Abstract
We examine the association between payout policy changes and going-concern decisions for financially distressed clients. Extant auditing standards indicate that payout reductions, which offer a prospect of short-term cash relief, can potentially mitigate going-concern uncertainty, whereas economic theory suggests payout decreases (increases) convey mixed but mostly negative (positive) signals about a company’s future financial status. We find that, compared with a bankruptcy prediction model over short (not to exceed 1 year) and long (2–3 years) horizons, auditors seem to significantly underreact to payout decreases (i.e., negative signals) but react appropriately to payout increases (i.e., positive signals) in their going-concern decisions. Moreover, auditors are three times more likely to make Type II misclassification errors in payout-decreasing firms than in payout-increasing and no-change firms. We also find that auditors take longer to determine the appropriate opinion for clients with payout changes, especially for those who cut their payouts. Overall, our findings suggest that auditors respond differently to positive and negative signals about companies’ future prospects, reflecting the mixed nature of payout decreases relative to payout increases and the professional standards’ emphasis on the prospect of short-term cash relief from payout reductions.
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Notes
In this paper, payout policy refers to corporate decisions regarding cash dividends and share repurchases. The majority of the literature has assumed that firms use payout changes to signal changes in future earnings or cash flows, despite the presence of other alternative incentives (e.g., agency or tax motives). According to a recent survey paper by Farre-Mensa et al. (2014), in a world of asymmetric information, dividends and repurchases de facto convey information even if they are not meant as a signal. Net payouts can be thought of as the residual cash flow, after investment decisions have been made. Therefore, larger-than-expected payouts imply higher earnings/cash flows. Prior research also suggests that dividend and repurchase announcements have become stronger signals in today’s enhanced disclosure environment (e.g., Louis and White 2007; Aggarwal et al. 2012; Bonaimé 2014).
For example, U.S. auditing standards (e.g., AU Sect. 341) state that the horizon for going-concern assessment is “for a reasonable period of time, not to exceed 1 year beyond the date of the financial statements being audited”. The defined time horizon appears to focus narrowly on short-term prospects, compared with the consideration of “a period that should be at least, but is not limited to, twelve months from the end of the reporting period” under international auditing standards (ISA 570).
Mitigating factors are indicators that offset concerns related to going-concern, whereas contrary factors are indicators that question the going-concern assumption.
We define a company to be in financial distress if it has negative net income or negative cash flows from operations.
According to Mutchler et al. (1997), “this frequency is interpretable as a failure of the audit process by those who define audit failure as a bankruptcy filing soon after receipt of an unmodified opinion.” Nonetheless, as Francis (2011) points out, while the proportion of firms entering bankruptcy without a prior GCM opinion is high, the actual incidence of audit failures (i.e., the number of firms entering bankruptcy without a prior GCM opinion) in the population of audits tends to be low—representing less than one percent of audit engagements.
They also find that the weight of management forecasts is similar in the going-concern and bankruptcy models, consistent with auditors weighing management forecasts to maximize the accuracy of their going-concern opinions. Alternatively, auditor conservatism could be present if the mitigating factors are not significant in the going-concern decision or if auditors place less weight on management forecasts.
Importantly, dividend and repurchase announcements are backed by cash (not stock). The tax burden imposed on both types of distributions is one cost associated with these signaling mechanisms.
The dividend items in Compustat include non-regular dividend payments, such as special dividends and liquidating dividends. We found only three cases of liquidating dividends among our sample of financially distressed firms which we have removed from our final sample presented in Table 1. Including those three observations in our sample has no material effect on our main conclusions.
We omit a multiplier term, (1 + ∆DIV t,q ) in (1), if a firm routinely pays no dividends in the corresponding quarter.
We combine dividend initiations and dividend increases as there are relatively few (40 or 0.36 %) firms that initiate dividends in our financially distressed sample.
However, our results are similar when we broaden the scope of our analyses to include repurchase decreases (see Sect. 5.5).
Dividends constitute a more costly signal, as distributions through repurchases may be subject only to capital gains tax rates that has at times been lower than the ordinary income rates applicable to dividend income.
For ease of exposition, all variables are presented and defined in the “Appendix”.
We identified 702 dividend increases or initiations and 1192 increases in repurchases. Approximately one percent of the firms (120) increased both forms of distributions. Further, if a firm decreased dividends but increased repurchases, it is classified as a decrease in payouts, as dividend changes being stronger signals than repurchases (Asquith and Mullins 1986). However, our results are identical when we drop these few observations (only 56 or 0.5 percent of the sample).
The Altman Z-Score is not a significant determinant in the bankruptcy models. This is consistent with the claim that this measure of bankruptcy risk may lack sufficient statistical power to yield reliable results (e.g., Ohlson 1980; Hillegeist et al. 2004). Following Altman (2000), in untabulated tests we further replace Z-Score with an indicator variable, Z-Score_Dummy, equaling one for companies with Altman Z-scores less than 1.81 for manufacturing companies (1.1 for non-manufacturing companies) and zero otherwise. We find that the coefficient on Z-Score_Dummy is positive and statistically significant across all three bankruptcy models (p < 0.1 for BR_1YR, p < 0.05 for BR_2Y, and p < 0.01 for BR_3Y), while our main inferences are unchanged.
The Types I and II misclassification errors are 6.41 and 3.17 %, respectively, based on the three-year bankruptcy rate.
Note that LOG_SALE, AGE, INVESTMENT, GROWTH, and RE are only present in the first-stage model of payout decisions, but not in our second-stage going-concern/bankruptcy models. These exclusion restrictions are appropriate, as the collinearity between the inverse mills ratio (IMR) and the control variables of the second-stage models is generally low (Larcker and Rusticus 2010). For example, the choice of LOG_SALE (instead of SIZE) significantly relieved concerns about high multicollinearity in the second stage selection models due to the inclusion of the control for selection bias (with VIFs approximating 5.1 for the inverse mills ratio and less than 3.5 for other variables in the second stage models).
