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Managerial Auditing Journal

Going-concern audit opinions for bankrupt companies impact of credit rating


Dorothy Feldmann William J. Read
Article information:
To cite this document:
Dorothy Feldmann William J. Read, (2013),"Going-concern audit opinions for bankrupt companies impact
of credit rating", Managerial Auditing Journal, Vol. 28 Iss 4 pp. 345 - 363
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Going-concern
Going-concern audit opinions for audit opinions
bankrupt companies impact of
credit rating
345
Dorothy Feldmann and William J. Read
Accountancy Department, Bentley University, Waltham,
Massachusetts, USA

Abstract
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Purpose The purpose of this study is to examine whether credit ratings inform auditors going-concern
(GC) audit opinions for companies facing imminent bankruptcy.
Design/methodology/approach Using data from BankruptcyData.com the authors identify US
publicly-held, financially-distressed companies that filed bankruptcy from January 1, 2000 through
June 30, 2009. Logistic regression is applied by regressing audit opinion type on select financial,
industry, and credit rating data.
Findings Results show that the likelihood of an auditor issuing a GC opinion is associated with the
credit rating issued by Standard & Poors (S&P) preceding the audit report date. In results supporting
the idea that the auditors opinion has informational value, the paper also finds that after issuance of a
GC report, S&Ps credit rating tends to be downgraded.
Research limitations/implications While the findings indicate observable relationships
between audit opinions and credit ratings, the models used in primary analysis cannot determine
causality.
Originality/value This study sheds some light on how credit ratings and audit opinions may be
inter-related in distressed companies, an issue previously not investigated in the literature.
Keywords Going-concern opinions, Bankruptcy, Credit ratings, Auditors
Paper type Research paper

Introduction
In this paper, we investigate the relationship between audit opinions and credit ratings
issued by a major credit rating agency (CRA) for companies facing imminent
bankruptcy. The Dodd-Frank Act of 2010 highlights the importance of both auditors
and credit rating agencies (CRAs) in helping to maintain the efficient performance of
the US economy (Dodd-Frank, 2010, Section 931, par. 1). Credit ratings are of great
practical importance, as they impact a firms cost of debt, its financing structure and
even its ability to continue trading (Gray et al., 2006). In addition, pension plans and
some other government-regulated investment groups are restricted to purchasing
products rated investment grade by a NRSRO[1] (Mulligan, 2009). Although auditors
do not opine on a clients creditworthiness, they are required to report if there is
doubt as to a clients ability to continue as a going-concern (GC) (AICPA, 1988). Prior
research finds that a GC audit opinion results in significant economic consequences to
a company, such as negative stock returns and an increased likelihood of bankruptcy Managerial Auditing Journal
Vol. 28 No. 4, 2013
(Geiger et al., 1998; Kausar et al., 2009). pp. 345-363
Motivation for studying this issue comes from the continuing dissatisfaction with q Emerald Group Publishing Limited
0268-6902
both credit ratings and audit opinions. CRAs have been widely criticized for not DOI 10.1108/02686901311311936
MAJ adequately warning the public about impending bankruptcies (US Senate, 2002a;
28,4 SEC, 2003) and for their role in the 2007-2009 sub-prime financial crisis (SEC, 2008;
US House of Representatives, 2008; US Senate, 2010; Dodd-Frank, 2010).
Similarly, auditors were widely criticized following the accounting scandals and
high-profile bankruptcies of 2000-2002 (US Senate, 2002b, c). Recently, the Public
Company Accounting Oversight Board (PCAOB, 2011) issued a Concept Release for
346 comments concerning alternatives to the audit report, aimed to enhance its usefulness.
PCAOB member, Steven Harris, pointed out that auditors are unable to signal financial
reporting risks with the current audit reporting model. He notes that despite the many
risks that threatened the banking industry, the GC opinion was rarely used (Harris,
2011).
Existing literature does not address how credit ratings and audit opinions are
inter-related in distressed firms. Many studies have modeled the GC decision, yet the
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relationship between credit ratings and audit opinions remains largely untested.
Similarly, the credit rating literature has not directly assessed the impact that the audit
opinion has on determining a firms credit rating. In this paper, we identify US
companies that filed for bankruptcy and we examine the audit opinions and credit
ratings issued by the NRSRO and Standard & Poor (S&P), prior to bankruptcy. Every
sample firm is in financial distress, thereby providing a setting where both a GC
opinion and a low credit rating are plausible. With the benefit of hindsight, we know
with certainty that these companies did not, in fact, continue operations as usual and
thus the lowest possible credit rating and a GC opinion were warranted. These
conditions focus our investigation on the companies for which both CRAs and auditors
face a challenging decision.
Based on a GC model, we provide evidence that credit ratings inform auditors GC
decisions for clients subsequently filing bankruptcy. We find that companies that have
credit ratings closer to default in the month preceding the audit opinion date are
significantly more likely to receive a GC opinion. For the approximately 20 percent of our
sample companies that had the lowest credit rating category prior to the audit opinion
date, all but one received a GC opinion. Similarly, in results supporting the idea that the
auditors opinion has informational value, we find that companies receiving a GC report
are significantly more likely to be issued a lower credit rating in the month after the audit
opinion date. Specifically, S&P downgraded 56 percent of the companies that received a
GC report in the month following the audit opinion date if the credit rating was not
already at the lowest level possible. Also, we find evidence of more conservative auditor
reporting relative to S&Ps credit ratings with respect to signaling bankruptcy.
Furthermore, we investigate the relative conservatism of auditors and S&P before and
after SOX (2002) and find auditors to be more conservative in the post-SOX period.

