Question

During its deliberations on the Sarbanes-Oxley Act, the U.S. Senate considered numerous reports evaluating the quality of work done by external auditors. One study by Weiss Ratings, Inc., focused on auditors’ ability to predict bankruptcy. The study criticized auditors for failing to identify and report going-concern problems for audit clients that later went bankrupt. Based on a sample of 45 bankrupt companies, the Weiss study concluded that had auditors noted unusual levels for just two of seven typical financial ratios, they would have identified 89 percent of the sample companies that later went bankrupt. A follow-up to the Weiss study found that had the criteria in the Weiss study been applied to a larger sample of nonbankrupt companies, 46.9 percent of nonbankrupt companies would have been predicted to go bankrupt.^* (Links to an external site.) In other words, the Weiss criteria would have incorrectly predicted bankruptcy for nearly half of the companies in the follow-up study and would have led the auditors to report that these clients had substantial going-concern problems when, in fact, they did not.

1. Discuss the negative consequences that arise when auditors fail to identify and report going-concern problems.
2. Who is harmed by these failures? Discuss the negative consequences that arise when auditors incorrectly report going-concern problems when they do not exist.
3. Who is harmed by these errors? In your opinion, which of the potential consequences is worse?

Answer 1

This is a very difficult question to give an absolute answer for. I dont think there are any right or wrong answers to this question. It totally depends upon the judgement for individual perspectives.

Regarding to the question "Who are harmed by these errors or failulres" in both aspects , I feel it is more or less the same people who are affected in both the circumstances.

Let us first look at the case where the auditor actually fails to identify and report a company that had going concern issues and has now become bankrupt. In this case there are a lot of stakeholders who have to suffer because the auditors failed to identify such an issue. The suppliers who provided the firm with the required goods will not be able to get their payment, Shareholders who trusting the auditors report and placing reliance on them bought shares at the now bankrupt company recently. Other shareholders who were existing since long ago would have probably tried to sell off their shares or seek alternatives if they had already known that such an issue was at stake. Banks from whom the company had taken out loans as now they will not be able to repay these loans and the loss has to be suffered by the banks. etc. These are some of the many who have to suffer the consequences just because the auditor failed to identify the existence of such a going concern issue in their client.

Now looking at the case where the auditor falsely reports going concern issues about a company who actually have no issues and such a problem does not exist. In such a situation it is a big wrong that they are doing towards the shareholders and employees and all othe personal relating to the company as such a claim by the auditr will really have a negative impact on their entire business and its surroundings. Supplier will be resistant to further provide them with the required. Banks willl not be ready to issue loans for any needs of the company. Employees will have a feeling of insecurity when working at the company as they will have this in the back of their mind that their company could come to a halt at any time. The company will really struggle to go forward with their business even though they have done no wrong and have no going concern issues in reality.

Looking at both the cases I would say potential consequences are worse if a company where no going conern problems exist are falsely accused of having issue with their going concern status. As such an accusation will be almost similar to creating a going concern issue at a firm that was running smoothly till then. Because after such an accusation by the auditors all the realted stakeholders will be reluctant and resistant to conduct any further business with them.

Hope this answered your question. If you liked the answer, please give it an up-vote. It would be highly encouraging for me. Thank You.