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Journal of Business Ethics (2009) 86:347361 DOI 10.

1007/s10551-008-9851-8

Springer 2008

Different Pathways that Suggest Whether Auditors Going Concern Opinions are Ethically Based

Waymond Rodgers Andres Guiral Jose A. Gonzalo

ABSTRACT. Several critics have reopened the continuing debate regarding the credibility of the auditing profession in part because of auditors reluctance to issue warning signals to investors. At the root of auditors lack of independence issues are conflicts of interest resulting from the structural features of auditorclient relationship. The Throughput Model (TP) is advanced to illustrate how ethical issues may be influenced by conflicts of interest. In the first stage, the TP provides an isolation of auditors ethical positions from six ethical different perspectives. In the second stage, previous TP theory is built upon by arguing a simultaneous analysis of how conflicts of interests may induce auditors behavior. We conclude that in the current low litigation risk environment, Professor Waymond Rodgers is a professor at the A. Gary Anderson Graduate School of Management at the University of California, Riverside. He received his B.A. in accounting from Michigan State University, M.B.A. in nance from the University of Detroit, and Ph.D. in accounting from the University of Southern California. He also holds a psychology post-doctorate from the University of Michigan. He is a Certied Public Accountant (CPA) in California and Michigan, with extensive accounting and banking expertise as an auditor at PricewaterhouseCoopers and Ernst & Young, and a commercial loan ofcer at the Union Bank. His primary research areas are auditing, banking, decision analysis, ethics, nancial accounting, and cognitive modeling. Professor Rodgers has published in various prestigious accounting, management, and psychology journals in Australia, Europe, and the United States. He is the recipient of major research grants from the American Society of Engineering Education, Brazilian Research Foundation, Canada Research Foundation, Citibank, Curtin University in Australia, Ford Foundation, National Institute of Health, National Science Foundation, Department of Defense, and the Navy Personnel Research and Development Center. Andres Guiral, Ph.D., is an Associate Professor in the Management Sciences Department at the University of

auditors ethical behavior (both conscious and unconscious) is clearly unbalanced favoring the reluctance to issue warning signals. Finally, we offer a discussion of potential solutions to improve ethical issues. KEY WORDS: auditing, conicts of interest, decision making, ethics, Throughput Model, warning signals

Introduction Society has carved out a vital role for independent auditors, which is absolutely essential for the effective
Alcala, Spain. His research and teaching interests is in decision processes of users of information, such as auditors, nancial analysts and loan ofcers. His current research also focuses on corporate social responsibility, corporate governance, conicts of interests, and trust issues. His research has been published in peer reviewed journals such as Accounting & Finance, Managerial Auditing Journal, Corporate Ownership and Control, Spanish Accounting Review, and Spanish Journal of Finance and Accounting, among others. Jose Antonio Gonzalo is Full Professor in Accounting and Financial Economics at the University of Alcala, Spain. His areas of research interest are accounting and auditing regulation, international accounting, nancial statement analysis, corporate governance and business ethics. He served as President of the European Accounting Association for the period 200304. He chaired the Experts Committe appointed by the Spanish Goverment in 2002 to give advice on the accounting reform in Spain (the White Book for the Spanish Accounting Reform). At present, is co-editor of the Spanish Journal of Finance and Accounting. His previous research has been published in peer reviewed journals such as Accounting and Finance, Accounting Horizons, European Accounting Review and Spanish Accounting Review.

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Waymond Rodgers et al. ethical positions (ethical egoism, deontology, utilitarianism, relativism, ethics of care, and virtue ethics) highlight how different ethical perspectives may be used to explain the auditors opinions. In addition, in this article, we build on the theory of TP by (1) providing a simultaneous analysis regarding potential interactions among the different conicts of interest (e.g., between auditors and clients; auditors and others, including shareholders and third parties) and (2) analyzing auditors reluctance to alert stakeholders considering both auditors intentional and unintentional lack of independence (Bazerman et al., 2002, 2006; Moore et al., 2006). This approach leads us to conclude that due to certain changes in the auditing litigation risk environment, auditors ethical behavior is clearly unbalanced favoring the reluctance to issue warning signals. Finally, we suggest that the consideration of these threats to independence (e.g., between auditors and client relationships) could have important implications for policy makers, nancial statements users and for auditing education purposes. The remainder of the article is organized as follows: Second section provides background material into ethical issues involving auditors opinions. Third section describes the usefulness of the TP and the six ethical pathways. Fourth section examines empirical research regarding social and economic trade-offs to match the different ethical positions used by auditors. Fifth section provides a comprehensive approach to our simultaneous study of the ethical dilemmas faced by auditors. Finally, Sixth section presents the conclusion and implications.

