AUDIT COMMITTEE CHARACTERISTICS AND AUDITOR REPORTING

Joseph V. Carcello
University of Tennessee

Terry L. Neal
University of Tennessee

July 1997

ACKNOWLEGEMENTS: We acknowledge the helpful comments of Bill Adams, Susan

Ayers, Mark Beasley, Bruce Behn, Dana Hermanson, Jim McKeown, Jane Mutchler, Al
Nagy, Tim Pearson, Dick Riley, Dan Simunic, Pete Wilson, and participants at the
Boston College Accounting Research Workshop. We also thank Chris Daugherty and
Michelle Keasler for research assistance.

Address Correspondence:

Joseph V. Carcello
University of Tennessee
601 SMC
Knoxville, TN 37996-0560
Phone (423) 974-1757 Fax (423) 974-4631
JCARCELL@UTK.EDU
 AUDIT COMMITTEE CHARACTERISTICS AND AUDITOR REPORTING

1. Introduction

This paper examines the relationship between the independence of the audit

committee (from management) and auditor reporting behavior. More specifically, we

consider the relationship between the percentage of audit committee members who are

either insiders1 or “grey” directors2 and the likelihood that the auditor issues a going-

concern-modified report to firms experiencing financial distress.

We focus on the audit committee because the external auditors’ primary

interaction with the board of directors (BOD) is through the audit committee (POB

[1994]). It also is the audit committee that typically meets with management and the

external auditor to review the financial statements and the nature of the audit report

(AICPA [1988d], Price Waterhouse [1993]).3 We expect a negative relationship between

the proportion of audit committee members that are classified as either inside directors or

as grey directors and the likelihood of receiving a going-concern report, ceteris paribus.

We find evidence that the composition of the audit committee is associated with

the type of audit report issued to companies experiencing financial distress. There is a

significant negative relationship between the percentage of audit committee members who

are either insiders or grey directors and the likelihood of receiving a going-concern-

1 An inside director is an officer, employee, or an officer of an affiliate company. This

definition is consistent with those used in prior studies (Beasley [1996], Vicknair,
Hickman, and Carnes [1993], Wright [1996]).
2 A grey director includes: former officers or employees, relatives of management,

professional advisors to the firm (e.g., consultants, bank officers, legal counsel), officers
of significant suppliers or customers of the firm, and interlocking directors (e.g., Vicknair,
Hickman, and Carnes [1993], Wright [1996]).
3 SAS No. 61, para. 2 reads in part, “… requires the auditor to ensure that the audit

committee receives additional information regarding the scope and results of the audit …”
(AICPA [1988d]).
modified report. This result is robust across a number of different model specifications

and sensitivity tests.

Section 2 provides further background and presents the hypotheses. The research

design is presented in Section 3, and Section 4 discusses the sample. The results are

presented in Section 5. Section 6 contains a summary, and presents the implications and

limitations of our findings.

2. Background and Hypotheses

An effective audit committee is viewed as a critical link in providing investors

with reliable financial reporting. The SEC has stated that an effective audit committee

affords the “greatest possible protection to investors” (Price Waterhouse [1993]). In

addition, Wild [1996] documents a significant increase in an entity’s earnings response

coefficient subsequent to the formation of an audit committee. This suggests that the

market views audit committees as improving the quality of an entity’s financial reporting.

The audit committee has responsibilities to the entire BOD, current shareholders,

and regulators (Price Waterhouse [1993]). One function of the audit committee is to help

protect the independence of the external auditor (Price Waterhouse [1993]). Audit

committees sometimes fail to adequately perform this function. The POB [1993] has

stated that “... in too many instances the audit committee members do not perform their

duties adequately.” Similar findings have been reported by other professional and

regulatory groups, both domestically and internationally (e.g., Cadbury Committee

[1992], Sommer [1991], TSE [1994]). We posit that one reason for inadequate audit

committee performance is that in some instances members of the audit committee are not

independent of management.

Audit committee members may not be independent because some members may

have strong psychological and/or economic dependence on firm management (Baysinger

and Butler [1985]). For example, professional advisors to the firm may be economically
dependent on current management. Vicknair, Hickman, and Carnes [1993] provide some

evidence of potential independence-related problems on audit committees. They found

that 74% of NYSE companies have at least one grey director on their audit committee,

and 26% of such companies have an audit committee comprised of a majority of grey

directors.4

A growing body of evidence suggests that independent, outside directors increase

the effectiveness of the financial reporting process. Beasley [1996] finds an inverse

relationship between the percentage of outside directors and the likelihood of fraudulent

financial reporting. Wright [1996] finds a direct relationship between the quality of an

entity’s financial reporting and the percentage of outside directors on the audit committee.

Wright also finds an inverse relationship between the likelihood of being sanctioned by

the SEC for a financial reporting violation and the percentage of outside directors on the

audit committee. Finally, the Report of the National Commission on Fraudulent Financial

Reporting [1987], recommended that the SEC require all public companies to form audit

committees composed entirely of independent directors. 5

As discussed previously, a function of the audit committee is to help preserve the

independence of the external auditor. The audit committee fulfills this function by

helping to mitigate management pressure that might be placed on the auditor (Knapp

[1987]). One issue where management may seek to pressure the auditor relates to the

4 The NYSE proscribes inside directors from serving on the audit committee. However,
NASDAQ only requires that a majority of audit committee members be independent of
management. And the AMEX recommends, but does not require, that audit committees
be composed of directors that are independent of management. Therefore, lack of audit
committee independence is likely to be even more pronounced for companies traded on
the AMEX, NASDAQ, or via other means (e.g., pink sheets, regional exchanges).
5 The chairman of the Securities and Exchange Commission, Arthur Levitt, recently

described the relationship between independent directors and the SEC as a “partnership
in the public interest” (Levitt [1996]).
issuance of a going-concern-modified report.6 Prior research has found that modified

reports are associated with both stock price declines (Jones [1996]) and difficulty in

raising debt capital (Firth [1980]). We therefore expect management to resist the receipt

of such a report.

