type of going concern misclassication, there are potential costs to auditors, clients and nancial statement users. When a company survives after receiving a GC-modied opinion (type 1 error), potential costs to the auditor include loss of reputation and loss of the client (Kida, 1980; Chow and Rice, 1982; Carcello and Neal, 2003), and potential costs to clients include unwarranted nancial hardship (Loudder et al., 1992; Blay and Geiger, 2001) and an increase in the probability of company failure (Kida, 1980; Menon and Schwartz, 1987; Geiger et al., 1998; Carey et al., 2008). When a company collapses without a prior GC-modied opinion (type 2 error), potential consequences for the auditor are loss of reputation, litigation and increased regulation (Carcello and Palmrose, 1994; Chaney and Philipich, 2002). Descriptive evidence on the type 1 error rate nds that between 80 and 95 per cent of companies receiving a GC-modied opinion do not subsequently fail (see for example Altman, 1982; Mutchler and Williams, 1990; Citron and Taer, 1992; Garsombke and Choi, 1992; Nogler, 1995; Geiger et al., 1998; and Carey et al., 2008). Descriptive evidence on the type 2 error rate nds around 50 per cent of bankrupt companies did not receive a GC-modied opinion, though this percentage has varied over time (see for example Altman, 1982; Hopwood et al., 1989; Geiger and Raghunandan, 2001; Nogler, 2008; Carcello et al., 2009; Feldmann and Read, 2010). A number of studies have explored whether changing environmental conditions over time inuences auditors going concern reporting decisions and in particular, the type 2 error rate. For example, Geiger and Raghunandan (2001) examine auditors reactions to changes in the level of auditor liability (arguably the primary potential cost of a type 2 error) after the introduction of the Private
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Securities Litigation Reform Act 1995 in the United States, which provided auditors some litigation relief. The authors nd that when the risk of litigation declined, auditors issued fewer GC modications to avoid the cost of making type 1 errors. This result is conrmed in Francis and Krishnan (2002). Following intense media and public scrutiny after the collapse of Enron in 2001, both Geiger et al. (2005) and Nogler (2008) nd a lower type 2 error rate. Geiger et al. (2005) compare the type 2 error rate in 19911992 period with the 20022003 period and nd a lower type 2 error rate post-Enron, which they attribute to auditors becoming more conservative by issuing a greater proportion of GC-modied opinions to reduce type 2 errors. Using the population of US rms that led for bankruptcy for the period January 1997December 2005, Nogler (2008) reports the going concern modication rate of 44.5 per cent for bankrupt companies in the pre-Enron period was proportionately lower than the 61.5 per cent in the immediate post-Enron period (i.e. a lower type 2 error rate). However, two studies investigating the type 2 error rate during the post-Enron period nd evidence consistent with auditors going concern reporting behaviour returning to more normal levels from 2004. Feldmann and Read (2010) reported that by 20062007, the proportion of type 2 errors in the United States had returned to pre-Enron levels (i.e. 49 per cent). Fargher and Jiang (2008) report that while Australian auditors were issuing a higher proportion of going concern opinions after 2002 consistent with the trend to greater conservatism, the higher going concern modication rates in 2004 and 2005 were justied by client risk and other variables traditionally used to explain auditor reporting decisions. Few studies have investigated the change in the type 1 error rate over time. Carcello et al. (2009) examined the relation between type 1 and type 2 errors among private rms following the introduction in Belgium in 2000 of a rulebased reporting standard. Comparing the 19951996 and 20012002 periods, Carcello et al. (2009) nd a decrease in the type 2 error rate and a concomitant increase in the type 1 error rate. This relationship was explained by auditors issuing a greater number of GC-modied opinions in response to an increase in the costs of auditor acquiescence. The only other major study examining the type 1 rate is Geiger and Rama (2006) who report that Big 4 auditors exhibited lower type 1 and type 2 error rates than non-Big 4 audit reports during the 19902000 period. This study investigates whether Australian auditors maintained GC reporting accuracy subsequent to the turmoil following the collapse of Enron and HIH by comparing the type 1 error rate in the 1995/1996 and 2004/2005 periods. There is empirical evidence that the type 2 error rate declined immediately post-2001 (Geiger et al., 2005; Nogler, 2008) and then returned to more normal levels after 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010). While the type 1 error rate was found to have increased immediately post-2001 (Carcello et al., 2009), prior research has not explored whether, like the type 2 error rate, the type 1 error rate subsequently returned to more normal or pre-2001 levels.