governance of an organization (Duska, 2005). Independence and objectivity are the most fundamental and vital assets possessed by the auditing profession. Auditors opinions regarding an organization ability to continue in existence (i.e., going concern evaluation) is the glue that enables various users of information to make credit and investing decisions. Financial statements users are very concerned whether an entity is in danger of failure. One way to obtain this vital information is to examine auditors going concern opinions regarding a companys ability to continue in existence (Masocha and Weetman, 2005). The going concern assumption is fundamental to the preparation of nancial statements in accordance with generally accepted accounting principles. The claim states that, in the absence of evidence to the contrary, the company should be viewed as continuing in operation indenitely (AICPA, 1988). Typically, the auditor does not encounter any unusual audit opinion problems in situations where the going concern assumption is valid. However, when the continued existence of a rm is in question, the auditor is faced with potentially difcult decisions related to the audit opinion. Approximately 4050% of all companies ling for bankruptcy since SAS 59 was issued failed to receive a going-concern paragraph in the audit opinion on their last nancial statements issued prior to ling for bankruptcy (Venuti, 2004). In this article, we propose that the complexity of auditors opinion requires a more in depth analysis in corporate governance characteristics related to ethical issues regarding auditors opinions to the public in the U.S. and the international community. We believe that not only an identication of the conicts of interests is important, but also an understanding of how these ethical dilemmas interact is also needed. Further, since very little research (e.g., Bazerman et al., 2002) has dealt with ethical issues involving auditors opinions, we propose a cognitive model to explain most of the ethical dilemmas affecting auditors decision-making process. We expand on previous research analyzing auditors ethical behavior regarding auditors opinions in a Throughput Model (TP) (Rodgers, 1997; Rodgers and Gago, 2003, 2004). This model provides a broad conceptual framework for examining the impact that potential economic trade-offs have on the auditors opinions within an ethical context. In this regard, six dominant

Background The Organization for Economic Co-operation and Development (OECD, 2001) states corporate governance refers to the private and public institutions, including laws, regulations and accepted business practices, which together govern the relationship, in a market economy, between corporate managers and entrepreneurs (corporate insiders) on the one hand, and those who invest resources in corporations, on the other. In addition, Roche (2005, p. 9) acclaimed, ethical, sound and transparent corporate governance arrangements, both for the private and public sectors, are an essential pillar of healthy market economies.

Auditors Going Concern Opinions are Ethically Based Much discussion has occurred during the last few years regarding the ethical conduct of auditors in facilitating good corporate governance practices (Moore et al., 2006; Reiter and Williams, 2004; Snyder and McKnight, 2004). Several nancial scandals have implicated auditors lack of independence (WorldCom, Tyco, Enron, Global Crossing, Parmalat, etc.). The nancial press has asked why auditors did not warn investors. In addition, the public has been consistent in its demands for more information in the audit report on the probability of the clients viability (Reiter and Williams, 2004). The going concern evaluation is a clear example of an endless debate inside the auditing profession. The lack of consensus in the profession to assume this responsibility is an old issue. For instance, Campbell and Mutchler (1988) and Brown (1989) stated how some members of the auditing profession believe that the going concern evaluation goes beyond the traditional role of auditors, and requires a judgment about the future prospects of the client. Following this argument, auditors are not more enlightened than others to predict the bankruptcy of a client. More recently, the CPA Journal published an article entitled Weighing the Public Interest. In this article, Bellovary et al. (2006) defend that auditors opinions do not provide adequate and useful information for nancial statements users and recommend that the going concern evaluation should be eliminated. Another position taken is that auditors expert knowledge and their privileged access to non-public information places them in the best position to make a judgment about the ability of the client to continue in existence (Mutchler et al., 1997). However, the fact is that several empirical studies reveal auditors resistance to issue opinions even when the nancial distress of the client is clear.1 Moore et al. (2006) have recently stated that at the root of auditors lack of independence lies in conicts of interest. These authors, using the moral seduction theory, provide persuasive arguments demonstrating that audit rms have strong incentives to avoid the issuance of going concern opinions. In the present article, we adopt Moore et al. points that the structural features of the auditorclient relationship may provoke auditors lack of independence. Although these authors did not focus on the going concern evaluation, they attempted to explain some potential threats to independence and how conicts of interest

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may affect auditors judgment. After considering these features, Moore et al. (2006) concluded that the current accounting reforms, such as the SarbanesOxley Act,2 are not adequate in addressing the independence problem because the new regulation results from an incorrect understanding of the primary source of auditors biases. Therefore, the accounting profession may consider that a major problem lies with an unconscious lack of independence (Bazerman et al., 1997, 2002). Brown et al. (2007) have recently provided evidence supporting auditors unintentional bias since they found that auditors perceive themselves as ethically exemplars.

The Throughput Model and the six ethical pathways The TP model was selected since its six dominant decision making pathways relate to six signicant ethical positions (Rodgers, 1997). That is, this model posits that four major concepts of perception, information, and judgment are implemented in a certain sequence before a decision choice. Further, not all of the four major concepts are necessary in each of the six pathways. The TP approach allows for an analysis of the potential effects of auditors perceptions on their going concern decisions. The only previous research studying ethical auditors

Figure 1. The Throughput Conceptual Model, where P = perception, I = information, J = judgment, and D = decision. The six ethical positions are as follows:(1) P D, ethical egoism; (2) P J D, deontology; (3) I J D, utilitarianism; (4) I P D, relativism; (5) P I J D, virtue ethics; (6) I P J D, ethics of care.