Background and development of hypotheses


Credit rating agencies play an important role in the capital markets by providing
investors with information about the relative financial strength of the companies
they rate. Frost (2006) notes that credit ratings are widely available and therefore may
serve to reduce information asymmetry[2]. A long stream of research indicates that
credit ratings have information content based on stock price reactions to downgrades
(Holthausen and Leftwich, 1986), bond and equity price reactions (Hand et al., 1992;
Ederington et al., 1987), and analysts earnings revisions (Ederington and Goh, 1998).
An increase in the information content of credit ratings after the passage of Going-concern
Regulation Fair Disclosure in 2000 when CRAs were awarded preferred status above audit opinions
stock analysts under the new rules, has been documented (Jorion et al., 2005).
Auditors also provide important signals to investors about a distressed companys
financial condition and both CRAs and auditors inform a similar audience of investors
and lenders[3]. However, the structure of the relationship between a client and its audit
firm is quite different from the relationship between a CRA and its clients. Both are hired 347
by the company being evaluated, yet auditors typically answer directly to the audit
committee of the board of directors which helps preserve their independence. Both have
access to a clients financial information, but the audit firm invests more time conducting
the audit and can require a client to provide access to data they deem necessary to the
completion of the audit. CRAs are not bound by Regulation FD ( Jorion et al., 2005), thus
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they may have access to information from company management that may not be
available to all investors. Although CRAs can request information, management has no
obligation to comply. That said, corporate managers want a good credit rating, so
maintaining a good working relationship with CRAs is in their best interest.
There are several important differences between auditors and CRAs regarding
potential consequences of issuing a clean audit opinion (or a strong positive credit rating)
to a company that subsequently files for bankruptcy. For auditors, a more notable
difference relates to the Private Securities Litigation Reform Act of 1995 (Reform Act),
which elevates the status of the auditors responsibility for GC reporting to that of law,
instead of simply yet another audit procedure. In addition, with respect to auditors, a
widely held belief maintains that a company that receives a GC opinion is more likely to file
for bankruptcy (Pryor and Terza, 2001; Venuti, 2004). This self-fulfilling prophecy,
coupled with evidence of clients switching auditors after receiving a GC report, may make
auditors cautious about issuing GC opinions (Geiger et al., 1998; Carcello and Neal, 2003;
Venuti, 2004). However, failure to issue a GC opinion prior to a clients bankruptcy is costly
to auditors, both in terms of reputation and potentially costly litigation (Carcello and
Palmrose, 1994). In contrast, ratings issued by CRAs are protected by the First
Amendment right to free speech thus shielding CRAs from legal liability (Frost, 2006)[4].
There is little empirical accounting research examining the relationship
between auditor decision-making and clients credit ratings. Gul and Goodwin (2010)
demonstrate that poor credit ratings are related to higher audit fees. Their explanation
is that the auditors use credit ratings to inform their audit risk assessment. Specifically,
credit ratings that indicate lower creditworthiness result in a higher assessment of
audit risk, thus leading to higher audit fees. Another study demonstrates a relationship
between poor credit ratings and the issuance of GC opinions for a sample of UK
companies, most of which are financially stable (Gaganis et al., 2007).
In this paper, we explore the issue of whether credit ratings inform auditors GC
decisions for firms about to file bankruptcy. It is for this subset of the client population,
the most financially vulnerable, where differences in credit ratings may be most useful
to auditors. Because CRAs have access to company managers who can provide them
with important information concerning financial strength, it seems plausible that their
ratings might be useful to auditors in contemplating their audit reporting decision.
On the other hand, given the criticism that CRAs do not issue timely downgrades of
their ratings when financial situations deteriorate, it is possible that their ratings
are not particularly useful to auditors GC decisions.
MAJ Given that credit ratings seem to convey new information to the markets and to
28,4 stock analysts and that evidence exists suggesting that ratings are related to auditor
decision-making, we propose that auditors, when making a GC assessment for a
financially distressed client, will use the clients credit rating to inform the audit
opinion. Given that, our first hypothesis states:

