Are Auditors Professionally Skeptical? Evidence from Auditors’ Going‐Concern Opinions and Management Earnings Forecasts

• DOI: http://doi.org/10.1111/1475-679X.12064
• Date: 01 December 2014
• Published date: 01 December 2014
• Author: CHAN LI,MEI FENG

DOI: 10.1111/1475-679X.12064

Journal of Accounting Research

Vol. 52 No. 5 December 2014

Printed in U.S.A.

Are Auditors Professionally

Skeptical? Evidence from Auditors’

Going-Concern Opinions and

Management Earnings Forecasts

MEI FENG

∗AND CHAN LI

∗

Received 12 October 2011; accepted 2 September 2014

ABSTRACT

We examine whether auditors exercise professional skepticism about manage-

ment earnings forecasts when making going-concern decisions. Using pub-

licly issued management earnings forecasts as a proxy for earnings forecasts

provided by managers to auditors, we find that management earnings fore-

casts are negatively associated with both auditors’ going-concern opinions

and subsequent bankruptcy. The weight auditors put on management fore-

casts in the going-concern decision is not significantly different from the

weight implied in the bankruptcy prediction model. Moreover, compared

with the bankruptcy model, auditors assign a lower weight to management

forecasts they perceive as being less credible, including those (1) issued by

managers who issued optimistic forecasts in the previous two years, and (2)

predicting high earnings increases or high earnings. Taken together, our

∗Katz Graduate School of Business, University of Pittsburgh.

Accepted by Philip Berger. We would like to thank an anonymous referee, Linda

Bamber,Joseph Carcello, Willie Choi, Mike Ettredge, Harry Evans, Joshua Gunn, Chris Hogan,

Karla Johnstone, Adam Koch, Sarah McVay, Gary Peters, Jenny Tucker, Yuan Xie, workshop

participants at Carnegie Mellon University, Tsinghua University, University of Georgia, Uni-

versity of Pittsburgh, University of Wisconsin-Madison, and the conference participants at the

2011 AAA Annual Meeting, 2011 AAA Auditing Midyear Conference, and 2011 AAA FARS

Midyear Conference for their helpful comments and suggestions. We also thank Michele

Frank, Jared Smith, and Amy Yurko for their research assistance.

1061

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

1062 M.FENG AND C.LI

evidence is consistent with auditors being professionally skeptical about man-

agement earnings forecasts when making going-concern decisions.

JEL codes: M41

Keywords: professional skepticism; management forecast; going-concern

1. Introduction

This paper investigates whether auditors exercise professional skepticism

about management earnings forecasts when assessing a client firm’s

going-concern status. Professional skepticism is “an attitude that includes

a questioning mind and a critical assessment of audit evidence” (SAS 1

(AICPA [1972])).1Regulators have long been concerned that auditors rely

too much on what their clients tell them rather than applying professional

skepticism. For example, a lack of professional skepticism is one primary

cause of SEC actions against audit firms (The CPA Journal [1996], Beasley,

Carcello, and Hermanson [2001]). The PCAOB has questioned auditors’

professional skepticism in its summary of 2004–2007 inspections of the

eight largest audit firms (PCAOB [2008a]). Despite the importance of

professional skepticism, little archival evidence exists on this issue, and

experimental studies have not found consistent evidence that auditors

apply professional skepticism when the audit circumstances warrant it

(e.g., McMillan and White [1993], Brown, Peecher, and Solomon [1999],

Gramling [1999], Johnstone, Bedard, and Biggs [2002]).2

Our paper sheds light on auditor professional skepticism due to the joint

effect of three important factors. First, prospective financial information

provided by managers is an important input to auditors when they evaluate

the client’s going-concern status (SAS 59 (AICPA [1988])). Among this

information, management earnings forecasts are particularly important

because, if a financially distressed firm is expected to continue generating

losses, the losses are likely to drain the firm’s limited cash resources and

1Nelson [2009] discusses two perspectives of professional skepticism—“neutral” and “pre-

sumptive doubt.” Neutral perspective indicates that auditors neither assume that management

is dishonest nor assume unquestioned honesty, while “presumptive doubt” means auditors as-

sume some level of dishonesty unless data indicate otherwise (Bell, Peecher, and Solomon

[2005]). Under the “presumptive doubt” perspective, professionally skeptical auditors are

more likely to doubt evidence that an assertion is true than they are to doubt evidence that

an assertion is false, and it is possible for an auditor to be too skeptical (Nelson 2009). This

paper views auditors as being professionally skeptical when they adopt either the “neutral” or

“presumptive doubt” perspective.

2For example, McMillan and White [1993] suggest that auditors’ confirmatory behavior

that favors information confirming rather than refuting their initial assessments may not pre-

vail in the audit judgment process. Their subjects exhibited behavior consistent with focusing

on error-related evidence, which indicates responsiveness to professional skepticism. However,

Brown, Peecher, and Solomon [1999] find that auditors are confirmation prone in ascribing

diagnosticities, regardless of whether they are rewarded for truth discovery or rewarded for

efficiency.