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Waymond Rodgers et al. arrow leading from information to judgment in Figure 1. This stage also involves the possibility of alternative solutions or courses of action. Auditors can retrieve from their knowledge base: (1) ideas and suggestions, (2) examine concepts and pertinent accounting information, and (3) employ ingenuity and creativity. The appraisal of alternatives may be based upon a single criterion or methodology, or a combination of objective criteria or methodologies such as compensatory or non-compensatory weighting schemes (Rodgers, 1992, 1997). The TP draws attention to: (a) only 24 major concepts that are instrumental in arriving at a decision; (b) the order of a particular pathway (and its strength) will greatly inuence the outcome of a decision3 and (c) each decision making pathway relates to a particular ethical position. Previous research of Rodgers and Gago (2001, 2004, 2006) has dealt with the isolation of individual ethical positions rather than providing a simultaneous interpretation of their interactions. We discuss six prominent approaches depicted in the models six general pathways. The six ethical positions discussed below are ethical egoism, deontology, utilitarianism, relativism, virtue ethics, and ethics of care. (1) (2) (3) (4) (5) (6) P D P J D I J D I P D P I J D I P J D

behavior in the going concern evaluation is the work of Moizer (1995). He developed an ethical analysis of the dilemmas (i.e., conicts of interests) faced by auditors using only two streams of Western ethical thought: deontology and consequentialism. His results revealed that an auditing rm issued a clean opinion on a soon to be bankrupt company in order to prevent a collapse in investors condence that would result if a warning signal were issued. In order to clarify several critical pathways, the TP separates the decision making process into its four main parts: perception (P), information (I), judgment (J) and decision choice (D). In this model perception and information are interdependent because information can inuence how the decision-maker frames a problem (perception) or how he/she select the evidence (information) to be used in later decision-making stages (judgment and choice). In the case of auditing, the rst processing stage (see Figure 1) involves the framing of the auditors environment and the use of the information. This includes perceptual biases from auditing sources in the clients environment. It also includes other internal and external informational factors that could affect auditors area of responsibility. The doubleended arrow connecting perception and information in Figure 1 represents this relationship. For example, the auditors review of such items as marketing plans, nancial accounting and non-nancial reports associated with the internal operations should be highly interdependent with auditors perception of responsibility (Rodgers and Housel, 2004). Also, the review of such informational items as government legislation, competitors activities, market and industry indices, and economic trends is correlated to auditors perception. In the judgment stage, nancial and non-nancial information is analyzed and weights are placed on key information items in order to compare alternatives or the criteria across the alternatives. This enables auditors, for example, during the decision choice stage to make or to refuse a going concern opinion, that is, the issuance of an early warning signal to investors and other stakeholders. Auditors employ investigatory and analytical tools to diagnose the cause of a problem. Both deductive and inductive reasoning are required for effective diagnosis, and direct data gathering as shown by the direct

(1) P D. Ethical egoism, in this pathway, asserts that it is necessary and sufcient for an action to be ethically correct in that it maximizes ones self-interest (Rodgers and Gago, 2001). That is, each person is best suited to know his or her best interests. According to this reasoning, a circumstance is perceived (P) and the decision (D) is taken by downplaying previous judgment (J) or information (I). Hence, the most direct pathway to ones desired (ethical egoism) decision is facilitated from P D, since it bypasses any relevant information that may alter ones perspective or dismisses a more thoughtful analysis. (2) P J D. This second route represents the deontology position that is characterized by a focus upon adherence to independent moral rules or

Auditors Going Concern Opinions are Ethically Based duties. In order to make the adequate judgments, we have to understand what our ethical duties are and what correct rules exist to regulate those duties. This viewpoint examines the judgmental effects on decision choices. A basic premise to this pathway is that equal respect must be given to all individuals. For example, Kant (1996) argued that ethical decisions are based on a supreme principle of morality, which is objective, rational, and freely chosen: the categorical imperative. Therefore, the judgment stage implement decision rules that help guide individuals to a decision. Thus, deontologists regard the nature of ethical ideology as permanent and stable, and that compliance with these ideologies denes ethicalness. This pathway ignores additional information (I) in that the rules or laws are encoded in ones framing of the environment. Hence, rules and laws are framed (P) and applied and analyzed in a situation (J) before a decision is made (D). Thus, the decision is induced by a judgment based upon a perceptual circumstance. (3) I J D. The third pathway illustrates the utilitarian position, which is concerned with consequences, as well as the greatest good for the greatest number of people. Therefore, the available information (I) judgment is typical, customary or has been agreed upon, before analysis (J) en route to a decision (D). This pathway is based on collective economic egoism. Utilitarianism is an expansion of ethical egoism in that it is committed to the maximization of the good and the minimization of harm and evil to a society. Further, this theory advocates that society should always produce the greatest possible balance of positive value or the minimum balance of negative value for all individuals affected. Following this argument, a decision is ethically correct when its derived utility is higher than other alternative choices (e.g., costbenet analysis). (4) I P D. The fourth pathway reects the relativism position, which assumes that decisionmakers use themselves or the people around them as their basis for defending ethical standards. That is, this perspective allows individuals to change their ethical beliefs based on situational circumstances. A clash of values and interests, and tensions between what is and what some groups believe can prevent accommodations with other interested parties (Coser, 1957). Ethical relativism is the position that maintains that morality is relative to the norms of

