Steven Kaplan and Mike Mowchan of School of Accountancy

Transcription

1 Distinguished Lecture Series School of Accountancy W. P. Carey School of Business Arizona State University Steven Kaplan and Mike Mowchan of School of Accountancy W.P. Carey School of Business Arizona State University will discuss Institutional Flight and Market Responses to Going Concern Audit Reports on August 23, :00am in BA199

2 Institutional Flight and Market Responses to Going Concern Audit Reports Steven Kaplan Arizona State University Mike Mowchan Arizona State University and Eric Weisbrod University of Miami Summer Project 2013 August 16, 2013

3 Abstract Questions remain regarding the informativeness of going concern reporting as prior research provides mixed evidence on the reports usefulness. We investigate this further through examination of the incremental market reaction to the first-time GCAR modification. More importantly, we also extend prior work on the determinants and usefulness of GCAR modifications by recognizing that the information content of the GCAR must also be evaluated alongside the decisions of other sophisticated or informed parties in the marketplace. We find that, on average, the market exhibits an incrementally negative short-window abnormal return and incremental increase in market-adjusted share turnover for GCAR firms relative to similarly stressed firms. Furthermore, we find synergies among the behavior of auditors and institutions, such that, financially stressed firms that experience greater institutional flight over the preceding year are more likely to receive a first-time GCAR and that the magnitude of the incremental negative abnormal return and incremental market-adjusted share turnover that are associated with a first-time GCAR depend upon the extent of institutional flight in the preceding year. These findings suggest that auditors make similar assessments about a firm s level of financial distress to those of sophisticated institutions, and that the market benefits from being able to observe, in tandem, the decisions of both parties.

4 I. Introduction Understanding whether and when going concern audit reports (GCARs) are informative to investors has been of longstanding interest to audit researchers (Carson et al. 2013). Under current auditing standards (SAS No. 59, AICPA, 1988), auditors are required to modify their report if, based upon their assessment of relevant information, they have substantial doubt about their client s ability to continue as a going concern. Auditors are charged with this reporting responsibility to provide an early warning by an informed professional that the company is facing high levels of financial stress (Mutchler, 1984; McEnroe and Martens, 2001; Gray et al., 2011). Correspondingly, GCARs are potentially informative because auditors have access to proprietary client information. However, questions remain on the informativeness of going concern reporting, in part, because other publicly available information is often extensive and auditors generally are not considered experts with respect to judging the going concern status of firms (Menon and William, 2010). Using market reactions (e.g., cumulative short-window return), evidence on whether GCARs are informative has been mixed (Elliott, 1982; Dodd et al., 1984; Fleak and Wilson, 1994; Jones, 1996; Blay and Geiger, 2001). Recently, Menon and Williams (2010), using a much larger sample of first-time GCAR firms compared to previous research, document evidence of significant negative short-window abnormal returns in the days around the GCAR announcement and conclude that first-time GCARs reveal value relevant bad news to equity investors. Our study extends this line of research along two dimensions. First, similar to the analysis in some early small-sample studies (e.g. Fleak and Wilson, 1994; Jones, 1996), we recognize that the auditor s report is only one of a number of financial statement items that are announced simultaneously in a firm s annual report. Therefore, the information content of the auditor s

5 GCAR decision must be evaluated relative to other available information about the firm s level of financial stress. In other words, financially stressed firms with similar characteristics to those that receive GCARs may also experience negative abnormal returns around their annual report announcements. Therefore, to provide further evidence on whether investors react to the auditor s GCAR decision as opposed to other information in the annual reports of GCAR firms, we examine the incremental market reaction around the annual report announcement of firms that receive a first-time GCARs, relative to similarly stressed firms where the auditor did not determine that a GCAR modification was warranted. To determine the incremental information contained in GCARs, we examine both abnormal returns and abnormal trading volume around the annual reports of financially stressed firms. In contrast, prior research has primarily examined short window abnormal returns to evaluate the information content of GCARs (Carson et al., 2013). Cready and Hurtt (2002) recommend using both short window abnormal returns and volume measures, in part, to strengthen the power of tests designed to detect investor response. For example, abnormal trading volume provides insight into changes in investors uncertainty or opinion divergence around a public disclosure (e.g. Garfinkel, 2009). We expect GCARs to increase investors uncertainty about firms future prospects relative to other financially stressed non-gcar firms. Second, and perhaps more importantly, we extend prior work on the determinants and usefulness of GCARs by recognizing that the information content of the auditor s GCAR decision must also be evaluated alongside the decisions of other sophisticated or informed parties in the marketplace. Specifically, while prior work finds the reaction to first-time GCARs is associated with the level of institutional holdings, we focus on their trading behavior preceding the auditor s decision to issue a GCAR. In doing so, we recognize that institutional investors are 2