348 H1. The issuance of a GC audit opinion to a client facing possible bankruptcy is
more likely if the clients credit rating is poor.
The other side of that question is whether a CRA is likely to change its credit rating in
response to a client receiving a GC report. The audit opinion has been shown to have
informational value (Fleak and Wilson, 1994; Jones, 1996; Holder-Webb and Wilkens,
2000). Given that a GC opinion is such a public negative event, we propose that after a GC
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is issued, the CRA will likely lower a clients credit rating. Our second hypothesis states:
H2. The issuance of a GC audit opinion to a client facing possible bankruptcy
is likely to be followed by a downgrade to the clients credit rating.
An interesting issue is the relative conservatism of auditors and the major CRAs in their
roles as watchdogs protecting investors against financial calamities. In its report (Staff
Report) entitled Financial Oversight of Enron: The SEC and the Private Sector
Watchdogs (2002a), the Senate Committee on Governmental Affairs found that the
various governmental and private watchdogs that were supposed to monitor Enrons
activities and warn investors of its impending bankruptcy, did not fulfill their
responsibilities[5]. The Staff Report was critical of Arthur Andersen for its issuance
of a clean audit opinion prior to Enrons collapse. The nationally recognized CRAs
were criticized for continuing to rate Enrons long-term debt as investment grade, even as
its stock plummeted in value in the weeks before the companys demise[6]. Related
to this point, Cheng and Neamtiu (2009, p. 108) note that the major NRSROs maintained
investment grade ratings for Enron, California utilities, and other bankrupt companies,
days before each declared bankruptcy. Given the prominent watchdog roles of auditors
and the largest CRAs in providing the investing public with timely warning of bankruptcy
risk, an interesting question is whether one group is more conservative than the other.
Though CRAs have been criticized widely, they have not been subjected to the same
civil and criminal prosecution that applies to auditors. Rating agencies have been
protected by the First Amendment as members of the media, and the courts do not hold
credit rating agencies accountable for providing misleading information unless their
actions were reckless. Accountants on the other hand, face significant risk of legal
liability and are held to a much higher standard than CRAs (Kraft, 2009). Failing to
issue a GC opinion preceding a filing of bankruptcy subjects auditors to a higher
likelihood of litigation (Carcello and Palmrose, 1994). Thus, an auditor may have more
incentives to be conservative when contemplating a GC opinion relative to a CRA
deciding to downgrade a companys credit rating. Our third hypothesis states:
H3. The issuance of a GC audit opinion to a client facing possible bankruptcy is
more likely than an extremely low credit rating for that client at the same
point in time.
To test these hypotheses, we use a sample of public company bankruptcies and Going-concern
examine the relationship between the audit opinion and the credit ratings compiled audit opinions
by S&P.

Research method
Data 349
Our search of BankruptcyData.com for publicly-held companies that filed bankruptcy
extended from January 1, 2000 through June 30, 2009. Consistent with prior research
(Geiger et al., 2005), we eliminate firms in financial services (SIC: 60-69) and firms
not in financial distress[7]. To be classified as in financial distress, a firm must have
one of the following:
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.
negative working capital;
.
negative retained earnings; or
.
bottom line loss.

After identifying our initial sample, we search the SECs EDGAR database for each
firms 10-K for which the audit report date is 12 months or less prior to the bankruptcy
filing, thus identifying each firm as having received a GC report or a clean audit
opinion prior to filing bankruptcy. The 10-K also provides the fiscal year-end date, the
audit opinion date, the auditors identity and whether the firm was in technical
default or payment default. We then use Compustat to acquire financial and industry
data, specifically firm size, financial variables to predict bankruptcy and SIC codes.
Each financial statement variable is measured at the date of the fiscal year-end that
corresponds to the auditor opinion. Table I presents our selection process, which
results in a preliminary sample size of 610 companies that declared bankruptcy.
We then identify the subset of those firms that have S&P credit ratings available
prior to bankruptcy. This results in a final sample of 152 observations.

2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 Total

Publicly-held company
bankruptcies identified from
BankruptcyData.coma 156b 76 78 66 86 92 172 220 263 179 1,388
Less
Not in Compustat 56 16 23 21 16 13 42 49 36 40 312
In the financial services 12 5 7 1 4 3 8 8 9 10 67
No audit opinion within one
year prior to bankruptcy 40 35 15 20 26 35 37 52 57 62 379
Not financially stressed 3 1 2 1 1 0 1 3 6 2 20
Sub-total 45 19 31 23 39 41 84 108 155 65 610
Less
Not tracked by S&P 25 10 26 15 27 29 66 97 120 43 458
Final sample 20 9 5 8 12 12 18 11 35 22 152
Notes: aObservations classified by year in which bankruptcy occurred; bcompanies that declared Table I.
bankruptcy from January 1, 2009 through June 30, 2009 Sample selection details
MAJ Empirical model
28,4 To test our H1, we use a multivariate model with audit opinion type as the dependent
variable and control variables used by recent studies (Geiger et al., 2005; Myers et al.,
2008). We examine whether the propensity to issue a GC audit opinion is associated
with the credit rating issued by S&P immediately prior to the audit opinion date.
Control variables include firm size (measured as annual sales in dollars), probability
350 of bankruptcy, default status, the time between the audit opinion date and the
bankruptcy filing date, the time between the fiscal year-end and the audit opinion date,
a dichotomous variable to measure the riskiness of the clients industry, and auditor
type. We also include for control purposes a variable indicating whether the company
received a GC report prior to the last audit opinion before bankruptcy. Prior research
finds that companies that have been issued a GC opinion in the preceding year are
more likely to receive a GC in the current year (Reynolds and Francis, 2000; Heninger,
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2001; Hunt and Lulseged, 2007). To test H1, we examine whether the credit rating
itself is associated with the issuance of a GC opinion. We measure the credit rating
using a variable called Credit Category:

Going-Concern b0 b1 Ln_Sales b2 Prob_Bankruptcy b3 Default


b4 Bankruptcy_Lag b5 Reporting_Lag b6 Risky_Industry
b7 Auditor b8 Prior Going-Concern b9 Credit Category Model

The variables are defined as follows:


Going-Concern 1 if audit opinion includes a GC modification, 0 otherwise.
Ln_Sales natural log of total sales (sales measured in thousands).
Prob_Bankruptcy probability of bankruptcy measured by Hopwoods
score[8].
Default 1 if the company is in default on its debt, 0 otherwise.
Bankruptcy_Lag natural log of the number of days between audit opinion
date and bankruptcy date.
Reporting_Lag natural log of the number of days between fiscal year-end
and audit opinion date.
Risky_Industry 1 if company operates in a risky industry[9], 0 otherwise.
Auditor 1 if a Big 4 auditor, 0 otherwise.
Prior Going-Concern 1 if client was issued a GC modification prior to the last
opinion before bankruptcy.
Credit Category 1 if the S&P rating in month preceding the audit opinion
date is D or SD (default); 2 if the rating is CCC to CC
(lower speculative category); 3 if the rating is B to B 2
(medium speculative); and 4 if the rating is AAA to
BB 2 (upper speculative).
We use the long-term issuer credit rating for each firm compiled by S&P, as Going-concern
reported on Compustat (data item 280), to define our credit rating categories. This reflects audit opinions
the organizations assessment of the overall credit worthiness of the company. S&Ps
credit rating is one of 22 possible letter ratings that range from AAA (highest) to D and
SD (lowest). Since we limit our sample to financially distressed firms, it is not surprising
that 148 of our 152 bankrupt firms have ratings within the non-investment grade range
(ratings from BB to D). Compustat codes these letter ratings numerically, with low 351
numbers indicating better financial strength. In our sample, the Compustat scores range
from 11 (corresponding to BBB) to 27 (corresponding to D) plus 29, which signifies that
S&P has categorized the company as a selective default.
We define the variable, Credit Category, by following recent research (Ashbaugh-Skaife
et al., 2006; Bradley et al., 2008). We group the credit ratings into categories that represent
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four levels of risk within the non-investment grade range. The highest category (upper
speculative grade) encompasses credit ratings from BBB to BB 2 [10], while our lowest
category is composed of default (D) and selective default (SD) ratings. We also use a
medium speculative grade that consists of credit ratings from B to B 2 and a lower
speculative grade for ratings ranging from CCC to CC. Table II shows the credit ratings
collapsed into our four categories, the credit score per Compustat and the number of
sample companies with each credit score.
We do not know the exact date when S&P issues its credit rating and thus we do not
know whether the issuance of the credit rating precedes or follows the date of the
audit opinion in the month the audit opinion is issued. Therefore, we use the credit

S&P rating Grade Category Compustat rating Number of companies

BBB Investment 4 11 1
BBB 2 Investment 4 12 2
BB Speculative 4 13 1
BB Speculative 4 14 2
BB 2 Speculative 4 15 9
B Speculative 3 16 14
B Speculative 3 17 24
B2 Speculative 3 18 23
CCC Speculative 2 19 23
CCC Speculative 2 20 19
CCC 2 Speculative 2 21 4
CC Speculative 2 23 10
D Default 1 27 16
SD Selective default 1 29 4
Notes: S&P ratings are the long-term issuer credit ratings for the bankrupt firms issued in the month
immediately preceding the audit opinion date; the plus ( ) or (2 ) sign in the BBB to CC letter rankings
shows a firms relative standing within a major rating category; according to S&P (2002), BB Table II.
indicates less vulnerability than others in the speculative grade, with B less vulnerability than Credit ratings of
CCC; a CC rating indicates the firm is currently highly vulnerable; the rating C is not used by bankrupt firms, grade,
S&P in its long-term issuer credit ratings; included in category 1 are four bankrupt firms assigned the assigned category,
selective default (SD) rating; an SD rating is assigned by S&P when it believes the obligor has compustat rating, and
selectively defaulted on a specific issue or class of obligations but should continue to meet its other number of firms with
payment obligations in a timely manner each credit rating
MAJ rating from the month immediately preceding the audit opinion date for our analyses.
28,4 In this manner, we can be relatively assured that the S&P rating is not reflecting
information contained in the audit opinion.

Results
Results for H1
352 Table III summarizes the variable definitions and Table IV presents means and
standard deviations for the variables in our model by the four rating categories defined
in Table II. Using ANOVA, we find significant differences in means across the rating
categories ( p , 0.01) for several variables. Companies with poor credit ratings have a
higher probability of bankruptcy[11], a shorter Bankruptcy Lag, a longer Reporting
Lag and they are more likely to be in default on debt. These relationships are all in the
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expected direction. Worth noting is the finding that the reporting lag, the time that
auditors take after fiscal year-end to issue their audit opinion, is longer when the
clients credit rating is speculative and closer to default.
Of interest in H1 is the relationship between GC opinions and credit rating categories.
Table IV data clearly show that companies with S&P ratings closer to default in the
month preceding the audit opinion date, are more likely to receive a GC opinion.
Specifically, we see that for the 20 companies in default or in selective default, 19
(95 percent) were issued a GC report. The firms rated in the lower speculative category
(CCC to CC) were issued a GC opinion more than three-fourths of the time. In contrast,
firms assigned a rating in the medium speculative category (B to B 2 ) were issued a
GC opinion in less than one out of three cases. This provides preliminary support for H1.