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ones culture. An action that is right or wrong rests upon the moral norms of the society in which it is practiced. The same action may be ethical in one society but be unethical in another. For the ethical relativist, there are no universal moral standards since culture and changing environments dictates the appropriate ethical decision choices. The only moral standards against which an organization or societys practices can be judged are its own (Velasquez, 2006). Relativism is depicted by current information (I) that enhances or modies perception (P) en route to a decision (D). (5) P I J D. The fth route underscores the virtue ethics position, which is the classical Hellenistic tradition, represented by Plato and Aristotle, whereby the cultivation of virtuous traits of character is viewed as amoralitys primary function (it, arguably, has roots in Chinese philosophy that are even more ancient). Virtue ethics focuses on what makes a good person, rather than what makes a good action. In this pathway a situation is perceived (P), which inuences the selection of information (I) that is followed by an analysis or judgment (J) supporting the nal decision (D). In addition, this pathway could be interpreted within the concept of organizational image (Gioia et al., 2000). That is, organizational image suggests that perceptions, which are both internal and external to an organization, can inuence the information gathering process before an analysis is made. Therefore, according to the organizational image, auditors and managers can inuence decisions made by others (e.g., investment managers, pension funds, top management team equity and outside directors, etc). (6) I P J D. The last pathway represents the ethics of care position, which focuses on a willingness to listen to distinct and previously unacknowledged perspectives. In other words, auditors must build solidarity among shareholders, employees, suppliers, customers, and the community. This pathway is similar to the so-called stakeholder theory, which implies companies actions are tempered by not harming any stakeholders (Korsgaard et al., 1997). Further, stakeholders are those who have accepted some dimension of risk as a result of having invested capital (e.g., human or nancial) of value in an organization (Clarkson, 1995). The ethics of care position states that relevant and reliable information (I) inuences ones perception (P) in a particular

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TABLE I

Waymond Rodgers et al. line ISA No. 570 of the International Federation of Accountants (IFAC, 2008). This standard, similarly to other national auditing standards, such as SAS No. 59 of the American Institute of Certied Public Accountants (AICPA, 1988), requires an objective evaluation of clients ability to continue in existence in every audit. SAS 59 requires an auditor to evaluate conditions or events discovered during the engagement that raise questions about the validity of the going-concern assumption. An auditor who concludes that substantial doubt exists about a companys ability to survive as a going concern and who is not satised that managements plans are enough to mitigate these concerns is required to issue a modied (but unqualied) report called a going concern paragraph. According to the TP, the evaluation of the clients capacity to continue in existence may be represented by the ethics of care position (stakeholders position) I P J D. Thus, this pathway emphasizes auditors independence and objectivity as essential attributes to assist in avoiding harm to third party interests. This position allows for all relevant and reliable information to enhance or modify auditors perceptions before an analysis is performed en route to a decision. This process begins with a general identication of the environmental conditions that affect clients activities. After this overview, auditors examine nancial and non-nancial evidence that may cause a substantial doubt regarding the rms continuity. If doubt persists, the search for evidence does not end. Auditors then obtain information about the viability of managements plans and consider whether it is likely the adverse effects will be mitigated (I). Auditors perceptions regarding the likelihood that managements plans can be effectively implemented (P) affect their judgment about clients viability (J). If auditors believe that managements plans overcome doubts regarding the ability to continue, then the release of a warning signal is not required (D). If substantial doubt still continues, auditors must issue a red ag in their audit report. However, when the perception of a clients nancial performance indicators is insignicant or difcult to obtain (prior-years opinions received, long-term deterioration of economic and nancial indicators, lack of effective nancial support, etc.), auditors may consider the results of the evidence-

Ethical incentives: reasons to release or avoid warning signals Panel A. Reasons to release a warning signal in the Audit Report ISA 570 Ethics of care (I P J D) ISA 570 and strong nancial distress Deontology (P J D) High litigation-risk and reputation loss Utilitarianism (I J D) Panel B. Reasons to avoid the issuance of a warning signal in the Audit Report Economic dependence Ethical egoism (P D) Low litigation-risk environment Utilitarianism (I J D) Self-fullling prophecy effect Relativism (I P D) Overestimation of management plans Virtue ethics (P I J D)

situation. The modied perceptions are analyzed (J) (judgment stage) and then a decision is made (D). That is, in this pathway information dominates the perceptual stage in an open minded individual. In the next section of our article, we applied the aforementioned framework and its six major ethical viewpoints to describe and discuss auditors behavior in providing warning signals. This section emphasizes that the existence of certain pathways may be used in auditors opinions by providing some evidence to illustrate how different incentives can inuence an adopted pathway. Social and economic trade-offs matching the different ethical positions used by auditors This section describes the different incentives, which may induce auditors ethical behavior in relationship to provide a warning signal. Table I illustrates a relationship among the six ethical positions depicted by the TP and auditors ethical behavior in their evaluation. Ethical-positions: ethics of care and deontology When assessing client nancial status auditors may follow the international professional auditing guide-

