blay et al. (ajpt, 2011)

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-concernmodified opinion is a valuable risk communication to the equity market that results ina shift of the markets perception of financially distressed firms. Specifically, our analysesreveal 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 companyreceives a first-time going-concern modified opinion. These results hold even aftercontrolling for several common measures of financial distress and when examining alarger control sample of distressed firms. We also document that the market devalues acompanys inventory and places increased weight on cash, receivables, and long-termassets and liabilities as a result of the auditors modification. This indicates that thegoing-concern modification provides incremental information specifically related toabandonment or adaptation risk. Our results provide evidence that the market inter-prets the going-concern modified audit opinion as an important communication of riskthat results in a substantial shift in the structure of the market valuation for distressedfirms.

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

Data Availability: All data are available from public sources.

JEL Classications: 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 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

Allen D. Blay is an Assistant Professor at Florida State University. Marshall A. Geiger is a Professor, andDavid 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 2009Accepted: September 2010

Published Online: May 2011

77

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 publicly

available 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 doubt about 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 and

completeness 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, or

whether 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 financial

distress, 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 themajority of going-concern modified firms in our sample do not have public credit ratings nor pay dividends.

78 Blay, Geiger, and North

Auditing: A Journal of Practice & TheoryMay 2011

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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 distressed

firms. 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 our

results 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 assetsthrough the avoidance of bankruptcy costs (Darrough and Ye 2007).

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 potential

abandonment 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 Neal

2003). 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

occurs. They also do not examine the valuation of specific balance sheet components.



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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 the

weight 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

(p0.13, 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-place

to 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 afterthe 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 the

distressed 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-concernmodification and at least one of the preceding three years.

5 Firms were first matched in year t. This controlled for any differences in time-series valuation differences relatedto either the market or auditor tendencies over time to issue a going-concern opinion (Francis and Krishnan 2002;Geiger et al. 2005). They were then matched on industry, then firm size.



year it was matched to a going-concern modified company (t 0), along with available financialand market data for the preceding three years (i.e., t1, t2, t3).6

Summary statistics for the GC and NONGC sample firms are provided in Panel A of Table 1. Asindicated 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 measuredby 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-concernmodification 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 usesfinancial 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 a0 a1BVE a2BVE LO a3NI a4NI LO ei 1where:

MVE market value of equity;BVE book value of equity;NI net income before extraordinary items; andLO BVE or NI 1 if the firm is of lower financial soundness, 0 otherwise.Barth et al. (1998) find evidence in support of their predictions that BVE_LO is positive and

NI_LO is negative, indicating that book value is more relevant and net income is less relevant forfirms facing higher financial distress. Using this basic approach, we extend the Barth et al. (1998)

method to also include firms with negative BVE and negative NI and examine the change in marketvaluation 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 distressed NONGCfirms 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 netincome and replicate our primary results.



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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 year t 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, or MVE/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;i 1:0X2;i 10:6X3;i 0:3X4;i 0:17X5;i 2where:

X1,i (current assets current liabilities)/total assets;X2,i retained earnings/total assets;X3,i earnings before interest and taxes/total assets;X4,i market value of preferred and common equity/book value of total liabilities; andX5,i sales/total assets.In this model, the ZSCORE score represents the firms financial strength. The higher the

ZSCORE score, the less likely that a firm will terminate and the less likely they would receive agoing-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 theirZSCOREi , 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 time t3 to t 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 consistentwith those presented.

9 As noted in the Further Tests section, we replace the predicted going-concern modification as our indicator offinancial stress with a going-concern opinion prediction indicator based on Mutchlers (1983) F-score and with adefault status indicator and obtain similar results.



NONGC firms and treat each company as its own control over the four separate observations. Thisfirm 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 t 0. 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 (Francis

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

matched distressed NONGC firms at t0. Accordingly, in our full analysis we estimate coefficientsfor the following model:

MVEi;t a0 a1GCYEARi;t a2GCi;t a3BVEi;t a4NIi;t a5BVE NEGi;t a6BVE GCYEARi;t a7NI NEGi;t a8NI GCYEARi;t a9PREDi;t a10PRED BVEi;t a11PRED NIi;t a12GC BVEi;t a13GC NIi;t a14GCYEAR GCi;t a15GCYEAR GC BVEi;t a16GCYEAR GC NIi;t ei;t

3

where:

