Going-concern Opinions in Failing Companies: Auditor Dependence and Opinion Shopping

Clive S. Lennox* Economics Dept., University of Bristol.

Abstract: Contrary to public expectations, companies usually receive clean audit opinions shortly prior to failure. This study examines whether audit reports in failing companies are affected by auditor dependence or opinion shopping. I find audit fees, auditor size, auditor-client tenures and dominant directors are not significantly associated with going-concern opinions. This suggests audit reports are not affected by auditor dependence. I also find companies strategically appoint auditors who are less likely to issue going concern opinions. This suggests failing companies successfully engage in opinion shopping.

I would like to thank the Nuffield Foundation and the Centre for Market and Public Organisation for financial assistance.

1. Introduction The financial community and public expect auditors to disclose going-concern problems before companies fail. Despite this, companies frequently fail after receiving clean audit opinions. Companies may use auditor switching to avoid receiving going-concern opinions in two ways (Teoh, 1992). First, auditors may face dismissal threats and may not disclose goingconcern problems if they lack independence. Second, even when auditors report independently, companies may strategically dismiss (appoint) audit firms that are likely to give going-concern (clean) audit opinions - I call such behavior opinion shopping This . study examines whether failing companies avoid going-concern opinions because of auditor dependence and opinion shopping. Existing studies find audit opinions are not associated with proxies for auditor dependence. Krishnan et al., (1996) find no significant association between audit reports and switch probabilities, which suggests switch threats do not affect audit opinions. Since fees might compromise independence, most EU countries ban the provision of some or all nonaudit services.1 However, researchers find no significant association between non-audit fees and audit opinions in the UK and Australia, where non-audit services are not banned but fees are publicly disclosed (Lennox, 1999a; Craswell, 1999). Since long auditor-client tenures may increase auditor dependence, some countries require mandatory rotation of auditors.2 In the US, AICPA and the SEC Practice Section have rejected calls for mandatory rotation of audit firms (AICPA, 1978, 1992). Consistent with their position, Louwers (1998) finds no significant relation between auditor-client tenures and audit opinions in the US. Regulators respond to concerns about opinion shopping in a variety of ways. Several EU countries require mandatory retention of audit firms to deter strategic switching.3 In addition, most countries require communication between outgoing auditors, incoming
1

Belgium, France and Italy ban the provision of all non-audit services while other EU countries allow tax and financial advisory services. Bookkeeping services are banned in all EU countries except Denmark, Ireland, Luxembourg, Netherlands, Portugal, Sweden and the UK. Legal services are allowed in all EU countries except Belgium Denmark, France, Greece, Italy and Portugal. Corporate recovery services are allowed in all EU countries except Belgium, France, Italy and Portugal (Buijink et al., 1996). 2 Listed companies in Italy are required to rotate audit firms every nine years . In the UK, the Cadbury Committee (1992) recommends rotation of individual audit partners but not the rotation of audit firms. The Australian Society of Certified Public Accountants (1993) recommends partner rotation every seven years, but this is rejected by the Australian Joint Standing Committee (1996). In the US, members of the SEC Practice Section are required to rotate partners every seven years.

auditors and shareholders.4 The aim of such communication is to prevent companies switching auditors to conceal unfavourable information. Evidence on opinion shopping is conflicting because researchers employ different methodologies. Some studies conclude that companies do not successfully engage in opinion shopping, because post-switch opinions are not modified less often than pre-switch opinions (Chow and Rice, 1982; Smith, 1986; Krishnan, 1994; Krishnan and Stephens, 1995). More recently Lennox (2000a, 2000b) shows this conclusion is flawed, because it is necessary to compare the reports that companies would receive under opposite switch decisions. He finds the evidence strongly supports successful opinion shopping by UK and US companies. In contrast to the above studies, this paper focuses exclusively on failing companies for two reasons. First, auditor dependence may be more apparent in distressed companies since managers may fear that going-concern opinions increase the probability of failure (the self-fulfilling prophecy hypothesis). By sampling failing companies, I therefore expect to increase the power of my tests for auditor dependence. Second, the regulatory implications of auditor dependence and opinion shopping are clearer in failing than surviving companies. Going-concern opinions issued to surviving companies and clean opinions issued to failing companies are frequently classified as reporting errors (e.g., Koh, 1991; Lennox, 1999b). Therefore, the number of reporting errors is lower if surviving companies avoid goingconcern opinions and higher if failing companies avoid going-concern opinions. It follows there is a stronger case for regulatory intervention if failing companies use switch threats or opinion shopping to avoid going-concern opinions. This is not the first study to examine going-concern opinions in failing companies, but it is the first to consider auditor dependence and opinion shopping. Previous studies find failing companies receive going-concern opinions more often when financial conditions are

