Going Concern Risk and the Market’s Use of Earnings: Multi-Year Evidence Preceding First-Time Going Concern Opinions

This study examines whether earnings become less informative as firms near a first-time going concern audit opinion. The question is important because the going concern assumption underlies the measurement of earnings, and growing doubt about that assumption may substantially alter the market’s use of earnings information before the auditor formally issues the opinion. Using firms that receive first-time going concern audit opinions, the analysis traces the intertemporal behavior of earnings informativeness for up to six years before the opinion through the opinion year, measuring informativeness through the relation between abnormal stock returns and unexpected earnings. The results show a substantial decline in earnings informativeness as the going concern opinion approaches, with the earnings response coefficient becoming indistinguishable from zero at least two years before, and in the year of, the opinion. The decline occurs earlier and is more pronounced for firms receiving consecutive going concern opinions. Additional tests indicate that known determinants of earnings informativeness explain part, but not all, of the decline, while evidence on abnormal earnings and accruals is more consistent with severe distress or conservative reporting than with systematic income-increasing earnings management. Overall, the findings suggest that the market revises downward the usefulness of earnings well before the issuance of a first-time going concern audit opinion.