Going-Concern 1 if audit opinion has a GC modification, and 0 otherwise


Sales Annual sales in millions of dollars
Ln_Sales Natural log of annual sales (measured in thousands)
Prob_Bankruptcy Probability of bankruptcy measured by Hopwoods score, higher score
indicates bankruptcy in more likely
Default 1 if the company is in default on its debt, 0 otherwise
Bankruptcy Lag Number of days between audit opinion date and bankruptcy date
Ln_Bankruptcy_Lag Natural log of the number of days between audit opinion date and
bankruptcy date
Reporting Lag Number of days between fiscal year-end and audit opinion date
Ln_Reporting_Lag Natural log of the number of days between fiscal year-end and audit
opinion date
Risky_Industry 1 if company operates in a risky industrya, 0 otherwise
Auditor 1 if a Big 4/5 auditor, 0 otherwise
Prior Going-Concern 1 if client was issued a GC modification prior to the last opinion before
bankruptcy
Credit Category 1 if the S&P rating in month preceding the audit opinion date is D or
SD (default); 2 if the rating is CCC to CC (lower speculative
category); 3 if the rating is B to B 2 (medium speculative); and
4 if the rating is AAA to BB 2 (upper speculative)
Note: aRisky industries are represented by SIC codes 2833-2836, 3570-3577, 3600-3674, 7372-7379, and
Table III. 8731-8734 and relate to the following high technology industries, respectively: drugs, computers,
Variable definitions electronics, programming, and research and development services (Kasznik and Lev, 1995, p. 26)
Going-concern
S&P rating
at AODa 2 1 AAA to BB 2 B to B 2 audit opinions
(coding for (category 4) (category 3) CCC to CC D and SD
multivariate upper medium (category 2) lower (category 1)
tests) speculative speculative speculative default status ANOVA
n
F- 353
Variables 15 61 56 20 statistic

Going-
concern
opinion 0.13 (0.35) 0.31 (0.47) 0.77 (0.43) 0.95 (0.22) 22.86 * * *
Sales in
millions 2,891.02 (2,418.29) 2,270.87 (5,341.43) 3,967.68 (19,870.93) 572.08 (512.72) 0.40
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Probability
of
bankruptcy 0.25 (0.27) 0.50 (0.37) 0.77 (0.32) 0.50 (0.38) 11.40 * * *
Bankruptcy
lag in days 240.73 (78.84) 223.67 (93.06) 153.84 (99.24) 152.85 (105.82) 7.56 * * *
Reporting
lag in days 52.87 (22.94) 71.41 (28.289) 78.21 (26.32) 87.55 (29.70) 5.30 * * *
Default 0.00 (0.00) 0.23 (0.424) 0.32 (0.47) 0.90 (0.31) 17.41 * * *
Risky
industry 0.00 (0.00) 0.05 (0.218) 0.11 (0.31) 0.05 (0.22) 0.98
Prior going-
concern
opinion 0.00 (0.00) 0.07 (0.25) 0.09 (0.29) 0.10 (0.31) 0.55
Auditor 1.00 (0.00) 0.97 (0.18) 0.93 (0.26) 0.85 (0.37) 1.62
Table IV.
Notes: Significant difference between companies with different S&P ratings at: p * , 0.10, Variable means (SD)
p * * , 0.05 or p * * * , 0.01; aAOD audit opinion date; see Table III for variable definitions by S&P ratings

To explore further the relationship between receiving a GC opinion and credit rating,
we calculate the percentage of GC reports over S&P ratings and graph these results in
Figure 1. This analysis indicates that as S&P credit ratings become more speculative,
that is ratings no higher than CCC the auditor is much more likely to issue a GC
report.
While the results in Table IV and Figure 1 show an apparently strong relationship
between GC opinions and credit ratings, a multivariate model is needed to further test
this relationship. Table V tabulates the results of two logistic regressions based on the
model, using the 152 bankrupt companies in our sample. Column 1 shows the results
for the model with only the control variables. Column 2 repeats the test but includes the
variable, Credit Category, thus testing H1. Both models are highly significant
( p , 0.001) with x 2 of 103.55 and 118.95, respectively. The variable of interest,
Credit Category, is significant with a x 2 of 12.93 ( p , 0.005). Taken collectively, the
findings support H1, suggesting that the information provided by a clients credit
rating is reflected in the auditors opinion. Comparing Columns 1 and 2 shows that
adding the Credit Category variable improved the percentage correctly classified from
81.6 to 85.5 percent.
MAJ 100.00%
28,4 90.00%

80.00%

70.00%
354
60.00%

50.00%

40.00%
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30.00%

20.00%

10.00%
Figure 1.
Percentage of bankrupt 0.00%
companies receiving a BBB to BBB BB+ to BB B+ to B CCC+ to CCC CC D to SD
going-concern opinion by S&P Rating
S&P rating
Note: S&P ratings are grouped by triple letter, double letter, and single letter classes

The control variables for company size, default, reporting lag and auditor are
significant and in expected directions. The variables for bankruptcy probability,
bankruptcy lag, and prior GC opinion[12] are not significant.