3 4

There is mandatory retention of audit firms in France (six years), Portugal (four years), Belgium, Spain and Italy (three years),. In the US, the SEC must be informed of auditor changes within five business days and companies have to disclose disagreements with auditors and modified opinions in the two years preceding auditor changes. To ensure compliance and to identify companies who file late, the SEC Practice Section requires independent disclosure by audit firms as well as companies. The US Public Oversight Board (1994) recommends auditors meet with boards of directors and audit committees at least once a year and auditors discuss the appropriateness of financial statements. Communication requirements are less stringent in the UK than in the US (Dunn et al., 1994; Lennox, 2000b).

clearly poor (Menon and Schwartz, 1987; McKeown et al., 1991; Mutchler et al., 1997; Casterella et al., 1999). Consistent with these studies, I find auditors give clean opinions to companies that appear healthy but which subsequently fail. Section 2 explains how I test for auditor dependence and opinion shopping. Section 3 describes how I collect the sample and gives descriptive statistics. Section 4 tests for auditor dependence and Section 5 tests for opinion shopping. Section 6 concludes with implications for audit regulation.

2. Methodology This section explains how I test for auditor dependence and opinion shopping and describes the control variables shown to be important in previous studies. 2.1 Auditor dependence 2.1.1 Audit fees ( AFit ) When audit firms earn high fees, they may face economic pressures to give clean opinions in order to deter clients from switching to other auditors. This suggests a negative association between going-concern opinions and audit fees.5 However, auditors may give going-concern opinions more often when audit fees are high. Auditors who exert more effort (and charge higher fees) may be more likely to discover going-concern problems. Moreover, auditors may exert more effort or charge higher risk premiums when companies face going-concern problems. Therefore, the predicted relation between audit fees and going-concern opinions is ambiguous. An important contribution of this study is that I use actual audit fees, which are publicly disclosed by UK companies. Since US companies are not required to disclose fees, previous studies use client characteristics such as size to capture the effects of fees (e.g., Louwers, 1998; McKeown et al., 1991).6

UK companies are only required to disclose non-audit fees since 1994. Since most sample companies fail prior to 1994, I do not test the association between non-audit fees and audit opinions. 6 Threats to auditor independence may be more severe when an individual client fee is a large proportion of an audit firm s s total income. Unfortunately, data on total fees are unavailable for small audit firms. However, this is unlikely to be a problem as

2.1.2 Audit firm size ( AUDit ) I control for auditor size using a dummy variable ( AUDit ), which equals one if the audit firm is one of the Big Five and zero otherwise. Reputation and deep pockets theories predict a positive association between audit firm size and audit quality. DeAngelo (1981) argues large audit firms have more incentive to avoid reputation-damaging criticism compared to small audit firms. Dye (1993) suggests large audit firms are more likely to disclose problems because they have more wealth at risk from litigation. In addition, individual clients contribute proportionately less to the total incomes of large audit firms. These arguments mean large audit firms have more incentive to detect and report going-concern problems. I therefore expect a positive relation between audit firm size and going-concern opinions.

2.1.3 Auditor-client tenure ( TEN it ) My tenure variable ( TEN it ) equals the number of years that firms audit their clients. When auditors have long relations with their clients, expected future rents may be higher and may increase the threat to auditor independence. This suggests a negative association between auditor-client tenures and going-concern opinions. However, an opposite positive association is also possible. Long tenures may mean audit firms better understand clients financial conditions and are more likely to detect going-concern difficulties. Therefore, the predicted relation between tenures and audit opinions is ambiguous.

2.1.4 Dominant directors ( DOMS it , DOMRit ) Dominant directors may exert more pressure on auditors to issue clean opinions compared to boards where control is exercised democratically.7 I measure board dominance using two

large audit firms have more highly diversified client portfolios and I control for the association between audit firm size and going-concern opinions. 7 For example, Robert Maxwell held over 99% of the board shares in Maxwell Communications (MCC) and MCC received s clean opinions prior to failure. The Financial Times writes (17th June, 1992), Maxwell was able to seize money so quickly because the sweeping powers he had secured as chairman of his companies allowed him to move money with little reference to anyone else. His policy of divide and rule concealed what he was doing from many . . . the audit for the year to April 1991 never took place. One of the ways Maxwell avoided detection was by the simple device of extending the audit period. He simply declared that the next one would be in December 1991, a gap of 21 months.

variables -

the proportion of board shares held by the director who owns most shares

( DOMS it ) and the proportion of board remuneration earned by the highest paid director ( DOMRit ). If dominant directors exert more pressure on auditors compared to democratic boards, I expect a negative relation between director dominance and going-concern opinions. To my knowledge, this is the first paper to examine whether dominant directors influence audit opinions.