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Descriptive evidence that Australian auditors are issued proportionally more GC-modied opinions during the 2004/2005 period (11 per cent; Xu et al., 2011) compared with the 1995/1996 period (8 per cent; Carson et al., 2006), suggests that there may have been a corresponding increase in the type 1 error rate, consistent with the ndings reported in Carcello et al. (2009). A competing argument is that the type 1 error rate might have declined post-2002 because following the collapse of Arthur Andersen and the ensuing media, public and legislative scrutiny, there is evidence of greater professional scepticism (Bedard and Johnstone, 2005; Sercu et al., 2006) and increased audit eort (Ghosh and Pawlewicz, 2009). However, ndings that auditors GC reporting behaviour appeared to have returned to normal levels after 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010) suggest the type 1 error rate might have returned to its pre-2001 levels. Weighing up the preceding arguments, we hypothesise a static type 1 error rate comparing the 19951996 and 20042005 periods. H1: The bankruptcy rate for companies receiving a FTGC-modied audit opinion is constant between 19951996 and 20042005. If a company survives after receiving an FTGC-modied audit opinion, a type 1 error or misclassication has occurred. A type 1 error is not necessarily indicative of audit failure. Behn et al. (2001) report that nancially distressed companies are less likely to receive an FTGC-modied audit report when their auditors are aware that they plan to raise debt or equity to alleviate their problem. New nancing (or renancing) is a mitigating factor that reduces the probability of bankruptcy (Mutchler et al., 1997). Thus, when a company receives an FTGCmodied audit report, there is substantial doubt about the future prospects of the company in the absence of a new event, such as a signicant injection of funds. Yet, the outcome of such a new event that was either unconrmed or not known to the auditor at the time of signing the GC-modied audit report may be the reason an apparently failing company survives. In such a case, a type 1 error is not necessarily indicative of an audit failure. A contribution of this study is to undertake a richer investigation into the circumstances surrounding companies that received an FTGC-modied audit report and survived (apparent type 1 error). This study is the rst to look behind the type 1 error rate by focussing on companies that survived in the absence of a large injection of cash (i.e. a mitigating event). Comparing the proportion of rms disclosing mitigating circumstances pre- and post-2001 is a unique proxy measure of GC reporting accuracy. If GC reporting practices were stable during the 19951996 and 20042005 periods, then all things being equal the observed proportionate increase in GC opinions issued post-2001 would be associated with a corresponding increase in the proportion of rms that do not disclose subsequent mitigating events after 2001. Such a nding would prima facie suggest a decline in GC reporting accuracy. In contrast, if auditors had improved audit quality post-2001, we
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might observe a declining proportion of surviving companies not disclosing mitigating circumstances subsequent to receiving an FTGC audit opinion. In view of these competing predictions, we hypothesise a static proportion of surviving companies not disclosing mitigating events consistent with auditors maintaining GC reporting accuracy post-2001. H2: The proportion of surviving companies after receiving an FTGC-modied audit report where there is no disclosed mitigating event is constant between 1995/1996 and 2004/2005. 3. Methodology 3.1. The model Adapted from the model used in Geiger and Rama (2006), Equation (1) is a logistic regression model, which measures the bankruptcy rate for all companies receiving an FTGC-modied audit opinion (i.e. rms that do not go bankrupt are by denition type 1 errors).6 The model is used to test hypothesis one, which predicted a constant bankruptcy rate, after receiving an FTGC-modied audit opinion, between 1995/1996 and 2004/2005 (same proportion of type 1 errors comparing pre- and post-2001), using the independent variable TIME to distinguish the two time periods. The model takes the following form: PROBBKT b0 b1 LNTA b2 PROB b3 DFT b4 AUD b5 RSKY b6 TIME ebkt0

