Blay Et Al. (AJPT, 2011)

Auditing: A Journal of Practice & Theory
Vol. 30, No. 2

May 2011
pp. 77102
American Accounting Association

DOI: 10.2308/ajpt-50002
The Auditors Going-Concern Opinion as a

Communication of Risk
Allen D. Blay, Marshall A. Geiger, and David S. North
SUMMARY: In this study, we examine the proposition that the auditors going-concern
modified opinion is a valuable risk communication to the equity market that results in
a shift of the markets perception of financially distressed firms. Specifically, our analyses
reveal that the market valuation is significantly altered from a focus on both the income
statement and balance sheet to a balance sheet-only focus in the year a company
receives a first-time going-concern modified opinion. These results hold even after
controlling for several common measures of financial distress and when examining a
larger control sample of distressed firms. We also document that the market devalues a
companys inventory and places increased weight on cash, receivables, and long-term
assets and liabilities as a result of the auditors modification. This indicates that the
going-concern modification provides incremental information specifically related to
abandonment or adaptation risk. Our results provide evidence that the market interprets the going-concern modified audit opinion as an important communication of risk
that results in a substantial shift in the structure of the market valuation for distressed
firms.
Keywords: auditors opinion; going-concern; value-relevance; nancial distress.
Data Availability: All data are available from public sources.
JEL Classications: M41; M42.
INTRODUCTION
he 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, and
David S. North is an Associate Professor, both at the University of Richmond.
We gratefully acknowledge helpful comments from W. Robert Knechel (associate editor), the reviewers, Wendy Bailey,
Nathan Stuart, and workshop participants at the University of Florida, the University of California, Riverside, the
American Accounting Association Annual Meeting, and the AAA Auditing Section Midyear Meeting.
Editors note: Accepted by Robert Knechel.
Submitted: April 2009

Accepted: September 2010
Published Online: May 2011
77
78
Blay, Geiger, and North
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 the
balance sheet as negative financial news is released. We control for this explanation by comparing the firms
receiving a going-concern opinion to a similarly distressed control sample of non-going-concern modified firms.
The auditors going-concern opinion is certainly not the only informational event that could potentially cause
such 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 of
extreme financial distress (Kida 1980). In addition, we control for debt default in our robustness tests, and the
majority of going-concern modified firms in our sample do not have public credit ratings nor pay dividends.

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The Auditors Going-Concern Opinion as a Communication of Risk
79
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 assets
through the avoidance of bankruptcy costs (Darrough and Ye 2007).

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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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81
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
(p 0.13, one-tailed). However, the authors suggest that their nonsignificant results may be partially
attributed 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 evidence
that 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 after
the receipt of a first-time going-concern modified report compared with similarly
distressed firms not receiving a going-concern modified report.
RESEARCH METHOD
Sample Selection
To identify financially stressed firms that may likely receive a going-concern modified audit
opinion, we first adopt Mutchlers (1984) four criteria for financial distress: operating loss, bottom
line loss, negative working capital, or negative retained earnings in the last three years. We then
identify firms during the period 19892006 that met one of the distress criteria. Because of
previously documented differences in market valuation between industries (Barth et al. 1998), we
limit our study to durable manufacturing firms (SIC codes 27002899 or 30003999). All publicly
traded durable manufacturing firms receiving a first-time going-concern audit report modification
were then identified using Compustat and 10-K filings in the SEC EDGAR database. Of 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-concern
modification and at least one of the preceding three years.
Firms were first matched in year t. This controlled for any differences in time-series valuation differences related
to either the market or auditor tendencies over time to issue a going-concern opinion (Francis and Krishnan 2002;
Geiger et al. 2005). They were then matched on industry, then firm size.

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82
year it was matched to a going-concern modified company (t 0), along with available financial
and 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. As
indicated in Panel A, firms receiving the going-concern modification were generally smaller in terms
of book value of equity (BVE), and showed a higher level of financial distress (ZSCORE) as measured
by Altmans Z-score, using Begley et al.s (1996) coefficients, and had a lower market capitalization
(MVE).7 This is consistent with prior literature indicating that firms receiving a going-concern
modification are generally smaller and in greater financial distress than other financially distressed
firms (Mutchler et al. 1997). Accordingly, along with our matching procedure, we include additional
controls for level of financial distress and size in our statistical analyses discussed in the next section.
Models
Barth et al. (1998) provide evidence that as firms approach bankruptcy or show more signs of
financial distress, the market valuation mechanism places a higher weight on recorded net assets as
reflected on the balance sheet (BVE), and less, or no, weight on unrecognized net assets as reflected
in current net income (NI). These findings are predicated on the assumption that the market uses
financial information to predict the future viability of a firm. Barth et al. (1998) assume that there is
some association between stock market equity value and financial statement components, and
estimate the following equation:
MVEi a0 a1 BVE a2 BVE LO a3 NI a4 NI LO ei
where:
MVE market value of equity;
BVE book value of equity;
NI net income before extraordinary items; and
LO 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 for
firms 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 market
valuation in the year a financially distressed firm receives a first-time going-concern modified report
from their auditor.
In order to demonstrate that the going-concern firms in the study have a marked shift in market
valuation structure upon receipt of the first-time going-concern opinion, we not only include a
control sample of financially distressed non-going-concern modified firms, we also include a
control sample of prior years for all the sample firms (going-concern modified and non-going6
Using a matched pair sample produces a sample selection bias if the base occurrence rate of the studied event is
significantly smaller than half the firms in the population. We use a matched pair sample to be consistent with
prior studies on market reaction to going-concern opinions. More importantly, we are not studying going-concern
report recipients compared to the entire population of firms, but compared to similarly financially distressed firms
that did not receive a modified report. Thus, including a larger sample with less-distressed firms would bias the
study 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 NONGC
firms produces substantively similar results.
Because the going-concern recipient firms have a higher level of financial distress, as discussed in a subsequent
section, we include financial distress control variables in the regression analysis to control for any remaining
effects of financial distress. Further, in sensitivity testing we limit our sample to observations with negative net
income and replicate our primary results.