Management may exert pressure on the auditor by implying that the auditor will

suffer negative consequences from issuing a going-concern report. Geiger, Raghunandan,

and Rama [1996] find increased auditor switching following the receipt of a going-

concern-modified report by distressed companies. We expect that an audit committee

that is independent of management is more likely to be effective in mitigating such

management pressure. For example, management-auditor disputes that may lead to the

auditors’ termination should be reviewed by the audit committee (Price Waterhouse

[1993]). An audit committee that is independent from management is more likely to

resist efforts to replace an audit firm for issuing a going-concern report. Therefore, we

posit that an independent audit committee is likely to strengthen the auditors’ position in

addressing contentious issues with management (including issuing a going-concern report).

Audit committee members can be characterized as inside directors, grey directors,

or independent, outside directors. The NYSE proscribes insiders from serving on audit

committees, and both the AMEX and NASDAQ have similar, albeit weaker, requirements

(see footnote 4). None of these three organizations prohibit grey directors from serving

on audit committees.7 Therefore, although we expect the interests of both inside

6 Going-concern reporting is important both to the accounting profession and to society.

Carcello and Palmrose [1994] find that auditors of bankrupt companies that fail to issue
timely modified reports are more likely to suffer the adverse effects of litigation. The
Private Securities Litigation Reform Act [1995] requires the auditor to assess the going-
concern status of the entity for the ensuing fiscal year on all audits.
7 The NYSE maintains the most stringent requirement for audit committee members. The

audit committee is to be composed of independent directors who are “free from any
relationship that, in the opinion of the Board of Directors, would interfere with the
exercise of independent judgment as a committee member” (NACD [1996]).
directors and grey directors to be closely aligned with those of management, we will

examine these two groups separately. A separate analysis of inside and grey audit

committee members is appropriate since stock exchanges and registrants themselves

appear to view grey directors as being independent. By examining these two groups

separately, we hope to shed some light on whether grey directors on the audit committee

function more like inside directors or independent, outside directors.

Given the above arguments, we expect an audit committee composed of an

increasing percentage of inside and grey directors to be less independent from management

and, as a result, to be less effective in mitigating management pressure on the auditor.

This leads to our two research hypotheses (expressed in alternative form):

H1: There is a negative relationship between the percentage of inside directors on

the audit committee and the likelihood that an entity experiencing financial distress

will receive a going-concern-modified report.

H2: There is a negative relationship between the percentage of grey directors on

the audit committee and the likelihood that an entity experiencing financial distress

will receive a going-concern-modified report.

3. Research Design

The above hypotheses were tested using the following logistic regression model:

REPORT = b0 + b1 INSIDE + b2 GREY + b3 DEFAULT + b4 PRIOROPN + b5 SIZE +

b6 ZFC + b7 DEVELOP + b8 AUDCOMM + ε

The dependent and predictor variables are defined as follows:

REPORT. The type of audit report issued on the entity’s 1994 financial

statements (1 = going-concern-modified, 0 = unmodified, including modified for a

consistency exception).8

8Reports modified for non-going-concern reasons (e.g., uncertainty modifications) were

excluded (n = 8). The results for our two test variables of interest (INSIDE and GREY)
 INSIDE. The percentage of audit committee members that were classified as

insiders. A negative relationship between the percentage of inside directors on the audit

committee and the receipt of a going-concern-modified report is expected.

GREY. The percentage of audit committee members that were classified as grey

directors. A negative relationship between the percentage of grey directors on the audit

committee and the receipt of a going-concern-modified report is expected.

In addition to the test variables of interest, we control for the effects of other

variables that may relate to the receipt of a going-concern-modified report. These

variables are debt default status, prior audit report, entity size, the level of financial

distress, whether the entity is classified as a development stage firm, and whether the

entity had established an audit committee.9

DEFAULT. Chen and Church [1992] found a strong positive relationship

between debt default status and receipt of a going-concern-modified report. We use a

dummy variable (1 = debt default, 0 = other) to measure whether the entity is in default

prior to the issuance of the audit report.10 We expect a positive relationship between

default status and receipt of a going-concern-modified report.

PRIOROPN. Prior studies (e.g., Mutchler [1985], Nogler [1995]) indicate that

auditors tend to continue to issue a going-concern-modified report, once this report is

initially issued, unless the financial condition of the entity has clearly improved. We use

a dummy variable (1 = prior year going-concern-modified report, 0 = other) to measure

are qualitatively unchanged regardless of how these eight observations are treated (i.e.,
excluded, coded as a modified report, coded as a non-going-concern report).
9 Approximately one-third of the companies in our sample did not have a separate audit

committee. We initially assume that the entire board of directors was fulfilling the
functions normally performed by an audit committee. We relax these assumptions later in
the paper.
10 Consistent with Chen and Church [1992, 35], a firm is classified as being in default if it:

(1) had missed principal or interest payments, (2) had violated debt covenants, if the
covenant violation was not waived or if it was waived for a period of less than one year,
or (3) was in the process of restructuring debt.
whether the entity has received a going-concern-modified report in the preceding year.

We expect a positive relationship between having received a going-concern report in the

prior year and receipt of a going-concern-modified report in the current year.

SIZE. A number of prior studies (e.g., Carcello, Hermanson, and Huss [1995],

McKeown, Mutchler, and Hopwood [1991], Mutchler, Hopwood, and McKeown

[1996], Raghunandan and Rama [1995]) have found a negative relationship between client

size and the receipt of a going-concern-modified report. Size is measured as the natural

log of total sales (where sales are first expressed in thousands of dollars).11 We expect a

negative relationship between client size and the receipt of a going-concern-modified

report.