6 not passive market participants who simply consume and react to public announcements. On the contrary, institutional investors are often characterized as informed traders (Puckett and Yan, 2011). Compared to retail investors, institutional investors generally have greater resources and are able to devote more time to the investment task. These advantages may lead to opportunities for institutional investors to generate private information and/or process public information more quickly and completely. 1 Consistent with this view, evidence indicates that the trading skills of institutional investors are better than retail investors (Lakonishok et al., 1992; Gompers and Metrick, 2001; Puckett and Yan, 2011). Furthermore, institutional investors are required to publicly disclose quarterly information about their holdings, which can be used to infer their trading decisions. To the extent that institutional investors are or are perceived to be superior traders, their trading decisions may provide a signal about the firm s future prospects. For example, Parrino et al. (2003) predict and find that aggregate institutional ownership declines (e.g., net selling by institutional investors) in the year prior to forced CEO turnovers, and attribute this relation, in part, to institutional investors being better informed. Furthermore, Ke and Petroni (2004) examine institutional trading behavior prior to a break in a series of earnings increases and present evidence that some institutions may be able to predict the impending bad news and sell in advance of the bad news quarter prior to other investors. Given that institutional investors and the firm s auditor are both sophisticated parties with increased access to information or increased information-processing skills, we expect their decisions to be associated. First, we expect that increases in net selling by institutional investors occurring prior to the audit report, which we refer to as institutional flight, will be positively 1 In this regard, Bushee (2004, p. 29) states, Research has produced persuasive evidence that institutional investors as a group are more sophisticated than retail investors in the sense that they are more likely to see through obvious earnings management. 3

7 associated with the auditor s decision to issue a GCAR. Such an association can arise for a number of reasons. For example, institutional investors likely have greater access to management (Zuckerman and Portanger, 2004). If institutional investors are informed about management, and have serious concerns about management s ability to keep the firm afloat, they may foresee the auditor s GCAR decision and sell in advance of the announcement. Alternately, given that institutional investors trading behavior can be observed by the auditor prior to the auditors GCAR decision, auditors may monitor the trading behavior of institutional investors directly and/or indirectly through discussions with informed parties such as the firm s CFO or director of investor relations and view declining institutional support as a negative signal about the firm s viability. Another possibility is that institutional investors and the auditor might be independently assessing the firm s going concern status and reaching similar conclusions. More importantly, we expect that institutional investors observable trading decisions occurring during the fiscal year will help the market infer the severity of the negative information contained in GCARs. We contend that the informativeness of the GCAR modification is conditional upon the degree to which institutional investors, another sophisticated stakeholder group, are also concerned about the firm s financial condition. We expect that when a financially stressed firm receives a first-time GCAR, the incremental market reaction associated with the GCAR will be stronger when accompanied by greater institutional flight over the prior year. Observed in isolation, a GCAR is a noisy signal about a firm s future economic prospects. While a GCAR indicates that a firm s level of financial stress is sufficient to trigger substantial doubt about the firm s ability to continue, the report neither indicates the strength of doubt nor the extent of the firm s financial stress. When interpreting the GCARs, substantial institutional flight will suggest that the GCAR is a particularly strong signal of severe financial 4

8 stress, which in turn, will lead to more negative short window abnormal returns and enhanced incremental trading volume. Stated concisely, we predict that GCARs should, on average, provide investors with information beyond other publicly available information at the annual report announcement date, and, further, should be more informative when it is corroborated by the previous trading decisions of sophisticated institutions. To test our hypotheses, we examine a sample consisting of financially stressed firms for the fiscal years First, we document that financially stressed firms that experience greater institutional flight over the preceding year are more likely to receive a first-time GCAR, even after controlling for a number of other financial statement and market-based signals known to predict the auditor s GCAR decision. Specifically, controlling for other known determinants of GCARs, an increase of one standard deviation above the mean level of institutional flight increases the likelihood of the auditor issuing a GCAR by 8.3% relative to the base-rate probability. Second, we document that, on average, GCARs contain information that is incremental to other available information at the annual report announcement date. On average, the auditor s decision to issue a GCAR is associated with an incremental five-day size-adjusted abnormal return of -5.6% and a 1.0% increase in market-adjusted share turnover relative to similarly stressed firms. More importantly, we find evidence consistent with the market relying on institutional flight to interpret the informativeness of GCARs. We find that the magnitude of the incremental negative abnormal return associated with a first-time GCAR depends upon the extent of institutional flight in the preceding year. All else equal, the incremental return associated with a first-time GCAR is approximately 1.9% more negative for firms in the 75 th percentile of institutional flight compared with firms in the 25 th percentile of institutional flight in our 5

