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Concern over audit opinion
May, 24th 2007
In general, the hit rate for auditor opinions to capture the true underlying economics of the firm is rather limited. The reasons could be several ranging from extreme uncertainty in business conditions to gross incompetence.

Accounting as a fundamental discipline rests on three pillars. One among them is the "going concern" principle. A going concern implies a firm that does not face financial distress in the near future. Auditors are responsible for certifying if the state of the firm warrants it to be classified as being "at risk" or "not". Hence if an auditor believes that the foundation of the going concern pillar is weak, he raises the red flag for the investors and users of financial information by issuing a going concern opinion.

Why should we bother about a "going concern" opinion? If an auditor raises the red flag the investors do get some time to bail out of the firm before it goes belly up. This implies that there is some "informational" value from audit opinions.

The question one should then ask is: How good is the ability of auditors to spot failing firms or firms in financial distress? If they were so good would Enron, WorldCom, Adelphia, etc., have happened? While we hope that auditors can pick up signs early, empirical evidence indicates otherwise. In general, the hit rate for auditor opinions to capture the true underlying economics of the firm is rather limited. The reasons could be several ranging from extreme uncertainty in business conditions to gross incompetence. While taking these polar cases might be justified on occasion, for the average firm, the answer probably lies in economic incentives.

Three sets of players

Consider a typical situation. There are three sets of players interacting. We have the firm, the auditor and the "interested" parties. The interested parties are potential users of the financial information concerning the firm investors, creditors, regulatory agencies, etc. The game enfolds sequentially with strategic interaction primarily taking place between the auditor and the firm.

The auditor has access to records which "interested" parties might never get access to. Further, the interested parties are primarily dependent on an "independent" evaluation of the firm by the auditors. Given this scenario, we can see that alignment of incentives between the auditor, management and interested parties is the key to obtaining truthful reports which, in turn, maximise social welfare. While what we would prefer is that the incentives of the auditor are aligned more closely with the incentives of the independent parties, what is observed in practice could turn out to be completely different.

The game is first played between the auditor and the firm. The auditor collects all necessary information to provide his opinion. For the services rendered the auditor collects fees. Prior to the public receiving the audit opinion, the top management of the firm receives it. Therefore the auditor's opinion potentially affects the possible outcomes for the firm.

This raises strategic considerations from the perspective of both the auditor and the firm. For instance, the firm can decide to switch auditors in the hope of receiving a more favourable report. The auditor knowing that the likelihood of his services being terminated is high, thereby affecting his fees as well as reputation, restrains from issuing a going concern opinion.

In other words, the firms can use a credible threat of switching auditors in order to prevent the present auditor from issuing an adverse opinion. Hence, though there is a case for issuing a qualified opinion, the auditor might not actually do so. This reduces the effectiveness of the auditors and indicates that his incentives might be more closely aligned with that of the management as compared to the interested parties.

Trouble indicator

This also brings to question the issue of using the "going concern" opinion as a leading indicator for trouble within a firm. Given that there is considerable subjectivity in the auditor's statements, heterogeneity among different auditors is what makes the threat of switching "credible". In other words, if the current auditor knows that the opinion will not change regardless of the auditor doing the work, the threat of switching is no longer credible and, hence, he has incentive to engage in truthful reporting. Given uncertainty about the future, it is quite difficult to expect different auditors to have the same view on the subject. All that the management is looking for is somebody who gives them what they want. From the perspective of the users of financial information, this raises further doubt. Who is the better auditor? Which opinion is more reliable?

This brings us to the question the role of auditors and current regulations. What is inevitable is an auditor survives because his clients give him business. Therefore, strategic interplay is unavoidable. The question remains as to whether other mechanisms can be put in place to avoid "opinion shopping" by firms.

Anup Menon
(The author is a doctoral scholar in accounting in the US.)

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