ZFC. Prior studies (e.g., Carcello, Hermanson, and Huss [1995], McKeown,

Mutchler, and Hopwood [1991], Mutchler, Hopwood, and McKeown [1996]) find a

positive relationship between the extent of financial distress and the probability of

receiving a going-concern report. We compute the Zmijewski financial condition (ZFC)

score using Zmijewski’s [1984] financial distress prediction model (using the PROBIT

coefficients from his 40 bankrupt/800 non-bankrupt estimation sample). The predictor

variables in Zmijewski’s model were return on assets, financial leverage, and liquidity.

Jones [1987] finds that most bankruptcy prediction models produce similar results, and

that measures of liquidity, leverage, and profitability are common to these models. We

expect a positive relationship between the ZFC score and the receipt of a going-concern-

modified report.12

DEVELOP. Although prior going-concern studies have not explored the

relationship between development stage status and auditor reporting, we expect

11 There are 17 companies that did not report a sales figure. We excluded these companies
from the sample. However, our results are qualitatively unchanged if these entities are
included. Also, the results are qualitatively unchanged if client size is measured using the
natural log of total assets.
12 Higher ZFC scores indicate a greater degree of financial distress.
classification as a development stage entity to be related to the receipt of a going-concern

report. The direction of this relationship is not obvious. An auditor may view a

development stage entity as less likely to be able to withstand financial difficulties than a

more established firm. This would suggest a positive relationship between development

stage status and receipt of a going-concern report. Alternatively, given the start-up nature

of a development stage entity, their financial statements would frequently indicate some

degree of distress. Therefore, assuming equal levels of financial distress, a development

stage entity may be less likely to receive a going-concern report than an established

entity. Given these competing effects, we do not predict a sign for the development stage

variable. We include a dummy variable (1 = development stage entity, 0 = other) to

measure the effect of development stage status on the receipt of a going-concern report.

AUDCOMM. Approximately one-third of the companies in our sample did not

have a separate audit committee. We initially assume that the entire board of directors

was fulfilling the functions normally performed by an audit committee. We followed this

approach for three reasons. First, the professional literature (AICPA [1988a; 1988c])

suggests that in the absence of an audit committee, the auditor should communicate

certain required matters to the board of directors (e.g., see SAS No. 54, para. 17 and SAS

No. 60, para. 1). Second, the proxy statement of many of the firms that did not have an

audit committee stated that the entire BOD was performing this role. Finally, Wright

[1996] also treats the full BOD as the audit committee for those firms that do not

maintain a separate committee.

As discussed previously, one of the responsibilities of an audit committee is to

help mitigate management pressure that might be placed on the auditor. This suggests a

direct relationship between the presence of an audit committee and the receipt of a

modified opinion. However, other factors suggest an inverse relationship between the

presence of an audit committee and receipt of a modified opinion. First, in deciding

whether to issue a going-concern report, the auditor considers whether the adverse
conditions and events giving rise to the going-concern situation are effectively mitigated

by management’s plans (AICPA [1988b]). In making this evaluation, SAS No. 59, para. 9

suggests that the auditor might consider prospective financial plans prepared by

management. The auditor is more likely to rely on these plans if they are the product of a

reliable financial reporting system. Firms with reliable financial reporting are more likely

to have audit committees (DeFond and Jiambalvo [1991], McMullen [1996]). Second,

the fact that the entity has established an audit committee is often viewed as a positive

signal as to management’s credibility (Menon and Williams [1994]). These factors

suggest an inverse relationship between the presence of an audit committee and receipt of

a going-concern report. Given these competing effects, we do not predict a sign for the

audit committee variable. We include a dummy variable (1 = audit committee exists, 0 =

other) to measure the effect of having an audit committee on the receipt of a going-concern

report.
4. Sample Selection

To study the relationship between audit committee characteristics and auditor

reporting, we used the Compact D/SEC database to identify a sample of publicly-held

manufacturing companies (2000-3999 SIC codes) experiencing financial distress during

1994. We chose to focus on distressed companies since prior research (McKeown,

Mutchler, and Hopwood [1991]) indicates that auditors virtually never issue a going-

concern-modified report to companies that are not financially distressed.13 In addition,

we only included those companies whose level of financial distress was consistent with

the level at which auditors might reasonably be expected to issue a going-concern-

modified report. Prior studies (Davis and Ashton [1995], Krishnan and Krishnan [1996])

have indicated that it is not unusual for auditors to issue a going-concern-modified report

if the probability of bankruptcy is above 28%. We use the coefficients from Zmijewski’s

13
None of the 96 nonstressed firms (16 of which filed for bankruptcy) examined by
McKeown, Mutchler, and Hopwood [1991, 7] received a going-concern report.
[1984] weighted probit model to compute the probability of bankruptcy.14 Publicly-held

manufacturing companies with a probability of bankruptcy above .28, based on 1994

financial data, are included in our initial sample if the appropriate proxy and financial

statement data are available.15 The proxy and financial statement data were hand collected

from the Q-Data SEC files.

The details of our sample selection procedure are shown in table 1. There were

276 manufacturing companies in 1994 where the probability of bankruptcy, based on

Zmijewski’s [1984] model, was greater than .28. As discussed previously, we excluded

eight companies that received a modified report for non-going-concern uncertainties and

four companies where the applicable 10-K16 filing was not available. Since client size is

included as a control variable (measured via the ln of sales), entities that did not report

any sales (n=17) were excluded. Twelve companies were excluded because they filed for

bankruptcy prior to the issuance of the audit report on the 1994 financial statements.

Finally, a small number of companies (n=18) were excluded for sundry other reasons

(detailed in table 1). Our final sample was 217 companies. All of these companies are

manufacturers, and they all were experiencing significant financial distress based on

reported 1994 financial results. Of these 217 companies, 145 had established an audit

committee.