Results are available upon request.
The dependent variable is the natural log of audit fees, so the impact of a change in GC from 0 to 1 is given by e0.18 (1.19).
Results are available upon request.
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Acknowledgments
We thank C.-F. Lee (editor), an anonymous reviewer, Michael Ettredge, Julia Higgs, and Bill Hopwood for providing insightful feedback and suggestions. We also thank the workshop participants at Florida Atlantic University and the 2014 American Accounting Association annual meeting.
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Appendix
Appendix
Variable definitions | ||
|---|---|---|
GC | = | 1 if the auditor issues a GCM opinion, and 0 otherwise; |
BR_1YR | = | 1 if the client files for bankruptcy in the 12 months subsequent to the GCM opinion issuance date, and 0 otherwise; |
BR_2YR | = | 1 if the client files for bankruptcy in the 24 months subsequent to the GCM opinion issuance date, and 0 otherwise; |
BR_3YR | = | 1 if the client files for bankruptcy in the 36 months subsequent to the GCM opinion issuance date, and 0 otherwise; |
DIV_DEC | = | 1 if the client decreases, omit, or cease dividend distribution over the current year, and 0 otherwise; |
DIST_INC | = | 1 if the client increases dividend distribution and share repurchase over the current year, and 0 otherwise; |
DIV_INC | = | 1 if the client increases or initiates dividend distribution over the current year, and 0 otherwise; |
REP_INC | = | 1 if the client increases share repurchase over the current year, and 0 otherwise; |
ZSCORE | = | Altman’s (1968) Z-score; |
LLOSS | = | 1 if the client’s net income is negative for the prior year, and 0 otherwise; |
LOGAT | = | Natural logarithm of total assets for the current year; |
ABNRET | = | Firm’s market-adjusted stock return over the current year; |
VOLATILITY | = | Standard deviation of monthly stock returns over the current year; |
LEV | = | Ratio of total long-term debt to total assets for the current year; |
∆LEV | = | Change in LEV from previous year to current year; |
PRIORGC | = | 1 if the company receives a going-concern opinion in the prior year, and 0 otherwise; |
OCF | = | Operating cash flow (Compustat item OANCF) scaled by total assets for the current year; |
INVESTSECU | = | Short- and long-term investment securities (including cash and cash equivalents) (Compustat items CHE and IVPT), scaled by total assets; |
NEWDEBT | = | 1 if the client has a new debt issuance over the subsequent fiscal year (i.e., nonzero Compustat item DLTIS), and 0 otherwise; |
STD_EARN | = | Standard deviation of income before extraordinary items (scaled by total assets at the beginning of the fiscal year) in the past four years (t − 4 to t − 1); |
ROA | = | Return on assets defined as net income scaled by total assets for the current year; |
MB | = | Market value of equity divided by book value of equity; |
∆INVESTMENT | = | Change in INVESTMENT; INVESTMENT is the sum of research and development expenditure, capital expenditure, and acquisition expenditure less cash receipts from sale of property, plant, and equipment scaled by lagged total assets; |
AUDITOR | = | 1 if the auditor is a member of the Big 5 before 2002 or a member of the Big 4 after 2002, and 0 otherwise; |
TENURE | = | The duration of the auditor–client relationship in years starting from 1985; |
DEPENDENCE | = | The ratio of the client’s total fees divided by the total auditor office revenue for year t; |
INDEXPERT | = | 1 if the auditor: (1) has the largest annual market share in an industry, and its annual market share is at least 10 percentage points greater than its closest competitor in a national audit market; or (2) has an annual market share greater than 30 % in an industry in the national audit market, and 0 otherwise; |
LIT | = | 1 if the client operates in a high litigation industry (SIC codes of 2833–2836, 3570–3577, 3600–3674, 5200–5961, and 7370–7370), and 0 otherwise; |
AGE | = | Natural logarithm of the number of years of data for the client firm since the coverage in Compustat; |
GROWTH | = | Annual sales growth in percentage for the current year; |
AUDELAY | = | Natural logarithm of the number of days between the fiscal year-end and auditor opinion date for the current year; |
LNTA | = | Natural logarithm of client’s total assets for the current year; |
HIGHTECH | = | 1 if the client is a high-tech company, and 0 otherwise; |
DA | = | Ratio of total debt to total assets for the current year; |
EXT | = | 1 if the client reports extraordinary items for the current year, and 0 otherwise; |
SQSEG | = | Square root of the number of operating and geographic segments; |
LOSS | = | 1 if the client reports negative earnings for the current year, and 0 otherwise; |
RESTATE | = | 1 if the client restates its financial reports in the current year, and 0 otherwise; |
AOPIN | = | 1 if the client receives a modified opinion other than going-concern on current-year’s financial statements, and 0 otherwise; |
AUDCHG | = | 1 if a client changed auditors during the current year, and 0 |
otherwise; | ||
RECINV | = | Proportion of total assets in accounts receivable and inventory; |
FORGN | = | 1 if the client has foreign operations, and 0 otherwise; |
LIQ | = | Current assets divided by current liabilities |
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Cao, J., Kubick, T.R. & Masli, A.N.S. Do corporate payouts signal going-concern risk for auditors? Evidence from audit reports for companies in financial distress. Rev Quant Finan Acc 49, 599–631 (2017). https://doi.org/10.1007/s11156-016-0602-0
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DOI: https://doi.org/10.1007/s11156-016-0602-0