AUDIT COMMITTEE COMPOSITION AND AUDITOR REPORTING

Joseph V. Carcello Associate Professor Department of Accounting and Business Law College of Business Administration University of Tennessee Knoxville, TN 37996-0560 Phone: (865) 974-1757 Fax: (865) 974-4631 E-mail: jcarcell@utk.edu

Terry L. Neal Assistant Professor University of Kentucky E-mail: tneal2@pop.uky.edu

ACKNOWLEGEMENTS: We thank Mark Beasley, Bruce Behn, Dana Hermanson, Jim McKeown, Jane Mutchler, Zoe-Vonna Palmrose, Sean Peffer, Bob Ramsay, Dick Riley, Dan Simunic, participants at a Boston College Accounting Research Workshop, two anonymous referees, and Jerry Salamon (the former editor) for many helpful comments and suggestions. We also thank Chris Daugherty and Michelle Keasler for research assistance. DATA AVAILABILITY: The data are available from public sources. A list of sample firms is available from the second author.

This paper can be downloaded from the Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/paper.taf?abstract_id=229835

AUDIT COMMITTEE COMPOSITION AND AUDITOR REPORTING ABSTRACT: This study examines the relation between the composition of financially distressed firms audit committees and the likelihood of receiving going-concern reports. For firms experiencing financial distress during 1994, we find that the greater the percentage of affiliated directors on the audit committee, the lower the probability the auditor will issue a going-concern report. These results support regulators concern about financial reporting quality and the recent calls for more independent audit committees.

Key Words: Audit committee composition, Affiliated directors, Auditor reporting behavior, Going-concern reports Data Availability: The data are available from public sources. A list of sample firms is available from the second author.

AUDIT COMMITTEE COMPOSITION AND AUDITOR REPORTING I. INTRODUCTION The role of audit committees continues to be of importance to regulators, the accounting profession, and the business community. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) recently cosponsored a Blue Ribbon Committee to make recommendations for improving the effectiveness of audit committees (BRC 1999). The NYSE- and NASD-sponsored Blue Ribbon Committees first recommendation addresses the composition of audit committees and calls for audit committee members to be independent of management. In this study, we examine the relation between audit committee independence and auditor reporting behavior. More specifically, we consider the relation between: (1) the percentage of audit committee members affiliated with a company (i.e., directors who lack independence) experiencing financial distress, and (2) the likelihood that the auditor will issue a going-concern report. Affiliated directors include current or former officers or employees of the company or of a related entity, relatives of management, professional advisors to the company (e.g., consultants, bank officers, legal counsel), officers of significant suppliers or customers of the company, and interlocking directors.1 The BRC (1999) and the National Association of Corporate Directors (NACD 1999) both suggest that audit committees are likely to be more effective in protecting the credibility of the firms financial reporting if committee members are independent of management. Therefore, we expect that the greater the proportion of the audit committee comprised of affiliated directors, the less the committee will support the auditor in
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negotiations over the type of audit report to issue for a company experiencing financial distress. Our results support this expectation. We find an inverse relation between the likelihood of receiving a going-concern report and the percentage of affiliated directors on the audit committee. This result is robust across numerous model specifications and sensitivity tests. This study provides initial evidence of a relation between one corporate governance mechanism (audit committee composition) and an audit outcome of broad interest, going-concern reporting. Our findings are consistent with the BRCs recent recommendations for completely independent audit committees. The remainder of this paper is organized as follows. Section II provides further background and develops the prediction that we test. The research design appears in Section III, and Section IV discusses sample selection and data. The results follow in Section V. Section VI contains a summary and presents the implications and limitations of our findings. II. BACKGROUND AND EMPIRICAL PREDICTION Regulators often view independent auditors as public watchdogs over Corporate America (Levitt 1998, 5). However, according to Arthur Levitt, chairman of the Securities and Exchange Commission, even these watchdogs need help in performing their vital role, and that responsibility belongs to the audit committee (1998, 5). Birketts (1986) historical analysis suggests that audit committees were established primarily to safeguard the independence of the external auditor, and prior research suggests that audit committees strengthen the auditors position in disputes with management (e.g., Knapp
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1987). More recently, Levitt (2000) has indicated that safeguarding the independence of the accounting profession has never been more important. However, audit committee members do not always perform their duties adequately (POB 1993; Sommer 1991). For example, audit committees may perform inadequately if their members are not independent of management. Members such as affiliated directors may have personal and/or economic dependence on company management (Baysinger and Butler 1985). Audit Committee Composition and Going-Concern Reporting Management may pressure the auditor against issuing a going-concern report. Prior research associates modified reports with stock price declines (Jones 1996), difficulty in raising debt capital (Firth 1980), and a perception by management that a modified report may precipitate the companys failure (i.e., the self-fulfilling prophecy effect) (Mutchler 1984). We therefore expect management to resist a modified report (Mutchler 1984). Consistent with the extant literature (e.g., Antle and Nalebuff 1991; Knapp 1985; Teoh 1992), we view the issuance of a going-concern report as the outcome of an often contentious negotiation among management, the auditor, and the audit committee. Management may imply that issuing a going-concern report will adversely affect the auditor. For example, clients receiving a going-concern report are more likely to switch auditors (Chow and Rice 1982; Geiger et al. 1998; Mutchler 1984). Other adverse consequences might include increased fee pressure, a reduction in the purchase of nonaudit services, and deterioration in the working relationship with incumbent management.
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Prior research suggests that the going-concern reporting decision is among the most difficult and ambiguous audit tasks (Chow et. al. 1987, 129; Carmichael and Pany 1993, 49). Moreover, Salterio and Koonce (1997, 573) find that auditors facing an ambiguous situation are likely to adopt the clients position. Levitt (2000, 5) argues that it is in these gray areas where the temptation to see it the way your client does is subtle, yet real. The difficulty and ambiguity in the going-concern reporting decision may render the auditor susceptible to management pressure. An independent audit committee could help mitigate such pressure by supporting the auditor in disputes with management (Parker 2000). That is, we expect that an audit committee independent of management is more likely to mitigate any management pressure on auditors to issue a clean opinion when a going-concern report is warranted (McMullen 1996). More specifically, we expect that the greater the percentage of affiliated directors on the audit committee, the lower the likelihood of going-concern reports for financially distressed companies. III. RESEARCH DESIGN We test the relation between audit committee composition and auditor reporting using the following logistic regression model: REPORT = b0 + b1 AFFILIATED + b2 DEFAULT + b3 PRIOROPN + b4 SIZE + b5 ZFC + b6 DEVELOP + The variables are defined as follows: (1)