where: BKT, 1 if bankrupt within 12 months of scal year-end, 0 otherwise; LNTA, size, measured with natural log of total assets; PROB, probability of bankruptcy using the Hopwood model7; DFT, total liabilities/contributed equity (debt-to-equity); AUD, 1 if audited by a top tier (Big N) audit rm, and 0 otherwise; RSKY, 1 if operating in a risky industry (mining, technology), and 0

Geiger and Rama (2006) used the type 1 error rate to proxy audit quality, comparing the type 1 error rate for clients of top tier verses non-top tier audit rms during the period 19902000.

7 The Hopwood et al. (1994) model is a bankruptcy probability model that incorporates numerous nancial indicators, being net income/total assets, current assets/sales, current assets/current liabilities, current assets/total assets, cash/total assets, long-term debt/total assets and natural log of sales. This model is used in Geiger et al. (2005). Other studies (i.e. Geiger and Rama, 2006) use the Zmijewski (1984) probability score as a predictor for bankruptcy. When we replaced the Hopwood model with the Zmijewski score (see Section 4), we obtained substantively the same ndings.

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otherwise; TIME, 1 if bankruptcy date is during the time period 2004 or 2005, 0 otherwise; and ebkt, error term. A positive relation between subsequent bankruptcy (BKT) and company size (LNTA) is expected. While larger companies are generally less likely to receive GC modications, those that do are typically in great stress and thus more likely to subsequently fail (McKeown et al., 1991; Geiger and Rama, 2006). While all companies receiving an FTGC-modied audit opinion are nancially stressed, the evidence suggests that subsequent bankruptcy (BKT) is positively correlated with the level of nancial stress (PROB) (Chen and Church, 1992; Carcello et al., 1995; Mutchler et al., 1997; Geiger and Rama, 2006). The present study includes total liabilities to contributed equity (DFT) as an additional measure of nancial stress. Also, an indicator variable capturing companies operating in more risky industries (RSKY) is a further control for the risk of bankruptcy. A positive relationship is predicted between subsequent bankruptcy (BKT) and both DFT and RSKY. Geiger and Rama (2006) nd that top tier (Big N) audit rms exhibit higher quality reporting by having fewer type 1 reporting errors. Companies audited by top tier audit rms (Big N) (AUD) are expected to be positively associated with subsequent bankruptcy (BKT). The control variables LNTA, PROB and AUD replicate those used in Geiger and Rama (2006) and the variables DFT and RSKY are additional controls. A static type 1 error rate comparing the 19951996 and 20042005 periods is predicted in hypothesis 1. The variable of interest, TIME, measures the impact of the pre- and post-2001 time periods on the bankruptcy rate following an FTGC-modied audit opinion (the type 1 error rate). No association between bankruptcy (BKT) and the variable of interest (TIME) is predicted. To test hypothesis two, which predicts that the proportion of type 1 error observations (i.e. surviving companies) in the absence of a mitigating event will be constant between 1995/1996 and 2004/2005, we use a test of proportions. A comparison is made between the proportions of type 1 errors made in each time period that are not explained by a mitigating event. There is no prior research literature from which an established denition of a mitigating event is available. We therefore develop a unique measure to proxy mitigating events which denes such an event as a large (comprising 10 per cent or more of the base amount) injection of debt or equity capital. 3.2. Data collected The data set comprises the population of 165 Australian public companies that were issued an FTGC-modied opinion during the calendar years 19951996 and 20042005. The data for 19951996 (57 companies) were sourced from the private database of Professor A Craswell and supplemented through the Connect4 and FinAnalysis databases. The data for 20042005 (108 companies) were sourced entirely through the Connect4 and FinAnalysis databases (see Table 2). Within the data set of 165 companies, bankruptcy (BKT) is where a company
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Table 2 Companies receiving an FTGC-modied opinion who survived (type 1 error) Year of FTGC 1995/1996 Full dataset Eliminated as subsequently bankrupt Missing data Final dataset FTGC, rst-time going concern. 57 5 7 45 2004/2005 108 8 3 97 Total 165 13 10 142