Auditors Going Concern Opinions are Ethically Based gathering procedures that are not covered by auditing standards as unnecessary (I). In other words, the auditors framing of auditing standards as depicted in (P) will outweigh any informational sources that are contrary to the rules. In this particular situation, the deontology viewpoint P J D highlights auditors ethical behavior, where it is expected to release a warning signal to nancial statement users. Thus, in the absence of moral seduction and conicts of interest (Moore et al., 2006), the ethics of care position and the deontology viewpoints would be the ethical dominant pathways in auditors decision making (see Table I, panel A). However, the scarce number of nancially distressed rms receiving going-concern opinions (DeFond et al., 2002; Krishnan and Krishnan, 1996; Venuti, 2004) seems to suggest that auditors may not always comply with auditing standards requirements. Here, the TP can be very useful in understanding what causes auditors to act in a manner that seems unethical or noncoincidental with normative-ethical positions. We argue that six economic and social incentives affecting auditors reporting can be explained by four different ethical positions. These incentives are the followings: (1) Economic dependence; (2) Litigation risk; (3) Reputation loss; (4) The self-fullling prophecy effect; (5) the negative effect of the release of warning signals on clients market value; and (6) the possibility of overestimation of the managements plans. Economic dependence and ethical egoism Auditors may avoid a warning signal due to their economic dependence on their clients (DeAngelo, 1981). From this theoretical viewpoint, auditors could be motivated to act in their perceived selfinterest, i.e., to maintain future quasi-rents specic to a given client relationship (DeAngelo, 1981). The issuance of warning signals and auditors fees from the auditorclient relationship has been found in several empirical studies (Geiger and Rama, 2003; Vanstraelen, 2002). Client size, audit tenure and auditors changes are other surrogates widely used by empirical researchers in measuring auditors economic dependence (Ruiz-Barbadillo et al., 2004). The main conclusion of the empirical research is that the larger the client, the smaller chance of receiving a Litigation risk exposure and reputation loss: utilitarianism

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warning signal (Behn et al., 2001; Geiger and Raghunandan, 2001; Mutchler et al., 1997). Others authors also conclude that auditors are less likely to modify the opinion for new clients and for those that have been clients for a long period of time (Casterella et al., 2000). Further, there is evidence that recent loss of audit clients appears to signicantly moderate the willingness of auditors to disclose a warning signal (Vanstraelen, 2003). Finally, an audit committee with greater governance expertise should reduce the likelihood that the company will dismiss its auditors after the issuance of a warning signal (Uang et al., 2006). When afliated directors dominate the audit committee, management often can put pressure on auditors decision, i.e., to threaten them with switching if they do not issue a clean audit report (Carcello and Neal, 2003). The aforementioned economic incentives (audit fees, audit tenure, opinion shopping, and the characteristics of audit committee) could be explained by the ethical egoism pathway (P D). That is, auditors decisions would be strongly inuenced by the perceived economic consequences of disclosing a warning signal. In this regard, economic dependence may induce auditors to report fewer warning signals in order to retain more clients (see Table I, panel B). Thus, auditors stressed by economic dependence on their clients (P) would downplay the consideration of any negative nancial evidence (I) and its potential effect on the clients viability (J) to issue a clean audit report (D).

Contrary arguments to auditors reluctance to issue a warning signal may be reected by the second and third incentives. These incentives, called risk exposure and loss of reputation, are associated with the costs of two types of audit misclassications (Geiger et al., 1998). A type I error occurs when a company receives a warning signal from its auditors but subsequently remains viable and does not fail. While a type II error occurs when a company enters bankruptcy without receiving a warning signal. Both errors are not technically reporting errors; however, a type II error can result in damaging auditors reputation (Geiger and Raghunandan, 2002). This

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Waymond Rodgers et al. market position (J), deciding to act in its own benet with the issuance of a going concern audit report (D) (see Table I, panel B). However, as shown in Table I, panel B, reasons to avoid the issuance of a warning signal in the audit report may arise in the case of a low litigation exposure where auditors may have an incentive to issue a clean audit report.

loss of reputation could lead to auditors losing present clients and become non competitive in bidding for future clients. Auditors exposure risk is related to the possibility of being sued by their clients or third parties (Lasalle and Anandarajan, 1996). Some empirical evidence supports the notion that the issuance of warning signals to stressed companies may depend on the litigation environment. For example, Citron and Tafer (2004) point out how the increase of opinions during the 1990s in the United Kingdoms nancial distressed rms is directly associated with the introduction of the audit report standard SAS No. 600 issued by the Institute of Chartered Accountants in England & Wales. That is, this statement indicates that there must be reasonable assurance that the nancial statements are free of material misstatement. Further, it adds the phrase whether caused by fraud or error (Citron and Tafer, 2002). Geiger and Raghunandan (2001) also conducted a similar study to the Citron and Tafers (2004) study in the U.S. context. The results indicated that auditors were less likely to have issued prior warning signals for bankrupt companies after the Private Securities Litigation Reform Act of 1995. Furthermore, LaSalle et al. (1996), Lam and Mensah (2006) and Carcello and Palmrose (1994) suggest that most auditors are sensitive to litigations and believe that the issuance of a warning signal would offer some protection in terms of liabilities.4 Costs associated with reputation loss may be considered another incentive to alert investors regarding the clients danger of bankruptcy (Craswell et al., 1995; DeFond et al., 2002). For example, Wilson and Grimlund (1990) analyzed the effects of disciplinary actions by the SEC on auditors reputation. Their results indicate that SEC actions have an adverse effect on audit rms market share relative to their competitors. Thus, in a high risk-litigation environment the utilitarian pathway I J D could be selected by those auditors perceiving that the potential costs of not issuing a clean audit report are higher than issuing a warning signal (loss of audit fees, the self-fullling prophecy effect, etc). Thus, in spite of the economic effects that may cause a negative opinion on the clients nancial statements (I), auditors ethical behavior is primarily based on the negative consequences of lawsuits and bad reputation in its audit