May 2011
S.D.
Mean
S.D.
NONGC
Mean
GC
S.D.
Mean
S.D.
NONGC
Year t1
Mean
GC
S.D.
S.D.
NONGC
Mean
Year t2
Mean
GC
S.D.
S.D.
NONGC
Mean
Year t3

May 2011
0.102
0.165
0.163
0.222
0.011
0.030
0.048
0.057
*, ** Significantly different at the 0.05, and 0.01 levels, respectively.

Variable Definitions:
GC sample firm received a first-time going concern modification in year t 0;
NONGC sample firm received an unmodified audit opinion in year t 0;
MVE market value of common equity ten days subsequent to the 10-K filing date;
BVE book value of common equity;
NI net income before extraordinary items available to common shareholders; and
ZSCORE financial distress score calculated as per Altman (1968) using Begley et al. (1996) coefficients.
Announcement Date
3-Day Window (1,1)
5-Day Window (2,2)
12-Day Window (1,10)
S.D.
Mean
GC
0.004
0.001
0.005
0.002
Mean
Panel B: Stock Returns for Windows Surrounding Report Announcement Date (t 0)

NONGC
0.075
0.122
0.132
0.174
S.D.
0.015*
0.031**
0.053**
0.055**
Difference
# of obs.
431
431
391
399
355
394
346
388
MVE
156.09 1784.09 208.28 1735.15 143.97 861.72 177.25 1293.69 196.75 977.15 216.16 1473.94 330.00 2899.41 286.47 3140.52
BVE
36.10 383.11 61.53 415.20 55.78 285.31 69.22 347.65 77.50 347.20 95.09 641.35 149.96 1568.89 119.74 1359.90
# of obs , 0 81
21
31
11
19
26
33
18
NI
33.37 169.19 2.38 134.86 16.82 112.26
1.24 105.20 75.58 1304.06 32.81 723.58 11.04 168.88
5.01 107.58
# of obs , 0 410
312
307
215
241
192
231
199
ZSCORE
5.19
15.74
3.88
8.86
3.48 17.69
5.61
5.61
6.58
15.55
6.13
8.55
4.09
25.81
6.57
10.22
Mean
GC
Year t 0
Panel A: Means and Standard Deviations by Classification
Descriptive Summary
TABLE 1

83
84
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 there
emerges a difference in valuation in year t 0 for recipients of a going-concern opinion compared
to firms earlier years and to other distressed firms. A finding that the coefficients for the goingconcern modification are the same in year t 0 after controlling for firm-specific effects would
indicate 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 is
not 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
2
where:
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; and
X5,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 a
going-concern modified opinion from their auditor. We use Altmans (1982) viability cutoff score
of 1.81, and consider a firm as a predicted going-concern modification recipient (PRED) if their
ZSCOREi , 1.81, and a predicted viable firm without a modification if their score exceeds 1.81,
after applying Begley et al.s (1996) adjustment factor.8 Including this additional control provides a
more robust assessment of the incremental effect of the going-concern modification beyond the
level of stress exhibited in the firms financial statements.9
Cross-Sectional Time-series Analyses
In order to assess the change in the markets valuation of financial statement components for
individual distressed firms across our four year examination period (i.e., from time t3 to t 0), we
use 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 section
we report that when we replace the indicator variable with the continuous measure we obtain results consistent
with those presented.
As noted in the Further Tests section, we replace the predicted going-concern modification as our indicator of
financial stress with a going-concern opinion prediction indicator based on Mutchlers (1983) F-score and with a
default status indicator and obtain similar results.