9 sample. 2 Similarly, when evaluated relative to the sample mean, the incremental marketadjusted turnover associated with a first-time GCAR varies widely with institutional flight, ranging from 0.13% to 1.71% for the 25 th and 75 th percentiles of institutional flight, respectively. Interestingly, increases in institutional flight are also associated with increases in abnormal announcement-window trading volume for financially stressed firms that do not receive a GCAR. Lastly, in supplemental analysis, we find that among firms receiving a first-time GCAR, an increase in institutional ownership in the subsequent fiscal year provides a 21% increase in the probability of GCAR withdrawal relative to the base-rate probability. Our study contributes to the auditing and financial reporting literatures in a number of ways. First, we provide the first modern, large-sample evidence that auditors first-time GCARs provide incremental information to investors beyond other information released at the annual report date. Our work extends Menon and Williams (2010) and should be useful to regulators and others concerned with the auditor s responsibility to report on the firm s going concern status (Carson et al. 2013). Our study is also the first to document that a first-time GCAR generates incremental trading volume at the time of the announcement, which suggests that while the auditor s GCAR decision contains useful information, it may also increase market uncertainty regarding the value of the firm s equity. Untabulated sensitivity analysis further supports this interpretation of our results as we find that first-time GCARs are also associated with an increase in the standard deviation of the firm s daily equity returns over the year surrounding GCAR announcement. While a first-time GCAR modification represents an important auditor communication, it is an ambiguous signal of the firm s future prospects. Our results suggest that the market makes 2 Notably, in contrast to the importance of institutional flight for interpreting the GCAR, we find no evidence that the incremental information contained in the auditor s GCAR decision is conditioned on two other commonly used market measures: fiscal year buy and hold abnormal returns and fiscal year standard deviation in daily returns. 6

10 its assessment of the GCAR s information content by taking into account the past trading behavior of another informed and sophisticated set of investors (e.g., institutional investors). Further, we find that the past trading decisions of these sophisticated investors are more useful in interpreting the auditor s GCAR decision than past changes in the firm s equity price. This is important because other research finds that the market as a whole may have difficulty incorporating information about financial distress (e.g., Campbell et al., 2008; Balakrishnan et al., 2010; Li, 2011). Thus, our results provide new information about how the market determines the informativeness of auditor communications about financial distress, specifically as it relates to the previously unrecognized role for institutional investors in equity markets. Taken as a whole, our results contribute to the literature by demonstrating that the auditor s decision to issue a GCAR, as well as investors interpretation of that decision, do not occur in a vacuum. We find that auditors make similar assessments about a firm s level of financial distress to those of sophisticated institutions, and that the market benefits from being able to observe, in tandem, the decisions of both parties. The remainder of the paper is organized as follows: Section 2 reviews prior literature and develops hypotheses. Section 3 describes the measures of investor anticipation and presents the model specifications, sample selection and descriptives, as well as the results of empirical tests. Section 4 concludes. II. Hypothesis Development Auditors Going Concern Reporting As part of their normal audit activities, auditors are required to assess their client s goingconcern status. Further, at the end of the audit and after considering all relevant information, when auditors have substantial doubt about a client s ability to continue as a going concern for 7

11 one year following the audit report date, they need to include an explanatory paragraph expressing such doubt in their audit report (SAS No. 59, AICPA, 1988). This responsibility reflects the fact that, relative to external third parties, auditors have access to proprietary firm information including management s plans to respond to the firm s financial stress. When auditors modify their report to express their concern, they typically use the phrase, that raise substantial doubt about the Company s ability to continue as a going concern. This is a relatively imprecise statement. For example, auditors do not define nor further describe the meaning of substantial doubt. Because GCARs are potentially consequential to financially stressed firms, their auditors, and their stakeholders, auditors are likely to consider strategic aspects when deciding whether to issue GCARs. Among financially stressed clients, auditors face an elevated risk of litigation by not issuing a GCAR but face an elevated risk of losing the client by issuing a GCAR (Kaplan and Williams, 2013). These strategic considerations have the potential to further increase the noisiness of GCARs as a signal of firms riskiness and/or expected future outcomes. A substantial body of research has investigated auditors decisions to issue GCARs to financially stressed clients (Carson et al. 2013). This research generally shows that multiple financial statement variables such as firm size, leverage, liquidity, and profitability are associated with the auditor s decision to issue a GCAR to a financially stressed firm. In addition, GCARs are associated with market measures such as fiscal year industry-adjusted returns and fiscal year return volatility (DeFond et al. 2002). Audit researchers have also explored whether equity markets find GCARs informative by examining short-window market reactions to GCARs. To the extent that GCARs represent bad news that is new to the market, short-window market returns to GCARs should be negative. 8

12 Evidence on whether GCARs are informative has been mixed (Elliott, 1982; Dodd et al., 1984; Fleak and Wilson, 1994; Jones, 1996; Blay and Geiger, 2001). Recently Menon and Williams (2010), using a much larger sample compared to previous research, document evidence of significant negative short-window abnormal returns in the days around first-time GCAR announcements, and infer from this that investors are responding negatively to the information contained in the GCAR. The vast majority (91%) of the GCAR announcements in their sample coincide with the annual report release date while the authors use the press release for the small fraction of firms that announce the GCAR before issuing the annual report. For many financially stressed firms the annual report release date is also the first announcement of the firm s earnings news. Thus whether the market is responding to the GCAR or to other relevant financial statement and market information at the time of the annual report announcement is somewhat unclear. Menon and Williams (2010) also highlight the importance of institutional investors for the market s response to the GCAR announcement. They find that higher levels of institutional investor ownership are associated with more negative announcement-window abnormal returns Further, the authors provide evidence that aggregate institutional ownership declines during the period spanning the beginning of the quarter in which the GCAR is disclosed though the end of the subsequent quarter. Importantly, this approach does not allow one to determine how much, if any, of the institutional trading behavior occurred before or after the GCAR. Menon and Williams (2010) interpret their evidence as consistent with the GCAR announcement providing useful information to investors, and institutions using their sophistication to interpret the auditor communication. 9