REPORT. The type of audit report issued on the entitys 1994 financial statements (1 = going-concern-modified, 0 = unmodified or modified for a consistency exception). AFFILIATED. The percentage of audit committee members classified as affiliated directors. We expect a negative relation between the percentage of affiliated directors on the audit committee and the receipt of a going-concern report. In addition to the independent variable of interest, we control for the effects of other factors that are likely to affect the auditors propensity to issue a going-concern report: debt default status, prior audit report, company size, level of financial distress, and whether the company is classified as a development stage company. DEFAULT. Chen and Church (1992) find that debt default increases the likelihood the auditor will issue a going-concern report.2 Chen and Church (1992, 31) argue that difficulty in complying with debt agreements, evidenced by missed payments or covenant violations, clarify the companys going-concern problems. Since the auditor is more likely to be blamed for failing to issue a going-concern report after events suggesting that such an opinion may have been appropriate, the cost of failing to issue a goingconcern report when a company is in default is particularly high. We therefore expect default to increase the likelihood the auditor will issue a going-concern report. We use a dummy variable to measure whether the entity is in default before the issuance of the audit report (1 = debt default, 0 = other).3 PRIOROPN. Mutchlers (1985, 675) interviews with practicing auditors suggest that companies receiving a going-concern opinion in the prior year are more likely to
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receive the same opinion in the current year. Nogler (1995, 62) finds that after auditors have issued a going-concern opinion a company must show significant financial improvement to receive a clean opinion in a subsequent year. We expect a going-concern report in the prior year to increase the auditors propensity to issue another goingconcern report in the current year. We use a dummy variable to measure whether the entity received a going-concern report in the preceding year (1 = prior year going-concern report, 0 = other). SIZE. Prior studies find a negative relation between client size and going-concern reports (e.g., Carcello et al. 1995; McKeown et al. 1991; Mutchler et al. 1997). Large companies may be less likely to fail (Carcello et al. 1995, 136), and auditors may hesitate to issue a going-concern report to a large client due to a concern about losing the significant fees that large clients generate (McKeown et al. 1991, 11). We measure size as the natural log of total sales (in thousands of dollars),4 and we expect a negative relation between client size and receipt of a going-concern report. ZFC. Prior studies find that the greater the clients financial distress, the greater the probability of receiving a going-concern report (e.g., Carcello et al. 1995; McKeown et al. 1991; Mutchler et al. 1997). We measure financial distress using Zmijewskis financial condition score (ZFC). Specifically, we use Zmijewskis (1984) financial distress prediction model based on: return on assets, financial leverage, and liquidity, and the PROBIT coefficients from his 40 bankrupt / 800 non-bankrupt estimation sample. Higher ZFC scores indicate greater financial distress, so we expect a positive relation between ZFC and the receipt of a going-concern report. 5
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DEVELOP. Although we control for the clients financial condition (via ZFC score), Rosman et al. (1999, 39) conclude that financial information may not truly reflect current activities and may not be predictive of a start-up companys going-concern status. Given the start-up nature of development stage entities, their financial statements may indicate some degree of distress. The auditor is likely to view the financial distress of a development stage entity as a function of the companys stage in its life cycle rather than as an indication of impending failure. Therefore, after controlling for financial distress level, we expect that development stage entities will be less likely to receive going-concern reports than established entities.6 We identify development stage entities by examining financial statement headings. Per Statement of Financial Accounting Standards No. 7 (FASB 1975), a development stage entity must be clearly identified as such in its financial statement headings. IV. SAMPLE SELECTION AND DATA We use the Compact D/SEC database to identify a sample of public companies experiencing financial distress during 1994 (financial institutions are excluded).7 We focus on distressed companies since prior research indicates that auditors virtually never issue going-concern reports to companies that are not financially distressed (McKeown et al. 1991).8 However, because auditors reporting discretion declines when a company has filed for bankruptcy, we exclude companies that filed for bankruptcy before the issuance of the 1994 audit report (n = 14).9 Our sample includes only companies whose level of financial distress is high enough to prompt auditors to question the entitys going-concern status. Prior research
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indicates that auditors are more likely to issue a going-concern report when the probability of failure (calculated from Zmijewskis (1984) financial distress prediction model) exceeds 28 percent (Davis and Ashton 2000; Krishnan and Krishnan 1996).10 Thus, our sample includes publicly held non-financial companies with a probability of failure above 0.28 (based on 1994 financial data) that had not filed for bankruptcy before the audit report, provided that appropriate proxy and financial statement data are available from the Q-Data SEC files. Table 1 presents the details of our sample selection procedure. Of the 383 companies in our initial sample, almost one-third (117) did not maintain an audit committee and so are excluded from further analysis. Eleven companies are excluded because they were subsidiaries of other sample companies. Since client size (measured in sales) is a control variable, we excluded entities that did not report any sales (n = 10). We excluded seven companies that received a modified report for non-going-concern uncertainties and fifteen companies for miscellaneous other reasons [the prior audit opinion was not available (n = 6); foreign companies (n = 4); outliers (n = 3);11 and no audit opinion was issued in 1994 (n = 2)]. Our final sample includes 223 companies. ____________________ Insert Table 1 about here ____________________ To compute the percentage of affiliated directors, we read the following sections of the proxy statements: (1) biographical background of directors and officers, and (2) certain relationships and related transactions. Companies are required to disclose the
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backgrounds of their directors, including affiliations between the company and the director, in these sections of the proxy statement. Reg. 229.401 of SEC Regulation S-K requires board nominees and directors to disclose family relationships, prior business experience (used to determine if a director was a former officer), and other directorships held (used to determine the existence of an interlocking directorate). In addition, Reg. 229.404 requires disclosure of nominees or directors who have been a member of, or counsel to, law firms the registrant retained during the past year. Also, companies must disclose nominees or directors who are executive officers of suppliers (customers) of the registrant, if the amount of goods or services purchased (sold) exceeds five percent of either partys consolidated gross revenues. V. RESULTS Descriptive Statistics Table 2 presents descriptive statistics, by audit report type, for each of the studys independent variables. Since we later split the percentage of affiliated directors on the audit committee into two components (the percentage of inside directors and the percentage of gray directors), Table 2 also includes descriptive statistics on the percentage of inside directors and gray directors on the audit committee. Inside directors are current officers or employees of the company or of a related entity. Gray directors include former officers or employees of the company or of a related entity, relatives of management, professional advisors to the company (e.g., consultants, bank officers, legal counsel), officers of significant suppliers or customers of the company, and interlocking directors.