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

GCYEAR 1 if t is 0, 0 otherwise;GC 1 if the company received a going-concern modification in time t, 0 otherwise;BVE book 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 in

time t;

BVE_NEG BVE multiplied by 1 if BVE for firm i is negative in time t, 0 otherwise;BVE_GCYEAR BVE multiplied by 1 if GCYEAR for firm i is 1 in time t, 0 otherwise;NI_NEG NI multiplied 1 if NI for firm i is negative in time t, 0 otherwise;NI_GCYEAR NI multiplied by GCYEAR for firm i at time t;PRED 1 if predict a bankruptcy for firm i at time t per Altmans model, 0 otherwise;PRED_BVE PRED multiplied by BVE for firm i at time t;PRED_NI PRED multiplied by NI for firm i at time t;GC_BVE BVE multiplied by 1 if a going-concern firm, 0 otherwise;GC_NI NI multiplied by 1 if a going-concern firm, 0 otherwise;GCYEAR_GC GCYEAR multiplied by GC for firm i at time t;GCYEAR_GC_BVE GCYEAR multiplied by GC multiplied by BVE for firm i at time t; andGCYEAR_GC_NI GCYEAR multiplied by GC multiplied by NI for firm i at time t.To appropriately isolate the valuation effects of BVE and NI on the market valuation structure

for our GC firms in the year they receive the first-time modification, we include several controlvariables. 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) hasshown 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

of differential valuation related to negative book value.



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 tocontrol for firm-specific factors affecting the coefficients on BVE and NI. The coefficient for firmswith positive book value of equity receiving a going-concern modification is the sum of GC BVE_GC. Likewise, the coefficient for firms with negative book value but no going-concernmodification is BVE BVE_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 theircoefficients to be positive. Since negative net income cannot persist, we expect that NI_NEG will benegative, 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 similarlydefined variables for book value (BVE_GCYEAR) and net income (NI_GCYEAR). Because netincome 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 for NI (i.e., NI NI_NEG GC_NI GCYEAR_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, theincremental 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 t 0 compared to the financially distressed NONGC firms andcompared to the GC firms themselves in years prior to receiving the going-concern modification,we expect GCYEAR_GC_BVE will be positive, indicating the higher relevance of book value forthe GC firms in the year they receive the modified report. Similarly, we expect GCYEAR_GC_NI,the coefficient on net income for the GC firms to be negative; indicating that it is less relevant tomarket valuation for the GC firms in the year the firm receives a going-concern modificationrelative 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 value of adaptationdemonstrated 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 experiencednegative net income at time 0 (see Table 1).

11 We would not expect specific pricing differences for individual income statement components. If the auditorscommunication increases the markets assessment of the risk of financial failure, all components of incomewould be devalued.



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;t a0 a1GCYEARi;t a2GCi;t a3NIi;t a4NI NEGi;t a5NET CASHi;t a6RECi;t a7INVi;t a8PPEi;t a9INTANi;t a10OAi;t a11LTLi;t a12PREDi;t a13PRED NIi;t a14GC NIi;t a15GCYEAR NIi;t a1622GC i;t a2329GCYEAR i;t a3036PRED i;t a37GCYEAR GCi;t a38GCYEAR GC NIi;t a3945GCYEAR GC i;t ei;t

4

where previously undefined variables are defined as:

NET_CASH cash less current liabilities for firm i in time t;REC total receivables for firm i in time t;INV inventory for firm i in time t;PPE property and equipment for firm i in time t;INTAN intangible assets for firm i in time t;OA all other assets for firm i in time t;LTL long-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 t per Altmans model, 0 otherwise;

GCYEAR_*GCYEAR multiplied by each individual asset or liability defined above for firm iat time t; and

GCYEAR_GC_*GCYEAR multiplied by GC multiplied 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 weathershort-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 of NET_CASH and REC for firms receiving a going-concernmodification from their auditors relative to firms not receiving a going-concern modification

(GCYEAR_GC_NET_CASH. 0 and GCYEAR_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 if

the 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) forthese 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 Ye2007) for all firms. These hidden assets can also represent a greater opportunity to avoid bankruptcy



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 distressedfirm 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

LTL should have a higher negative effect on market value than LTL for financially distressed firmsthat 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 agoing-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 parameterestimates.



