Conservatism of the Big Six Audit Firms and Going-Concern Modified Audit Reports
Geiger, Marshall A., Raghunandan, K., Academy of Accounting and Financial Studies Journal
This study examines whether Big 6 audit farms exhibit a more conservative reporting posture than non-Big 6 audit firms by examining differences in "reporting errors "for going concern uncertainties. Specifically, based on an analysis of relative error costs, we hypothesize that Big 6 firms are more conservative in their reporting decisions, leading to differences in error proportions for both type 1 (companies receiving going-concern modified opinions that do not fail) and type II (failed companies that did not receive a prior going-concern modification) reporting errors. Evidence from samples of companies with first-time going-concern modified opinions and bankrupt companies is generally consistent with the hypotheses. Big 6 firms were found to have a significantly higher type I reporting error rate when failure was defined as filing for bankruptcy or entering default on debt payments, and a significantly lower type II reporting error rate than non-Big 6 firms. Our findings suggest that reporting decisions are associated with the relative magnitude of the firms' expected losses, resulting in more conservative reporting decisions regarding the issuance of going -concern modified audit reports for Big 6 firms.
Prior research has addressed the existence of differences between Big 6 and non-Big 6 (1) audit firms on a variety of dimensions, including audit quality, audit fees, client retention and industry concentration (DeAngelo, 1981; Palmrose, 1986; Francis & Simon, 1987; Simunic & Stein, 1996; Gul, 1999; Hogan & Jeter, 1999). Some recent studies have also examined whether the largest audit firms are more conservative than smaller audit firms in various settings. Recent papers examining issues related to the market for audit services have documented that Big 6 firms are (a) less concentrated in industries perceived as having high litigation risk compared to those perceived as having low litigation risk (Hogan & Jeter, 1999), (b) less likely to accept clients where the predecessor auditor resigned (Raghunandan & Rama, 1999), and (c) have maintained historically less risky client portfolios than non-Big 6 auditors (Francis & Reynolds, 1999). While these studies have examined several facets of the auditor-client interaction, no study has examined Big 6 firms compared to non-Big 6 firms for conservatism in their resultant reporting decisions--the final outcome of the audit process.
Audit reporting, and particularly reporting on going-concern uncertainties, continues to remain an important issue for U. S. legislators and the public accounting profession. This is evidenced by the fact that the U. S. recently enacted the Private Securities Litigation Reform Act which provides the first and only instance where a specific auditing procedure, related to reporting on going-concern uncertainties, has been mandated by law. This study provides additional evidence on the conservatism of the Big 6 firms by empirically examining reporting decisions regarding going-concern.
An analysis of an audit reporting model, developed below, suggests that rational economic behavior on the part of Big 6 auditors would lead to more conservative audit opinions, after controlling for other going concern related factors. Our findings support this analysis and suggest that Big 6 firms generally do exhibit more conservative reporting decisions related to issuing going-concern modified reports. Specifically, we find that type I reporting errors (defined as instances where a company receives a going-concern modified opinion but does not subsequently fail), as expected, were higher for the Big 6 than the non-Big 6 firms when failure was defined as entering bankruptcy or payment default on debt. We also find that type II reporting errors (defined as instances where a company enters into bankruptcy without a prior going-concern modified opinion), as expected, were significantly lower for the Big 6 firms. …