14 Zmijewski’s [1984] weighted probit model has been used in numerous prior studies to
measure financial distress (e.g., Bamber, Bamber, and Schoderbek [1993], Carcello,
Hermanson, and Huss [1995], Carcello and Palmrose [1994], Klock [1994], Wheeler,
Pany, and Chewning [1993]).
15 We did not select our sample using the McKeown, Mutchler, and Hopwood [1991]

criteria for identifying stressed firms for two reasons. First, MMH focus on bankrupt
firms; our focus is on firms experiencing financial distress. Second, the MMH approach
identifies significantly more firms as financially stressed. Given the high costs of data
gathering in this study, we chose to focus on a measure that identified highly distressed
firms. There were seven companies in our sample that were not stressed per the MMH
criteria; our results are qualitatively unchanged if these companies are excluded.
16 10-K filings / annual reports were needed to determine the debt default status of the

company and the nature of prior audit reports.

 To compute the percentage of inside and grey directors we read the following

sections of the applicable proxy statements: (1) biographical background of directors and

officers, and (2) certain related transactions section (much of the detail on grey directors

was gathered from this section).

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Insert Table 1 about here

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5. Results

5.1 DESCRIPTIVE STATISTICS

Descriptive statistics are presented in tables 2 and 3. Table 2 presents descriptive

statistics, by audit report type, for each of the independent variables in our model. Panel

A of table 2 presents descriptive statistics for the entire sample (n=217). Approximately

47% of these companies had received a going-concern report. This is consistent with the

highly stressed nature of the firms in our sample. Companies receiving a going-concern

report and companies receiving an unqualified report had approximately the same

representation of inside directors. This result is inconsistent with our expectations;

however, univariate analysis fails to consider the incremental effect of inside directors on

the audit report issued. Consistent with our expectations, there was an inverse

relationship between the percentage of grey directors and the likelihood of receiving a

going-concern report (p < .01). As expected, firms that were more distressed (measured

by default status, prior audit report, and ZFC index) were more likely to receive a going-

concern report (p < .01 for each variable). Also, as expected, smaller firms were much

more likely to receive a going-concern report (p < .01). Development stage entities and
firms without an audit committee were more likely to receive a going-concern report (p <

.10 and p < .01, respectively).17

Panel B of Table 2 presents descriptive statistics for the 145 companies that had

established an audit committee. Slightly over 40% of these companies had received a

going-concern report. For companies with an audit committee, there was an inverse

relationship between the percentage of both inside directors and grey directors and the

likelihood of receiving a going-concern report (p < .10 and p < .01, respectively). The

results for the other independent variables were similar to the results for the full sample.

A further analysis of panel B indicates that inside directors (grey directors)

represented eight percent (10%) and 12 percent (26%) of audit committee members for

going-concern and non-going-concern firms, respectively. This non-trivial representation

of inside and grey directors on audit committees is in direct conflict with

recommendations that such committees be composed entirely of independent, outside

directors (GAO [1996], NACD [1996], Price Waterhouse [1993]).

Panel C of table 2 presents descriptive statistics for the 57 firms18 that had not

established an audit committee (i.e., the variables for INSIDE and GREY refer to the

composition of the full BOD). Consistent with our expectations, there was an inverse

relationship between the percentage of inside directors and the likelihood of receiving a

going-concern report (p < .01). There was not a significant relationship between the

percentage of grey directors and the likelihood of receiving a going-concern report.

17 However, in our multivariate models, there is a significant negative relationship between

development stage status and receipt of a going-concern report.
18 Table 1 indicates that there are 72 sample firms that had not established an audit

committee. Fifteen of these firms were either in default (n = 11) or were development
stage entities (n = 4). All of these firms received going-concern reports. These
observations were excluded from further analysis since statistical results for these
variables (default / development stage status) were not meaningful (given the lack of
variation). Our results for the test variables of interest are qualitatively unchanged if the
analysis is performed for all 72 firms without an audit committee.
 A further analysis of panel C indicates that firms that had not established an audit

committee were more likely to have received a going-concern report than those firms that

had established such a committee. Fifty-one percent of firms without an audit committee

received a going-concern report. Approximately two-thirds of the BOD was composed

of insiders and grey directors. As expected, insiders and grey directors represent a larger

proportion of the full BOD than of the audit committee. Firms that had not established

an audit committee were also smaller, more likely to have received a going-concern report

in the prior year, and more distressed.

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Insert Table 2 about here

____________________

Table 3 presents the frequency of inside and grey directors for the full sample, the

audit committee sample, and for firms without an audit committee (categorized by stock

exchange). Although the NYSE proscribes insiders from serving on audit committees, a

small (1%) percentage of audit committee members are insiders. Approximately one-third

of audit committee members for NYSE-listed firms are grey directors. Insiders represent

four percent of audit committee members for firms traded on the AMEX, 10% for

NASDAQ firms, and 16% for firms traded over-the-counter or via other exchanges. The

percentage of audit committee members who are grey directors varies between 15 and 19

percent for firms traded via the AMEX, NASDAQ, and OTC / other exchanges. For our

sample of distressed entities, NYSE firms have a higher combined percentage of insiders

and grey directors on the audit committee than do firms traded on other exchanges. This

result was unexpected.

A review of panel C of table 3 indicates that some firms traded via NASDAQ do

not maintain an audit committee. This result is surprising since the National Association

of Securities Dealers’ requires firms traded via its National Market System to maintain an

audit committee (Bacon [1988, 8]). We examined the 25 NASDAQ firms without an
audit committee. Only two of these firms were traded on the National Market System,

and one of these two firms stated that it was planning to establish an audit committee in

1995.19

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Insert Table 3 about here

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Table 4 presents the correlations between the independent variables for the full

sample, the audit committee sample, and for companies without an audit committee. The

correlations are generally quite low; most of the correlations are below .3. As expected,

there were relatively high negative correlations between the percentage of inside directors

and the existence of an audit committee, between firm size and the nature of the prior

audit report, and between size and development stage status.