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NONGC firms and treat each company as its own control over the four separate observations. This
firm fixed-effects analysis technique allows us to examine the differential effect of the markets
change in valuation of the GC firms compared to that of the NONGC firms at 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 their
first-time going-concern opinion compared to the firm itself in the prior three years, as well as to the
matched distressed NONGC firms at t 0. Accordingly, in our full analysis we estimate coefficients
for the following model:
MVEi;t a0 a1 GCYEARi;t a2 GCi;t a3 BVEi;t a4 NIi;t a5 BVE NEGi;t
a6 BVE GCYEARi;t a7 NI NEGi;t a8 NI GCYEARi;t a9 PREDi;t
a10 PRED BVEi;t a11 PRED NIi;t a12 GC BVEi;t a13 GC NIi;t
a14 GCYEAR GCi;t a15 GCYEAR GC BVEi;t a16 GCYEAR GC NIi;t
ei;t
where:
MVE market value of common equity for firm i, ten days subsequent to the date of the 10-K
release 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; and
GCYEAR_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 control
variables. First, we include partitions for negative book value (BVE_NEG) and negative net income
(NI_NEG) to control for firms with negative capital and negative net income. Hayn (1995) has
shown that the information content of negative net income is lower than that of positive net income
because of the general lack of persistence of negative net income. Thus, allowing the valuation
coefficient for net income to differ for positive and negative values of income will allow us to
separate the effect of the going-concern modification from the effect of negative net income.
Because market capitalization cannot be negative, the effect of negative book value is
indeterminate. However, it is essential to allow the coefficients to vary because of the likelihood
of differential valuation related to negative book value.
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To control for other firm-specific risk and valuation factors, we include an additional intercept
variable, GC, set to 1 for all years in our sample for firms receiving the going-concern modification.
We also include variables for book value (GC_BVE) and net income (GC_NI) for all firm-years to
control for firm-specific factors affecting the coefficients on BVE and NI. The coefficient for firms
with 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-concern
modification is BVE BVE_NEG, and firms with both negative book value and a going-concern
modification would be GC BVE BVE_NEG. A similar structure also exists for net income.
Further, because BVE and NI are generally expected to be accretive to MVE, we expect their
coefficients to be positive. Since negative net income cannot persist, we expect that NI_NEG will be
negative, but do not make any predictions on BVE_NEG.
Because our financially distressed sample was matched in time 0, we also control for timespecific risk factors by including a variable, GCYEAR, equal to 1 in time 0, as well as similarly
defined variables for book value (BVE_GCYEAR) and net income (NI_GCYEAR). Because net
income for firms likely to fail within the next year is not expected to persist, and therefore should
not provide relevant information about the future value of the firm, we expect that the sum of the
coefficients for NI (i.e., NI NI_NEG GC_NI GCYEAR_GC_NI) will be essentially zero for
going-concern opinion recipients.10
Additionally, if the market devalues firms receiving a going-concern modified opinion
unrelated to recognized financial statement items, we also predict that GCYEAR_GC, the
incremental valuation effect on going-concern firms in the year they receive the going-concern
modification, will be negative.
If the going-concern modification causes the market to employ a substantively altered valuation
methodology for the GC firms in t 0 compared to the financially distressed NONGC firms and
compared 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 for
the 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 to
market valuation for the GC firms in the year the firm receives a going-concern modification
relative to their earlier years and to the distressed NONGC firms.
Pricing of Balance Sheet Components
If the market uses the auditors going-concern modification as a specific communication of the
increased risk of financial failure, we would also anticipate that differences in the perceived
abandonment or adaptation values of the firms assets and liabilities would result in a shift in the
market pricing of these balance sheet components upon receipt of a going-concern modification.11
Berger et al. (1996) document that investors use information in the balance sheet to value the option
to abandon the continuing business of a distressed firm in exchange for the assets exit values.
Similarly, Darrough and Ye (2007) document that investors value the hidden value of adaptation
demonstrated by the presence of intangible assets that may enable a distressed firm to avoid
10
11
This assumes that firms receiving a going-concern modification all have negative net income. In practice, this is
essentially 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 not
true72.4 percent (312 out of 431) of control firms without a going-concern modification also experienced
negative net income at time 0 (see Table 1).
We would not expect specific pricing differences for individual income statement components. If the auditors
communication increases the markets assessment of the risk of financial failure, all components of income
would be devalued.