2.2 Control variables 2.2.1 Financial condition ( BLAGit , Rit ) Previous studies find auditors disclose going-concern problems more often when companies are close to failure. Consistent with previous studies, I include a bankruptcy lag variable ( BLAGit ) as an ex-post measure of financial condition (McKeown et al., 1991; Citron and Taffler, 1992; Mutchler et al., 1997). The bankruptcy lag equals the number of calendar days between audit opinions and failure. I expect a negative association between bankruptcy lag and going-concern opinions since it is easier for audit firms to detect going-concern problems when the bankruptcy horizon is short.8 Auditors may have difficulty in identifying going-concern problems when companies fail with little warning. Therefore, an ex-ante measure of financial condition is also likely to be correlated with audit opinions. Some studies use financial ratios or bankruptcy probabilities predicted from accounting variables as ex-ante controls for financial condition (Menon and Schwartz, 1987; McKeown et al., 1991; Mutchler et al., 1997; Casterella et al., 1999).9 In contrast, I use stock returns ( Rit ) for two reasons. First, predicted bankruptcy probabilities likely do not capture all publicly available information about financial condition. For example, the information content of financial ratios and predicted bankruptcy

Similarly, bankruptcy prediction models are more accurate over shorter bankruptcy horizons (e.g., Dambolena and Khoury, 1980). 9 Chen and Church (1996) show debt covenant violations significantly predict US going-concern opinions. Since UK companies do not generally disclose debt covenant violations, I am unable to test their association with audit opinions.

probabilities may be reduced if distressed companies choose accounting policies that cover up poor performance (Murphy and Zimmerman, 1993). In contrast, share prices reflect all publicly available information if the semi-strong efficient markets hypothesis holds. Second, going-concern opinions and share prices are forward looking variables, whereas financial statements are primarily backward looking. Therefore, going-concern opinions are likely more strongly associated with stock returns than accounting variables. Since going-concern problems are more apparent in companies with poor stock returns, I expect a negative relation between rates of return and going-concern opinions.

2.2.2 Audit lag ( ALAGit ) The audit lag is defined as the number of calendar days between financial year-ends and audit opinions. Research shows auditors give going-concern opinions more often when audit opinions are delayed (McKeown et al., 1991; Louwers, 1998). There are several possible explanations for this. First, auditors may discover problems more frequently when they carry out more audit tests. Second, auditors may undertake more tests if they expect going-concern problems. Third, managers and auditors may engage in prolonged negotiations when there are going-concern uncertainties. Finally, auditors may delay issuing audit reports in the hope that companies can resolve their problems and avoid going-concern opinions. I expect a positive association between audit lag and going-concern opinions.

2.2.3 Prior audit opinions ( Git 1 ) The audit report dummy ( Git ) equals one when auditors issue going-concern opinions and zero otherwise. Several studies find auditors issue going-concern opinions more often when prior opinions disclose going-concern problems (e.g., Mutchler, 1985). In other words, there is persistence in audit reporting. Therefore, I expect a positive relation between prior and current going-concern opinions.

2.3 Opinion shopping I test for opinion shopping using the methodology employed by Lennox (2000a, 2000b). I use an audit reporting model to predict the opinions that companies would receive if they switch and if they do not switch. I include these predicted opinions in an auditor switching model to test whether companies would receive going-concern opinions more often under opposite switch decisions. Since auditor changes may be associated with financial distress, I control for the effects of financial condition ( BLAGit , Rit ) on auditor switching. I also include audit lag ( ALAGit ) in the switching model, as newly appointed auditors may take longer to issue their opinions compared to retained incumbent auditors.

3. The Data 3.1 Sample My sample consists of UK companies traded on the London Stock Exchange (LSE), the Unlisted Securities Market (USM) or the Alternative Investment Market (AIM). There are 355 companies that fail between 1980-99, where failure is defined as compulsory liquidation, creditors voluntary liquidation, receivership or administration.10 I identify failed companies using the CGT Capital losses publication. Fig. 1 shows the time-line for failing companies and Table 1 describes how I obtain my final sample.

[INSERT TABLE 1 & FIG. 1 HERE]

I first require a minimum of two years accounts in order to identify auditor changes and prior audit opinions. Where available, I collect final (t = -2) and penultimate (t = -3) accounts from Companies House. There are 283 companies that meet this restriction. Second, I require stock returns from Datastream and this results in the loss of a further 31 companies.11

10 11

I exclude voluntary liquidations by shareholders as these companies are typically non-distressed. In 9 companies there are insufficient data to calculate final annual returns because they become listed after the penultimate year-end (t = -2). The remaining 22 companies are not listed by Datastream.