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Insert Table 4 about here

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5.2 HYPOTHESIS TESTS

Entire Sample. Table 5 presents the results of the logistic regression model

developed in section 3 for the full sample (n=217). The overall model is highly significant

(p < .0001), and the model’s pseudo-R2 is 47%. In terms of individual variables, there is

a significant negative relationship between the percentage of inside directors on the audit

committee and the presence of a going-concern audit report (p < .01). This result

supports H1. There also is a significant negative relationship between the percentage of

grey directors on the audit committee and the presence of a going-concern report (p <

.01). This result provides support for H2.

19 The other 23 NASDAQ firms were NASDAQ Small-Cap Issues.

 The relationships between the control variables and the audit report are consistent

with prior studies. There is a positive relationship between debt default status and

receipt of a going-concern report (p < .01), and between receiving a going-concern report

in the prior year and receiving such a report in the current year (p < .01). There is a

negative relationship between company size and receipt of a modified report (p < .01),

and between development stage status and receipt of a going-concern report (p < .05).

There is a marginally significant positive relationship between the level of financial

distress and receipt of a going-concern report (p < .10).20 Prior studies have not

considered the relationship between the existence of an audit committee and the receipt of

a going-concern report. We find a significant negative relationship between the presence

of an audit committee and receipt of a going-concern report (p < .01). This result

suggests that firms that establish an audit committee are less likely to receive a going-

concern report.

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Insert Table 5 about here

____________________

Audit Committee Sample. As discussed previously, we believe that the full BOD

performs the functions of an audit committee for those entities that have not established

such a committee. Based on this assumption, we initially analyzed all sample

observations (n=217) together. However, some readers may be uncomfortable with our

aggregation of firms with and without an audit committee. Table 6 presents the results

from (essentially) the same logistic regression model shown in table 5 for those firms with

an audit committee (n=145). The overall model is highly significant (p < .0001), and the

model’s pseudo-R2 is 43%. In terms of individual variables, there is a significant negative

20The marginal level of significance on ZFC may be due to the homogeneity among
sample firms in terms of distress level (i.e., all firms had a probability of bankruptcy
above .28).
relationship between the percentage of inside directors on the audit committee and the

presence of a going-concern audit report (p < .01). This result supports H1. There also

is a significant negative relationship between the percentage of grey directors on the audit

committee and the presence of a going-concern report (p < .01). This result provides

support for H2.

The relationships between the control variables and the audit report are basically

consistent with those shown in table 5. However, for the sample of companies that have

established an audit committee, there is not a significant relationship between the level of

financial distress (ZFC) and the receipt of a going-concern report. As a sensitivity test,

we replaced the ZFC index with the four financial ratios found to be significant predictors

of financial stress by McKeown, Mutchler, and Hopwood [1991, 8]. These four ratios

are: (1) current assets / sales, (2) current assets / current liabilities, (3) current assets /

total assets, and (4) long-term debt / total assets. There continues to be a significant

negative relationship between the percentage of inside / grey directors and the receipt of a

going-concern report (p < .01 for INSIDE and GREY). The only one of these four

financial ratios that was significantly related to the presence of a going-concern report was

the current ratio (p < .05).21

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Insert Table 6 about here

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21 As a further sensitivity test, we used the (significant) financial ratios used to control for
financial distress in Raghunandan and Rama’s [1995, 58] going-concern model. These
four ratios are: (1) current ratio, (2) recurring loss from operations, (3) cash flow from
operations / total liabilities, and (4) total liabilities / total assets. There continued to be a
significant negative relationship between INSIDE (p < .01) and GREY (p < .01) and
receipt of a going-concern report. Again, the only one of these four financial ratios that
was significantly related to the presence of a going-concern report was the current ratio (p
< .10).
 Companies Without an Audit Committee. Table 7 presents the results from

(essentially) the same logistic regression model shown in table 5 for those firms without

an audit committee (n=57). The percentage of insiders / grey directors represent the

composition of the full BOD for these firms. The overall model is highly significant (p <

.0001), and the model’s pseudo-R2 is 49%. There is a significant negative relationship

between the percentage of inside directors on the BOD and the likelihood of receiving a

going-concern report (p < .01). There also is a (marginally) significant negative

relationship between the percentage of grey directors and the receipt of a going-concern

report (p < .10). These results should be interpreted cautiously given the modest sample

size (n = 57).

____________________

Insert Table 7 about here

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5.3 SENSITIVITY TESTS

It is possible that the composition of the audit committee is correlated with the

composition of the full BOD, and that it is the composition of the full BOD that is

related to the likelihood of receiving a going-concern report. An advisory panel,

appointed by the Public Oversight Board of the SEC, has recently recommended that the

external auditor view the BOD as the client (POB [1994]). Given this recommendation, it

might be the full BOD that acts as a buffer between the auditor and management, and it

may be this group, and not the audit committee, that serves to safeguard the auditors’

independence.

To address this possibility, we first consider the relationship between the

composition of the full BOD and the nature of the audit report.22 We examine the

22This sensitivity analysis is only meaningful for the firms in our sample that have an
audit committee (n=145).
relationship between the percentage of Board members who are either insiders or grey

directors and the likelihood that the auditor issues a going-concern report.

Table 8 presents the results of testing the same model utilized in table 6 with the

exception that the percentage of insiders / grey directors is computed by referring to the

entire BOD rather than to the audit committee. The overall model is highly significant (p

< .0001), and the model’s pseudo-R 2 is 40%. There is not a significant relationship

between the percentage of inside directors on the entire BOD and the likelihood of

receiving a going-concern report. However, there is a significant negative relationship

between the percentage of grey directors on the entire BOD and the likelihood of receiving

a going-concern report (p < .01). Therefore, it appears that the relationship between the

percentage of insiders on the audit committee and the nature of the audit report does not

result from overall Board effects. The negative relationship between the percentage of

grey directors and receipt of a going-concern report was observed for both the audit

committee and for the full BOD.