May 2011
87
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 a1 GCYEARi;t a2 GCi;t a3 NIi;t a4 NI NEGi;t a5 NET CASHi;t
a6 RECi;t a7 INVi;t a8 PPEi;t a9 INTANi;t a10 OAi;t a11 LTLi;t
a12 PREDi;t a13 PRED NIi;t a14 GC NIi;t a15 GCYEAR NIi;t
a1622 GC i;t a2329 GCYEAR i;t a3036 PRED i;t a37 GCYEAR GCi;t
a38 GCYEAR GC NIi;t a3945 GCYEAR GC i;t ei;t
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 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; and
GCYEAR_GC_* GCYEAR multiplied by GC multiplied by each individual asset and liability
defined above for firm i at time t.
Substantial amounts of cash (NET_CASH) and receivables (REC) enable the firm to weather
short-term financial difficulties and proxy for the firms ability to survive despite the modified audit
opinion (Altman 1968). If the modified audit opinion is a signal that there is an increase in the risk of a
firm incurring the high costs of bankruptcy (Altman 1984), the market is likely to interpret higher
levels of net current assets as indicative of a lower likelihood of bankruptcy. Thus, we would expect an
increase in the valuation coefficients of NET_CASH and REC for firms receiving a going-concern
modification 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) for
these distressed firms upon receipt of a modified audit opinion (GCYEAR_GC_PPE . 0).
Intangible assets (INTAN) may indicate the presence of hidden assets (Darrough and Ye
2007) for all firms. These hidden assets can also represent a greater opportunity to avoid bankruptcy
May 2011
88
costs for distressed firms (Darrough and Ye 2007). However, in liquidation, intangible assets are
likely to have a value of zero (Holthausen and Watts 2001). Thus, the direction of the effect of a
modified audit opinion on the valuation of recognized intangible assets is unclear. We also do not
make any directional predictions regarding Other Assets (OA).
Bankruptcy can also be triggered if firm value is less than the value promised to borrowers
(Merton 1974). In addition, there are limits to the amount of leverage a company can acquire
(Leland and Toft 1996; Faulkender and Peterson 2006). The higher the risk level of a firm, the
greater the probability of default on any debt claims, and the less capital a firm should optimally
borrow (Myers 1984). Thus, higher levels of long-term liabilities (LTL) for a more risky distressed
firm indicate less available financing and higher risk of incurring costs of default. Based on these
arguments, if the going-concern modification signals increased risk, we expect that greater levels of
LTL should have a higher negative effect on market value than LTL for financially distressed firms
that do not receive an auditors modification (GCYEAR_GC_LTL , 0).
RESULTS
Correlation
Table 2 presents the Spearman correlation coefficients for most variables used in the study.12,13
As would be expected, there are high degrees of correlation between many of the variables used in
the models presented in this paper. Panel A presents correlations among all observations in our
sample; Panel B presents correlations among observations in time 0, the year of the going-concern
modification. Predicted bankruptcy is highly correlated with the issuance of the going-concern
opinion (p , 0.01). In addition, net income is highly negatively correlated with the issuance of a
going-concern opinion (p , 0.01). Most notably, these relations are stronger during the goingconcern 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
13
14
We use Spearman rank-order correlation coefficients because of the high variances in our sample. Spearman
coefficients provide as much information as Pearson coefficients and are of wider validity (Altman 1991).
We do not present correlation coefficients for the separated asset and liability accounts.
Multicollinearity does not bias the parameter estimates, nor does it make significance levels higher. In fact, high
correlation increases the standard errors and decreases the likelihood of obtaining significant parameter
estimates.

May 2011

May 2011
0.25**
PRED
GC
PRED
BVE
BVE_NEG
GCYEAR_GC_BVE
NI
NI_NEG
GCYEAR_GC_NI
BVE_PRED
0.49**
PRED
Panel B: GC Year Only
GC
PRED
BVE
BVE_NEG
GCYEAR_GC_BVE
NI
NI_NEG
GCYEAR_GC_NI
BVE_PRED
Panel A: All Years
BVE_NEG
0.21**
0.29**
0.56**
0.31**
0.32**
0.13**
0.29**
0.45**
0.13**
0.29**
BVE
BVE_NEG
BVE
0.58**
0.19**
0.30**
0.53**
GCYEAR_GC_BVE
0.25**
0.16**
0.06**
0.33**
GCYEAR_GC_BVE
0.37**
0.46**
0.00
0.25**
0.17**
NI
0.27**
0.43**
0.11**
0.20**
0.14**
NI
Correlation Table
TABLE 2
0.37**
0.46**
0.02
0.26**
0.17**
0.99**
NI_NEG
0.28**
0.43**
0.05*
0.20**
0.15**
0.98**
NI_NEG
0.84**
0.54**
0.25**
0.27**
0.43**
0.62**
0.62**
GCYEAR_GC_NI
0.37**
0.36**
0.20**
0.19**
0.52**
0.35**
0.36**
GCYEAR_GC_NI
0.49**
0.88**
0.23**
0.32**
0.19**
0.68**
0.68**
0.66**
0.46**
NI_PRED
0.27**
0.81**
0.23**
0.29**
0.17**
0.59**
0.60**
0.42**
0.47**
NI_PRED
(continued on next page)
0.21**
0.53**
0.34**
0.57**
0.64**
0.24**
0.24**
0.23**
BVE_PRED
0.13**
0.62**
0.16**
0.47**
0.41**
0.25**
0.25**
0.16**
BVE_PRED

89
TABLE 2 (continued)
GC 1 if the company received a going-concern modification, 0 otherwise;
BVE book value of common equity;
NI net income before extraordinary items available to common shareholders;
BVE_NEG BVE multiplied by 1 if BVE is negative, 0 otherwise;
GCYEAR_GC_BVE BVE multiplied by 1 in the year going-concern modification is received, 0 otherwise;
NI_NEG NI multiplied by 1 if NI is negative, 0 otherwise;
GCYEAR_GC_NI NI multiplied by 1 in the year a going-concern modification is received, 0 otherwise;
PRED predicted going-concern modification, 1 if ZSCORE , 1.81, 0 otherwise;
PRED_BVE BVE multiplied by 1 if there is a predicted going-concern modification, 0 otherwise; and
PRED_NI NI multiplied by 1 if there is a predicted going-concern modification, 0 otherwise.
*, ** Spearmans Rho significant at the 0.05 and 0.01 level, respectively.
90

May 2011

May 2011
Intercept
GCYEAR
GC
BVE
NI
BVE_NEG
BVE_GCYEAR
NI_NEG
NI_GCYEAR
PRED
PRED_BVE
PRED_NI
GC_BVE
GC_NI
GCYEAR_GC
GCYEAR_GC_BVE
GCYEAR_GC_NI
Adj. R2
n
Model:
?
?
?
?