TA

BL

E2

Co

rrel

ati

on

Ta

ble

Pa

nel

A:

All

Yea

rs

PR

ED

BV

EB

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ED

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0.2

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**

0.1

3*

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**

0.2

7*

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0.3

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**

0.2

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0.2

9*

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**

0.1

6*

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**

0.4

3*

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**

0.6

2*

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**

BV

E0

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**

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6*

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**

0.0

5*

0.2

0*

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**

0.2

3*

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BV

E_N

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0.3

3*

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**

0.2

0*

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**

0.4

7*

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**

GC

YE

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_BV

E0

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**

0.1

5*

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**

0.4

1*

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NI

0.9

8*

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**

0.2

5*

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NI_

NE

G0

.36

**

0.2

5*

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0.1

6*

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BV

EB

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GC

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YE

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GC

0.4

9*

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0.2

1*

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0.3

7*

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0.8

4*

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0.4

9*

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PR

ED

0.3

2*

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0.1

9*

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0.4

6*

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0.5

3*

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BV

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0.3

0*

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0.0

20

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0.3

4*

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BV

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EG

0.5

3*

*0

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0.2

6*

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0.5

7*

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GC

YE

AR

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7*

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4*

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0.9

9*

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**

0.2

4*

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NE

G0

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**

0.2

4*

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**

GC

YE

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0.2

3*

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**

BV

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RE

D0

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**

(con

tinu

edo

nn

ext

pa

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TA

BL

E2

(co

nti

nu

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*,

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Spea

rman

sR

ho

signifi

cant

atth

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5an

d0.0

1le

vel

,re

spec

tivel

y.

Var

iable

Defi

nit

ions:

GC

1if

the

com

pan

yre

ceiv

eda

goin

g-c

once

rnm

odifi

cati

on,

0oth

erw

ise;

BV

E

book

val

ue

of

com

mon

equit

y;

NI

net

inco

me

bef

ore

extr

aord

inar

yit

ems

avai

lable

toco

mm

on

shar

ehold

ers;

BV

E_N

EG

BV

Em

ult

ipli

edby

1if

BV

Eis

neg

ativ

e,0

oth

erw

ise;

GC

YE

AR

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_BV

E

BV

Em

ult

ipli

edby

1in

the

yea

rgoin

g-c

once

rnm

odifi

cati

on

isre

ceiv

ed,

0oth

erw

ise;

NI_

NE

G

NI

mult

ipli

edby

1if

NI

isneg

ativ

e,0

oth

erw

ise;

GC

YE

AR

_GC

_NI

NI

mult

ipli

edby

1in

the

yea

ra

goin

g-c

once

rnm

odifi

cati

on

isre

ceiv

ed,

0oth

erw

ise;

PR

ED

pre

dic

ted

goin

g-c

once

rnm

odifi

cati

on,

1if

ZSC

OR

E,

1.8

1,

0oth

erw

ise;

PR

ED

_BV

E

BV

Em

ult

ipli

edby

1if

ther

eis

apre

dic

ted

goin

g-c

once

rnm

odifi

cati

on,

0oth

erw

ise;

and

PR

ED

_NI

NI

mult

ipli

edby

1if

ther

eis

apre

dic

ted

goin

g-c

once

rnm

odifi

cati

on,

0oth

erw

ise.



TA

BL

E3

Fir

ma

nd

Yea

rF

ixed

-Eff

ects

Reg

ress

ion

An

aly

ses

Mo

del

:

MV

Ei;

t

a0

a1G

CY

EA

Ri;

t

a2G

Ci;

t

a3B

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i;t

a4N

I i;t

a5B

VE

NE

Gi;

t

a

6B

VE

GC

YE

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i;t

a7N

IN

EG

i;t

a8N

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EA

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t

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Di;

t

a

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DB

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i;t

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I i;t

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CY

EA

RG

Ci;

t

a

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CY

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RG

CB

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i;t

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CY

EA

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CN

I i;t

e i;t

Pre

dic

ted

Sig

na

Pa

nel

AP

an

elB

Pa

nel

CP

an

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a

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eff.

Std

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rror

Coef

f.S

td.

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or

Coef

f.S

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Err

or

Coef

f.S

td.

Err

or

Inte

rcep

t0

.14

1.6

08

.79

7.7

41

6.9

57

.04

5.3

14

.02

GC

YE

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?