____________________

Insert Table 8 about here

____________________

To investigate whether the negative relationship between grey directors and

receipt of a going-concern report is driven by the composition of the audit committee or

by the composition of the full BOD, we examine the relationship between non-audit

committee Board members and the likelihood of receiving a going-concern report. Since

we view the audit committee as the nexus between the auditor and firm management, we

do not expect the percentage of non-audit committee Board members who are insiders /

grey directors to be associated with the receipt of a going-concern report.

Table 9 presents the results of testing the same model utilized in table 6 with the

exception that the percentage of insiders / grey directors is computed by referring to the

non-audit committee Board members rather than to audit committee members. The
overall model is highly significant (p < .0001), and the model’s pseudo-R2 is 38%. There

is not a significant relationship between the percentage of non-audit committee inside

directors on the BOD and the likelihood of receiving a going-concern report. There also is

not a significant relationship between the percentage of non-audit committee grey

directors on the BOD and the likelihood of receiving a going-concern report. This result,

when considered in conjunction with the results in tables 6 and 8, suggests that it is the

composition of the audit committee and not the composition of the remainder of the

Board that is related to the receipt of a going-concern report.23

____________________

Insert Table 9 about here

____________________

6. Summary, Implications, and Limitations

This paper presents evidence of the relation between a corporate governance

mechanism and one type of auditor reporting. It represents the first study to consider the

relation between audit committee characteristics and going-concern reporting. We find a

significant negative relationship between both the percentage of insiders and grey

directors on the audit committee and the likelihood of receiving a going-concern report.

Further analyses of both the composition of the entire BOD and of the non-audit

committee members of the BOD, indicates that these results are driven by the

composition of the audit committee not by the composition of the entire Board.

Our results add to the growing body of literature that documents the importance

of various corporate governance mechanisms within the financial reporting process (e.g.,

23We also ran one model with the following four test variables: (1) percentage of inside
directors on the audit committee, (2) percentage of grey directors on the audit committee,
(3) percentage of non-audit committee inside directors on the BOD, and (4) percentage of
non-audit committee grey directors on the BOD. Both audit committee test variables
were negatively associated with receipt of a going-concern report (p < .05). Neither of
the non-audit committee BOD test variables were significant. The correlations between
these four variables were quite low, they ranged from -.09 to .15.
Beasley [1996], Wright [1996]). These results have two important implications. First,

they provide empirical support for the often espoused position of regulators that the

audit committee should be composed entirely of independent, outside directors. Only the

NYSE currently proscribes insiders from serving on the audit committee, and no exchange

precludes grey directors from serving on this committee. Second, our results add to the

extant literature that documents a negative effect of certain client characteristics on auditor

independence. McKeown, Mutchler, and Hopwood [1991] suggest that the negative

relationship between client size and receipt of a going-concern report (after controlling for

the effect of size on the probability of bankruptcy) might be due to an impairment of the

auditors’ independence. Our results suggest that auditors are less likely to modify the

reports of distressed firms as the percentage of insiders / grey directors on the audit

committees of these firms increases.

This study is exploratory in that it represents an initial attempt to understand the

relationship between audit committee characteristics and going-concern reporting. This

study is subject to a number of limitations. Although we believe that the composition of

the audit committee affects the audit reporting process, we only document association,

not causation. Second, there may be variables that are correlated with both the

composition of the audit committee and with the likelihood of receiving a going-concern

report. We attempted to select control variables that were related to both the likelihood

of receiving a going-concern report and to the composition of the audit committee. For

example, we expect that firms experiencing financial distress (measured via DEFAULT,

PRIOROPN, and ZFC) would find it more difficult to attract independent, outside

directors. We also expect large firms to have more outside directors due to their expertise

in monitoring and project evaluation (e.g., see Shivdasani [1993]). Finally, it may take

development stage firms a period of time to find and attract outside directors. Although

one can never eliminate the risk of a correlated omitted variable, we selected our control

variables in such a way as to minimize this risk.

 Given the continuing focus on issues of corporate governance by both the

accounting profession and regulators, additional research into the relationship between

audit committee composition and auditor behavior is needed. We believe that this work

serves as a useful springboard for these future studies.

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 TABLE 1
Sample Description

Initial sample 276

Other uncertainty opinions (8)

Default status not available (3)
Prior audit opinion not available (1)
Firms with no sales in 1994 (17)
No audit opinion for 1994 (4)
Filed for bankruptcy prior to 1994 opinion (12)
Foreign companies (3)
Subsidiaries of other sample items (9)
Private companies (2)

Final sample 217

Breakdown of Sample:
Firms with an audit committee 145
Firms without an audit committee 72

Total sample 217

 TABLE 2
Descriptive Statistics

PANEL A: ALL FIRMS (n = 217)

Mean Response
Going-Concern Non-GC Expected Actual Test
Variable (n = 103) (n = 114) Difference Difference Statistic b

INSIDE .23 .25 - -.02 -0.18

GREY .12 .22 - -.10 -2.94***
DEFAULTa .28 .03 + .25 27.91 ***
PRIOROPN .65 .12 + .53 64.11 ***
SIZE $14.03 $283.82 - -$269.79 -7.08***
ZFC 4.76 1.63 + 3.13 4.72 ***
DEVELOPa .13 .06 none .07 2.70 *
AUDCOMM .57 .75 none -.18 -8.01***

PANEL B: FIRMS WITH AN AUDIT COMMITTEE (n = 145)

Mean Response
Going-Concern Non-GC Expected Actual Test
Variable (n = 59) (n = 86) Difference Difference Statistic b

INSIDE .08 .12 - -.04 -1.51*

GREY .10 .26 - -.16 -3.43***
DEFAULTa .31 .03 + .28 20.49 ***
PRIOROPN .59 .13 + .46 34.74 ***
SIZE $17.86 $302.63 - -$284.77 -26.58***
ZFC 3.86 1.42 + 2.44 14.28 ***
DEVELOPa .15 .08 none .07 1.79