13 Institutional Investors Trading Behavior and Auditors Going Concern Reporting Institutional investors, compared to retail investors, generally have more time and resources (Walther, 1997), and utilize these advantages to engage in more information search, including the search for non-public information (Potter, 1992). Institutional investors also use their advantages to process information more comprehensively, allowing them to interpret available information more accurately (Hand, 1990). Thus, institutional investors are generally considered to be more informed traders (Puckett and Yan, 2011). Further, changes in aggregate institutional holdings are disclosed to the public each calendar quarter via SEC Form 13F, and reflect the net effect of all trades by institutional investors (Utama and Cready, 1997). Net increases or decreases in aggregate institutional holdings over a period of time indicate that institutional investors beliefs about the firm become more or less favorable relative to the overall market over the period. In fact, the view that institutional investors let their buying and selling behavior act as the primary signal indicating their opinion of the firm and their approval of managerial actions is so common that it has been dubbed the Wall Street Rule (Lowenstein, 1988). 3 Consistent with the Wall Street Rule, Parrino et al. (2003) predict and find that aggregate institutional ownership declines (e.g., net selling by institutional investors) in the year prior to forced CEO turnovers, and attribute this relation, in part, to institutional investors being better informed. Furthermore, Ke and Petroni (2004) examine institutional trading behavior prior to a break in a series of earnings increases and present evidence that some institutions may be able to predict the impending bad news and sell prior to other investors. Accordingly, to the extent that institutional investors are able to infer that the auditor will issue a GCAR, which will trigger abnormal negative returns, institutional investors would have an incentive to sell ahead of the bad news. An association between institutional flight and 3 This practice is also commonly described as institutional investors voting with their feet (Parrino et al., 2003). 10

14 GCARs also could arise for other reasons. Institutional investors, even if they are not predicting the auditor s report, might be independently assessing firms going concern status, reaching conclusions similar to auditors, and selling ahead of auditors reports as they can do so anytime during the year while auditors only report on their clients going concern status once a year. Alternatively, auditors could be monitoring the trading behavior of institutional investors directly and/or indirectly through discussions with informed parties such the firm s CFO or director of investor relations. Potential litigation concerns represent an important reason for auditors to particularly attend to institutional investors and changes in their ownership. 4 Based on this discussion, our first prediction is that, contrary to the view of institutional traders as passive market participants who react to auditor-provided information, we expect that institutional trading behavior during the fiscal year will be associated with the auditor s decision to issue a first-time GCAR. Formally, we propose the following hypothesis: H1: Controlling for other determinants of the auditor s GCAR decision, institutional flight over the fiscal year will be positively associated with the auditor subsequently issuing a first-time GCAR in the annual report. If we observe evidence consistent with H1, such that institutional investors trading decisions contain information that is correlated with the auditor s GCAR decision, controlling for publicly available information, this reflects either a) institutions and auditors observe similar private information and view it as a negative signal about the firm s future prospects, or b) institutions possess independent private information that is positively correlated with the auditors private information. Either scenario suggests that institutional trading behavior should 4 Under the Private Securities Litigation Reform Act (PSLRA) of 1995, the plaintiff with the largest stake in the lawsuit becomes the lead plaintiff. In this regard, Choi et al. (2005, p. 869) state, Congress s stated purpose in enacting the lead plaintiff provision was to encourage institutional investors pension funds, mutual funds, hedge funds, etc. to come forward to serve as lead plaintiff. Further, class action lawsuits with an institutional investor serving as the lead plaintiff are less likely to be dismissed and result in larger settlements, compared to lawsuits with an individual serving as the lead plaintiff (Cheng et al., 2010). 11

15 provide a signal about the severity of the information observed by the auditor when the auditor makes its GCAR decision. In other words, we believe that if institutional investors trading decisions are correlated with auditors private information, they should provide incremental information about the severity of the auditor s decision, which will help the market infer the relative informativeness of GCARs. Institutional Investors Trading Behavior, Going Concern Reporting, and the Market Response As discussed above, the usefulness of first-time GCARs to equity markets is an open question, in part, because of the highly structured language typically used in GCARs, as well as, the strategic aspects of the auditor s decision to issue the report. Consequently, GCARs represent noisy signals of elevated risk and/or expected future economic outcomes. In this regard, Carson et al. (2013, p. 356) report that over 98% of firms receiving a GCAR survive (e.g., do not file for bankruptcy) for at least twelve months beyond the date of the audit opinion. While the vast majority of GCAR firms survive, some continue to struggle, some merge with other firms, and others show signs of improvement. From another perspective, among firms filing for bankruptcy, approximately 40% of audit reports immediately prior to the filing did not include a going concern modification (Carson et al., 2013). These findings suggest that the presence or absence of a GCAR is a relatively poor predictor of firms future economic outcomes. Because GCARs represent a noisy signal, equity markets have incentives to understand the relative severity of the signal contained in GCARs for firms future economic outcomes. In this regard, Menon and Williams (2010) contend that equity markets will react more negatively to GCARs citing financing problems. As expected, they find that short-window returns are significantly more negative when auditors cite financing problems in GCARs. We extend this line of research. Our primary objective is to determine whether institutional trading prior to a 12