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Approximately 37 percent (83 out of 223) of the sample companies received a going-concern report. As expected, companies that receive going-concern reports have on average a smaller percentage of affiliated directors on the audit committee (p < 0.01). For entities receiving a going-concern report, only 19 percent of audit committee members are affiliated directors. By contrast, almost 40 percent of audit committee members are affiliated directors for entities receiving an unmodified report. Evidence on the relation between the percentage of inside directors on the audit committee and the type of audit report (going-concern or clean) is mixed: parametric ttests are insignificant, but the Wilcoxon rank sum test is marginally significant (p < 0.10). However, both tests indicate that companies receiving going-concern reports have on average a smaller percentage of gray directors on the audit committee (p < 0.01). As expected, companies that receive a going-concern report are more likely to be distressed (measured by default status, prior audit report, and ZFC index) and smaller (p < 0.01). There is no significant negative relation between receipt of a going-concern report and development stage. ____________________ Insert Table 2 about here ____________________ Although not reported in a table, we also examine audit committee size and composition for going-concern and unmodified report recipients. Sixty-four percent of the companies receiving a going-concern report have audit committees consisting solely of independent directors, but only 31 percent of the companies receiving an unmodified
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report have fully independent audit committees. There are no noticeable differences in audit committee size between companies receiving going-concern or unmodified reports. Table 3 presents the correlations among the independent variables. The correlations are quite low, generally below 0.3, except for AFFILIATED, INSIDE, and GRAY, which are correlated by construction. As expected, larger firms are less likely to receive prior going-concern audit reports and are less likely to be in development stage. ____________________ Insert Table 3 about here ____________________ Primary Tests Table 4 presents the results of the logistic regression model used to test the relation between audit committee composition and auditor reporting behavior.12 The overall model is highly significant (p < 0.0001), and the models pseudo-R2 is 51 percent. As predicted, the greater the percentage of affiliated directors on the audit committee, the less likely the auditor is to issue a going-concern audit report (p < 0.01).13 The relations between going-concern reports and the control variables are consistent with prior studies. The likelihood of a going-concern report increases with debt default (p < 0.01), a going-concern report in the prior year (p < 0.01), and financial distress level (p < 0.05). The likelihood of a going-concern report declines with company size (p < 0.01), and development stage status (p < 0.01). ____________________ Insert Table 4 about here
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____________________ Sensitivity Analyses Our main model (table 4), controls for key variables where prior literature has documented a relation between the variable and the incidence of going-concern reports. We also performed sensitivity tests controlling for other company and audit firm characteristics that, although not explicitly documented in prior literature, might be correlated with both audit committee composition and the incidence of going-concern reports. Client Industry There may be a relation between industry and both audit committee composition and the incidence of going-concern reports. Since our sample includes companies from all non-financial industry groups, we control for industry by adding 2-digit SIC code dummy variables to the model presented in table 4. In general, the industry dummy variables are not significant (p > 0.10),14 but we continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a goingconcern report (p < 0.01). Stock Exchange Since various stock exchanges have differing requirements regarding audit committee composition, there may be a relation between stock exchange and the percentage of affiliated directors on audit committees. The NYSE proscribes company management or employees (a subset of affiliated directors) from serving on the audit committee. NASDAQs National Market System proscribes members of company
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management or employees from constituting a majority of the audit committee. The requirements as to audit committee composition for companies traded via AMEX, NASDAQs Small Capitalization market, or over-the-counter were either less stringent or non-existent. We add separate dummy variables to identify companies traded on the NYSE (1 = NYSE-listed company, 0 = other) or traded via NASDAQs National Market System (1 = NASDAQ National Market, 0 = other) to the model presented in table 4. Neither the NYSE nor the NASDAQ dummy variable is significant (p > 0.10), but we continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a going-concern report (p < 0.01). Size of Audit Committee Beasley (1996) finds that the likelihood of fraudulent financial reporting increases with board size. Beasleys result suggests that smaller audit committees may be more effective than larger committees. If smaller committees are more effective, audit committee size might be associated with a higher incidence of going-concern reports for financially distressed companies. We add audit committee size to the model presented in table 4. While audit committee size is not significant (p > 0.10), all our other inferences are unaffected. Audit Firm Type Prior research concludes that Big 6 (8) auditors provide higher quality audit service (e.g., DeAngelo 1981; Palmrose 1988). Mutchler et al. (1997, 303) find univariate evidence that Big 6 auditors are more likely than non-Big 6 auditors to issue going-concern
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reports to companies experiencing financial distress. Audit committee composition could also affect the type of audit firm selected. We add audit firm type (1 = Big 6 auditor, 0 = other) to the model presented in table 4. Audit firm type is not significant (p > 0.10), but all our other inferences are unaffected. Audit Firm Industry Specialization Large audit firms, in particular, increasingly emphasize industry specialization in their audit practices (Hogan and Jeter 1999). If industry specialists provide higher quality audits, specialists may be more likely to issue going-concern reports to companies experiencing financial distress. In addition, if independent audit committees are more concerned about audit quality, they may also be more likely to select an industry specialist auditor. We add to the model presented in table 4 audit firm industry specialization measured as a continuous variable: the percentage of industry sales audited by that accounting firm relative to the total industry sales in that same industry. Audit firm industry specialization is not significant (p > 0.10), but we continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a going-concern report (p < 0.01).15 Audit Firm Tenure Auditors who have long served a particular client may establish close relationships with management that impair the auditors professional skepticism. A less independent