2

8.7

5*

8.0

51

8.9

8*

6.9

31

6.5

5*

5.3

8

GC

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1

6.5

7*

3.5

32

2.0

2*

3.3

53

.48

3.0

2

BV

E

1.8

4*

0.0

12

.00

*0

.01

2.0

3*

0.0

10

.51

*0

.05

NI

5

.86

*0

.11

4.5

2*

0.1

64

.24

*0

.01

52

.81

*0

.13

BV

E_N

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?3

.23

*0

.05

3.9

6*

0.0

63

.85

*0

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1.8

6*

0.1

1

BV

E_G

CY

EA

R?

0.7

8*

0.0

80

.42

*0

.07

0.0

40

.09

NI_

NE

G

6.1

0*

0.1

14

.66

*0

.16

5.8

8*

0.2

4

NI_

GC

YE

AR

?4

.41

*0

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4.4

7*

0.2

21

.64

*0

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PR

ED

?

1

2.7

1*

3.9

01

.42

2.9

9

PR

ED

_BV

E?

1.0

3*

0.0

40

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*0

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PR

ED

_NI

?

0

.73

*0

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0.9

8*

0.1

3

GC

_BV

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0.2

0*

0.0

20

.30

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1.1

9*

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6

GC

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*0

.03

0.4

6*

0.0

31

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*0

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GC

YE

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_GC

4

7.2

3*

11

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47

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*1

.03

2.9

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2.8

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13

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*0

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GC

YE

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_NI

3

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3.4

0*

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*0

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Ad

j.R

20

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0.9

70

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0.9

9

n3

11

53

11

53

10

02

10

6

(con

tinu

edo

nn

ext

pa

ge)



TA

BL

E3

(co

nti

nu

ed)

*S

ignifi

cant

atth

e0.0

1le

vel

.a

Pre

dic

ted

Val

ue

for

net

inco

me

coef

fici

ents

are

only

appli

cable

for

Pan

els

A,

B,

and

C.

Pan

elD

incl

udes

only

neg

ativ

eN

Ifi

rms,

whic

hch

anges

the

inte

rpre

tati

on

of

inco

me

stat

emen

tco

effi

cien

ts(a

nd

likel

yre

ver

ses

the

sign

on

man

y).

Var

iable

Defi

nit

ions:

MV

E

mar

ket

val

ue

of

com

mon

equit

yfo

rfi

rmi,

on

dat

eof

the

10

-Kre

leas

ein

tim

et;

GC

YE

AR

1if

t

0,

0oth

erw

ise;

GC

1if

the

com

pan

yre

ceiv

eda

goin

g-c

once

rnm

odifi

cati

on

inti

me

t,0

oth

erw

ise;

BV

E

book

val

ue

of

com

mon

equit

yfo

rfi

rmi

inti

me

t;N

I

net

inco

me

bef

ore

extr

aord

inar

yit

ems

avai

lable

toco

mm

on

shar

ehold

ers

for

firm

iin

tim

et;

BV

E_N

EG

BV

Em

ult

ipli

edby

1if

BV

Efo

rfi

rmi

isneg

ativ

ein

tim

et,

0oth

erw

ise;

BV

E_G

CY

EA

R

BV

Em

ult

ipli

edby

1if

GC

YE

AR

for

firm

iis

1in

tim

et,

0oth

erw

ise;

NI_

NE

G

NI

mult

ipli

edby

1if

NI

for

firm

iis

neg

ativ

ein

tim

et,

0oth

erw

ise;

NI_

GC

YE

AR

NI

mult

ipli

edby

GC

YE

AR

for

firm

iat

tim

et;

PR

ED

1if

pre

dic

ta

ban

kru

ptc

yfo

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

Panel A, the coefficients on BVE and NI from this initial regression are positive and significant atthe 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_NEG is negative and significant at the0.01 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 of BVE and NI for financially distressed firms.16 These high Adjusted R2 results suggestthat our fixed-effects models are capturing a larger amount of the variation in MVE for the stressedfirms 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 on GCYEAR_GC is negative and significant at the 0.01 level, indicating that beyond thevaluation of financial statement components, overall, the market negatively valued the GC firms inthe year in which they received their first-time going-concern modification.