16 first-time GCAR announcement provides incremental information about the GCAR announcement s severity. Before examining any variation in the informativeness of first-time GCARs, we believe it is important to first extend Menon and Williams (2010) examination of the average information content of first-time GCARs. Specifically, we determine whether, on average, the information contained in first-time GCAR announcements is incremental to other publicly available information at the announcement date for financially stressed firms. Recall that Menon and Williams (2010) do not compare the market reaction of GCAR firms with the market reaction to the annual report announcement for other financially stressed firms. Thus, it is difficult to assess whether the auditor s GCAR decision, or even the auditor s discussion of financing problems in the GCAR, actually provide incremental information beyond other publicly available information at the announcement date. Further, to assess the incremental information content of GCARs in a more comprehensive fashion compared to prior research, we examine both shortwindow abnormal returns and abnormal trading volume. To provide further evidence that, on average, GCARs provide bad news to the equity markets, we propose the following hypotheses: H2a: On average, the abnormal returns around the annual report announcements of firms that receive first-time GCAR modifications are more negative than the announcement-window abnormal returns for similarly distressed firms that do not receive GCAR modifications. H2b: On average, there is higher abnormal trading volume around the annual report announcements of firms that receive first-time GCAR modifications than around those of similarly distressed firms that do not receive GCAR modifications. If we find evidence consistent with these predictions, our results will extend Menon and Williams (2010) in two ways. First, it will provide more powerful evidence that the information contained in first-time GCARs is useful to investors by demonstrating that the information is incremental to other publicly available information. Second, while Cready and Hurtt (2002) 13

17 recommend supplementing return-based tests of information content with trading-volume tests to increase power, abnormal trading volume is also used as a proxy for investor uncertainty or disagreement with respect to public disclosures (e.g., Bamber et al., 1997, Bamber et al., 2011). Given that prior literature demonstrates that abnormal trading volume around earnings announcements reflects investor uncertainty (Bamber et al., 1997), evidence of incremental trading volume associated with first-time GCARs would indicate that first-time GCARs increase investor uncertainty at the time of the annual report announcement. Finally, our primary inquiry relates to the potential that equity markets use institutional investors aggregate trading behavior during the fiscal year to interpret the severity of the information contained in GCARs. Given the noise inherent in the GCAR signal, there may be substantial cross-sectional variation in the informativeness of the GCAR signal. GCARs that signal more severe financial distress should be viewed as containing more bad news than GCARs that are less severe or biased by auditors strategic concerns. Because the usefulness of the auditor s GCAR signal is believed to stem from the auditor s access to private information, one of the most effective ways to gauge the severity of the GCAR signal should be to compare it to signals from other informed/sophisticated parties. If, as predicted in H1, institutional trading behavior contains information that is correlated with the auditor s GCAR decision after controlling for publicly available indicators of financial distress (including prior market signals such as equity returns or volatility), then higher levels of institutional flight during the fiscal year should act to corroborate the severity of the auditor s private information. That is, higher levels of institutional flight during the fiscal year will suggest that the private information that led the auditor to issue the GCAR is a more severe signal of the firm s difficult and risky future. Thus, we expect that equity markets will use institutional trading behavior to interpret the 14

18 severity of GCARs, as the combined signal of both sophisticated/informed parties will be more informative than the noisy GCAR signal in isolation. This discussion leads to the following hypotheses. H3a: Around the annual report announcements of financially stressed firms, the incremental announcement-window abnormal returns associated with a first-time GCAR modification are more negative for firms that experience higher levels of institutional flight over the fiscal year preceding the announcement. H3b: Around the annual report announcements of financially stressed firms, there is greater incremental announcement-window abnormal trading volume associated with a first-time GCAR modification when firms experience higher levels of institutional flight over the fiscal year preceding the announcement. III. Empirical Testing Method and Models We examine the relation between institutional owner flight and several outcomes for financially stressed firms, including auditor reporting as well as short term market reactions based upon returns and trading responses to audit reports. Auditor Reporting Our first analysis focuses on the association between changes in institutional ownership and auditor reporting for financially stressed firms. Our model of auditor reporting, which we refer to as Model 1, is as follows: FIRSTGC = α + β1io_flight + β2io_ye_level + β3low_z + β4ln_age + β5py_bhar + β6std_ret + β7lev + β8clev + β9pyloss + β10scalecfo + β11ln_mve + β12investments + β13reportlag + β14bign + ε, (Model 1) 5 The dependent variable, FIRSTGC, is a binary variable taking the value of one if the auditor issues a first-time GCAR during the year, and zero otherwise. Our primary variable of 5 Formal definitions for all variables also appear in the Appendix. 15

