The Effect of SAS No. 59: How Treatment of the Transition Period Influences Results

Key Words: SAS No. 59, Audit opinion, Bankruptcy, Going concern. Data Availability: The data are available from public sources. Statement on Auditing Standards No. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, (AICPA 1988b) was issued in response to concerns about auditors' reporting of clients' impending business failure. A gap existed between users' expectations and auditors' performance, and SAS No. 59 was designed to help close this gap. The question of vital importance to the auditing community is, "Have auditors changed their going-concern reporting behavior since the issuance of SAS No. 59? " Evidence concerning this question could have numerous implications for practice and theory. For example, the future actions of the Auditing Standards Board relative to going-concern evaluation may depend, in part, on results from research that addresses this question. Two previous studies have reached different conclusions regarding the association between SAS No. 59 and auditors' going-concern reporting behavior. Raghunandan and Rama (1995) found evidence that, after the issuance of SAS No. 59, auditors were more likely to modify the opinions of bankrupt companies prior to failure. In addition to their analysis of bankrupt companies, these authors also tested whether auditors were more likely to modify the opinions of distressed, non-bankrupt clients after the issuance of SAS No. 59. They found that auditors were more likely to modify such opinions after the issuance of SAS No. 59. The authors state, "These results are consistent with the position that the efforts of the Auditing Standards Board, in issuing SAS No. 59 as an expectation gap auditing standard, have been successful" (Raghunandan and Rama 1995, 50). In contrast, Carcello et al. (1995) found evidence of a change in auditors' bankruptcy-related reporting behavior after the issuance of SAS No. 34 (AICPA 1981), but not after the issuance of SAS No. 59. (1) The authors conclude, "As SAS No. 59 was implemented in response to a going-concern `expectations gap,' it does not appear that the gap between users' expectations and audit firm reporting has been reduced" (Carcello et al. 1995, 133). Unlike Raghunandan and Rama (1995), Carcello et al. (1995) did not examine distressed, non-bankrupt clients. The two studies above were quite similar, but differed in their handling of the "transition period," the period from April 1988 to December 30, 1989 when SAS No. 59 was published but not yet mandatory. Raghunandan and Rama (1995) (hereafter R&R) included 1988 financial statements (a portion of the transition period) in the pre-SAS No. 59 period. Carcello et al. (1995) excluded the entire transition period from their analysis and argued that it was not clear which standard was followed during this period. The handling of the transition period is critical in studies of SAS No. 59, for auditors' performance during this period was quite unusual. Approximately thirty-five percent of bankruptcy-related opinions during this time were modified, versus historical rates of approximately fifty percent (Carcello et al. 1995). In addition, based on the sample in the present study, auditors' propensity to modify the opinions of distressed, non-bankrupt clients also was extremely low during 1988, only seven percent versus approximately twenty to twenty-five percent in other years. The treatment of this unusual reporting behavior during the transition period could influence the results of SAS No. 59 studies, particularly those that examine short windows before and after SAS No. 59 issuance. This paper reconciles the results of R&R and Carcello et al. (1995) and illustrates the effect that transition-period treatment can have on certain SAS No. 59 analyses. First, using a sample of bankrupt companies, the effect of including 1988 financial statements in the pre-SAS59 period (as was done by R&R) is illustrated. …