?
?
?
?
?
?
Predicted Signa
0.94
3115
0.14
1.84*
5.86*
3.23*
6.10*
Coeff.
1.60
0.01
0.11
0.05
0.11
Std. Error
Panel A
Std. Error
7.74
8.05
3.53
0.01
0.16
0.06
0.08
0.16
0.28
0.02
0.03
11.48
0.11
0.31
Coeff.
8.79
28.75*
16.57*
2.00*
4.52*
3.96*
0.78*
4.66*
4.41*
0.20*
0.11*
47.23*
2.84*
3.61*
0.97
3115
Panel B
16.95
18.98*
22.02*
2.03*
4.24*
3.85*
0.42*
5.88*
4.47*
12.71*
1.03*
0.73*
0.30*
0.46*
47.17*
3.05*
3.40*
0.98
3100
Coeff.
7.04
6.93
3.35
0.01
0.015
0.05
0.07
0.24
0.22
3.90
0.04
0.16
0.02
0.03
1.03
0.09
0.25
Std. Error
Panel C

a10 PRED BVEi;t a11 PRED NIi;t a12 GCYEAR GCi;t
a13 GCYEAR GC BVEi;t a14 GCYEAR GC NIi;t ei;t
Firm and Year Fixed-Effects Regression Analyses
TABLE 3
4.02
5.38
3.02
0.05
0.13
0.11
0.09
0.32
2.99
0.04
0.13
0.06
0.05
7.07
0.10
0.31
Std. Error
(continued on next page)
5.31
16.55*
3.48
0.51*
2.81*
1.86*
0.04
1.64*
1.42
0.69*
0.98*
1.19*
1.43*
2.91
0.32*
2.33*
0.99
2106
Coeff.
Panel Da

91
TABLE 3 (continued)
MVE market value of common equity for firm i, on date of the 10-K release in time t;
GCYEAR 1 if t 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 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 by 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; and
GCYEAR_GC_NI GCYEAR multiplied by GC multiplied by NI for firm i at time t.
* Significant at the 0.01 level.

a
Predicted Value for net income coefficients are only applicable for Panels A, B, and C. Panel D includes only negative NI firms, which changes the interpretation of income
statement coefficients (and likely reverses the sign on many).
92

May 2011
93
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 at
the 0.01 level, indicating the incremental value relevance of both book value of equity and net
income in valuing the firm. In addition, the coefficient on NI_NEG is negative and significant at the
0.01 level, indicating, as expected, the lack of persistence in negative earnings. Thus, these model
results provide some baseline evidence that the sample of 862 firms in our study are valued
similarly to other samples of financially distressed firms examined in prior research. Further, the
model Adjusted R2 of 0.94 for this base regression model, and the subsequent regressions, is
relatively high and is substantially higher than what is presented in prior literature on the value
relevance of BVE and NI for financially distressed firms.16 These high Adjusted R2 results suggest
that our fixed-effects models are capturing a larger amount of the variation in MVE for the stressed
firms in our samples.
In order to assess the effect of the going-concern modification to the markets valuation
mechanism, next we add the GC and GCYEAR and related variables to the regression model.
Results of this expanded model are presented in Panel B of Table 3. As seen in Panel B, the
coefficient on GCYEAR_GC is negative and significant at the 0.01 level, indicating that beyond the
valuation of financial statement components, overall, the market negatively valued the GC firms in
the 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 0.01
level, and the coefficient on GCYEAR_GC_NI is negative and significant at the 0.01 level. The
results for the GCYEAR_GC_BVE variable indicate that, after controlling for firm- and year-specific
factors, the market places increased relevance on book value of equity for firms receiving a firsttime 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_NI
variable indicates a lower relevance of net income for the going-concern modified firms in the year
the auditor renders their first-time going-concern modification. The valuation of GC firms exhibits a
considerable shift from a balance sheet and net income focus to a focus only on the balance sheet in
the year these firms receive their first going-concern modified report from their external auditor.
Controlling for Bankruptcy Prediction
The results of our full model from Equation (3) incorporating the PRED, PRED_BVE, and
PRED_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 and
significant at the 0.01 level, and the coefficient on GCYEAR_GC_NI remains negative and
significant at the 0.01 level, and the other variables in the model typically retain the same signs and
significance levels obtained in the earlier regressions. These results indicate that even after
incorporating additional controls for probability of bankruptcy, the market places increased
relevance on book value and a decreased relevance on net income when firms receive a first-time
going-concern modification, compared to their earlier years and to financially distressed NONGC
firms.
In addition, as expected, we find that the sum of the coefficients on NI NI_NEG
NI_GCYEAR GC_NI GCYEAR_GC_NI is substantially equal to zero (0.11; F-test 0.38, p .
15
16
In addition, intercepts were allowed to vary by calendar year to allow for time differences in valuation. These
variables are not tabulated for ease of exposition.
Barth et al. (1998) find the R2 for their model to be between 0.53 and 0.80 for financially distressed firms that are
one to five years before delisting. By including fixed-effects controls for firm and year, our R2 is increased.

