Bungling the Oscars Isn’t the Worst of Accountants’ Mishaps

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Everyone knows by now that the Oscars’ worst snafu ever was caused by PricewaterhouseCoopers’ partner Brian Cullinan handing the wrong envelop to clueless Warren Beatty. Sad. The only attempt of accountants to be hip and glamorous came crashing down when the LaLa Land winner announcement was found out, albeit embarrassingly late, to be a mistake. Cullinan is out of the Oscars.

O.K., so accountants aren’t good at handing envelopes and being quick on their feet. This isn’t included in the CPA exams. But are they better in warning investors about the impending failure of the companies they audit for rather fat fees? Auditing standards require auditors (public accountants) to “… evaluate whether there is substantial doubt about the [audited] entity’s ability to continue as a going concern [financially viable] for a reasonable period of time, not to exceed one year… If the auditor concludes there is substantial doubt [about the company being able to continue operations], he should consider the adequacy of disclosure [to investors] about the entity’s possible inability to continue as a going concern …” Stripped of accounting jargon and legalese, when auditors suspect an impending failure (bankruptcy) of the company they audit, they should include in their report to shareholders a warning to that effect, generally known as “going concern qualification,” or opinion.

The number of major exchanges public companies receiving a going concern qualification is very small: 8 and 9 NYSE companies, and 130 and 148 Nasdaq companies in 2014 and 2013, respectively. The major reasons for such qualification are: operating losses, working capital inadequacy, and negative cash flows. (Audit Analytics, 2015 Going Concerns.) Examples: Lucas Energy, an independent oil & gas company, received a going concern qualification in 2016, as did CorMedix, a pharmaceutical company in 2015. Never heard about these companies? I don’t blame you. Most qualifications are given to small companies.

So, we know that accountants aren’t great at Oscars, but how good are they at predicting impending bankruptcy? Not great either. A survey of academic studies concludes: “In general, research has consistently found that… between 40 and 50 percent of [public] companies going bankrupt in the U.S. did not receive a prior GCO [going concern opinion].” This is known as “type II” error: a client fails without a pre-warning by the auditor. What about “type I” errors—the auditor warns of bankruptcy, but the client refuses to oblige with going under? The same survey concludes: “Prior studies have found that around 80-90 percent of companies receiving a GCO do not fail in the subsequent year.” (see Carson et al., 2013, Audit reporting for going concern uncertainty…, Auditing: A Journal of Practice & Theory, pp. 353-384.) Overall, rather unimpressive record of warning investors of corporate failure by presumed experts having access to company internal information and manager’s knowledge. (Auditors often claim that they have “industry expertise.”)

Another study on going concern qualifications compares auditors’ bankruptcy predictions with those of a statistical model reflecting company characteristics (profitability, financial leverage, etc.), concluding: “Interestingly, auditors predict fewer bankruptcies than our statistical model based solely on observable data…” (Gerakos et al., 2015, The effect of going concern opinions: Prediction vs. inducement, working paper.)

Other studies support accountant’s Oscar performance with respect to fraud, which often leads to bankruptcy. For example, a widely-mentioned research (Dyck, Morse, and Zingales, 2010, Who blows the whistle on corporate fraud? Journal of Finance) on who detects fraud in medium and large public U.S. firms concluded that auditors detect only 14% of fraud cases; the same percentage as reporters. Employees are the Sherlock Holmes’ of fraud detection with 19% of the cases, and the SEC closing the list with a paltry 6% of fraud detection. (Remember Bernie Madoff who was twice investigated by the SEC and emerged clean?)

To be fair to auditors, predicting bankruptcy isn’t their only task. They primarily attest to the fairness and integrity of financial reports. Furthermore, auditors have to consider the consequences of an erroneous warning—qualifying the report of a financially sound company—which can turn into a self-fulfilling prophecy. Nevertheless, being unable to predict bankruptcy better than a bunch of financial indicators (statistical model) should be disconcerting to investors and accountants, even more than messing up the Oscars.

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