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Review of Quantitative Finance and Accounting
Published in: Review of Quantitative Finance and Accounting 3/2017

13-09-2016 | Original Research

Do corporate payouts signal going-concern risk for auditors? Evidence from audit reports for companies in financial distress

Authors: Jian Cao, Thomas R. Kubick, Adi N. S. Masli

Published in: Review of Quantitative Finance and Accounting | Issue 3/2017

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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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Appendix
Available only for authorised users
Footnotes
1
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).
 
2
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).
 
3
Mitigating factors are indicators that offset concerns related to going-concern, whereas contrary factors are indicators that question the going-concern assumption.
 
4
We define a company to be in financial distress if it has negative net income or negative cash flows from operations.
 
5
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.
 
6
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.
 
7
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.
 
8
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.
 
9
We omit a multiplier term, (1 + ∆DIV t,q ) in (1), if a firm routinely pays no dividends in the corresponding quarter.
 
10
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.
 
11
However, our results are similar when we broaden the scope of our analyses to include repurchase decreases (see Sect. 5.5).
 
12
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.
 
13
For ease of exposition, all variables are presented and defined in the “Appendix”.
 
14
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).
 
15
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.
 
16
The Types I and II misclassification errors are 6.41 and 3.17 %, respectively, based on the three-year bankruptcy rate.
 
17
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).
 
18
Results are available upon request.
 
19
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).
 
20
Results are available upon request.
 
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Metadata
Title
Do corporate payouts signal going-concern risk for auditors? Evidence from audit reports for companies in financial distress
Authors
Jian Cao
Thomas R. Kubick
Adi N. S. Masli
Publication date
13-09-2016
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting / Issue 3/2017
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-016-0602-0

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