As hypothesized, the coefficient on GCYEAR_GC_BVE is positive and significant at the 0.01level, and the coefficient on GCYEAR_GC_NI is negative and significant at the 0.01 level. Theresults for the GCYEAR_GC_BVE variable indicate that, after controlling for firm- and year-specificfactors, 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 NONGC firms. In contrast, the negative coefficient on the GCYEAR_GC_NIvariable 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 of GC firms 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, andPRED_NI control 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_BVE remains positive andsignificant 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 NONGCfirms.

In addition, as expected, we find that the sum of the coefficients on NI NI_NEG NI_GCYEARGC_NIGCYEAR_GC_NI is 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 areone to five years before delisting. By including fixed-effects controls for firm and year, our R2 is increased.



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 NI NI_GCYEAR (8.71; F-test 1912.49, 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 the NONGC firms, net income continues to remain relevant tothe 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-concern

modification. 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 for t 0 and for each ofthe three years prior to t 0. In all three estimations, the coefficients on GCYEAR_GC_BVE andGCYEAR_GC_NI obtain the predicted signs at 0.01 significance levels. These consistent resultsprovide 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-concern prediction).



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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 on GCYEAR_GC and GCYEAR_GC_NI are negative and significant at less than the0.01 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, andGCYEAR_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 wereunable to predict signs, GCYEAR_GC_INTAN is positive and significant at the 0.01 level, providingsome 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 themarket 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 TESTSNegative 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 additionalanalysis, we re-estimate our primary model including only firms with negative net income.19 As

shown 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_NI remains significant (F-test 57.09, 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 substituting PRED with:(1) the continuous ZSCORE measure used to calculate the PRED indicator, (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 of NI, MVE, or PRED for the sample and control firms, indicating closely matched distress levels.

20 We are unable to interpret the sign of the GCYEAR_GC_NI coefficient because it is dependent on the value ofthree 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 tonegative NI firms.



TABLE 5

Firm and Year Fixed Effects Regression AnalysisBalance Sheet Components

MVEi;t a0 a1GCYEARi;t a2GCi;t a3NIi;t a4NI NEGi;t a5NET CASHi;t a6RECi;t a7INVi;t a8PPEi;t a9INTANi;t a10OAi;t a11LTLi;t a12PREDi;t a13PRED NIi;t a14GC NIi;t a15GCYEAR NIi;t a1622GC i;t a2329GCYEAR i;t a3036PRED i;t a37GCYEAR GCi;t a38GCYEAR GC NIi;t a3945GCYEAR GC i;t ei;t

Variablesa Pred Sign Coeff. Std. Error

Intercept ? 12.66 13.58GCYEAR ? 1.55 9.99GC ? 4.98 5.56NI 11.23** 0.26NI_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** 0.22LTL 0.90** 0.14GC_NI ? 1.87** 0.28GCYEAR_NI ? 0.03 0.41GCYEAR_GC ? 33.29** 13.79GCYEAR_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** 0.44GCYEAR_GC_OA ? 1.26* 0.42GCYEAR_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 for PRED, PRED_NI, nor the GC, PRED, and GC_YEAR interaction variables for ease

of presentation and because we do not predict signs for these variables.

Variable Definitions:NET_CASH cash less current liabilities for firm i in time t;REC total receivables for firm i in time t;INV inventory for firm i in time t;PPE property and equipment for firm i in time t;INTAN intangible assets for firm i in time t;OA all other assets for firm i in time t;LTL long-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 time t per

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 by GC multiplied by each individual asset and liability defined above for firm i

at time t.All other variables defined in Table 3.



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 financially

distressed 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-GCfirms, 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 on GCYEAR_GC_BVE that continues to be positive and significant at the 0.01 level, anda coefficient on GCYEAR_GC_NI that 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_BVE and GCYEAR_GC_NI) both retain their expected signsand remain significant (p , 0.01) in each of the sub-period analyses. Thus, we find no indicationthat our results differ substantively in the pre/post-PSLRA or the pre/post-SOX periods. Overall, we

find no substantive evidence that our findings are time-period sensitive.

We also partition our sample by median MVE for our GC sample ($23MM) and find that ourresults 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_BVE and GCYEAR_GC_NI) inthe 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) forthe upper three quartiles, but not for the lowest quartile of MVE firms. Thus, although our results donot appear to be overly size-dependent, there is some indication that the GC opinion does notcommunicate 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 post survival and removal of the audit report modification. We identified caseswhere the GC firm 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 differencesdetected.



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