Third, I use accounts prior to penultimate year-ends in order to identify auditor appointment dates and auditor-client tenures. In 15 companies I am unable to identify tenures because accounts are not available for a sufficient number of years. My final sample consists of 237 companies and wherever possible I collect data for the last three year-ends (t = -2, -3, -4). Although the potential sample size is 711 company-year observations (711 = 3*237), 51 observations are lost due to companies becoming listed during the sample period. Therefore, my final sample consists of 660 company-year observations. There are 237 observations at final year-ends (t = -2), 218 at penultimate year-ends (t = -3) and 205 at t = -4. With the exception of the bankruptcy lag and audit opinions, I measure all variables at year-ends rather than audit opinion dates.12

3.2 Descriptive statistics Table 2 reports current and prior audit opinions for switching and non-switching companies. There are 57 (8.64%) auditor changes and 90 (13.64%) going-concern opinions. Auditor changes occur more frequently when prior opinions disclose going-concern problems. There are 12 (28.57%) auditor changes when prior opinions disclose going-concern problems, but only 45 (7.28%) auditor changes when prior opinions are clean. The difference between these frequencies (28.57% and 7.28%) is statistically significant at the 1% level. Auditor changes are significantly associated with changes in audit opinions. There are 13 (22.81%) changes in opinions when companies change audit firms, but only 67 (11.11%) opinion changes when companies retain audit firms. The difference between these frequencies (22.81% and 11.11%) is statistically significant at the 5% level.

[INSERT TABLE 2 HERE]

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There is evidence that the market reacts negatively when going-concern opinions are announced (Firth, 1978; Banks and Kinney, 1982; Fleak and Wilson, 1994; Jones, 1996). This means there is a potential reverse causality problem from audit opinions to stock returns. I avoid the reverse causality problem by measuring stock returns at year-ends rather than audit opinion dates.

Consistent with extant research, post-switch reports do not disclose going-concern problems less often than pre-switch reports. Going-concern opinions are issued in 13 (22.81%) post-switch reports and 12 (21.05%) pre-switch reports. This does not refute the opinion shopping hypothesis, as we shall see that prior opinions poorly proxy the reports that companies would receive if they made different switch decisions. Table 3 summarises auditor changes, audit opinions, bankruptcy lags and share returns prior to failure. The frequency of auditor changes does not change significantly as bankruptcy draws near. In contrast, the frequency of going-concern opinions rises from 5.37% three periods prior to failure (t = -4) to 25.74% in final reports (t = -2). The median bankruptcy lag falls from 1076 to 291 days between the third and final audit opinions while the median lag between suspension and bankruptcy is only 3 days. Median (mean) stock returns fall from 8.69% (26.46%) three periods prior to failure to 26.89% (-7.49%) at final year-ends. Median (mean) returns are -75.93% (-67.10%) between final year-ends and suspension. This suggests going-concern difficulties often do not become apparent until shortly prior to failure.

[INSERT TABLE 3 HERE]

Table 4 provides descriptive statistics on the auditor dependence and control variables. Mean (median) audit fees are 96,450 (43,000); large firms audit 58% of companies; and, mean (median) auditor-client tenures are 7.33 (6) years. The mean (median) proportions of board shares held by dominant directors are 67.61% (67.62%). The mean (median) proportions of board remuneration earned by dominant directors are 32.41% (29.48%). Table 4 shows the audit fee ( AFit ), bankruptcy lag ( BLAGit ), returns ( Rit ), and audit lag ( ALAGit ) variables have skewed distributions and contain outlying variables. To account for this, I use log transformations ( ln( AFit ), ln( BLAGit ), ln( Rit ), ln( ALAGit ) ). In

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unreported results, I find my conclusions are robust to using either untransformed or log variables although explanatory power is higher with the latter.

[INSERT TABLE 4 HERE]

Table 5 reports descriptive statistics for the explanatory variables across goingconcern and non-going-concern opinions. The univariate associations between opinions and the auditor dependence variables are not statistically significant. In contrast, audit opinions are significantly associated with financial conditions. Going-concern opinions are issued more often when bankruptcy lags ( ln( BLAGit ) ) are short and returns ( ln( Rit ) ) are low. In addition, going-concern opinions are issued more often when audit lags ( ln( ALAGit ) ) are long.

[INSERT TABLE 5 HERE] 4. Auditor dependence 4.1 Model specification In this section, I test the multivariate associations between going-concern opinions and the auditor dependence variables ( ln( AFit ) ,

AUDit , TEN it , DOMS it , DOMRit ). As

explained in section 2.2, I also control for financial condition ( ln( BLAGit ) , ln( Rit ) ), audit lag ( ln( ALAGit ) ) and prior audit opinions ( Git 1 ). Eq. (1) is the model of going-concern opinions:
* Git = 0 + 1 ln( AFit ) + 2 AUDit + 3TEN it + 4 DOMSit + 5 DOMRit +

6 ln( BLAGit ) + 7 ln( Rit ) + 8 ln( ALAG) + 9 Git 1 + it

where:
* Git 0 if Git = 1 * Git < 0 if Git = 0.