Self-fullling prophecy effect and damage on clients market value: relativism The fourth and the fth incentives are related to the implications that warning signals may cause a reaction in the clients nancial condition and in the economic interests of the nancial statements users. The fourth incentive, called the self-fullling prophecy effect, is based on the argument that the issuance of a warning signal may precipitate a clients failure because of its negative impact on current and potential investors, creditors, suppliers, and customers (Citron and Tafer, 2001). That is, such an opinion can hasten the demise of an already nancially distressed company, reducing a loan ofcers willingness to grant a line of credit to that troubled rm, or increasing the point spread that would be charged if that company was granted a loan. Several lab experiments have been conducted to examine whether loan ofcers differ in their reactions to nancial statements when they are accompanied with warning signal disclosures rather than an unqualied audit report. Several studies conclude that warning signals from auditors affected negatively the loan ofcers risk assessment, the interest rate premium, and the decision whether or not to grant the loan (Guiral-Contreras et al., 2007). Thus, the auditors doubt about a companys ability to continue may contribute to companies receiving less favorable treatment from bankers and others (Nogler, 1995). However, the empirical research on the self-fullling prophecy effect is complex. The main limitation is the fact that it is not possible to observe whether a bankrupt company would still be in existence had auditors decided to issue a clean audit report rather than a warning signal. The latter could explain why the studies of Citron and Tafer (2001), Louwers et al. (1999) and Nogler (1995) did not nd a signicant association between the issuance of warning signals and the

Auditors Going Concern Opinions are Ethically Based subsequent bankruptcy. Although, other studies such as Mutchler (1984) found that six of the 16 interviewed auditors agreed with the self-fullling prophecy argument, and Vanstraelen (2003) demonstrated that warning signals signicantly increase the probability of bankruptcy. The fth motivation to avoid the disclosure of a warning signal is that it may cause economic damages to the nancial statement users investments. Here the main surrogate used by the empirical research is the abnormal stock returns surrounding the release of the auditors report. The empirical research of Carlson et al. (1998), Jones (1996) and Seipel and Tunnell (2000) show that auditors warning signals have information content. For example, Jones (1996) observed the market reaction on a sample of 68 audit reports, which disclosed warning signals, and a sample of 86 unqualied audit reports received by nancially distressed rms. The results indicated that the mean abnormal stock return surrounding the release of the auditors opinion was negative for rms which received warning signals and positive for distressed companies with clean opinions. Both the self-fullling prophecy effect and the fear to provoke a negative market reaction may be explained by the relativism position pathway I P D (see Table I, panel B). Thus, when auditors evaluate a distressed company (I) and presumes that the issuance of a warning signal will precipitate clients failure or contribute to decrease stock returns (P), they may feel responsible for the bankruptcy or potential damage to third parties, downplaying the judgment over the probability of failure, and deciding not to release a warning signal in the audit report (D).

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Anandarajan, 1996; Mutchler, 1984). However, often managements plans include prospective information that attempts to demonstrate the clients ability to overcome the adverse circumstances. Behn et al. (2001) found in a sample of 296 nancially distressed rms that warning signals are strongly linked to publicly available mitigating information regarding the existence of plans to issue equity and to borrow additional funds. Goodman and Braunstein (1995) used the responses of 29 auditors referring to the managements capability of nancially troubled companies (11 rms were given a clean opinion, while 18 received a warning signal). The results indicated that non-nancial variables, such as auditors involvement in helping the client to obtain additional nancing or the assessment of the clients accounting personnel morale, are signicantly related to the issuance of warning signals. Lennox (2005) examined whether audit quality could be affected by executive ofcers afliations. The results showed that afliated clients are more likely than unafliated ones to receive a clean audit report. These examples seem to support that auditors might overestimate the viability of managements plans when evaluating their clients nancial status. In this situation, the virtue ethics position pathway P I J D represents auditors ethical behavior. Thus, when auditors assess clients nancial status personal values from their clients rela-

Ethics of Care I P - J - D

Deontology P-J-D

Overestimation of viability of managements plans and virtue ethics Finally, the sixth incentive is derived from the auditorclients relationship values, such as sympathy, delity, compassion, friendship, etc (Bazerman et al., 2002). These values may affect the auditors decision, provoking a willingness to listen to distinct and previously unacknowledged perspectives (Rodgers and Gago, 2004, 2006). The consideration of managements plans viability as a mitigating evidence is a key factor in the decision of whether to issue or not issue a warning signal (LaSalle and
High litigation risk I-J-D

Figure 2. Auditors ethical positions under a high litigation risk environment. Auditors may have incentives to favor an ethical behavior based on the deontology and ethics of care pathways in order to avoid potential lawsuits and reputation losses. Hence, they may move away from a utilitarian position.