PANEL C: FIRMS WITHOUT AN AUDIT COMMITTEE (n = 57)

Mean Response
Going-Concern Non-GC Expected Actual Test
Variable (n = 29) (n = 28) Difference Difference Statistic b

INSIDE .42 .66 - -.24 -2.83***

GREY .15 .11 - .04 0.51
PRIOROPN .72 .11 + .61 21.86 ***
SIZE $11.58 $226.05 - -$214.47 -3.60***
ZFC 4.47 2.27 + 2.20 2.47 ***

INSIDE = percentage of "inside" directors on the audit committee / full board of directors
GREY = percentage of "grey" directors on the audit committee / full board of directors
DEFAULT = 1 if firm is in default on debt covenants, else 0
PRIOROPN = 1 if going-concern-modified report in prior year, else 0
SIZE = total sales (in millions of dollars)
ZFC = Zmijewski's [1984] financial condition index
DEVELOP = 1 if firm is a development stage company, else 0
AUDCOMM = 1 if firm has an audit committee, else 0
a
= Default status and development stage status are excluded from the model for
companies without an audit committee. A going-concern report is always issued in
the presence of either of these two conditions.
b
= Test statistics are a mean t-test except for binary variables for which a χ2 test for
independence is used.
*
, ** , ***
Statistically significant at less than the .10, .05, .01 level, based on one-tailed (two-
tailed) tests for variables whose expected difference is (is not) predicted.
 TABLE 3
Frequency of Inside and Grey Directors on Audit Committees by Exchange

PANEL A: ALL FIRMS (n = 217)

Percentage Percentage
Exchange of Insiders of Grey

New York Stock Exchange 1% 33%

American Stock Exchange 4% 15%
NASDAQ 22% 17%
Over-the-Counter / Other Exchanges 33% 15%

PANEL B: FIRMS WITH AN AUDIT COMMITTEE (n = 145)

Percentage Percentage
Exchange of Insiders of Grey

New York Stock Exchange 1% 33%

American Stock Exchange 4% 15%
NASDAQ 10% 19%
Over-the-Counter / Other Exchanges 16% 15%

PANEL C: FIRMS WITHOUT AN AUDIT COMMITTEE (n = 57)

Percentage Percentage
Exchange of Insiders of Grey

New York Stock Exchange NAa NAa

American Stock Exchange NAa NAa
NASDAQ 55% 9%
Over-the-Counter / Other Exchanges 53% 15%
a
Not applicable since all NYSE and AMEX firms in our sample have an audit committee
 TABLE 4
Correlation Matrix of Independent Variables

PANEL A: ALL FIRMS (n = 217)

GREY DEFAULTa PRIOROPN SIZE ZFC

INSIDE -.27 .00 .03 .00 .03

GREY -.15 -.09 .12 -.02
DEFAULT .24 -.05 .14
PRIOROPN -.38 .09
SIZE -.24
ZFC
DEVELOP

PANEL B: FIRMS WITH AN AUDIT COMMITTEE (n = 145)

GREY DEFAULTa PRIOROPN SIZE ZFC

INSIDE -.20 .01 -.01 .09 -.01

GREY -.18 -.16 .17 -.05
DEFAULT .27 -.04 .11
PRIOROPN -.37 .29
SIZE -.30
ZFC

PANEL C: FIRMS WITHOUT AN AUDIT COMMITTEE (n = 57)

GREY PRIOROPN SIZE

INSIDE -.45 -.23 .28

GREY .11 -.11
PRIOROPN -.36
SIZE

INSIDE = percentage of "inside" directors on the audit committee / full board of directors
GREY = percentage of "grey" directors on the audit committee / full board of directors
DEFAULT = 1 if firm is in default on debt covenants, else 0
PRIOROPN = 1 if going-concern-modified report in prior year, else 0
SIZE = total sales (in millions of dollars)
ZFC = Zmijewski's [1984] financial condition index
DEVELOP = 1 if firm is a development stage company, else 0
AUDCOMM = 1 if firm has an audit committee, else 0
a
= Default status and development stage status are excluded from the model for companies without an audit comm
report is always issued in the presence of either of these two conditions.
 TABLE 5
Logistic Regression Results - All Firms

REPORT = b0 + b 1 INSIDE + b2 GREY + b3 DEFAULT + b4 PRIOROPN + b 5 SIZE +

b6 ZFC + b7 DEVELOP + b8 AUDCOMM + ε

Predicted Estimated Standard Wald

Variable Relation Coefficients Errors Chi-Square

INTERCEPT none 5.159 1.169 19.476 ***

INSIDE - -3.077 0.951 10.472 ***
GREY - -2.881 1.017 8.017 ***
DEFAULT + 2.936 0.751 15.281 ***
PRIOROPN + 2.185 0.435 25.290 ***
SIZE - -0.469 0.108 18.968 ***
ZFC + 0.052 0.042 1.582 *
DEVELOP none -1.412 0.686 4.241 **
AUDCOMM none -1.593 0.594 7.188 ***

Number of Observations 217

Chi-Square for Model
(8 degrees of freedom) 141.278
p-value 0.0001
Pseudo R 2 = 0.47
Concordant Pairs 91.4%

INSIDE = percentage of "inside" directors on the audit committee / full board of directors
GREY = percentage of "grey" directors on the audit committee / full board of directors
DEFAULT = 1 if firm is in default on debt covenants, else 0
PRIOROPN = 1 if going-concern-modified report in prior year, else 0
SIZE = natural log of sales (in thousands)
ZFC = Zmijewski's [1984] financial condition index
DEVELOP = 1 if firm is a development stage company, else 0
AUDCOMM = 1 if firm has an audit committee, else 0
* ** ***
, , Statistically significant at less than the .10, .05, .01 level, based on one-tailed (two-
tailed) tests for variables whose relation to the dependent variable is (is not)
predicted.
 TABLE 6
Logistic Regression Results - Firms with an Audit Committee
Audit Committee Members Only

