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Academy of Accounting and Financial Studies Journal, Volume 6, Number 1, 2002
CONSERVATISM OF THE BIG SIX AUDIT FIRMS
AND GOING-CONCERN MODIFIED AUDIT REPORTS
Marshall A. Geiger, University of Richmond
K. Raghunandan, Texas A & M International University
ABSTRACT
This study examines whether Big 6 audit farms exhibit a more conservative reporting posture than non-Big 6 audit firms by examining differences in "reporting errors "for going concern uncertainties. Specifically, based on an analysis of relative error costs, we hypothesize that Big 6 firms are more conservative in their reporting decisions, leading to differences in error proportions for both type 1 (companies receiving going-concern modified opinions that do not fail) and type II (failed companies that did not receive a prior going-concern modification) reporting errors. Evidence from samples of companies with first-time going-concern modified opinions and bankrupt companies is generally consistent with the hypotheses. Big 6 firms were found to have a significantly higher type I reporting error rate when failure was defined as filing for bankruptcy or entering default on debt payments, and a significantly lower type II reporting error rate than non-Big 6 firms. Our findings suggest that reporting decisions are associated with the relative magnitude of the firms' expected losses, resulting in more conservative reporting decisions regarding the issuance of going -concern modified audit reports for Big 6 firms.
INTRODUCTION
Prior research has addressed the existence of differences between Big 6 and non-Big 61 audit
firms on a variety of dimensions, including audit quality, audit fees, client retention and industry concentration (DeAngelo, 1981; Palmrose, 1986; Francis & Simon, 1987; Simunic & Stein, 1996; Gul, 1999; Hogan & Jeter, 1999). Some recent studies have also examined whether the largest audit firms are more conservative than smaller audit firms in various settings. Recent papers examining issues related to the market for audit services have documented that Big 6 firms are (a) less concentrated in industries perceived as having high litigation risk compared to those perceived as having low litigation risk (Hogan & Jeter, 1999), (b) less likely to accept clients where the predecessor auditor resigned (Raghunandan & Rama, 1999), and (c) have maintained historically less risky client portfolios than non-Big 6 auditors (Francis & Reynolds, 1999). While these studies have examined several facets of the auditor-client interaction, no study has examined Big 6 firms compared to non-Big 6 firms for conservatism in their resultant reporting decisions - the final outcome of the audit process.
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13
We performed sensitivity analysis by including a dummy variable for firms in high-tech industries, as defined in Kasznik and Lev (1995). In such analysis, the results remained substantively similar to those presented in Table 4 and the Big 6 variable continued to remain significant (p < .05).
14
The financial stress indicators are based upon the measures used by prior researchers, such as McKeown et al. (1991a). Note that the third factor used here, negative stockholder's equity, is a more stringent measure than the negative retained earnings measure used by McKeown et al. (1991a).
15
Mutchler et al. (1997) found that their Big 6 variable was not significant in explaining differences in audit opinions prior to bankruptcy. One possible reason for our different results may be the different nature of the samples. In particular, Mutchler et al. (1997) include only companies traded on the NYSE or AMEX, while our sample includes a substantial number of companies (191 out of 247) not traded on these exchanges. Companies listed on the NYSE and AMEX may be different along many dimensions than companies not traded on such exchanges.
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