Breaking bad news may deter suits

October 03, 2013

First published in W. P. Carey Magazine, Autumn 2013

When a company is struggling financially, its auditors feel their own kind of pain. Should the auditors issue a going-concern report, triggering possible selling by the company’s investors or financial backlash from its creditors, or should the auditors hold back and hope no one sues over a failure to warn of the company’s problems?

It turns out that auditors fare better when they make the tougher decision, unpopular as it may be.

Research co-authored by Steven E. Kaplan, KPMG Professor of Accountancy in the W. P. Carey School of Business, provides hard, statistical evidence that auditors reap two important benefits from issuing going-concern audit reports. First, the research shows such reports reduce auditors’ likelihood of being named in lawsuits. Second, the research shows such reports reduce the likelihood that auditors who are sued wind up paying larger settlements.

“If I was an audit partner, it would hopefully make me more comfortable that I’m doing the right thing when I issue a going-concern report,” Kaplan said. “I think the law helps encourage auditors to do the right thing and alert investors when the companies they audit are struggling financially.”

Previous research on the topic was limited, mixed and outdated. So Kaplan and co-author David Williams of The Ohio State University brought two important innovations to the topic. First, they used what Kaplan calls the “more modern ... more sophisticated” simultaneous-equations approach to prove what audit professionals had traditionally assumed about the odds of a lawsuit. Second, they extended the research by examining the relation between going-concern reporting and the outcomes of lawsuits.

Going-concern audit reports have long been red flags in the financial world, arising when auditors have substantial doubt about a client’s ability to remain a going concern for a reasonable period of time. Securities laws and professional standards require auditors to issue the reports in such situations, providing investors and creditors with an early-warning system for gauging the risk of troubled companies.

But when it comes to such companies, disgruntled investors can and do sue auditors in an attempt to recover their financial losses. Auditing firms obviously are vulnerable if they performed negligently, but they also are vulnerable to even frivolous lawsuits because of their perceived “deep pockets.” The resulting legal costs can run into the hundreds of millions of dollars -- the second largest expense facing auditing firms.

The bad publicity also can do untold damage to the audit firm’s reputation. Headlines and pundits might scream, “Where were the auditors?” Enron, Bernie Madoff, the business failures in the recent financial crisis, overvalued dot-coms – the list goes on of companies that either misled their auditors through fraud or that undeservedly escaped going-concern reports.

Even when a company is honestly struggling to turn around its business, “auditors are somewhat caught in the middle,” Kaplan said. “Their clients are trying to tell them how damaging this can be, and on the other hand they do have this public responsibility to issue this warning when they have substantial doubt … So how do auditors balance trying to be a good professional and work with their clients but still meet their professional responsibilities?”

The competing pressures prompted Kaplan and Williams to test their two hypotheses:

  • First, as a company’s financial stress and the risk of lawsuits against the company and its auditors rise, so does the likelihood that auditors will issue going-concern reports.
  • Second, when auditors issue going-concern reports, class-action lawsuits against them become less likely.

Coming up with a new approach

The researchers started with a list of 1,211 publicly-traded firms that were involved in securities class-action lawsuits between 1986 and 2009. They then looked for cases in which the auditors’ client companies were under financial stress, which the researchers defined as two consecutive years of net losses and negative retained earnings in the latest year. After excluding lawsuits against private and/or small firms, the researchers ended up with a sample of 147 financially stressed companies that were publicly traded, had market values of at least $1 million, and had engaged a major auditing firm. Of the 147 firms, they then found information on the outcomes of 127 lawsuits.

A first look at the data indicated that auditors had issued going-concern reports in one-third of the lawsuits over troubled companies. But financial stress, lawsuit risks and the decision to issue going-concern reports form a vicious circle. Which are causes, and which are effects?

Previous research had used probit analysis, with its limited variables, to search for answers. By using simultaneous equations, Kaplan and Williams were able to separate out relationships in that vicious circle. The simultaneous-equations approach is key, Kaplan said, because it sheds more light on auditors’ decisions about whether to issue going-concern reports and on investors’ subsequent decisions about whether to file lawsuits against the auditors.

They also tackled a topic of little previous research: the relationship between going-concern reports and whether lawsuits resulted in dismissal, small settlements ($2 million or less) or large settlements (above $2 million). The researchers were curious about whether issuing going-concern reports makes dismissal of lawsuits or small settlements more likely. And they wondered whether when financial settlements occur, does having issued going-concern reports reduce the amount that audit firms pay?

Results Show Benefits of Growing-Concern Reports

The results confirmed that Kaplan’s and Williams’ hypotheses were valid. Specifically, separating out the relationships enabled the researchers to clearly show that as the risk of lawsuits rises, auditors are more likely to issue going-concern reports.

The results also clearly showed that when auditors issue going-concern reports, they are less likely to be included in lawsuits. To Kaplan, this means investors have found the reports useful and thus were deterred from naming auditors in lawsuits.

Regarding outcomes, the research found that having issued a going-concern report reduces the likelihood of auditors paying large financial settlements. The reports also reduce the overall amount of auditors’ settlements.

However, the results were less clear on whether going-concern reports reduce the likelihood of the other outcomes: dismissals and small settlements. In some cases, Kaplan said, there might have been factors beyond the going-concern issue. Or some might have been “nuisance” cases, in which firms decide that paying a small settlement costs less than going to the expense of defending themselves in court.

The results stood throughout the 24 years studied, a period that included swings in the stock market, growth in public companies, consolidation in the accounting industry, and the enactment of legislation such as the Private Securities Litigation Reform Act and the Sarbanes-Oxley Act.

The Bottom Line

Based on the research findings, Kaplan has this advice for the various stakeholders in financially stressed companies:

  • Auditors who feel pressured by client companies and who are weighing the pros and cons of issuing a going-concern report should be mindful that issuing the report will have two big benefits for the audit firm. The reports reduce both the likelihood of the auditor being sued and the likelihood that the audit firm would pay a large settlement.
  • Financially stressed companies should realize that the best way to avoid a going-concern report is to have a plan to remedy the underlying problem. Pressuring or firing the auditor isn’t much of a solution, because the auditor is getting significant competing pressure – namely, the need to reduce the audit firm’s risk of being sued and the need to reduce its risk of paying a huge settlement.
  • Investors in publicly traded companies should read the auditor’s report in the financial statements, looking for going-concern or other warnings. If the statements contain a going-concern report, investors should decide on their risk tolerance. The risk-averse might prefer to sell at a small loss, while a risk taker who believes the company can turn around might decide to hang on for the ride.
  • Lawyers weighing the possible outcomes of a case by unhappy investors should look at whether the company’s auditor has issued a going-concern report. If such a report was issued, statistics show only a slim chance of winning big. The case is more likely to be dismissed or to be settled for a smaller sum.

--This article was first published in W. P. Carey Magazine, Autumn 2013.