REPORT = b0 + b 1 INSIDE + b2 GREY + b3 DEFAULT + b4 PRIOROPN + b 5 SIZE +

b6 ZFC + b7 DEVELOP + ε

Predicted Estimated Standard Wald

Variable Relation Coefficients Errors Chi-Square

INTERCEPT none 4.510 1.352 11.119 ***

INSIDE - -2.626 1.202 4.772 ***
GREY - -3.058 1.159 6.959 ***
DEFAULT + 2.681 0.799 11.267 ***
PRIOROPN + 1.797 0.526 11.685 ***
SIZE - -0.554 0.142 15.288 ***
ZFC + 0.049 0.063 0.606
DEVELOP none -1.884 0.787 5.728 **

Number of Observations 145

Chi-Square for Model
(7 degrees of freedom) 84.206
p-value 0.0001
Pseudo R 2 = 0.43
Concordant Pairs 90.2%

INSIDE = percentage of "inside" directors on the audit committee

GREY = percentage of "grey" directors on the audit committee
DEFAULT = 1 if firm is in default on debt covenants, else 0
PRIOROPN = 1 if going-concern-modified report in prior year, else 0
SIZE = natural log of sales (in thousands)
ZFC = Zmijewski's [1984] financial condition index
DEVELOP = 1 if firm is a development stage company, else 0
** ***
, Statistically significant at less than the .05, .01 level, based on one-tailed (two-
tailed) tests for variables whose relation to the dependent variable is (is not)
predicted.
 TABLE 7
Logistic Regression Results - Firms without an Audit Committee

REPORT = b0 + b 1 INSIDE + b2 GREY + b3 PRIOROPN + b 4 SIZE + b5 ZFC +ε

Predicted Estimated Standard Wald

Variable Relation Coefficients Errors Chi-Square

INTERCEPT none 3.708 1.804 4.222 **

INSIDE - -4.223 1.828 5.337 ***
GREY - -3.545 2.637 1.806 *
PRIOROPN + 3.116 0.894 12.160 ***
SIZE - -0.289 0.175 2.728 **
ZFC + 0.082 0.063 1.732 *

Number of Observations 57
Chi-Square for Model
(5 degrees of freedom) 38.739
p-value 0.0001
Pseudo R 2 = 0.49
Concordant Pairs 92.0%

INSIDE = percentage of "inside" directors on the full board of directors

GREY = percentage of "grey" directors on the full board of directors
PRIOROPN = 1 if going-concern-modified report in prior year, else 0
SIZE = natural log of sales (in thousands)
ZFC = Zmijewski's [1984] financial condition index
* ** ***
, , Statistically significant at less than the .10, .05, and .01 levels, based on one-tailed (two-
tailed) tests for variables whose relation to the dependent variable is (is not)
predicted.

35
 TABLE 8
Logistic Regression Results - Firms with an Audit Committee
All Board Members

REPORT = b0 + b 1 INSIDE + b2 GREY + b3 DEFAULT + b4 PRIOROPN + b 5 SIZE +

b6 ZFC + b7 DEVELOP + ε

Predicted Estimated Standard Wald

Variable Relation Coefficients Errors Chi-Square

INTERCEPT none 4.471 1.419 9.928 ***

INSIDE - 0.035 1.414 0.001
GREY - -4.015 1.758 5.218 ***
DEFAULT + 2.547 0.757 11.314 ***
PRIOROPN + 1.781 0.514 11.994 ***
SIZE - -0.573 0.143 16.041 ***
ZFC + 0.045 0.063 0.510
DEVELOP none -1.560 0.757 4.248 **

Number of Observations 145

Chi-Square for Model
(7 degrees of freedom) 78.527
p-value 0.0001
Pseudo R 2 = 0.40
Concordant Pairs 89.5%

INSIDE = percentage of "inside" directors on the full board of directors

GREY = percentage of "grey" directors on the full board of directors
DEFAULT = 1 if firm is in default on debt covenants, else 0
PRIOROPN = 1 if going-concern-modified report in prior year, else 0
SIZE = natural log of sales (in thousands)
ZFC = Zmijewski's [1984] financial condition index
DEVELOP = 1 if firm is a development stage company, else 0
** ***
, Statistically significant at less than the .05, .01 level, based on one-tailed (two-
tailed) tests for variables whose relation to the dependent variable is (is not)
predicted.
 TABLE 9
Logistic Regression Results - Firms with an Audit Committee
Non-Audit Committee Board Members Only

REPORT = b0 + b 1 INSIDE + b2 GREY + b3 DEFAULT + b4 PRIOROPN + b 5 SIZE +

b6 ZFC + b7 DEVELOP + ε

Predicted Estimated Standard Wald

Variable Relation Coefficients Errors Chi-Square

INTERCEPT none 3.706 1.411 6.894 ***

INSIDE - 0.402 0.758 0.282
GREY - -1.257 1.337 0.884
DEFAULT + 2.556 0.748 11.668 ***
PRIOROPN + 1.759 0.510 11.869 ***
SIZE - -0.556 0.140 15.712 ***
ZFC + 0.039 0.070 0.317
DEVELOP none -1.441 0.760 3.594 *

Number of Observations 145

Chi-Square for Model
(7 degrees of freedom) 74.622
p-value 0.0001
Pseudo R 2 = 0.38
Concordant Pairs 87.9%

INSIDE = percentage of "inside" directors not on the audit committee

GREY = percentage of "grey" directors not on the audit committee
DEFAULT = 1 if firm is in default on debt covenants, else 0
PRIOROPN = 1 if going-concern-modified report in prior year, else 0
SIZE = natural log of sales (in thousands)
ZFC = Zmijewski's [1984] financial condition index
DEVELOP = 1 if firm is a development stage company, else 0
* ***
, Statistically significant at less than the .10, .01 levels, based on one-tailed (two-tailed)
tests for variables whose relation to the dependent variable is (is not) predicted.

37