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audit committee may also be less likely to challenge or replace an audit firm for diminished professional skepticism. We add audit firm tenure (the number of consecutive years that the accounting firm has served as the companys auditor) to the model presented in table 4.16 The variable measuring audit firm tenure is not significant (p > 0.10), but we continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a going-concern report (p < 0.01). Additional Analyses Partitioning Affiliated Directors into Inside and Gray Prior literature often distinguishes between insiders and gray affiliated directors (e.g., Vicknair et al. 1993; Wright 1996). To this point, we have treated affiliated directors as a single class, consistent with regulators current concern that neither inside directors nor gray directors are independent of management. As additional analyses, we consider the relation between auditor reporting behavior and the percentage of: (1) inside directors, and (2) gray directors. The NYSE has historically proscribed insiders from serving on audit committees, and both the AMEX and NASDAQ have had similar, albeit weaker, requirements. Until recently, none prohibited gray directors from serving on audit committees. However, the major securities exchanges recently adopted the BRC (1999) recommendations that generally proscribe gray directors from serving on audit committees. Therefore, regulators currently view gray directors more like insiders than independent directors. Evidence on the relation between auditor reporting and inside vis-a-vis gray directors may yield insight
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into whether gray directors are more like independent directors (consistent with previous stock exchange treatment of gray directors) or more like insiders (consistent with the BRCs recent recommendations). Table 5 presents the results of our original model except that the percentage of affiliated directors on the audit committee is split into two components: the percentage of inside directors (INSIDE), and the percentage of gray directors (GRAY). As expected, there is a significant negative relation between the percentage of inside directors on the audit committee and the receipt of a going-concern report (p < 0.01). Table 5 also reveals a significant negative relation between the percentage of gray directors and the receipt of a going-concern report (p < 0.01), consistent with regulators concern that led the BRC to recommend that all audit committee members be completely independent of management. ____________________ Insert Table 5 about here ____________________ Interaction between Default Status and Affiliated Directors The composition of the audit committee should be less important when there is less ambiguity, less need for judgment, and so the going-concern decision is more obvious.17 The more justification for issuing a going-concern report: (1) the less likely management pressure can sway the auditor (i.e., the auditor has less need for the independent audit committees support), and (2) the less likely affiliated directors are to side with management.