(1)

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4.2 Estimation results The probit estimation results for Eq. (1) are given in Table 6.13 Column (1) shows the coefficients on audit fees ( ln( AFit ) ), audit firm size ( AUDit ), tenure ( TEN it ) and director dominance ( DOMS it , DOMRit ) are all statistically insignificant. Moreover, the coefficients on audit firm size and director dominance have opposite signs to those predicted by the auditor dependence hypothesis. Therefore, the auditor dependence variables do not explain why failing companies avoid going-concern opinions.14

[INSERT TABLE 6 HERE]

Columns (1) and (2) show auditors disclose going-concern uncertainties more often when financial conditions are poor. The significant negative coefficients on bankruptcy lag ( ln( BLAGit ) ) indicate more frequent going-concern opinions when companies are close to failure. The significant negative coefficients on returns ln(Rit ) ) show auditors issue going( concern opinions more often when companies have poor market performance. The significant positive coefficients on audit lag (ln( ALAGit ) ) show auditors give going-concern opinions
15 more often when audit reports are delayed. The significant positive coefficients on prior

opinions (Git 1 ) reveal strong persistence in audit reporting. Audit firms give going-concern opinions more often when companies receive prior going-concern opinions. The explanatory
2 power of the reporting model compares favourably with previous studies. The pseudo R is

41.6% in Column (2), compared with 36.4% in Casterella et al., (1999), 30.6% in Mutchler et al., (1997), 24.7% in McKeown et al., (1987), and 10.5% in McKeown et al., (1991).

13 14

In unreported estimations, I find probit and logit results are very similar.

In unreported estimations, I find average audit fees ( AFi. ) ) and abnormal audit fees ( ln( AFit ) ln( AFi. ) ) are not ln( significantly correlated with going-concern opinions. I also find no evidence of a non-monotonic relation between tenure and going-concern opinions.

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5. Opinion shopping 5.1 Model specifications In this section, I estimate an audit reporting model in order to predict the opinions companies would receive if they switch or do not switch auditors. Eq. (2) omits the auditor dependence variables as Section 4 shows them to be insignificant. It includes an auditor switch dummy ( S it ), which equals one if there is a change in audit firm and zero otherwise. Eq. (2) also includes an interaction term between the switch dummy and prior opinionsS(it Git 1 ), to test whether auditor changes are associated with less reporting persistence 6 < 0 ). (
* Git = 0 + 1 ln( BLAGit ) + 2 ln( Rit ) + 3 ln( ALAGit ) + 4Git 1

+ 5 Sit + 6 Sit Git 1 + it

where:
* Git 0 if Git = 1 * Git < 0 if Git = 0.

(2)

I use Eq. (2) to predict the opinions companies would receive if they switch Git* ) or (1

0 do not switch ( Git * ). My opinion shopping variable is the difference between these predicted 1 0 1 0 opinions (Git* Git * ). When Git* Git * > 0, companies are more likely to receive going1 0 concern opinions if they switch auditors. WhenGit* Git * < 0, companies are more likely to
receive going-concern opinions if they do not switch. If companies use auditor appointments

1 0 to avoid going-concern opinions, auditor changes occur whenGit* Git * < 0 and do not 1 0 occur when Git* Git * > 0. I include the opinion shopping variable in Eq. (3) to test whether
companies receive going-concern opinions less often as a result of auditor switching. Under the alternative hypothesis that companies successfully engage in opinion shopping, the

1 0 coefficient on Git* Git * is negative (1 < 0 ). Under the null hypothesis that companies do

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In unreported results, I find the abnormal audit lag ( ALAG it ) ln( ALAG i . ) ) is significantly associated with goingln(

concern opinions, but its association is weaker than the unadjusted audit lag ln( ALAG it ) ). (

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not successfully engage in opinion shopping, 1 = 0 . Eq. (3) also controls for financial condition (ln(BLAGit ), ln( Rit ) ) and audit lag (ln( ALAGit ) ).
* 1 0 S it = 0 + 1 (Git* Git * ) + 2 ln( BLAGit ) + 3 ln( Rit ) + 4 ln( ALAGit ) + it

(3)

where:
* S it 0 if S it = 1 * S it < 0 if Sit = 0.

Substituting Eq. (2) into Eq. (3) gives a reduced form model of auditor switching (Eq. (4)):
* S it = 0 + 1 5 + 2 ln( BLAGit ) + 3 ln( Rit ) + 4 ln( ALAGit ) + 1 6Git 1 + it

(4)

where:
* S it 0 if S it = 1 * S it < 0 if Sit = 0.