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Waymond Rodgers et al. clients unexpected bankruptcy. Apparently, this could be the case of the U.S. audit market, which is characterized by a high litigation risk environment. That is, many times auditors are named in lawsuits by stakeholders dissatised with a company performance. Hence, an audit context with a high litigation risk exposure might positively inuence auditors behavior in order to protect third parties interests along with professional standards compliance. Figure 2 depicts this hypothetical situation in which auditors would, consciously or unconsciously, have incentives to favor an ethical behavior based on the deontology and ethics of care pathways in order to avoid potential lawsuits and reputation losses. Thus, a high litigation risk environment would contribute to mitigate potential conicts of interests as a result of close auditorclient relationships. Although, lawsuits are quite prominent in the U.S., some researchers have noted certain changes in the auditing environment. For instance, Geiger et al. (2006) conclude that the Private Securities Litigation Reform Act of 1995 has signicantly reduced the litigation exposure of U.S. audit rms. In other contexts, such as the cases of Europe and Asia, the studies of Ruiz-Barbadillo et al. (2004), Vanstraelen (2002) and Lam and Mensah (2006) have found low litigation risk in audit environments like Spain, Belgium and Hong Kong. Low litigation-risk exposure economic dependence may be at the root of a few incentives to issue unqualied audit reports (see Figure 3). In other words, a conscious fear of losing clients could be assumed to induce some auditors unethical behavior based on ethical egoism. Not withstanding, according with Moore et al. (2006), an intentional corruption, such as the case of Arthur Andersen, is often the exception to the rule. That is, when analyzing the conict of interest affecting some auditors economic dependence, two other ethical dilemmas may simultaneously contribute to reinforce auditors reluctance to issue warning signals. First, economic dependence, in terms of the fear of losing clients, may inadvertently lead some auditors to perceive the occurrence of the self-fullling prophecy effect as highly probable. Furthermore, once auditors issue an unqualied audit report for a nancially distressed rm their dependence on that client may even increase based on the relativism position. Moore et al. (2006) refer to this effect as escalation of commitment.

tionship are considered (P). This situation affects the evidence-gathering process, i.e., the consideration of aggravating and mitigating circumstances (I). These personal values have a favorable inuence on the possibility that managements plans can reduce the doubt regarding the clients ability to continue in existence (J). Finally, auditors will decide not to release a warning signal (D).

Ethical dilemmas faced by auditors After isolating some of the incentives that could bring about conicts of interests in the going concern evaluation, another step is necessary in order to understand why auditors sometimes resist issuing these types of opinions. In this regard, emphasis is made to the TP theory by analyzing how the simultaneous interaction of ethical dilemmas may induce auditors decision making. Since one of the major purposes of the auditing profession is to honor public trust in attesting the verity and correctness of nancial statements (Duska and Duska, 2003), audit rms are susceptible of being sued by nancial statement users as a result of a

Self-fulfilling prophecy I -P -D

Economic Dependence P -D

Overestimation Management plans P -I -J -D

Low litigation risk I -J -D

Figure 3. Auditors ethical positions under a low litigation risk environment. A conscious fear of losing clients could result in some auditors unethical behavior leading to one or more of the following conditions: self-fullling prophecy effect (relativism), economic dependence (ethical egoism), and/or overestimation of management plans (virtue ethics).

Auditors Going Concern Opinions are Ethically Based That is, assuming that after the issuance of an unqualied audit report, auditors will keep the client, they will be morally compromised to act in the same unethical way for subsequent audits. Second, economic dependence may also induce auditors to overestimate the reliability of managements plans. This effect, called selective perception, refers to the possibility that auditors incur a selfserving bias as a consequence of tight relations with their clients based on the virtue ethics viewpoint. Moore et al. (2006) and Bazerman et al. (2002) argued that once auditors are dependent on the client, even the most meticulous and honest of auditors may distort clients real nancial situation, being unable to objectively assess the data elaborated by that client. This inadvertent behavior will provoke auditors to rely on managements plans and issue an unqualied audit report. Finally, Figure 3 also indicates how the overestimation of the managements plans may subsequently contribute to reinforce both ethical dilemmas based on economic dependence and the self-fullling prophecy (e.g., escalation of commitment). In sum, our simultaneous analysis suggests that in an environment characterized by a low litigation risk, different conicts of interests may induce auditors to be highly reluctant to issue warning signals. As a result, auditors evaluation of the clients ability to survive may be ethically challenged. In other words, reasons for the issuance of a warning signal could be considered weak in comparison with auditors economic and non-economic incentives to avoid such an opinion. In addition, the negative effects of this dilemma, due to the structural features of auditorclient relationship, are especially relevant in the case of low litigation risk audit environments. Under these conditions, there is very little likelihood that auditors may employ other behaviors (i.e., ethics of care and deontology positions) in their decision making, since both intentional and unintentional nonnormative incentives would set them apart from an objective information-gathering process.