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Prior literature suggests that default on debt is such an important predictor of whether an auditor issues a going-concern report (e.g., Carcello et al. 1995; Chen and Church 1992), that we expect audit committee composition to have less effect on the auditors report if the company is already in default. To test this conjecture, we run the model presented in table 4 after adding an interaction term between debt default status and the percentage of affiliated directors on the audit committee. Since we expect affiliated directors to have less influence when the company is in default, we expect a positive relation between the interaction term and the incidence of going-concern reports. Consistent with our conjecture that audit committee composition becomes less important when the appropriateness of a going-concern report is more evident, we find that the issuance of a going-concern report is positively associated with the interaction of default status and the percentage of affiliated directors (p < 0.05). We also continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a going-concern report (p < 0.01).18 VI. SUMMARY, IMPLICATIONS, AND LIMITATIONS This study presents evidence on the relation between a corporate governance mechanism (audit committee composition) and auditor going-concern reporting behavior. We find that the greater the percentage of affiliated directors on the audit committee, the lower the likelihood of receiving a going-concern report. Like all research, our study is subject to limitations. Although our results are consistent with the audit committee affecting the audit reporting process, we document association, not causation. While we run numerous sensitivity tests controlling for other
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variables that may be correlated with both audit committee composition and auditor reporting behavior, we may not have successfully identified all potential correlated omitted variables. Notwithstanding these limitations, our results add to the growing body of literature that documents the importance of various corporate governance mechanisms in the financial reporting process (e.g., Beasley 1996). Our evidence supports regulators concern that the audit committee should consist entirely of independent, outside directors. Our results also add to the literature that documents adverse effects of certain client characteristics on auditor reporting behavior. Specifically, our results suggest that auditors are less likely to modify the reports of distressed companies that have a greater percentage of affiliated directors on their audit committees.

