Even as top executives at failing companies dump their shares, auditors of those same companies often fail to issue a going concern opinion to warn other investors of the precarious nature of the corporation’s finances.

A new study by a group of academic researchers suggests a correlation between a high level of stock sales by top execs of distressed companies and the diminishing chances that outside auditors will warn investors about the corporation’s future viability. The study appears in the March/April issue of the American Accounting Association’s journal The Accounting Review.

Going concern opinions have become an increasing cause of investor complaints lately, and a topic in which both the Public Company Accounting Oversight Board and the Financial Accounting Standards Board have taken an interest. A senior official of a major pension fund, Anne Simpson of CalPERS, was recently quoted in The Wall Street Journal saying that going concern opinions are "rarer than a hen's teeth" and that a company has "to be dangling off a cliff...before the auditor blows the whistle."

The new research is likely to raise further doubts about going concern opinions as an auditing tool, as it strongly suggests that auditors' reluctance to issue it is too often driven by pressures from company higher-ups who have recently unloaded stocks of their distressed firms.

"Insiders have incentives to discourage auditors from issuing going-concern opinions after abnormal insider sales because the bad news from a first-time going-concern opinion is likely to attract regulators' scrutiny and class-action lawsuits against insider trading from investors,” said the study, written by Xiumin Martin of Washington University of St. Louis, Chen Chen of the University of Auckland (New Zealand) and Xin Wang of the University of Hong Kong, “We find evidence that abnormal insider sales are negatively associated with the likelihood of receiving a first-time going concern opinion."

The greater the amount of recent stock sales by executives of distressed companies, the less chance there will be of auditors issuing going-concern opinions.

The study also suggests that auditors are more or less likely to issue GCOs depending on the economic importance to them of the client and their own concern about litigation costs and reputational harm. The greater the percentage of the auditors' total fees accounted for by the client, the greater the likelihood that insider selling incentives will inhibit the issuing of a GCO. The greater the auditor's risk of being sued, which is heightened if another client has admitted to fraud, and the higher its reputation, the less chance there is of a GCO being issued.

In addition, the influence of insider-selling incentives diminishes in companies where the board's audit committee has a high degree of independence. The opposite is the case, however, where audit committee members are themselves involved in selling company stock.

The study's findings derive from an analysis of the relationships among three factors: insider selling during a giving year; audit opinions for that year; and company financial results for that year. The data covers an eight-year period for a sample of financially distressed companies that either suffered from negative earnings or negative operating cash flow in the current year. The analysis encompasses a total of 12,329 firm years, 801 featuring first-time going concern opinions and 11,528 with clean opinions.

In their study, the professors found an inverse relationship between insider selling in a given year and the likelihood of an auditor's issuing a going concern opinion in the financial statement for that year. More precisely, "an increase of roughly $60,250 [from year to year] in the change of net insider sales reduces the likelihood of receiving a going-concern opinion by 1.39 percent." While that percentage sounds small, it amounts to 21 percent of the rate of going concern opinions for the entire sample, since an average of 6.5 percent of these financially distressed companies received GCOs in a given year.

In other words, the effect of insider selling on the likelihood of a GCO being issued is more than one fifth as great as the effect of such essential features of economic distress as negative earnings or negative operating cash flow.

A major challenge for the researchers was determining that pressures from top company management accounted for the inverse relationship between the amount of insider selling and the likelihood of GCOs. Suppose, for example, this relationship merely reflected the executives' increased skittishness about selling shares when they believed the chance of a GCO was considerable.

To test this possibility, the professors analyzed auditor switches following the issuance of clean opinions and found that "auditors who issue clean opinions for clients with higher levels of insider selling have a lower frequency of dismissals in the subsequent year. These results are consistent with the notion that management influences auditors' opinions but are inconsistent with the notion that insiders reduce their selling in anticipation of going concern reports."

The researchers also tested whether the greater insider selling in companies with clean opinions might simply reflect some basic difference between those firms and those that receive GCOs—perhaps stronger market demand for stock of companies that will receive clean opinions. They re-run their analysis using a control group of 801 companies that receive clean opinions but are closely matched to the GCO group in terms of stock returns and Altman's Z, a measure of future bankruptcy risk. The results are fundamentally the same as for the larger sample, thereby "alleviat[ing] the concern that firms receiving going-concern opinions are fundamentally different from those receiving clean opinions."

While the study reveals that insider selling incentives had less influence after the passage of the Sarbanes-Oxley Act of 2002 than was the case earlier, the authors do not propose additional regulation as the answer to the significant problem that remains. "

To some extent, investors can protect themselves," said Martin. "As part of the caution called for any time one buys shares of an economically distressed company, especially one with a lot of recent insider selling, investors do well to check on the status of the auditor. Does the auditor have a good name to protect, and is it a leader in terms of local market share? Both factors are likely to increase the auditor's inclination to withstand insider pressures. What investors should be particularly wary of are companies that hire lower-quality auditors who charge high fees."

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