Results for H2
Next, we test whether S&P reacts to the issuance of a GC opinion by lowering its
credit rating. For this analysis, we limit our sample to the 122 companies with ratings
above CC in the month prior to the audit opinion date since these ratings can be
lowered. We categorize any company for which the S&P rating was lower the month
after the audit opinion date relative to the month prior to the audit opinion date as a
downward move. There are three companies which S&P no longer rated after the
audit opinion date; we classify those as downward moves as well. Table VI presents
the results of a x2 comparison of downward moves by type of audit opinion. For
56 percent of the companies with a GC opinion, the S&P rating moved downward,
whereas only 21 percent of companies without a GC opinion had a downward
movement in their S&P ratings. This is significant with a x2 statistic of 15.96
( p , 0.001), and provides support for the H2.

Results for H3
To test H3, we have to define whether the auditor or S&P provided the more
conservative signal of impending bankruptcy. Since all sample companies enter
bankruptcy within 12 months of the audit opinion, a GC opinion is appropriate.
Determining the appropriate S&P rating is not as straightforward. The language S&P
Going-concern
Column 1 Column 2
Variable Coefficient (x 2) Coefficient (x 2) audit opinions
Constant 6.72 6.63
2.09 1.62
Ln_Sales 2 0.31 2 0.33
3.56 * 3.34 * 355
Prob_Bankruptcy 0.70 0.48
0.94 0.33
Default 2.86 2.58
19.28 * * * 11.38 * * *
Ln_Bankruptcy_Lag 2 2.32 2 2.22
17.06 * * * 11.68 * * *
Ln_Reporting_Lag 0.64 0.19
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0.92 0.07
Risky_Industry 1.45 1.44
2.22 1.70
Auditor 3.46 4.73
8.05 * * * 10.51 * * *
Prior Going-Concern Opinion 21.72 21.85
0.00 0.00
Credit Category (12.93) * * *
Model x 2 103.55 * * * 118.95 * * *
Percentage correct 81.6 85.5
Cox & Snell R 2 (%) 49.4 54.3
Nagelkerke R 2 (%) 66.1 72.6
Notes: Significant with p-values * , 0.10, * * , 0.05 or * * * , 0.01:
Going-Concern b0 b1 Ln_Sales b2 Prob_Bankruptcy b3 Default b4 Bankruptcy_Lag
Table V.
b5 Reporting_Lag b6 Risky_Industry b7 Auditor b8 PriorGoing-Concern Results of logistic
b9 Credit Category regression model

Downward move No downward move Total

No going-concern opinion 14 (21%) 54 (79%) 68


Going-concern opinion 30 (56%) 24 (44%) 54
Total 44 78 122
Notes: x 2 15.96, p , 0.001; a downward move is defined as an S&P rating in the month following
the audit opinion date that is worse than in the month preceding the audit opinion date; also, in three
cases S&P stopped rating a company after the audit opinion date; we classify those as downward Table VI.
moves; for this analysis, we exclude the 30 cases which were defined above as S&P successes since S&P downgrades
a downward move for these observations is not possible following audit opinions

uses to describe its ratings indicates that the rating categories are relative. S&P defines
its triple-C (CCC) rating category as currently vulnerable, and is dependent upon
favorable business, financial and economic conditions to meet its financial
commitments. In its description of the double-C (CC) category, S&P uses the
language: currently highly vulnerable (S&Ps, RatingsDirect, 2009, p. 11). On the
MAJ web site of CRISIL, a S&Ps company, this terminology is used: In most cases, unless
28,4 the rating is deep into the speculative category, a downgrade does not mean default is
anticipated (CRISIL Ratings, 2010, www.crisil.com/index.jsp). The deepest category
within the speculative group of ratings is CC.
Given these descriptions, we consider an observation as having an appropriate
credit rating if the company had a rating of CC, D, or SD the month before the audit
356 opinion was issued. These cases are considered S&P successes with respect to
signaling bankruptcy. To be considered a success for the auditor, the S&P rating
preceding the opinion must be higher than CC and the auditor must issue a GC opinion.
Table VII presents the results of a x 2 test comparing successes in signaling
bankruptcy for S&P to successes for the auditor. In all but one of the 30 observations
with S&P ratings of CC, D, or SD, the auditor issued a GC opinion. Thus, when S&P
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issued a very low rating, the auditor almost always issued a GC report. On the other
hand, there are 54 companies that received a GC from their auditor, while having S&P
ratings higher than a CC. With our classification system these observations are auditor
successes in signaling impending bankruptcy with overly optimistic S&P ratings.
In addition, 68 firms have a clean audit opinion and S&P rating above CC, thus overly
optimistic assessments by both the auditor and S&P. This analysis is highly
significant with a x 2 statistic of 26.68 ( p , 0.000). This result indicates greater auditor
conservatism relative to S&P and thus provides support for H3. Graphing the tabular
results shows the relationship between auditor and S&P successes visually in Figure 2.

No GC opinion GC opinion
(Type II error) (negative signal) Total
Table VII. S&P rating higher than CC (relatively optimistic) 68 (56%) 54 (44%) 122
Audit opinions preceding S&P rating CC, D, and SD (strong negative signal) 1 (3%) 29 (97%) 30
bankruptcy compared Total 69 83 152
with S&P ratings before
audit opinion date Note: x 2 statistic 26.68 with p , 0.000

Figure 2.
Relative performance of
auditors and S&P in
signaling impending
bankruptcy
We next compare the 30 companies that have a CC, D, or SD rating (S&P successes) Going-concern
to the 54 companies with GC opinions and ratings above CC (auditor successes) audit opinions
to determine if any systematic differences between the two groups exist. This analysis
is not tabulated. We find a significant difference in default status with a x 2 statistic
of 5.81 ( p , 0.02). Of the 30 S&P successes, 70 percent are in default and of the 54 with
going-concern opinions but higher ratings only 43 percent are in default. Note that our
measure of default captures a company either missing debt payments or in technical 357
violation of covenants. S&P categories D and SD indicate payment defaults only.
We tested all the other control variables in our model and no other significant
differences between the groups are observed.