It is important to note that Eq. (3) includes the difference between predicted going-concern

1 0 opinions (Git* Git * ) while Eq. (4) includes prior audit opinions Git 1 ). Eq. (4) demonstrates (
there is a positive association between prior going-concern opinions and auditor changes if

1 6 > 0 . This condition holds if auditor changes are associated with less reporting persistence ( 6 < 0 ) and companies successfully engage in opinion shopping 1 < 0 ). (

5.2 Estimation results The probit estimation results for Eqs. (2)-(4) are given in Columns (1)-(3) of Table 7. Column (1) shows the coefficient on the interaction term ( it Git 1 ) is negative and statistically S significant. This means there is significantly less persistence in going-concern opinions when

there are auditor changes ( 6 < 0 ). In other words, audit opinions change more often when
there are changes in audit firms. The coefficients on the other variables are consistent with the models in Table 6. Companies receive going-concern opinions more often when financial

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conditions ( ln(BLAGit ), ln( Rit ) ) are poor, audit lags (ln( ALAGit ) ) are long, and prior opinions (Git 1 ) disclose going-concern uncertainties.

[INSERT TABLE 7 HERE]

The results for the reporting model in Column (1) are used to predict going-concern opinions if companies switch or do not switch auditors. When prior opinions disclose goingconcern problems, the mean predicted going-concern probabilities are 39.42% if companies switch and 69.05% if companies do not switch. Therefore, companies are less likely to receive repeat going-concern opinions if they change auditors. When prior opinions do not disclose going-concern problems, the mean predicted going-concern probabilities are 12.21% if companies switch and 10.01% if companies do not switch. Therefore, companies are more likely to receive repeat clean opinions if they do not change auditors. The results for the auditor switching models in Columns (2) and (3) are consistent with successful opinion shopping. In Column (2), the significant negative coefficient ( < 0 ) 1

0 on the opinion shopping variable ( it* Git * ) shows companies receive going-concern G1
opinions less often as a result of auditor changes. In Column (3), the significant positive

coefficient (1 6 > 0 ) on prior reports (Git 1 ) shows auditor changes occur more frequently
after companies receive going-concern opinions. This is what we would expect since Column

(1) shows that 6 < 0 . Auditor changes are not significantly associated with financial
condition (ln(BLAGit ), ln( Rit ) ). The significant positive coefficients on audit lag ( ln( ALAGit ) ) indicate newly appointed auditors take longer than retained incumbents to issue their audit opinions.

6. Conclusions and implications for audit regulation There are a number of regulatory measures that aim to strengthen auditor independence and

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prevent opinion shopping. These include banning non-audit services, mandatory rotation, mandatory retention and communication between outgoing auditors, incoming auditors and shareholders. This paper investigates whether auditors give clean opinions to failing companies due to auditor dependence or opinion shopping. I sample failing rather than surviving companies in order to increase the power of my tests for auditor dependence and to provide clearer recommendations for policy-makers. Since bargaining between audit firms and clients occurs behind closed doors it is arguably difficult to observe the effects of auditor dependence on audit opinions. Despite this, I hypothesise managers are more likely to exert pressure and auditors are more likely to acquiesce when: audit fees are high, audit firms are small, auditor-client tenures are long and individual directors dominate boards. I find no significant association between these variables and going-concern opinions, which suggests either failing companies do not pressurise auditors or auditors report independently. I test for opinion shopping by predicting the reports switching and non-switching companies would receive under opposite switch decisions. My results suggest companies would receive going-concern opinions significantly more often if auditor changes were different to those actually observed. This suggests failing companies successfully engage in opinion shopping. My results indicate policy-makers should be more concerned with opinion shopping than auditor dependence. Regulators might curb opinion shopping by introducing mandatory retention of audit firms or by requiring greater disclosure about auditor changes. The need for more communication between investors, outgoing and incoming auditors is particularly relevant in the UK. Companies and auditors are not required to disclose auditor changes or disagreements to the stock market and incoming auditors do not have access rights to the working papers of outgoing auditors. However, policy recommendations such as increased communication or mandatory retention carry an important caveat. If regulators deter opinion shopping, the number of going-concern opinions is likely to increase in surviving as well as failing companies.

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t = -4 Third year-end prior to failure

t = -3 Penultimate year-end

t = -2 Final year-end

t = -1 Suspension of share trading

t=0 Bankruptcy date

Fig. 1. The time-line for failing companies.

Table 1 Derivation of the final sample. Companies Company-year observations . . . . . (51) 660

Population of failing UK companies (1980-99). Less: 72 companies where final and penultimate accounts are unavailable. Less: 31 companies where stock returns are unavailable. Less: 15 companies where auditor-client tenures are unavailable. Final sample of companies. Less: 51 observations where companies become listed during the sample period. Final sample of company-year observations.

