Balance sheet conservatism and audit reporting conservatism

Asad Kausar, Clive Lennox

Research output: Contribution to journalArticle

8 Citations (Scopus)

Abstract

Financial reports are prepared on a going-concern (GC) basis rather than a liquidation basis even when companies are highly distressed. This allows distressed companies to report book values of assets that greatly exceed their liquidation values, implying a lack of conservatism in the balance sheet. We argue that auditors issue going-concern opinions in order to warn investors about this lack of balance sheet conservatism. This argument leads to two testable hypotheses. First, for companies that are at risk of bankruptcy, auditors are more likely to issue GC opinions when the book values of assets under the GC assumption are high relative to the expected liquidation values of assets (i.e., when the GC assumption causes the balance sheet to lack conservatism). Second, for companies that enter bankruptcy, the issuance of a prior GC opinion has predictive information content with respect to the wedge between the book values of assets and the future liquidation values of those same assets. Our results strongly support both hypotheses. The findings are important because they indicate that conservative audit reporting helps to compensate for a lack of conservatism in the balance sheet, which arises because the GC assumption permits the book values of assets to exceed their liquidation values.

Original languageEnglish
Pages (from-to)897-924
Number of pages28
JournalJournal of Business Finance and Accounting
Volume44
Issue number7-8
Early online date19 Apr 2017
DOIs
Publication statusPublished - 1 Jul 2017

Keywords

  • book values
  • conservatism
  • going concern audit opinions
  • liquidation values

ASJC Scopus subject areas

  • Accounting
  • Business, Management and Accounting (miscellaneous)
  • Finance

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