Corporate failure models as analytical procedures for assessing going concern : an investigation into their relevance and efficacy within the audit decision framework

Abstract

Previous research has identified the issuance of clean audit reports to companies that subsequently fail as a major factor contributing to the audit expectations gap. This often results in large costs to auditors in terms of litigation, loss of client and the loss of professional reputation. Consequently, this also leads to the loss of confidence in the statutory audit function, which is that of adding credibility to financial statements.

However, prior research conducted mainly in the United States, which has a debtor-oriented insolvency framework, indicate that statistical bankruptcy prediction models significantly outperform auditors' opinions issued to failed companies. This suggests that objective corporate failure models may have a valuable role as analytical procedures that can assist auditors in forming more appropriate going concern opinions.

A number of significant issues remain, however, that not only questions the relevance and appropriateness of bankruptcy predictions models for assessing going concern, but also of their practical efficacy within the audit decision framework as an effective analytical procedure. However, if the contention that corporate failure models are a useful and effective analytical procedure can be validated from a practical perspective, it will lend much credibility to the possible routine use of such models to assist auditors in making more accurate going concern assessments. Given the high costs associated with misclassifying failing clients, research in this area will provide auditors with the necessary knowledge about the practical value of corporate failure models for assessing going concern, with respect to the strengths and weaknesses of such models in practice. This research examines these issues by addressing the following key questions.

Firstly, although previous research generally find bankruptcy prediction models to outperform auditors' accuracy in identifying failing companies, recent research questions whether bankruptcy is the best proxy for assessing going concern, since filing for bankruptcy is not synonymous with the invalidity of the going concern assumption. Furthermore, in contrast with debtor-oriented countries such as the US, liquidation is the more likely outcome of corporate insolvency in creditor-oriented countries such as the UK, Germany and New Zealand. This suggests that bankruptcy prediction models may have a limited role in assessing going concern in creditor-oriented countries, where liquidation prediction models may be more appropriate. Previous research has not recognised the implications of this distinction between corporate bankruptcy and liquidation when suggesting statistical bankruptcy prediction models as audit tools for assessing going concern. Consequently, the accounting and auditing literature frequently refers to the possible use of bankruptcy prediction models, without any qualification that such an approach might, in fact, be inappropriate. As a result, the use of bankruptcy prediction models in creditor-oriented countries may increase audit misclassification errors, and undermine the contended use of such models in auditing. This research examines the issues and implications surrounding the use of bankruptcy and liquidation prediction models in creditor-oriented insolvency frameworks, in the light of their potential to improve auditors' assessments of clients' going concern status, which is fundamental to the validity of the audit report.

Secondly, prior research has made inferences about the usefulness of corporate failure models for assessing going concern, by comparing the outcomes of various models to the auditors' report issued prior to bankruptcy filing. As a result, the usefulness and efficacy of statistical prediction models within the audit decision framework for actually assessing going concern has not been directly examined. This, as a consequence, leads to significant factors such as the effects of human information processing limitations that influence the final audit opinion to be discounted. As a result, it is not possible, based on prior research, to conclusively form an assessment of the value of corporate failure models for assisting auditors form more appropriate going concern opinions. Furthermore, in order to holistically examine the efficacy and usefulness of corporate failure models as analytical procedures for assessing going concern, it is also necessary to examine auditors' perceptions about the use of such models for assessing going concern, both in practice and in terms of how auditing standards can guide auditors to their possible use. Specifically, it is necessary to gain an understanding of where in the audit decision framework corporate failure models can be applied to, what reliance auditors can place on them as a source of audit evidence, and how auditing standards can guide auditors to their use.

The results indicate that corporate failure models are highly effective in assisting auditors to mitigate effects of human information processing limitations, thereby facilitating the formation of more appropriate going concern opinions. Auditors' not utilising corporate failure models exhibit greater erroneous going concern opinions. However, the use of bankruptcy prediction models in creditor-oriented countries was found to be inappropriate. This has significant implications on the choice of corporate failure model for assessing going concern, depending on the type of insolvency framework. Further analyses of auditor perceptions indicate that such models are recognised as being able to gather relevant audit evidence and reduce subjectivity involved in the going concern assessment. Interestingly, corporate failure models are seen to be more effective in the planning stages of the audit as analytical procedures than at the final stages of the review. Moderate levels of accuracy are also perceived to be necessary for corporate failure models to be useful for assessing going concern. This indicates that auditors do not relegate professional judgement to a somewhat secondary role in assessing going concern, by requiring such models to be very accurate. With reference to the level of guidance on corporate failure models afforded by current auditing standards, auditors overwhelmingly perceive the need for more explicit guidance on the use of such models for assessing going concern. Specifically, more guidance is perceived as been necessary in the auditing standard on analytical procedures, than in the auditing standard on going concern, on the availability of corporate failure models for assessing going concern.

The results of this study are, therefore, of considerable practical value to the accounting profession. Furthermore, auditors' perceptions about the usefulness and efficiency of corporate failure models, with respect to the current auditing standards, have significant policy implications for accounting standard setters and the investing public.