Auditors issue going concern opinions when they have substantial doubts about a client’s ability to continue as a going concern for one year beyond the financial statement date. Abundant anecdotal evidence shows that  companies that received these opinions went through restructurings, with managers and employees losing their jobs or seeing their pay cut. For example, after Ernst & Young sent Texas utility Dynegy Holdings, Inc. a going concern opinion in 2011, a majority of the company’s directors said they wouldn’t consider being re-elected,  and the CEO and CFO said they might leave the company. After Clearwire Corp. received a going concern opinion in 2010, it sold a large amount of debt, and Craig McCaw resigned as chairman. And after receiving such an opinion in 2012, Sharp announced that it would cut 5,000 jobs after having already cut salaries, sold assets, and scaled back investments.

While these detrimental effects are well documented, little is known about what actions boards of directors take to strengthen monitoring of managers (agents) and restore investor confidence after receipt of a going concern opinion.  ]

In our recent study “Going-Concern Opinions and Corporate Governance,” we empirically examine how going concern opinions affect various aspects of  corporate governance, including corporate control, executive compensation, and turnover among executives and auditors.

Though the issuance of going concern opinions decreases firm value and conveys a negative signal to the stock market, its impact on corporate control is not straightforward. On one hand, since the incentives provided by equity-based compensation are needed most when firms are in a crisis, it’s reasonable to expect that financial distress would cause executive and non-executive directors to own more stock. On the other hand, institutional investors or blockholders of stock might be more likely to increase their ownership stakes in distress situations. The overall effect should be that ownership concentration increases because widely-dispersed equity exaggerates the free-rider problem.

Financially distressed companies are usually subject to strategic or political constraints on how much CEOs can be compensated. Directors, being afraid of losing their own jobs or sued, are likely to reduce executive compensation to avoid any appearance of self-dealing. What’s more top executives feel hesitant to negotiate higher compensation because it is costly for them to leave the firm, especially when they are responsible for the financial problems. In addition, the issuance of going concern opinions and the associated financial distress impose financial and personal costs on  managers (for example, reduction in compensation and decision-making authority and loss of reputation and prestige). Hence, managers might resign. In addition, the negative stock performance following the announcement of a going concern opinion motivates boards of directors to terminate top managers. And not surprisingly, companies in financial distress are more likely to change auditors due to disputes over audit opinions, accounting methods, or disclosure policies.

Empirically, we utilize the issuance of Auditing Standard No. 5 (AS5) as the exogenous shock to draw causality from going concern opinions to changes in corporate governance.  The AS5 aims to increase auditors’ ability to issue going concern opinions but has no impact on corporate governance. From a sample of going concern opinions issued from 1995 to 2012, we find strong evidence that subsequent to the issuance of going concern opinions, the  institutional investors and other large stockholders tend to reduce their stakes. Furthermore, the issuance of going concern opinions also motivates companies to decrease executive compensation and terminate top managers and auditors.

With these findings, we demonstrate the importance of auditors in corporate governance.  While companies pay their external auditors and have the power to fire them, regulators and external stakeholders push for auditor independence.  Our study supports the latter conclusion and shows how enhancing the power of auditors can improved company performance.

This post comes to us from professors Ning Ren at Long Island University and Yun Zhu at St. John’s University. It is based on their recent paper, “Going-Concern Opinions, Institutional Ownership and CEO Compensation,” available here.