19 interest, IO_FLIGHT, is a ranked measure of percentage institutional ownership change during the four quarters prior to the fiscal year end date, scaled to range from 0 to 1. 6 The four quarter change in institutional ownership ends at the date of the firm s fiscal year-end (FYE), or the most recent calendar quarter prior to the firm s FYE if the firm s FYE date does not fall at the end of a calendar quarter (hereafter, we refer to this date as QYE), 7 and is scaled by the beginning level of institutional ownership. For example, a firm whose institutional ownership level declined from 10% of shares outstanding to 5% of shares outstanding over the fiscal year would have a 50% decrease in institutional ownership. Because our primary focus is on decreases in institutional ownership ( institutional flight ), we assign higher rankings of IO_FLIGHT to firms with greater percentage decreases in institutional ownership. Under H1, IO_FLIGHT is predicted to have a positive coefficient, indicating that increases in institutional flight (i.e. decreases in institutional holdings) are associated with greater GCAR likelihood. To isolate the effect of changes in institutional ownership as opposed to the ownership level at the time of the GCAR announcement, we control for IO_YE_LEVEL, which represents percentage of shares outstanding held by institutions at QYE (Kausar et al., 2006; Menon and Williams, 2010). We also include 12 control variables that have been identified to predict first-time GCARs in prior research (e.g., Dopuch et al., 1987; Mutchler et al., 1997; Reynolds and Francis, 2000; DeFond et al., 2002). 8 Financial distress is an important factor auditors consider in their choice to issue the GCAR. We use an indicator variable, LOW_Z, to indicate firms in extreme 6 Given that some firms may have low initial levels of institutional ownership, we utilize a ranked approach to mitigate the impact of extreme values in our analysis. Our results are robust to alternative measures of institutional flight, which are discussed in further detail in the section describing our robustness tests. 7 The Form13F is required to be filed by institutional investment managers each calendar quarter. Ninety percent of our final sample is comprised of firms with a calendar quarter year-end. The institutional flight measurement period for the remaining 10% of our sample does not perfectly match the firm s fiscal year. For example, our measurement of institutional flight for a January 31, 2011 year-end spans from January 1, 2010 to December 31, Our results remain unchanged if we limit our sample to firms with calendar-quarter fiscal year-ends. 8 The predicted sign for each of these variables are presented in Table 3 and follow the predictions of DeFond et al. (2002). 16

20 financial distress as identified by an Altman (1968) z-score of less than Dopuch et al. (1987) provide evidence that younger firms are more likely to fail. As such, we include the variable LN_AGE which is measured as one plus the log of the number of years the company has been publicly traded as identified by the CRSP database. Dopuch et al. (1987) also proposes that market measures will be associated with auditors going concern reporting decisions. Consequently, we include PY_BHAR and STD_RET, which are measures of the market-adjusted buy and hold abnormal returns and standard deviation of daily returns over the firm s fiscal year, respectively. We also include several financial statement variables that may impact auditors going concern reporting decisions. LEV and CLEV are measures of leverage and change in leverage, respectively, to capture closeness to debt covenant violations. PYLOSS is an indicator variable to identify firms with a loss in the prior fiscal year. We include a measure of current year operating cash flows (SCALECFO), as this represents a signal of the firm s ability to generate cash flows from operations. LN_MVE is a measure of firm size, and is measured as the natural logarithm of market value of equity at fiscal year-end in millions of dollars. INVESTMENTS, measured as the sum of cash and investments scaled by total assets, is included as a proxy for a company s ability to raise cash quickly. As suggested by Raghunandan and Rama (1995) and Carcello et al. (1995), REPORTLAG, measured as the number of days between the fiscal year-end date and the earnings announcement date, is included to capture the time and complexity involved in determining earnings. Lastly, we include an indicator variable for audit firm size, BIGN. While prior research generally suggests that BIGN audit firms (e.g., the largest four or five largest 9 Altman (1968), Altman and La Fleur (1981), and Altman (1984) all reference companies with a z-score below 1.8 as prime candidates for bankruptcy. 17