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McKeown, J. C., J. F. Mutchler, and W. Hopwood. 1991. Towards an explanation of auditor failure to modify the audit opinions of bankrupt companies. Auditing: A Journal of Practice & Theory 10 (Supplement): 1-13. McMullen, D. A. 1996. Audit committee performance: An investigation of the consequences associated with audit committees. Auditing: A Journal of Practice & Theory 15 (Spring): 87-103. Mutchler, J. F. 1984. Auditors perceptions of the going-concern opinion decision. Auditing: A Journal of Practice & Theory 3 (Spring): 17-30. _____. 1985. A multivariate analysis of the auditors going-concern opinion decision. Journal of Accounting Research 23 (Autumn): 668-682. _____, W. Hopwood, and J. C. McKeown. 1997. The influence of contrary information and mitigating factors on audit opinion decisions on bankrupt companies. Journal of Accounting Research 35 (Autumn): 295-310. National Association of Corporate Directors. 1999. Report of the NACD Blue Ribbon Commission on Audit Committees: A Practical Guide. Washington, D.C. Nogler, G. E. 1995. The resolution of auditor going concern opinions. Auditing: A Journal of Practice & Theory 14 (Fall): 54-73. Palmrose, Z-V. 1986. Audit fees and auditor size: Further evidence. Journal of Accounting Research 24 (Spring): 97-110. _____. 1988. An analysis of auditor litigation and audit service quality. The Accounting Review 63 (January): 55-73.

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Parker, S. 2000. The association between audit committee characteristics and the conservatism of financial reporting. Working paper, Santa Clara University. Public Oversight Board. 1993. In the Public Interest: A Special Report by the Public Oversight Board of the SEC Practice Section, AICPA. Stamford, CT. Rosman, A. J., I. Seol, and S. F. Biggs. 1999. The effect of stage of development and financial health on auditor decision behavior in the going-concern task. Auditing: A Journal of Practice & Theory 18 (Spring): 37-54. Salterio, S. and L. Koonce. 1997. The persuasiveness of audit evidence: The case of accounting policy decisions. Accounting, Organizations and Society 22 (August): 573-587. Sommer, A. A., Jr. 1991. Auditing audit committees: An educational opportunity for auditors. Accounting Horizons 5 (June): 91-93. Stone, M., and J. Rasp. 1991. Tradeoffs in the choice between logit and OLS for accounting choice studies. The Accounting Review 66 (January): 170-187. Teoh, S. H. 1992. Auditor independence, dismissal threats, and the market reaction to auditor switches. Journal of Accounting Research 30 (Spring): 1-23. Vicknair, D., K. Hickman, and K. C. Carnes. 1993. A note on audit committee independence: Evidence from the NYSE on grey area directors. Accounting Horizons 7 (March): 53-57. Wright, D. W. 1996. Evidence on the relation between corporate governance characteristics and the quality of financial reporting. Working paper, University of Michigan.
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Zmijewski, M. E. 1984. Methodological issues related to the estimation of financial distress prediction models. Journal of Accounting Research 22 (Supplement): 5982.

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TABLE 1 Sample Description Initial sample a Firms with no audit committee Subsidiaries of other sample firms Firms with no sales in 1994 Firms received an audit report modified for non-going-concern reasons Prior audit opinion not available Foreign companies Outliers removed No audit opinion issued for 1994 Final sample
a

383 (117) (11) (10) (7) (6) (4) (3) (2) 223

The sample frame is defined as publicly held non-financial companies that are financially distressed (i.e., probability of failure is greater than 0.28, as derived from Zmijewskis financial distress prediction model), based on 1994 financial data.

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TABLE 2 Descriptive Statistics Mean (Median) [Standard Deviation] Going-Concern Report (n = 83) 0.19 (0.00) [0.27] 0.08 (0.00) [0.19] 0.11 (0.00) [0.20] 0.40 (0.00) [0.49] 0.61 (1.00) [0.49] 29.53 (3.56) [70.93] 4.27 (2.09) [7.51] 0.13 (0.00) [0.34] Clean Report (n = 140) 0.39 (0.33) [0.33] 0.10 (0.00) [0.20] 0.29 (0.25) [0.32] 0.06 (0.00) [0.25] 0.09 (0.00) [0.28] 533.14 (54.94) [2,103.25] 1.17 (0.49) [2.11] 0.05 (0.00) [0.22] Difference (GC - Clean)

Variable a AFFILIATED

-0.20 *** (-0.33) *** -0.02 (0.00) * c -0.18 *** (-0.25) *** 0.34 *** (0.00) *** c 0.52 *** (1.00) *** -503.61 *** (-51.38) *** 3.10 *** (1.60) *** 0.08 (0.00)