May 2011
94
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 positive
net 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 results
reinforce our earlier findings that for the NONGC firms, net income continues to remain relevant to
the market in valuing the firm, even if net income is negative.
Cross-Sectional Results
The results presented in the prior section suggest that the auditors issuance of the goingconcern 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 of
the three years prior to t 0. In all three estimations, the coefficients on GCYEAR_GC_BVE and
GCYEAR_GC_NI obtain the predicted signs at 0.01 significance levels. These consistent results
provide additional evidence that communication of the going-concern modification provides
incremental value relevance to the market, regardless of which prior period the results are
compared. Moreover, these additional separate cross-sectional tests provide additional support that
the shift in valuation is not gradual, but that the auditors communication of the first-time goingconcern 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
18
As discussed previously, 95.1 percent of the firms in the sample receiving a going-concern opinion had
negative net income; thus, all five coefficients apply to the going-concern recipients. Further, 72.4 percent of
the matched control firms also had negative net income; thus, negative net income was common throughout the
sample.
These tests, however, do not rule out the possibility that another risk factor not related to the going-concern
opinion, but generally coinciding with its issuance, is actually driving the valuation implications found in Tables
3 and 4. Nonetheless, our results provide additional support that the risk factor associated with the shift in market
valuation occurs in the year the firm receives their first-time going-concern modification and does not occur in
the years immediately prior to the going-concern opinion, even for financially stressed firms. In the Further Tests
section, we attempt to control for some of these possibilities (e.g., debt default, negative net income, goingconcern prediction).

May 2011

May 2011
?
?
?
?

?
?
?
?
?
?
Predicted Sign
1.12
13.27**
15.38**
1.31**
7.94**
2.82**
0.29**
11.00**
2.30**
9.10**
0.93**
0.76**
0.22**
1.71**
29.05**
2.08**
1.25**
0.95
1639
Year t 0, 1
4.22
5.23
5.11
0.05
0.21
0.76
0.06
0.28
0.22
4.37
0.06
0.20
0.07
0.24
7.55
0.08
0.25
Std. Error
Std. Error
4.45
5.12
4.36
0.06
0.26
0.09
0.07
0.34
0.24
4.18
0.06
0.22
0.06
0.05
7.62
0.10
0.26
Year t 0, 2
3.97
11.26*
10.24*
0.49**
8.21**
2.91**
0.48**
12.91**
2.21**
13.03**
0.92**
2.68**
0.10*
1.34**
29.02**
2.57**
1.06**
0.95
1597
Yearly Comparisons

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

All variables are defined in Table 3.
Intercept
GCYEAR
GC
BVE
NI
BVE_NEG
BVE_GCYEAR
NI_NEG
NI_GCYEAR
PRED
PRED_BVE
PRED_NI
GC_BVE
GC_NI
GCYEAR_GC
GCYEAR_GC_BVE
GCYEAR_GC_NI
Adj. R2
n
Model:

Comparison to Prior Years
TABLE 4
3.01
11.19*
20.64**
2.01**
4.78**
3.79**
0.51**
7.92**
4.27**
6.96
1.04**
0.81**
0.48**
0.01
33.74**
2.99**
1.27**
0.95
1550
Year t 0, 3
5.05
5.78
5.10
0.02
0.33
0.07
0.07
0.33
0.31
4.99
0.06
0.26
0.03
0.32
8.55
0.08
0.42
Std. Error