21 international audit firms) are more likely to issue GCARs, this tendency may be changing (Kaplan and Williams, 2012). Consequently, we do not form an expectation for BIGN. Short-Window Abnormal Returns Our second analysis examines the short-window returns surrounding the 10-K filing date for financially stressed firms. In order to test H2a and H3a, we estimate three versions of the following model: A) A non-interacted version (H2a), B) A version including an interaction term to test H3a, C) A fully-interacted version of the model to test the robustness of H3a. The control variables included in these models are primarily based upon Menon and Williams (2010). Model 2 Version B is as follows: SW_BHAR = α + β1firstgc + β2io_flight + β3firstgc*io_flight + β4io_ye_level +β5py_bhar + β6std_ret + β7low_z + β8scalecfo + β9ln_mve + β10bign + β11ebit_adj + β12chg_ib + β13scaleexit + β14latefiler + ε, (Model 2) The dependent variable, SW_BHAR, is a measure of size-adjusted excess buy-and-hold returns during the (-2, +2) day window surrounding the 10-K (GCAR) issuance date. 10 H2a predicts a negative coefficient for FIRSTGC when the model is estimated without any interaction terms. H3a predicts a negative coefficient on FIRSTGC*IO_FLIGHT, which would indicate that the incremental reaction to a first-time going concern is more negative for firms with higher levels of institutional flight over the preceding fiscal year. 10 These excess returns are computed by taking the firm s buy-and-hold return and subtracting the corresponding size-decile portfolio return for the same period from CRSP. 18

22 The remaining variables in Model 2 are control variables 11, many described above. We include two variables, excluded from the Menon and Williams (2010) model, to control for general market behavior. The first, STD_RET, represents a proxy for information uncertainty. We expect a negative relation between STD_RET and short window returns. We also include PY_BHAR to control for possible momentum effects (Kausar et al., 2009). However, we do not have an expectation for PY_BHAR with respect to short window returns. Model 2 also includes two additional control variables not included in Model 1 that capture aspects of current year financial performance: EBIT_ADJ, and CHG_IB. EBIT_ADJ is a measure of the firm s earnings before interest and taxes scaled by total assets less the industry mean, and CHG_IB represents the change in net income before extraordinary items scaled by total assets. We expect the coefficients on these financial performance variables to be positive. SCALEEXIT, the next control variable, represents a measure of the firm s exit value scaled by market value of equity. This measure is a proxy for the liquidation value of assets. We compute this measure as detailed in Berger et al. (1996) and expect SCALEEXIT to have a positive coefficient. Lastly, the model also includes a control variable, LATEFILER, which takes the value of one if a firm files its 10-K more than five days after the SEC specified filing date. 12 LATEFILER allows investors more time to incorporate news into current stock prices. However, we do not predict a sign for this coefficient as it is unclear whether the additional time to process information for our distressed firm sample will diminish the market reaction to negative or positive news. 11 The predicted sign for each control variable is generally consistent with Menon and Williams (2010). However, for several of our control variables we do not identify an expected sign because we examine a broader set of financially stressed firms compared to Menon and Williams (2010). 12 For years ending before December 15, 2003, the statutory due date is the first non-holiday/business day 90 days after fiscal year-end. For fiscal years ending on or after December 15, 2003, accelerated filers with a market capitalization larger than $75 million are required to file within 75 days of fiscal-year end. For fiscal years ending on or after December 15, 2006, large accelerated filers with a market capitalization larger than $700 million are required to file within 60 days of fiscal-year end. 19

23 Short-Window Abnormal Volume In our third analysis, we examine the short-window abnormal volume surrounding the 10-K filing date for financially stressed firms. Similar to our abnormal return tests, we test H2b and H3b by estimating three versions of the following model: AVOL = α + β1firstgc + β2io_flight + β3firstgc*io_flight + β4io_ye_level + β5py_bhar + β6std_ret + β7low_z + β8scalecfo + β9ln_mve + β10bign + β11ebit_adj + β12abs_chg_ib + β13latefiler + β14abs_sw_bhar + ε, (Model 3) The dependent variable, AVOL, is a measure of excess volume during the (-2, +2) day window surrounding the 10-K (GCAR) issuance date. 13 H2b predicts a positive coefficient for FIRSTGC when the model is estimated without any interaction terms. That is, we expect to observe incremental abnormal trading volume associated with first-time GCAR announcements relative to similarly distressed firms receiving clean opinions. H3b predicts a positive coefficient on FIRSTGC*IO_FLIGHT, which would indicate that the incremental volume associated with a first-time GCAR is greater for firms with higher levels of institutional flight over the preceding fiscal year. The independent variables, except for the inclusion of ABS_SW_BHAR and removal of SCALEEXIT, are all consistent with those presented in Model 2; however, we utilize a number of absolute value measures as we are modeling abnormal volume which prior research has been shown to be influenced by the magnitude of financial statement variables, such as change in 13 Excess volume is defined as the difference between the firm s log-transformed relative volume and the logtransformed relative volume of the CRSP market index. Log transformed relative volume is computed following the procedure described in Campbell and Wasley (1996). This technique is similar to that utilized in Garfinkel and Sokobin (2006) and Garfinkel (2009). 20