enters external administration 12 months after scal year-end. Bankruptcy data were drawn from a custom report ordered from the Australian Securities and Investment Commission (ASIC). The two periods subject to analysis, 19951996 and 20042005, are both similar relatively stable periods. The period 20002003 is intentionally excluded from the study because it involved the initial post-Enron collapse adjustment and the associated exceptional level of GC reporting activity (Xu et al., 2011), and prior research had previously considered type 1 GC reporting errors during the 20012002 period (Carcello et al., 2009). The stability of the 20042005 period is supported by research ndings that auditors GC reporting behaviour had returned to its pre-2001 levels after 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010). The 19951996 years predate the Asian economic crisis of 1997 and the technology bust of 2000, events associated with heightened nancial risk. The 19951996 period also represents a stable audit market mirroring the subsequent 2004/2005 period with a constant number of top tier audit rms. The period falls between the Ernst and Whinney merger with Arthur Young in 1989 and the Price Waterhouse merger with Coopers and Lybrand in 1998.8 Finally, the method comparing two, 2-year periods is consistent with the approach used in prior research (see for example Fargher and Jiang, 2008; Carcello et al., 2009).9 The data set used to test hypothesis 2 comprises all companies issued an FTGC modication that survived for 12 months after scal year-end (see Table 2). Of the 57 companies issued an FTGC-modied audit report in
8

While the auditing standards governing the GC opinion that operated during the 1995/ 1996 period (AUP 7) and 2004/2005 period (AUS 708) diered, they required substantively the same reporting. In both periods, a GC qualication signalled that an auditor believes there was a real risk that the company would fail in the following year. When a company adequately disclosed that risk the auditor would issue a subject to opinion in 1995/1996 and an unqualied opinion with an emphasis of matter in 2004/2005.

9 As noted previously, Carcello et al. (2009) examine changes to auditors GC reporting behaviour by comparing the period 19951996 with 20012002, while Fargher and Jiang (2008) compare the 19981999 period with the 20032005 period.

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19951996, ve went bankrupt, there is missing data for a further seven, leaving 45 surviving companies (type 1 errors) to be investigated. Of the 108 companies issued an FTGC-modied audit report in 20042005, eight went bankrupt, there is missing data for a further three, leaving 97 surviving companies (type 1 errors) to be investigated. Following the approach in DeFond et al. (2002), we have chosen to examine type 1 errors using only rst-time GC opinions so that the captured data represent reporting decisions within each particular period. This is opposed to a continuing GC opinion, which may not only indicate the current period decision criteria but also reect circumstances at the time the GC opinion was rst issued.10 3.3. Bootstrap procedure Although the data set used consists of the population of Australian FTGCmodied audit opinions in the years of interest, a problem arises because of the relatively small number of FTGC modications in the population and the small number of those that subsequently go bankrupt (discussed further in the results section below). Because of the small population data set available, drawing statistical inferences as to the dierence between those companies that subsequently go bankrupt and those that survive is problematic.11 To overcome this problem, we apply a bootstrapping procedure which provides repeated observations which are then subject to the regression analysis to test hypothesis 1 (model 1). Bootstrapping is an approach aimed at drawing statistical inferences from a limited population by building a sample distribution using a replacement random sampling technique (Efron, 1979). The larger data set is the result of repeatedly drawing from the sample, replacing data and drawing again. The replacement method is used so that a new data set is created rather than simply reproducing the original sample a number of times (Fox, 2002). The new and larger sample distribution becomes the basis for statistical tests from which conclusions can be drawn. Research nds bootstrapping is a statistically sound analytical technique (Brownstone and Valletta, 2001; Fox, 2002; Hesterberg et al., 2005). In the conclusion section of this paper, we outline the limitations of the bootstrap technique.

10 Because the auditor sees the removal of a GC classication once it is given as a serious and deliberate act, warranted only in exceptional circumstances, they are unlikely to change it because their current mindset has shifted, but rather only when the issue behind it is resolved (Nogler, 1995). 11 After running the model with the unaltered data set, the model is non-signicant, likely due to the small sample size. All the coecients within the model are similarly insignicant, with the exception of the size control variable (LNTA, p < 0.10).