95
96
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 goingconcern 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 the
0.01 level in our expanded Model (4) regression. In addition, GCYEAR_GC_NET_CASH,
GCYEAR_GC_REC, and GCYEAR_GC_PPE are positive and significant at the 0.01 level, and
GCYEAR_GC_INV is negative and significant at the 0.01 level, as predicted. Further,
GCYEAR_GC_LTL is negative and significant at the 0.01 level, as predicted. Although we were
unable to predict signs, GCYEAR_GC_INTAN is positive and significant at the 0.01 level, providing
some support that intangible assets proxy for opportunities to avoid failure (Darrough and Ye
2007). GCYEAR_GC_OA is also positive and significant. These findings are consistent with the
market assessing going-concern modified firms a higher risk of abandonment and provide
additional support for the proposition that the auditors going-concern opinion communicates firmspecific information about increased continuance risk beyond what is communicated through other
information sources.
FURTHER TESTS
Negative Income Firms
Although we control for negative net income in our model, we cannot eliminate the possibility
that our results are driven by negative net income firms having a higher prevalence among goingconcern recipients (95 percent for GC firms and 72 percent for control firms). As an additional
analysis, we re-estimate our primary model including only firms with negative net income.19 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 firmyear observations, GCYEAR_GC_BVE is positive (0.31, F-test 9.52, p , 0.01) and
GCYEAR_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 variable
based 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
20
21
After eliminating firms with negative net income, there is no longer a significant difference ( p . 0.10) between
the means of NI, MVE, or PRED for the sample and control firms, indicating closely matched distress levels.
We are unable to interpret the sign of the GCYEAR_GC_NI coefficient because it is dependent on the value of
three other variables and related to negative net income. We can only infer that the valuation of this loss is
different for these firms in this year.
Our findings related to individual balance sheet components also continue to hold for the sample limited to
negative NI firms.

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97
TABLE 5
Firm and Year Fixed Effects Regression Analysis
Balance Sheet Components
MVEi;t a0 a1 GCYEARi;t a2 GCi;t a3 NIi;t a4 NI NEGi;t a5 NET CASHi;t
a6 RECi;t a7 INVi;t a8 PPEi;t a9 INTANi;t a10 OAi;t a11 LTLi;t
a12 PREDi;t a13 PRED NIi;t a14 GC NIi;t a15 GCYEAR NIi;t
a1622 GC i;t a2329 GCYEAR i;t a3036 PRED i;t a37 GCYEAR GCi;t
a38 GCYEAR GC NIi;t a3945 GCYEAR GC i;t ei;t
Variablesa
Intercept
GCYEAR
GC
NI
NI_NEG
NET_CASH
REC
INV
PPE
INTAN
OA
LTL
GC_NI
GCYEAR_NI
GCYEAR_GC
GCYEAR_GC_NI
GCYEAR_GC_NET_CASH
GCYEAR_GC_REC
GCYEAR_GC_INV
GCYEAR_GC_PPE
GCYEAR_GC_INTAN
GCYEAR_GC_OA
GCYEAR_GC_LTL
Adj. R2
n
Pred Sign
Coeff.
Std. Error
?
?
?

?
?
?
?
?
12.66
1.55
4.98
11.23**
13.05**
0.97**
0.77**
1.04**
0.18**
1.89**
1.02**
0.90**
1.87**
0.03
33.29**
3.17**
1.53**
2.83**
2.37**
1.79**
3.56**
1.26*
2.07**
0.98
3115
13.58
9.99
5.56
0.26
0.38
0.14
0.25
0.22
0.10
0.22
0.22
0.14
0.28
0.41
13.79
0.28
0.36
0.77
0.66
0.18
0.44
0.42
0.26

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.
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; and
GCYEAR_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.

May 2011
98
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-GC
firms, we re-estimate our models. Results of these expanded sample regressions are very similar to
the results presented in Table 3, and in particular, the re-estimate of Equation (3) produces a
coefficient on GCYEAR_GC_BVE that continues to be positive and significant at the 0.01 level, and
a 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/postSarbanes-Oxley Act of 2002 (SOX). We present the coefficients of interest in Table 6 for the preand post-SOX periods, as well as pre- and post-PSLRA. Re-estimating our models in these subperiods 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 signs
and remain significant (p , 0.01) in each of the sub-period analyses. Thus, we find no indication
that our results differ substantively in the pre/post-PSLRA or the pre/post-SOX periods. Overall, 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 our
results are similar for the larger half of our sample; however, they become only marginally significant (p , 0.10) for our main variables of interest (GCYEAR_GC_BVE and GCYEAR_GC_NI) in
the smaller half of our sample. To further test for a size effect, we partition into quartiles and find
that our main variables of interest retain their expected signs and remain significant (p , 0.01) for
the upper three quartiles, but not for the lowest quartile of MVE firms. Thus, although our results do
not appear to be overly size-dependent, there is some indication that the GC opinion does not
communicate the same information for the smallest firms in our study.
CONCLUSION
This study provides evidence regarding the auditors communication of business risk through
the issuance of a first-time going-concern modified audit report and the relevance of this
communication to the securities market in adjusting share price valuations. Subramanyam and Wild
(1996) and Barth et al. (1998) demonstrate that for distressed firms the market shifts from using
both book value and net income in valuing firms to using only book values. In this study we present
22
An additional test examined ex post survival and removal of the audit report modification. We identified cases
where the GC firm survived and received an unmodified opinion in the subsequent year and the matched control
firm also survived and received an unmodified opinion. The results (not presented) indicate that the goingconcern partition no longer provides any explanatory power upon removal of the report modification, providing
further evidence that the initial audit report modification was the driving factor behind the valuation differences
detected.

