Anticipation and reaction to going‐concern modified audit opinions by sophisticated investors

• Author: Abdullah Kumas,Marshall A. Geiger
• DOI: http://doi.org/10.1111/ijau.12135
• Published date: 01 November 2018
• Date: 01 November 2018

ORIGINAL ARTICLE

Anticipation and reaction to going‐concern modified audit

opinions by sophisticated investors

Marshall A. Geiger |Abdullah Kumas

Robins School of Business, University of

Richmond, Richmond, Virginia

Correspondence

Marshall A. Geiger, Robins School of Business,

University of Richmond, 1 Gateway Road,

Richmond, VA 23173.

Email: mgeiger@richmond.edu

The purpose of this paper is to examine whether institutional investors (i) anticipate a

distressed firm's receipt of a first‐time going‐concern modified audit opinion, and (ii)

react to a first‐time going‐concern modified opinion by engaging in abnormal net

selling of firm shares. Using a proprietary database of US institutional investor trades,

we find that institutional investors are net sellers of first‐time going‐concern opinion

firms beginning 6 months before the release of the report and remain net sellers

through the subsequent 3 months. We also find that the severity of the reasons audi-

tors modify their opinions is associated with increased trading activity, but only after

the opinion is publicly available. Our results support the position that an auditor's

going‐concern modified opinion is influential in the marketplace by documenting that

institutional investors anticipate this price‐relevant information and react through

increased selling. The finding of increased net selling of firms with more severe rea-

sons for report modifications provides evidence of the incremental informational

value of the wording in the modified opinion.

KEYWORDS

auditor opinions, going concern, institutional investors

1|INTRODUCTION

In this study, we examine whether institutional investors, as a group of

sophisticated investors, are able to anticipate bad news from the

company's external auditor in the form of a first‐time going‐concern

modified audit opinion (GCMO), and whether this opinion is associ-

ated with trading after its release. External auditors obtain a vast

amount of private information when conducting the audit (Beattie,

Fearnley, & Brandt, 2000; Kida, 1980), most of which is never revealed

to the public. However, in the case of a GCMO, the auditor is required

to indicate their overall doubt regarding the continued viability of the

company, along with the salient factors that have caused them to

maintain such doubt (Auditing and Assurance Standards Board

[AUASB], 2015; Blay & Geiger, 2013; Carson, Fargher, & Zhang,

2017; Carson, Ferguson, & Simnett, 2006; Public Company Account-

ing Oversight Board [PCAOB], 2015a; Xu, Carson, Fargher, & Jiang,

2013). Professional standards indicate that a GCMO is not a predic-

tion of failure. Nonetheless, it is a credible signal from the auditor

regarding the financial condition of the company and the auditor's

professional assessment of continued future viability that has the

potential to provide price‐relevant information to the market (Blay,

Geiger, & North, 2011; Carson et al., 2017; Fleak & Wilson, 1994;

Ianniello & Galloppo, 2015; Menon & Williams, 2010; Renart &

Barnes, 2013). Therefore, we examine trading around announcements

of first‐time GCMOs to determine whether institutional investors in

the US appear to anticipate this GCMO, and whether it provides addi-

tional information to these investors.

A large literature establishes the important role that the external

auditor plays in the financial markets (DeFond & Zhang, 2014; Hay,

Knechel, & Willekens, 2014). Prior research has found that an audit

by independent external auditors increases the credibility of financial

information produced and disseminated by company management

(Duréndez Gómez‐Guillamón, 2003; Fan & Wong, 2005; Wallace,

2004), which then enables companies to reduce their overall cost of

capital (Lennox & Pittman, 2011; Minnis, 2011). In addition, prior

research finds that specific communications from external auditors

directly affect both a company's cost of capital (Karjalainen, 2011;

Ogneva, Subramanyam, & Raghunandan, 2007) and their equity price

Received: 21 November 2017 Revised: 23 March 2018 Accepted: 24 April 2018

DOI: 10.1111/ijau.12135

522 © 2018 John Wiley & Sons Ltd Int J Audit. 2018;22:522–535.wileyonlinelibrary.com/journal/ijau