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4. Results Descriptive statistics comparing the population of Australian public companies that were issued an FTGC-modied audit opinion in 19951996 and 20042005 are presented in Table 3. Of the 56 companies receiving an FTGC-modied audit report in 19951996, 8.9 per cent (n = 5) went bankrupt within a year of their annual report balance date (the remaining 91.1 per cent survived, n = 51). Of the 108 companies receiving an FTGC-modied audit report in 20042005, 7.4 per cent (n = 8) went bankrupt within a year of their annual report balance date (the remaining 92.6 per cent survived, n = 100). The non-signicant dierence in bankruptcy rate (BKT) between the two periods suggests that auditors have, consistent with H1, maintained their reporting accuracy after 2001. Given the increase in the number of GC-modied opinions issued in Australia after 2001 (Xu et al., 2011), the constant type 1 error rate is indicative of auditors maintaining reporting accuracy in the issuing of the FTGC-modied opinions by auditors. A comparison of companies across 19951996 and 20042005 time periods shown in Table 3 reveals non-signicant dierences in rm size (LNTA), the probability of bankruptcy (based on the Hopwood prediction model) (PROB)

Table 3 Descriptive statistics for FTGC-modied companies 19951996 and 20042005 Variable 1995/1996 (n = 56) 2004/2005 (n = 108)

Descriptive statistics, continuous variables: mean (SD) [median] LNTA 15.7525 (1.7457) [15.6300] PROB )0.0933 (0.6628) [0.0000] DFT* 1.5415 (2.8322) [0.2736] Descriptive statistics, discrete variables BKT 0.089 (n = 5) AUD 0.51 RSKY 0.54

15.6278 (1.5271) [15.5802] )0.6107 (2.7794) [)0.0003] 0.5679 (1.8062) [0.0896] 0.074 (n = 8) 0.39 0.44

*Signicant dierence between the two time periods at p < 0.05. FTGC, rst-time going concern; TIME, 1 if bankruptcy date during calendar year 2004 or 2005, and 0 otherwise; LNTA, company size, measured with natural log of total assets; PROB, probability of bankruptcy using the Hopwood model; DFT, total liabilities/contributed equity (debt-to-equity); BKT, 1 if company goes bankrupt within 12 months of scal year-end, 0 otherwise; AUD, 1 if audited by a top tier (Big N) audit rm, 0 otherwise; RSKY, 1 if company operates in risky industry (mining, technology), 0 otherwise.

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Table 4 Bootstrapped logistic regression results: FTGC 1995/1996 and 2004/2005

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Prob(BKT) = b0 + b1LNTA + b2PROB + b3DFT + b4AUD + b5RSKY + b6TIME + eBKT Full sample Variable Constant LNTA PROB DFT AUD RSKY TIME Expected sign Coecient )9.6238 0.4489 0.83 )0.271 0.9482 )0.2179 )0.2302 p-Value* 0.0001* 0.0001* 0.0108* 0.0042* 0.0003* 0.3813 0.3834

+ + + + + )

Model chi-square = 51.7886; FTGC, rst-time going concern. p-Value < 0.01. *p < 0.05. BKT, 1 if company goes bankrupt within 12 months of scal year-end, 0 otherwise; LNTA, company size, measured with natural log of total assets; PROB, probability of bankruptcy using the Hopwood model; DFT, total liabilities/contributed equity (debt-to-equity); AUD, 1 if audited by a top tier (Big N) audit rm, 0 otherwise; RSKY, 1 if company operates in risky industry (mining, technology), 0 otherwise; TIME, 1 if bankruptcy date during calendar year 2004 or 2005, and 0 otherwise.

and whether the companies operate in risky industries (RSKY). However, in the 20042005 time period, companies were less highly geared (DFT, p < 0.05) and though the variable was marginal, less likely to use a top tier audit rm (AUD, p < 0.10), than companies in the corresponding 19951996 time period. These descriptive results suggest companies in both periods were similar, providing further support for the choice of these two relatively stable periods. A review of correlations between the variables in Equation (1) (not tabulated) reveals the highest correlation is between company size (LNTA) and liabilities to equity (DFT) (0.383), suggesting that larger companies tend to be more highly geared. The correlations between the independent variables did not raise any concerns with collinearity. Table 4 presents results for the logistic regression model for the bankruptcy rate for all companies receiving an FTGC-modied audit opinion. The model adequately distinguishes the bankruptcy rate (v2 = 51.79, p < 0.01). The coecients for LNTA (size), PROB (bankruptcy probability)12 and AUD (audit rm) were all signicant and in the expected direction. A signicant positive coecient on the AUD variable indicates that top tier audit rms are more likely to issue
Results were unaected when we replace the Hopwood bankruptcy score used to measure the variable PROB with a Zmijewski nancial stress score based on coecients with the following model: )4.803 ) 3.599(net income/total assets) + 5.406(total debt/total assets) ) 0.100(current assets/current liabilities) (Zmijewski, 1984). 2011 The Authors Accounting and Finance 2011 AFAANZ
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Table 5 Proportion of Type 1 errors with/without a mitigating event Audit opinion period 1995/1996 Type 1 error no mitigating event Type 1 error mitigating event Total 16 (35.6%) 29 (64.4%) 45 (100%) 2004/2005 43 (44.3%) 54 (55.7%) 97 (100%) Total 59 (41.5%) 83 (58.5%) 142 (100%)