May 2011

May 2011
Coeff.
1.28**
4.27**
4.89**
13.63*
1.30**
1.03**
2175
Predicted Signa

0.05
0.32
0.36
8.55
0.12
0.26
Std. Error
Pre-SOX
1.97**
5.28**
8.89**
191.22**
4.01**
5.13**
925
Coeff.
0.01
0.18
0.53
49.90
0.28
0.74
Std. Error
Post-SOX
0.99**
7.82**
8.16**
11.71*
4.12**
1.60**
528
Coeff.
0.08
0.64
0.79
9.34
0.63
0.22
Std. Error
Pre-PSLRA

2.06**
3.84**
5.12**
71.82**
3.19**
4.01**
2572
Coeff.
0.01
0.15
0.25
15.66
0.09
0.27
Std. Error
Post-PSLRAa

a
For ease of presentation, we only present variables with predicted directions in the time period partitions. Pre-SOX is defined as fiscal years ending prior to August 29, 2002. PrePSLRA is defined as fiscal years ending prior to December 31, 1996.
All variables are defined in Table 3.
BVE
NI
NI_NEG
GCYEAR_GC
GCYEAR_GC_BVE
GCYEAR_GC_NI
n
Model:

By Time Period
TABLE 6

99
100
the first evidence that this shift coincides with the external auditors communication of a first-time
going-concern report on the financially stressed firm. Specifically, we find that book value of equity
has a greater valuation weight for firms receiving a first-time going-concern modified audit report
compared to their earlier years and to similar financially distressed firms not receiving a
going-concern modification. In addition, we document that the market prices the risk communicated
by the auditor through the going-concern modified opinion at the individual balance sheet
component level, supporting the contention that the risk factor communicated by the going-concern
opinion provides relevant information specifically about the potential abandonment or adaptation of
firm assets (Berger et al. 1996). Thus, this crucial auditor communication results in the markets
increased assessment of the relevance of net cash, receivables, long-term assets, and long-term
liabilities, and a decreased valuation of inventory, all consistent with an increased risk of
abandonment.
We also demonstrate that the results hold even after controlling for several other measures of
financial distress, expanding our control sample of distressed firms, and examining sub-periods
within our 18-year examination period. In sum, our results provide consistent support that the
equity markets consider the auditors business risk evaluation of the company, as communicated in
a first-time going-concern modified report, as incrementally value-relevant even in conjunction with
other financial distress measures found in the financial statements.
Our results provide additional insight regarding the relevance of specific nonfinancial
information communicated by external auditors to the valuation of financially stressed firms and
provide impetus for future research in several areas. For example, are there specific financial
reporting situations, economic conditions, or industries in which these going-concern communications from the auditor are more or less impactful to the securities markets? In addition, are there
other types of modified audit opinions (e.g., other uncertainty or except for qualifications) that are
used in the markets valuation of firm risk, and what, if any, are the financial statement components
affected?
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Auditing: A Journal of Practice & Theory

Vol. 30, No. 2

American Accounting Association

The Auditors Going-Concern Opinion as a

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

Submitted: April 2009

Blay, Geiger, and North

Auditing: A Journal of Practice & Theory

The Auditors Going-Concern Opinion as a Communication of Risk

Auditing: A Journal of Practice & Theory

Blay, Geiger, and North

The Auditors Going-Concern Opinion as a Communication of Risk

Auditing: A Journal of Practice & Theory

Blay, Geiger, and North

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

*, ** Significantly different at the 0.05, and 0.01 levels, respectively.

Panel B: Stock Returns for Windows Surrounding Report Announcement Date (t 0)

Panel A: Means and Standard Deviations by Classification

The Auditors Going-Concern Opinion as a Communication of Risk

Blay, Geiger, and North

Auditing: A Journal of Practice & Theory

The Auditors Going-Concern Opinion as a Communication of Risk

Blay, Geiger, and North

Auditing: A Journal of Practice & Theory

The Auditors Going-Concern Opinion as a Communication of Risk

where previously undefined variables are defined as:

Blay, Geiger, and North

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

Panel B: GC Year Only

Panel A: All Years

(continued on next page)

The Auditors Going-Concern Opinion as a Communication of Risk

*, ** Spearmans Rho significant at the 0.05 and 0.01 level, respectively.

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

MVEi;t a0 a1 GCYEARi;t a2 GCi;t a3 BVEi;t a4 NIi;t a5 BVE NEGi;t

Firm and Year Fixed-Effects Regression Analyses

(continued on next page)

The Auditors Going-Concern Opinion as a Communication of Risk

* Significant at the 0.01 level.

Auditing: A Journal of Practice & Theory

The Auditors Going-Concern Opinion as a Communication of Risk

Auditing: A Journal of Practice & Theory

Blay, Geiger, and North

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

MVEi;t a0 a1 GCYEARi;t a2 GCi;t a3 BVEi;t a4 NIi;t a5 BVE NEGi;t

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

Firm and Year Fixed-Effects Regression Analyses

The Auditors Going-Concern Opinion as a Communication of Risk

Blay, Geiger, and North

Auditing: A Journal of Practice & Theory

The Auditors Going-Concern Opinion as a Communication of Risk

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

Auditing: A Journal of Practice & Theory

Blay, Geiger, and North