Additional analyses
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Another question of interest is whether the passage of SOX (2002) impacted differences
between auditor reporting decisions and CRA ratings. Prior research finds auditors to
be more conservative after the events surrounding Enrons collapse and the issuance of
SOX (2002) when compared to earlier time periods (Geiger et al., 2005; Nogler, 2008;
Myers et al., 2008; Feldmann and Read, 2010). While the regulatory actions following
Enron had immediate and well-documented implications for the audit profession,
specific regulatory changes for CRAs were not included in the legislation. Cheng and
Neamtiu (2009) find increased accuracy and improved timeliness of credit ratings
issued by the major NRSROs since passage of SOX in 2002 when compared to ratings
from a pre-SOX period. They attribute their findings to the reaction of the agencies to
the possibility of increased regulatory intervention and to reputation concerns.
We examine this issue to determine whether successes in signaling bankruptcy for
S&P and auditors differ depending on whether the events happened before or after the
enactment of SOX (2002). Table VIII shows that for the 37 companies that had audit
opinion dates prior to the passage of SOX, the auditors and S&P each were successful
approximately 50 percent of the time. For the 47 firms with audit opinion dates after
SOX, the auditors success rate increased to about 74 percent. Note that we exclude the
observations where neither the auditor nor S&P were successful. This result is
consistent with prior research that finds auditors to be more conservative after the events
surrounding Enrons collapse when compared to earlier time periods (Geiger et al., 2005;
Nogler, 2008; Feldmann and Read, 2010). Here, we see that the auditors appear to be more
conservative when compared to S&P after SOX, but no different prior to SOX.
Since the models we use in primary analysis cannot determine causality, we follow the
work of Ederington and Goh (1998) to test for Granger causality between GC opinions and
ratings changes. In un-tabulated analysis, we examine whether a GC opinion Granger

Going-concern opinion and


S&P rating of CC, D and SD S&P rating higher than CC
(strong negative signal) (negative signal) Total

Pre-Sarbanes Oxley 18 (49%) 19 (51%) 37


Post-Sarbanes Oxley 12 (26%) 35 (74%) 47 Table VIII.
Total 30 54 84 S&P negative signal and
auditor negative signal
Notes: x 2 4.82; p , 0.03 by time period
MAJ causes S&P to downgrade credit ratings. In addition to a test of mean ratings changes
28,4 where we find evidence of a significant mean rating change following a GC report, we
estimate the regression model referenced in Ederington and Goh (1998): the joint test of
the lagged GC opinion change variables being equal to zero. After regressing ratings
changes on GC change variables, we find evidence that GC opinions Granger cause
ratings downgrades. Thus, the results from testing Granger causality are consistent with
358 our findings regarding H2 of a significant relationship between companies receiving a
GC opinion and S&P subsequently lowering the companys credit rating[13].