z-score = 0.8988 (p > 0.30). A mitigating event is dened in the present study as a large (comprising 10 per cent or more of the base amount) injection of debt or equity capital.

FTGC-modied opinions to companies that subsequently fail.13 This result is consistent with US evidence of a lower type 1 reporting error rate for top tier audit rms (Geiger and Rama, 2006) and empirical evidence that the top tier (Big N) audit rms provide a higher-quality service (see for example Francis, 2004). The coecient for DFT (debt-to-equity) was signicant but negative, indicating that contrary to expectations, subsequently bankrupt companies had proportionately less debt-to-equity than surviving companies. This is unusual as it would normally be expected that highly geared companies are at greater risk of bankruptcy. Perhaps borrowers had reduced their exposure to these bankrupt companies in anticipation of nancial crises. The variable of interest, TIME (1995/1996 or 2004/2005), is not signicant, suggesting that auditors FTGC reporting accuracy is unchanged over the two periods. The results are consistent with hypothesis 1. Companies subject to an FTGC-modied audit opinion are no less likely to go bankrupt in the post-2001 period than pre-2001 period. This result suggests that auditors maintained their FTGC reporting accuracy during the 20042005 period consistent with evidence that error rates in auditors reporting had returned to more normal levels after 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010). The data in Table 5 are the FTGC companies that survived (the type 1 errors). These companies are separated into two categories: (i) companies that survived and there was no subsequent disclosure of a mitigating event, which might explain why the company survived, and (ii) companies that survived that subsequently disclosed a mitigating event which might explain why the company survived. In the current study, a mitigating event is dened as a large (comprising 10 per cent or more of the base amount) injection of debt or equity capital. In such an instance, the type 1 error is less indicative of an audit reporting error.
13 In 1995/1996, there were six top tier rms (Arthur Andersen, Coopers and Lybrand, Deloitte Touche Tohmatsu, Ernst and Young, KPMG and Price Waterhouse), and in 2004/2005, there were four (Deloitte Touche Tohmatsu, Ernst and Young, KPMG and PriceWaterhouseCoopers). Second tier rms are the remaining international, national and local rms.

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Our second hypothesis predicted that the proportion of FTGC-modied surviving companies in the absence of a mitigating event will be constant between 1995/1996 and 2004/2005. Table 5 shows that 36 per cent (16 of the 45) of surviving companies in 1995/1996 did not disclose a mitigating event which may have explained their survival. In 2005/2006, the proportion was 44 per cent (43 of 97) surviving companies. Tests of proportions, where the value in each period (proportion of mitigating events) is compared to the population mean (the mean combining the two periods), indicate the dierence between the two periods is not signicant (z-score = 0.8988, p > 0.30). Findings are consistent with our prediction in H2. The nding of no variation in the rate of disclosure of mitigating circumstances across the 19951996 and 20042005 periods is consistent with auditors maintaining GC reporting accuracy.14 5. Summary and conclusions This study investigates whether Australian auditors have maintained GC reporting accuracy after 2001 using the type 1 error rate to proxy GC reporting quality. Specically, we compare failure rates for companies that survived after receiving an FTGC-modied audit opinion (type 1 error rate) in 1995/1996 and 2004/2005. We nd that a similar proportion of companies receiving FTGC audit opinion survived post-2001 compared to pre-2001 (i.e. a constant type 1 error rate comparing the 1995/1996 and 2004/2005 periods). While the low absolute number of bankruptcies may have inuenced our result (see discussion of this limitation below), the constant type 1 error rate is nonetheless indicative of auditors maintaining reporting accuracy post-2001. Our ndings demonstrate that while the proportion of GC reports issued increased after 2001 (Carson et al., 2006; Xu et al., 2011), this was not at the expense of a decline in auditor reporting accuracy measured using the type 1 error rate. This nding is consistent with evidence of auditors increasing audit eort and professional scepticism following the collapse of Enron in 2001 (Bedard and Johnstone, 2005; Sercu et al., 2006) and empirical evidence that auditors GC reporting behaviour returned to a normal level after 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010). Our ndings extend the study by Carcello et al. (2009) who report an increase in the type 1 error rate among a sample of Belgium companies in the period immediately post-Enron (20012002). Carcello et al. attributed their nding to the trend to greater conservatism through the issuance of more GC opinions immediately post-2001 (representing a technical reduction in GC reporting accuracy). The contrasting results in the present study might be explained by the