INSIDE

GRAY

DEFAULT

PRIOROPN

SIZE

ZFC

DEVELOP

* and *** indicate significance at p < 0.10 and p < 0.01, respectively, based on one-tailed tests. a Variable definitions: AFFILIATED = percentage of affiliated directors on the audit committee. Affiliated directors include both inside and gray directors as defined below. INSIDE = percentage of inside directors on the audit committee. Inside directors include current employees of the company or of a related party. GRAY = percentage of gray directors on the audit committee. Gray directors include former employees of the company, relatives of management, and directors with other business relationships. DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0. PRIOROPN = 1 if going-concern-modified report in prior year, else 0. SIZE = total sales (in millions of dollars). ZFC = Zmijewskis (1984) financial condition index. DEVELOP = 1 if firm is a development stage company, else 0. b Tests for differences in the means are based on t-statistics (z-statistics) for continuous variables (proportions). Nonparametric tests for differences in location are based on the Wilcoxon rank sum test. c The Wilcoxon rank sum test does not test whether the medians for the two groups are different. Instead, the test identifies a difference in location, specifically, whether the observations in the two groups are from populations with different medians. Thus, the test indicates a significant difference even though the medians for the two groups are the same.

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TABLE 3 Correlations Among Independent Variables a,b INSIDE ZFC AFFILIATED INSIDE GRAY DEFAULT PRIOROPN SIZE ZFC 0.45*** GRAY DEVELOP 0.80*** -0.16** -0.11 0.06 -0.16** -0.15** -0.02 -0.18*** 0.26*** 0.14** 0.02 0.14** 0.00 -0.37*** -0.09 0.01 -0.11* 0.16** 0.28*** -0.27*** -0.11* -0.08 -0.07 -0.02 0.25*** -0.42*** 0.12* DEFAULT PRIOROPN SIZE

*, **, and *** indicate significance at p < 0.10, p < 0.05, and p < 0.01, respectively. a We report Spearman-rank correlation coefficients for discrete variables (DEFAULT, PRIOROPN, DEVELOP) and Pearson correlations otherwise. b Variable definitions: AFFILIATED = percentage of affiliated directors on the audit committee. INSIDE = percentage of inside directors on the audit committee. GRAY = percentage of gray directors on the audit committee. DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0. PRIOROPN = 1 if going-concern-modified report in prior year, else 0. SIZE = natural log of sales (in thousands). ZFC = Zmijewskis (1984) financial condition index. DEVELOP = 1 if firm is a development stage company, else 0.

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TABLE 4 Logistic Regression of Going-Concern Modified Reports on the Percentage of Affiliated Directors and Control Variables REPORT = b0 + b1 AFFILIATED + b2 DEFAULT + b3 PRIOROPN + b4 SIZE + b5 ZFC + b6 DEVELOP + Variable a INTERCEPT AFFILIATED DEFAULT PRIOROPN SIZE ZFC DEVELOP Number of Observations Chi-Square for Model (6 degrees of freedom) p-value Pseudo R2 = Concordant Pairs Predicted Relation none + + + 223 150.857 0.0001 0.51 93.0% Estimated Coefficients 4.458 -3.040 2.920 2.447 -0.601 0.138 -1.836 Standard Errors 1.231 0.789 0.612 0.500 0.131 0.081 0.767 Wald Chi-Square 13.119*** 14.825*** 22.743*** 23.970*** 21.185*** 2.949** 5.733***

** and *** indicate significance at p < 0.05 and p < 0.01, respectively, based on one-tailed tests. a Variable definitions: AFFILIATED = percentage of affiliated directors on the audit committee. DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0. PRIOROPN = 1 if going-concern-modified report in prior year, else 0. SIZE = natural log of sales (in thousands). ZFC = Zmijewskis (1984) financial condition index. DEVELOP = 1 if firm is a development stage company, else 0.

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TABLE 5 Logistic Regression of Going-Concern Modified Reports on the Percentage of Inside and Gray Directors and Control Variables REPORT = b0 + b1 INSIDE + b2 GRAY + b3 DEFAULT + b4 PRIOROPN + b5 SIZE + b6 ZFC + b7 DEVELOP + Variable a INTERCEPT INSIDE GRAY DEFAULT PRIOROPN SIZE ZFC DEVELOP Number of Observations Chi-Square for Model (7 degrees of freedom) p-value Pseudo R2 = Concordant Pairs Predicted Relation none + + + 223 150.880 0.0001 0.51 93.0% Estimated Coefficients 4.469 -2.899 -3.121 2.913 2.447 -0.602 0.137 -1.832 Standard Errors 1.234 1.196 0.952 0.613 0.500 0.131 0.081 0.767 Wald Chi-Square 13.124*** 5.879*** 10.756*** 22.598*** 23.957*** 21.178*** 2.840** 5.705***

** and *** indicate significance at p < 0.05 and p < 0.01, respectively, based on one-tailed tests. a Variable definitions: INSIDE = percentage of inside directors on the audit committee. GRAY = percentage of gray directors on the audit committee. DEFAULT = 1 if firm is in default or in the process of restructuring debt, else 0. PRIOROPN = 1 if going-concern-modified report in prior year, else 0. SIZE = natural log of sales (in thousands). ZFC = Zmijewskis (1984) financial condition index. DEVELOP = 1 if firm is a development stage company, else 0.