24 earnings, regardless of directionality. Variable names that begin with the prefix ABS_ refer to the absolute values of variables previously described above. 14 The predicted signs for our control variables are presented in Table 5. We develop (or refrain from) expectations for the following controls based on prior literature: IO_YE_LEVEL (Utama and Cready, 1997), LN_MVE (Bamber, 1987), STD_RET (Atiase and Bamber, 1994), PY_BHAR (Kausar et al., 2009; Weisbrod, 2013), ABS_SW_BHAR (Karpoff, 1987), Asthana et al. (2004). We expect that ABS_CHG_IB will represent a measure of unexpected financial performance as Kim and Verrecchia (1991) suggest volume increases with the magnitude of unexpected performance. As such, we expect that ABS_CHG_IB to have a positive coefficient as it represents performance relative to the firm s own prior year performance. We include LOW_Z, SCALECFO, EBIT_ADJ, LATEFILER, and BIGN to control for their associations with FIRSTGC but do not develop expectations for their coefficients. Sample Selection The sample for this study consists of financially stressed firms with fiscal years ended in the period 2001 to The sample period begins in 2001 as it represents the year in which Audit Analytics has a comprehensive set of filing information that allows us to identify first-time GCARs. We identify financially stressed firms as those which have negative net income and/or negative cash flow from operations during the fiscal year, consistent with prior research (e.g., Reynolds and Francis, 2000; Defond et al., 2002). Within our sample we identify firms receiving a first-time going concern report as those Audit Analytics recognizes as having a GCAR issued in the current year which did not also receive a GCAR in the previous year. We obtain firm 14 This is consistent with Kim and Verrecchia s 1991 model which suggests trading increases with the absolute magnitude of the surprise in the earnings announcement. 21

25 characteristic data from Compustat, security price and trading information from CRSP, and institutional ownership information from Thomson-Reuters Institutional (13F) Holdings Data. Our initial sample consists of 75,878 firm-year observations in Compustat having received audit opinions for the year as identified in Audit Analytics. Table 1, Panel A describes how we arrived at the final sample. We first exclude firms that do not exhibit signs of financial distress resulting in 31,401 firm-year observations. Of these stressed firms, we exclude those which received a GCAR in the previous year. 15 We further exclude observations that are missing necessary financial data from Compustat or audit information from Audit Analytics. These restrictions reduce our sample to 20,471 stressed (1,856 GCAR) firms. We then merge this dataset with CRSP and Thomson Reuters to obtain annual return information and institutional holdings, respectively. Ensuring all necessary market data are available leads to a final sample of 14,106 firm-year observations for stressed firms, including 13,441 non-gcar and 665 first-time GCAR firms. 16 Table 1, Panel B provides the percentage of GCAR firms in our sample by year, as well as the frequency of observations by year. TABLE 1 GCARS BY YEAR Table 2 contains descriptive information on our final sample of 14,106 financially stressed firms partitioned by GCAR status. As shown, GCAR firms differ from non-gcar firms along a number of financial, market, and reporting related variables. For example, GCAR firms are significantly smaller (mean total assets=$517m /market value of equity=$77m) than non- GCAR firms (mean total assets=$1,680m /market value of equity=$668m). Further, GCAR 15 We focus our analysis on first-time going-concern reports because it represents the first notification from the auditor to investors of the company s elevated likelihood of not remaining a going concern. Our approach is consistent with the following studies: Blay and Geiger (2001), Jones (1996), and Herbohn et al. (2007). For simplicity, unless noted otherwise, GCAR refers to a first-time going concern report. 16 One data requirement unique to our research question, which focuses on changes in institutional ownership, is that we restrict our sample to firms with non-zero institutional ownership four quarters prior (Q -4) to fiscal year-end. This requirement led to a reduction of 1,260 observations of which 60 were GCAR firms. 22

26 firms tend to exhibit signs of greater financial stress (mean ROA= -45%, and z-score= -5.0) in comparison to non-gcar firms (mean ROA= -17%, and z-score= 2.5). GCAR firms also announce earnings much later (mean=79 days) than non-gcar firms (mean=57 days). Regarding variables related to institutional ownership, Table 2 shows that institutional holdings at fiscal year-end are significantly lower among GCAR firms (mean=20%) compared to non-gcar firms (mean=42%). However, mean institutional ownership at fiscal year is higher among firms in our GCAR sample compared to the GCAR sample from Menon and Williams (2010) (mean=13%). The table also shows that 67% of the GCAR firms in our sample exhibit a decrease in institutional ownership over the fiscal year of the audit opinion while the percentage for non-gcar firms is only 46%. The median change in institutional ownership over the fiscal year of audit opinion for GCAR firms is a decrease of 15% while non-gcar firms exhibit an increase of 1%. IO_FLIGHT is significantly greater for GCAR firms (mean =.61, median =.73) compared to non-gcar firms (mean =.49, median =.49). This provides preliminary evidence consistent with H1. TABLE 2 DESCRIPTIVES BY OPINION TYPE Results Predicting GCAR Issuance Table 3 presents the results of estimating Model 1. The table displays a column of the marginal effect of a one standard deviation change in the designated variable. 17 The economic significance of these marginal effects can be interpreted relative to the base-rate probability of first-time GCAR in our sample, which is 2.65%. TABLE 3 GOING CONCERN AUDIT REPORT MODELS 17 The marginal effect for all indicator variables represents a discrete change from 0 to 1. 23