14 It is noteworthy that this result also serves as a control to ensure that a change in the underlying rate of disclosure of mitigating events did not provide an alternative explanation for the constant bankruptcy rate between 19951996 and 20042005 periods (H1).

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choice of time period. Carcello et al. (2009) investigated the immediately post2001 time period when the audit market was in its greatest turmoil, while the present study uses the 20042005 period, when the audit market had stabilised. For companies that received an FTGC audit opinion and survived (type 1 errors), this study is the rst to distinguish between those companies that disclosed mitigating events in their subsequent nancial statements, which provides some explanation for their survival, from companies that did not disclose mitigating events. Mitigating events are dened in the present study as a large (comprising 10 per cent or more of the base amount) injection of debt or equity capital. We nd that 36 per cent (16 of the 45) of surviving companies in 1995/ 1996 did not disclose a mitigating event which may have explained their survival, whereas in 2005/2006 the proportion was 44 per cent (43 of 97). However, tests of proportions indicate that the dierence between the two periods is not signicant. Given the increase in the proportion of GC opinions issued post-2001 (Carson et al., 2006; Xu et al., 2011), a corresponding reduction in the proportion of surviving companies disclosing mitigating circumstances would have suggested that auditors were simply being more conservative in issuing more GC opinions. Our results provide evidence of auditors maintaining reporting accuracy post-2001. The stable rate of disclosure of mitigating events over the pre- and post-2001 periods provides further support for the argument that auditors have maintained GC reporting accuracy. A limitation of this study is the small sample size owing to the small number of companies issued an FTGC opinion in Australia. In particular, the non-signicant dierences in both bankruptcy rates (H1) and the rate of non-disclosure of mitigating events (H2) might have changed had the actual population size been larger. The strength of the method used in this paper is that the results reect the population of companies issued an FTGC audit opinion and are therefore indicative of auditors reporting habits. Future research could extend the sample size by conducting the analysis over a longer time period or replicating the analysis in a jurisdiction with a larger population of FTGC audit opinions (i.e. USA). To overcome concerns regarding the small population of FTGC audit opinions, we used a bootstrapping technique. A limitation of this method is that individual data points appear in the data set more than once to increase the overall size of the data set. Notwithstanding this potential limitation, a number of studies conrm the validity of statistical inference from bootstrapping (see for example, Brownstone and Valletta, 2001; Fox, 2002; Hesterberg et al., 2005). In motivating our second hypothesis, we note that mitigating events may explain why companies that receive a GC-modied opinion survive. In the current study, we identify only one mitigating event, a large (comprising 10 per cent or more of the base amount) injection of debt or equity capital. We acknowledge that this is a limitation as there are potentially other events that could explain why companies survive after receiving a GC-modied audit report.
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Finally, although this study focuses on identifying change in auditors decision making process, it is limited by the fact that the method used cannot directly measure the changes that have occurred or have been enacted in audit processes. Type 1 error rates, the tool of the present study, are measurable outcomes of this process, indicating changed reporting habits but not specically what changes have occurred in the audit process. Future studies may attempt to collect more direct evidence from audit rms (for example internal policy documents) to identify whether in fact there is a genuine change in the criteria used for judging the appropriateness of the GC assumption after 2001. References
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