31

ENDNOTES
1

Our definition of an affiliated director is consistent with prior studies (e.g., Beasley

1996; Vicknair et al. 1993; Wright 1996).

2

By adding default status to a going-concern prediction model that contained only

financial variables, Chen and Churchs (1992) achieved R2 increased from 38 percent to 93 percent.
3

Consistent with Chen and Church (1992, 35), we classify as in default a company that:

(1) has missed principal or interest payments, (2) has violated debt covenants, if the covenant violation is not waived or if it is waived for a period of less than one year, or (3) is in the process of restructuring debt.
4

Measuring client size using the natural log of total assets does not affect any of our

inferences, except that the DEVELOP variable is no longer significant (p > 0.10).
5

Prior research has used Zmijewskis (1984) weighted probit model to measure financial

distress (e.g., Bamber et al. 1993; Carcello et al. 1995).

6

Given the limited evidence of a relation between development stage status and going-

concern reports, we repeated the analysis excluding the development stage variable. Our inferences are unaffected.
7

We exclude financial institutions (6000 SIC codes) because most financial distress

prediction models (including ZFC) are not designed to predict distress for financial entities.

32

None of the 96 nonstressed companies (16 of which subsequently filed for bankruptcy)

in McKeown et al. (1991, 7) received a going-concern report.

9

All 14 of these companies received a going-concern report. We tested the sensitivity of our results to various cutoff probabilities (number of

10

observations): 0.35 (201), 0.50 (165), 0.60 (149), 0.70 (132), 0.80 (115), and 0.90 (92). Our results are robust to the level of financial distress employed since we continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a going-concern report (p < 0.01).
11

We deleted three outliers with studentized residuals greater than 3.0 in absolute value.

If we include these outliers, we continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a goingconcern report (p < 0.01).
12

Many of our variables, including AFFILIATED, are right-skewed. Although logistic

regression is robust to non-normality (Maddala 1983; Stone and Rasp 1991), we use an approach similar to Chen and Church (1992, 38), by truncating observations such that the skewness of the distribution is not greater than three. The only variable affected is ZFC. Our inferences are unaffected by truncating (three) extreme values of ZFC (p < 0.01).
13

We also measure the independence of the audit committee using two alternative

dichotomous variables. Using the BRCs (1999) definition, we code the audit committee as non-independent (1 = non-independent, 0 = independent) if at least one member of the committee is an affiliated director. Using a much less conservative definition of audit

33

committee independence, we code the audit committee as non-independent only if a majority of audit committee members are affiliated directors. As expected, we find that auditors are less likely to issue going-concern reports when the audit committee is nonindependent (p < 0.01 for both alternative definitions).
14

Companies in the following SIC codes are marginally more likely to receive going-

concern reports: SIC code 35 (industrial and commercial machinery; computer equipment); SIC code 37 (transportation equipment); and SIC code 87 (engineering, accounting, research, management, and public relations services) (p < 0.10).
15

We also measure audit-firm industry specialization using two dichotomous measures

(Palmrose 1986). We define a firm as an industry specialist if it audits 15 (or 20) percent or more of total industry sales in a particular industry. Neither dichotomous measure of industry specialization is significant, and all our other inferences are unaffected.
16

This sensitivity test is limited to companies that disclosed the length of auditor tenure

in the proxy statement (n = 111).

17

We are indebted to an anonymous referee for suggesting this reasoning. We also examine the interaction between ZFC and the percentage of affiliated directors.

18

While the interaction is not significant (p > 0.10), we continue to find that the greater the percentage of affiliated directors on the audit committee, the lower the probability of receiving a going-concern report (p < 0.01). The interaction terms lack of significance may reflect that auditors are reasonably likely to issue an unmodified report even for companies experiencing high levels of distress. For example, of those companies with a

34

ZFC score above the median (above the 75th percentile), 50.4 percent (38.6 percent) received an unmodified report. By contrast, only 21.4 percent of companies in default received an unmodified report.

35