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Conclusions and implications Auditors opinions are at the heart of corporate governance in that it deals with important questions of accountability and control, incomplete contracts

and agency problems, performance and incentives. Legislators, media, and regulators demand that auditors play an active and independent role in corporate governance issues. However, recent nancial scandals have reopened the continuing debate regarding the credibility of the auditing profession. As a result, audit reputation and, in particular, the usefulness of auditors warning signals remains hotly disputed. In this article, we have employed the TP to examine how conicts of interests may induce auditors to be reluctant to release warning signals. In the rst stage, we were able to isolate the six ethical positions depicted by the TP (ethical egoism, deontology, utilitarianism, relativism, ethics of care, and virtue ethics) after considering auditing standards requirements and different economics and cultural incentives. In the second stage, we also investigate the simultaneous interaction of those dilemmas to conclude that in the current low litigation risk environment auditors ethical behavior is clearly unbalanced favoring the reluctance to issue warning signals. Our research has several implications for research and practice. First, our analysis demonstrates potential situations in which auditors lack of independence may be caused by an unconscious bias rather than an intentional corruption. This nding is extremely important and deserves an intensive debate by both practitioners and legislators. In this regard, auditors should monitor virtue ethics behaviors, in which their independence is compromised by a closed proximity to a client (Bazerman et al., 2002; Moore et al., 2006). Even though personal values (e.g., sympathy, delity, compassion, friendship, etc.) might not adversely affect independence from an economic viewpoint, this behavior can lead auditors to reach client-preferred outcomes and lead to the issuance of clean audit reports. Second, auditors should also pay special attention to situations in which they perceive that a warning signal might cause additional damage to an already nancially distressed client (self-fullling prophecy effect, negative stock market reaction, rejection of loan requests, etc.). This fear, illustrated by the relativism perspective, may also cause an unconscious reluctance to alert investors and the rest of stakeholders. Thus, if auditors offer a high sensibility to this fear, the issuance of clean audit reports could contribute to poor decisions made by nancial statements users.

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appraisals or valuation services, legal or expert services unrelated to audit services) and taking jobs with the audited rm. In addition, the Act enforces a mandatory partner audit rotation and auditors are only chosen by the audit committee. Finally, the Sarbanes Oxley Act applies to public companies and the auditors that audit them. 3 In order to provide an empirical foundation for the six decision-making pathways, Rodgers (1997) performed a covariance structural analysis with unobservable variables, based on a survey of loan ofcers and novices perception, information, judgment, and decision. The results of his calculation from his survey, the coefcients, represent the relations between the analyzed variables. A coefcient, r, is a number such that: 1 r + 1. Overall coefcients, greater than 0.5, had more inuence on a concrete pathway, whereas coefcients less than 0.5 had a weak effect on the variables associated with each pathway (Rodgers, 1997). 4 Also, Krishnan and Krishnan (1996) argued that auditors could reduce their exposure to litigation by becoming more selective in their choice of new clients and by withdrawing from high-risk engagements. In addition, the conclusions of Joe (2003) and Frost (1991) indicated that negative events in the press inuenced auditors perception of a clients bankruptcy probability, increasing auditors propensity to release a warning signal as a shield for potential lawsuits.

Once again we believe the auditing profession has the challenge to publicly address whether the selffullling prophecy is a myth or a reality. Third, a high litigation risk environment, depicted by the utilitarianism position, might help to reduce economic dependence and other conicts of interests favoring the issuance of warning signals to stakeholders. However, just increasing litigation risk will be not guarantee auditors ethical behavior. In other words, from a normative-ethical viewpoint auditors decisions (clean vs. warning signals) should be based on a cognizant and objective evaluation of the clients nancial status rather than through the comparison (e.g., a costbenet strategy) between the expected audit fees and the potential cost of litigation and reputation loss. Finally, assuming the argument that the profession is essentially self-correcting, the implications of our approach should be of interest for the auditing profession. In this regard, although the introduction of new measures aim to make auditors more independent, neither the current auditing standards nor the code of ethics (AICPA, IFAC) mention how auditors should face potential conicts of interest such as the self-fullling prophecy and the litigation risk exposure. This research article might aid in improving ethical issues involving auditors opinions. The TP can assist the audit profession, regulators, legislators and other nancial statements users to understand the underlying economic and cultural incentives that make this task really complex. In summary, this article can serve an educational and research purpose (Koehn, 2005), providing an alternative framework to examine the impact of conicts of interest on auditors reporting decisions. Notes
For example, Krishnan and Krishnan (1996), DeFond et al. (2002) and Ruiz-Barbadillo et al. (2004) reported a 6.7, 4 and 3.2% of warning signals in samples of 1,837, 2,428 and 1,099 nancially distressed companies. 2 In an attempt to restore the public image of the auditing profession, the Sarbanes Oxley Act of 2002 has banned audit rms from providing certain types of nonaudit services (e.g., bookkeeping, actuarial services, internal audits, management and human resources services, broker/dealer and investment banking services, information systems design and implementation,
1

Acknowledgments
This study has been carried out with the nancial support of the Spanish National R+D+I Plan through the research projects SEJ2007-62215/ECON, SEJ200400791ECON, SEJ 2006-14021 and a Fulbright postdoctoral grant EX2004-0294. A previous draft of this manuscript was selected as best paper at the 4th Workshop on Corporate Governance at the European Institute for Advanced Studies in Management (EIASM) in Brussels (November 1516, 2007). We thank participants of the 30th European Accounting Annual Congress held in Lisbon 2007.

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Waymond Rodgers University of California, Riverside, CA, U.S.A. E-mail: waymond.rodgers@ucr.edu Andres Guiral and Jose A. Gonzalo Department of Management Sciences, University of Alcala, Alcala de Henares, Madrid 28802, Spain E-mail: andres.guiral@uah.es; josea.gonzalo@uah.es