355 (72) (31) (15) 237 . 237

Notes:
Company-year observations are taken from the last three accounting year-ends (t = -4, -3, -2). See Fig. 1.

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Table 2 Current ( Git ) and prior (Git 1 ) going-concern opinions. Auditor retentions (S it = 0)

Git = 1 Git 1 = 1 Git 1 = 0

Totals 20 57 77

Git = 0
10 516 526

Totals 30 573 603

Auditor changes (S it = 1)

Git = 1 Git 1 = 1 Git 1 = 0

Totals 6 7 13

Git = 0
6 38 44

Totals 12 45 57

Notes:
t = -4, -3, -2 at the last three year-ends prior to failure. See Fig. 1.

S it = 1 if company i changes audit firm at time t; 0 otherwise. G it = 1 if company i receives a going-concern opinion at time t; 0 otherwise.

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Table 3 Auditor changes, audit opinions, and financial conditions prior to failure. Time (t) No. (%) of auditor changes -4 16 (7.80%) 11 (5.37%) 1076 (1098) 8.69% (26.46%) 205 -3 21 (9.63%) 18 (8.26%) 684 (707) -9.67% (6.58%) 218 -2 20 (8.44%) 61 (25.74%) 291 (321) -26.89% (-7.49%) 237 -1 . . . . 3 (39) -75.93% (-67.10%) 237

No. (%) of going-concern opinions

Median (mean) bankruptcy lag ( BLAGit ) Median (mean) returns (Rit ) Observations

Notes:
t = -4, -3, -2 at the last three year-ends prior to failure and t = -1 at suspension. See Fig. 1.

BLAG it = Number of days between the audit opinion and the bankruptcy date. Rit = ( SPit + DPS it SPit 1 ) SPit 1 SPit = Share price of company i at time t. DPS it = Dividend per share of company i at time t.

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Table 4 Descriptive statistics for the explanatory variables. Mean Auditor dependence variables Median Min Max

AFit AUDit TEN it DOMS it DOMRit

Control variables

96.45 0.58 7.33 67.61 32.41

43.00 1 6 67.62 29.48

0.10 0 1 21.25 5.52

3300 1 26 100 100

BLAGit Rit ALAGit

Notes:

690 7.70% 135

673 -8.10% 122

17 -98.86% 27

2135 1622% 548

t = -4, -3, -2 at the last three year-ends prior to failure. See Fig. 1. Observations = 660.

AFit = Audit fee (000). AUD it = 1 if audit firm is one of the Big Five; = 0 otherwise. An audit firm belongs to the Big Five if it is Ernst and Young, Price WaterhouseCoopers, Arthur Andersen, KPMG, Deloitte and Touche or a pre-merger firm (Arthur Young, Ernst & Whinney, Price Waterhouse, Coopers & Lybrand, Deloittes Haskins and Sells, Peat Marwick Thomson McLintock, Touche Ross, Spicer and Pegler, Spicer and Oppenheim). TEN it = Number of years the audit firm has audited the client. DOMS it = 100% * Largest individual director' s shareholding Board shareholdings DOMR it = 100% * Remuneration of highest paid director Board remuneration BLAG it = Number of days between the audit opinion and the bankruptcy date. Rit = ( SPit + DPS it SPit 1 ) SPit 1 SPit = Share price of company i at time t. DPS it = Dividend per share of company i at time t. ALAG it = Number of days between the year-end and the audit opinion.

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Table 5 Descriptive statistics for going-concern and non-going-concern opinions. Going-concern opinions (Git = 1) Mean Auditor dependence variables Median Non-going-concern opinions (Git = 0) Mean Median

ln( AFit ) AUDit TEN it DOMS it DOMRit

Control variables

10.75 0.53 7.46 72.67% 34.16%

10.67 1 5.50 76.81% 29.57%

10.69 0.59 7.32 66.81% 32.14%

10.66 1 6.00 66.36% 29.48%

ln( BLAGit ) ln(Rit ) ln( ALAGit )

Observations Notes:

5.76** -74.16%** 5.24** 90

5.76** -61.15%** 5.19**

6.43 -7.47% 4.75 570

6.58 -3.90% 4.76

** Significant difference between going-concern and non-going-concern opinions (1% level). t = -4, -3, -2 at the last three year-ends prior to failure. See Fig. 1.

G it = 1 if company i receives a going-concern opinion at time t; 0 otherwise. AFit = Audit fee (000). AUD it = 1 if audit firm is one of the Big Five; = 0 otherwise. An audit firm belongs to the Big Five if it is
Ernst and Young, Price WaterhouseCoopers, Arthur Andersen, KPMG, Deloitte and Touche or a pre-merger firm (Arthur Young, Ernst & Whinney, Price Waterhouse, Coopers & Lybrand, Deloittes Haskins and Sells, Peat Marwick Thomson McLintock, Touche Ross, Spicer and Pegler, Spicer and Oppenheim).

