Managerial ability and the going concern opinion

Abstract

Current audit guidance (AU-C section 570) requires the auditor to modify their opinion in the presence of significant doubt about the firm's ability to continue as a going concern. Prior literature has examined firm and auditor characteristics that act as determinants of the auditor's reporting choice. This paper extends the literature by examining the dynamic role of managerial ability in the auditor's reporting decision. Managerial ability refers to the idiosyncratic impact of management on firm performance. In order to proxy for managerial ability, I use a contemporary measurement that estimates the incremental impact of management on the firm's ability to generate revenues from operational inputs. I posit that managerial ability improves the accuracy of the auditor's opinion through its positive impact on the accuracy of the prospective financial information utilized by the auditor. However, documented results demonstrate that high managerial ability is associated with a clean opinion regardless of the subsequent viability of the firm, simultaneously decreasing the occurrence of false positives and increasing the occurrence of false negatives. I also posit that managerial ability impacts the auditor's reporting decision by changing the way that the auditor utilizes financial condition information. Documented results demonstrate that the auditor's opinion is less sensitive to prominent signals of financial distress when managerial ability is high than when managerial ability is low. My analyses contribute broadly to literature examining managerial ability as well as literature examining the determinants and accuracy of the going concern modified audit report.