Conclusions and limitations


In this paper, we examine the credit ratings and audit opinions of distressed companies
before they file bankruptcy. We analyze 152 bankrupt companies with S&P ratings
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available prior to bankruptcy. Since all the sample companies declare bankruptcy
within a year following the audit opinion date, it is not surprising that almost all have
credit ratings in the speculative range. Only four companies were rated as investment
grade. We model the GC opinion decision using S&Ps credit ratings transformed into a
variable, Credit Category, and find that variable to be significant in the expected
direction. It appears that credit ratings are related to the issuance of going-concern
opinions for a sample of companies approaching bankruptcy. Similarly, we investigate
whether credit ratings are lowered in the month following the GC opinion and find
that downward moves in credit ratings occurred 56 percent of the time compared
with only 21 percent downward moves for companies with clean audit opinions.
We then compare S&P credit ratings to audit opinions to determine which provides
the earlier signal of bankruptcy. In 30 cases, we find that S&P clearly signals
impending corporate failure with a credit rating of CC, D or SD. The auditor issued a
GC modification for 29 of these companies the following month. For the 122 companies
with higher credit ratings, 44 percent received a GC from their auditors. In these cases,
S&P had room to lower its rating, but did not. This implies that the auditors take a
more conservative stance earlier than the CRA. While audit firms have been criticized
for a high incidence of Type II errors, they seem to provide a timelier signal of
impending business failure relative to S&P. We also find support suggesting that
auditor conservatism relative to S&P increased following SOX (2002). Apparently,
SOX had a greater influence on auditor behavior than on S&P.
One limitation of our study is that there is no clear definition of when a credit rating
is indicating a likely bankruptcy. Our measure is very conservative the credit rating
must be at the bottom of the speculative category to be considered an S&P success.
Another limitation is that our examination of credit ratings is limited to those compiled
by S&P. Future research could extend the context of this study by including the
ratings issued by other major NRSROs.
Our findings indicate that there are observable relationships between audit opinions
and credit ratings. However, the models we use in primary analysis cannot determine
causality. To provide insight into whether GC opinions result in rating changes, we test
Granger causality and find evidence suggesting that auditor issuance of GC opinions
Granger cause downgrades of S&P credit ratings. However, we note that our study
does not examine the impact of GC reports or other factors that may give rise to a
change of credit rating. We recognize that there is no clear definition of when a credit
rating indicates a likely bankruptcy, and that the range of factors that affect a credit Going-concern
rating may be outside the scope of the audit in question. audit opinions
These research findings may be useful as the SEC completes its study of credit rating
agencies during the next two years as mandated by the Dodd-Frank Act (see Section
939f). An interesting avenue for future research would be to examine whether the major
rating agencies have become conservative in their overall credit assessments in the
wake of the recent financial crisis. In particular, future research can examine the 359
impact of the Dodd-Frank Act (2010) on the behavior of credit rating agencies. Early
indications suggest that the CRAs are not willing to accept the increased level of
liability they face as a result of the Act without further clarification (Shrivastava, 2010).
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Notes
1. The term, NRSRO, refers to a Nationally Recognized Statistical Rating Organization that
issues credit ratings that the US SEC permits other financial firms to use for certain
regulatory purposes. According to the SEC, the single most important factor in the
Commission staffs assessment of NRSRO status is whether the rating agency is nationally
recognized in the U.S. as an issuer of credible and reliable ratings by the predominant users
of securities ratings (SEC, 2003, p. 9).
2. Milne and Sanderson (2010) recently reported that UK partners of KPMG and PwC were
considering entering the credit rating business citing their firms skills, knowledge, and
manpower to provide credit ratings.
3. Of these two information intermediaries, CRAs emphasize the needs of debt holders while
auditors focus on being helpful to equity investors.
4. CRAs faced no penalty for poor performance prior to the Dodd-Frank Act (2010), which
equates their role to that of security analysts and auditors, thus justifying a similar level of
public oversight and accountability (Section 931, par. 2).
5. The Staff Report identifies the SEC, Enrons Board of Directors, its auditors (Arthur
Andersen), investment banking firms, attorneys, Wall Street security analysts, and the credit
rating agencies as having failed to properly discharge their appointed roles as watchdogs.
6. On October 24, 2001, the day Enrons chief financial officer, Andrew Fastow, resigned the
stock traded at $16.41. On November 8, 2001, less than a month before Enrons bankruptcy,
Enrons stock closed at $8.41, when Enron disclosed it had overstated earnings by half a
billion dollars since 1997. Nevertheless, S&P continued to rate the firm through most of
November at investment grade.
7. Limiting our sample to stressed firms is consistent with Hopwood et al. (1994) and McKeown
et al. (1991). Prior researchers have maintained that it is appropriate to model auditors GC
decisions using a sample of firms exhibiting signs of financial distress.
8. The Hopwood score for the probability of bankruptcy is derived from the following model:
27:322 215:756* NI=TA 0:973* CA=Sales 1:677* CA=CL 5:985* CA=TA
29:145* Cash=TA 4:224* LTD=TA 0:214* LnSales where NI is net income, TA is
total assets, CA is current assets, CL is current liabilities, LTD is long term debt and LnSales
is the natural log of total sales. The model coefficients are from Table III in Hopwood et al.
(1994) except for the intercept. Geiger and Raghunandan (2001) note that the appropriate
intercept is 2 7.322; they confirmed this with the original authors.
9. Risky industries are represented by SIC codes 2833-2836, 3570-3577, 3600-3674, 7372-7379,
and 8731-8734 and relate to the following high technology industries, respectively: drugs,
MAJ computers, electronics, programming, and research and development services (Kasznik and
Lev, 1995, p. 26).
28,4
10. We define our highest category as upper speculative grade since 73 percent (11 of 15) of its
observations are rated as non-investment grade. Also note that we deviate from the seven
categories used by Ashbaugh-Skaife et al. (2008) because the distribution of our highly
distressed sample firms across the credit ratings is dramatically different from their
360 samples distribution.
11. Categories 1-3 (more risky) have a higher probability of bankruptcy than category 4
(less risky).
12. Following prior literature, we also restrict our multivariate analyses to companies receiving
a first-time going-concern report (Mutchler and Williams, 1990; Geiger and Rama, 2006;
DeFond et al., 2002). Our results are substantively similar when firms with prior GC opinions
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are excluded from the sample.


13. While we find evidence that a GC opinion Granger causes credit ratings downgrades,
a related question is whether S&P ratings changes Granger cause GC opinions? However,
testing Granger causality in this direction may provide little or no informational value since
auditors issue their audit opinion once a year at the completion of the audit. Thus, unlike
CRAs that can revise their ratings at any time or stock analysts who may issue several updates
or revisions of their opinions (i.e. forecasts), the auditors opinion is not issued in response
to a clients rating change nor is it revised post-issuance in reaction to a credit rating change.
Thus, in the context of the respective opinions of CRAs and auditors, we believe Granger
causality flows one way only; specifically, GC opinions Granger cause ratings downgrades.

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About the authors


Dorothy Feldmann is Associate Professor of Accountancy at Bentley University.
William J. Read is Professor of Accountancy at Bentley University. William J. Read is the
corresponding author and can be contacted at: wread@bentley.edu

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