TEN it = Number of years the audit firm has audited the client. DOMS it = 100% * Largest individual director' s shareholding Board shareholdings DOMR it = 100% * Remuneration of highest paid director Board remuneration BLAG it = Number of days between the audit opinion and the bankruptcy date. ln( Rit ) = ln(( SPit + DPS it ) SPit 1 ) SPit = Share price of company i at time t. DPS it = Dividend per share of company i at time t. ALAG it = Number of days between the year-end and the audit opinion.

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Table 6 The association between going-concern opinions and auditor dependence. Expected sign Auditor dependence variables (1) (2)

ln( AFit ) AUDit TEN it DOMS it DOMRit

Control variables

? + ? -

-0.078 (-1.098) -0.018 (-0.107) 0.015 (0.999) 0.004 (1.177) 0.001 (0.176) -0.370 (-2.976)** -0.745 (-6.066)** 1.526 (6.092)** 1.710 (6.037)** -6.477 (-3.644)** 42.36%

. . . . . . . . . . -0.352 (-2.820)** -0.693 (-5.684)** 1.543 (6.534)** 1.729 (6.082)** -7.055 (-5.126)** 41.58%

ln( BLAGit ) ln(Rit ) ln( ALAGit ) Git 1

CONSTANT
Pseudo R2 Notes:

+ + ?

t = -4, -3, -2 at the last three year-ends prior to failure. See Fig. 1. Observations = 660. z-statistics reported in parentheses. ** Significant at the 1% level. * Significant at the 5% level.

G it = 1 if company i receives a going-concern opinion at time t; 0 otherwise. AFit = Audit fee (000). AUD it = 1 if audit firm is one of the Big Five; = 0 otherwise. An audit firm belongs to the Big Five if it is Ernst and Young, Price WaterhouseCoopers, Arthur Andersen, KPMG, Deloitte and Touche or a pre-merger firm (Arthur Young, Ernst & Whinney, Price Waterhouse, Coopers & Lybrand, Deloittes Haskins and Sells, Peat Marwick Thomson McLintock, Touche Ross, Spicer and Pegler, Spicer and Oppenheim). TEN it = Number of years the audit firm has audited the client. DOMS it = 100% * Largest individual director' s shareholding Board shareholdings DOMR it = 100% * Remuneration of highest paid director Board remuneration BLAG it = Number of days between the audit opinion and the bankruptcy date. ln( Rit ) = ln(( SPit + DPS it ) SPit 1 ) SPit = Share price of company i at time t. DPS it = Dividend per share of company i at time t. ALAG it = Number of days between the year-end and the audit opinion.

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Table 7 The association between going-concern opinions and opinion shopping. Expected sign Dependent variable Opinion shopping variable (1)
* Git

Expected sign

(2)
* S it

(3)
* S it

1 0 Git* Git *
Control variables

. . ? + + ? 0.174 (0.522) -1.461 (-2.447)* -0.349 (-2.773)** -0.709 (-5.831)** 1.608 (6.428)** 2.088 (6.050)** -7.429 (-5.233)** 42.69%

-0.555 (-3.571)**

. .

S it S it Git 1

ln( BLAGit ) ln(Rit ) ln( ALAGit ) Git 1

CONSTANT
Pseudo R2 Notes:

+ + ?

. . . . . . . . 0.080 0.080 (0.776) (0.776) -0.047 -0.047 (-0.423) (-0.423) 0.398 0.398 (2.101)* (2.101)* . 0.811 . (3.571)** -3.803 -3.899 (-3.156)** (-3.244)** 5.50% 5.50%

t = -4, -3, -2 at the last three year-ends prior to failure. See Fig. 1. Observations = 660. z-statistics reported in parentheses. ** Significant at the 1% level. * Significant at the 5% level.

G it = 1 if company i receives a going-concern opinion at time t; 0 otherwise.

* * G it 0 if G it = 1; G it < 0 if G it = 0. 1* G it = Predicted going - concern variable if company i changes audit firm. 0* G it = Predicted going - concern variable if company i does not change audit firm.

S it = 1 if company i changes audit firm at time t; 0 otherwise.

* * S it 0 if S it = 1; S it < 0 if S it = 0.

BLAG it = Number of days between the audit opinion and the bankruptcy date. ln( Rit ) = ln(( SPit + DPS it ) SPit 1 ) SPit = Share price of company i at time t. DPS it = Dividend per share of company i at time t. ALAG it = Number of days between the year-end and the audit opinion.

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