The Impact of Going Concern Notes on Firm Downsizing and Exit, Exercises of Accounting

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Going Concern Note, Downsizing and Exit

August 2017

Abstract

This paper investigates the effect of accounting standard requiring financial

statement going concern notes on subsequent bankruptcy as well as the effects on

subsequent corporate downsizing. We examine that extreme poor performing firms are

more likely to disclose going concern uncertainties with a restructuring plan

announcement. But firms with more financial institutional ownership, more managerial

ownership hesitate to disclose uncertainties about business survival. The average going

concern note effect on subsequent bankruptcy is statistically and economically

significant. In particular, there are aggressive downsizing in assets, borrowings and

labor workforce for survival firms as results of proposed solutions to mitigate disclosed

adverse conditions and events. Our going concern note effects estimators are in

comparison with potential outcomes if the going concern note had not been disclosed.

We provide important evidence that newly adopted management going concern

disclosure requirement works as a means to enhance downsizing or exit of extreme poor

performing firms by informing market participants.

Keywords: going-concern note; accounting standards; downsizing; exit

JEL classification: M41, M48, G 33 , G 34.

After the sensational Enron and WorldCom bankruptcies, Raghunandan and

Subramanyam (2003) find that a model that uses both financial statement and market

information is an unambiguously superior predictor of bankruptcy than the going

concern opinion. However, the going concern opinion has incremental predictive ability

for bankruptcy beyond both financial statement and market-driven variables. Also,

auditors appear to underweight stock price information and overweight conventional

financial ratios and firm size when issuing going concern opinions. Recently, Carson,

Fargher, Geiger, Lennox, Raghunandan, and Willekens(2013) show that the percentage

of US public companies received a going concern opinion has risen and that there is a

high probability that a going concern audit report indeed leads to a survival problem.

Audit going concern reporting is known as its self-fulfilling prophecy effect. The

self-fulfilling prophecy effect is the adverse effects of the auditor’s public expression of

doubt about a client’s ability to remain a going concern itself on the company’s fate. This

leads auditors to issue fewer going-concern opinions. Regarding this issue, Kida's (1980)

survey suggests that a going concern opinion might bring a company to financial

distress. Tucker, Matsumura and Subramanyam (2003) argue that a firm can attempt

to avoid a going concern opinion for its potential self-fulfilling prophecy effect by

switching auditors when the auditor conveys the intention to issue a going-concern

opinion. In the regulatory context of Belgium, Vanstraelen (2003) examines the

self-fulfilling prophecy effect.

On the other hand, given quite a number of bankruptcies without prior warning

from either the management or the auditors, it is debated that more information is

needed from management to inform investors and creditors of pressing firm failure.

Conversely, it is argued that voluntary management MD&A disclosures provide

sufficient information in predicting a firm's ability to continue as a going concern.

Mayew, Sethuraman and Venkatachalam (2015) find that both management's opinion

about going concern reported in the MD&A and the linguistic tone of the MD&A

together provide significant explanatory power in predicting whether a firm will cease

as a going concern. Moreover, the predictive ability of MD&A disclosure is incremental

to financial ratios, market-based variables, and even the auditor's going concern opinion.

In contrast, only 27% had specific going concern disclosure in their MD&A prior to

bankruptcy in Canada where accounting standard mandates management going

concern disclosure (Ontario Securities Commission, 2010). In addition, Uang, Citron,

Sudarsanam and Taffler (2006) find that the mandatory management going concern

statements do not provide incrementally information for predicting bankruptcy.

Therefore, it remains controversial whether mandatory management going concern

opinion. Downsizing is also a significant feature of management going concern

disclosure. Importantly, we find that assets, debt and workforce shrink sharply as

results of proposed restructuring solutions to mitigate disclosed adverse conditions and

events about going concern uncertainties. This suggests that managers of firms

disclosing uncertainties about business survival recognize that they themselves must

downsize sharply; otherwise they have to exit.

This paper contributes to empirical literature on going concern disclosures as follows.

First, we provide important evidence on the efficiency of accounting standard requiring

management’s disclosure regarding going concern uncertainties. More importantly, the

mandatory management going concern disclosure requirement applied in Japan

provides a solution with the aim of forcing extreme poor performing firms to

restructure or to exit by informing market participants in due time, whereas impaired

banks and troubled firms have perverse incentives to avoid or to delay bankruptcy. In

an environment of excess capacity, extreme poor performing firms ought to downsize

or exit. Mandatory management going concern disclosure requirement works as a part

of market mechanisms by informing market participants in selecting firms. Also, we

find that a firm with more financial institutional ownership, with more management

ownership is less likely to disclose uncertainties about business survival. This suggests

incidence of perverse incentives of financial institutions and top management with more

stakes. Finally, we explore more appropriate methodologies to deal with the endogeneity

of going concern notes. Our estimators are robust in an environment with endogeneity

and omitted variables.

The paper is organized as follows. In Section 2, we review the introduction of going

concern disclosure in Japan. In Section 3, we describe our econometric methodologies.

Section 4 describes the data and empirical results. In Section 5, we conclude.

2. Restructuring, Bankruptcy and Going Concern Disclosure in Japan

It was viewed as a striking aspect of the Japanese main bank system: it provided a

flexible and more effective private alternative to bankruptcy reorganization, for dealing

with financial distress and debt restructurings. Till the early the 1990s, bankruptcy

resolutions were rarely employed for large Japanese firms. Most financially distressed

large firms in Japan restructured troubled debt privately with main bank intervention,

rather than through formal bankruptcy.

Since the late 1990s, bankruptcy filings in Japan substantially increased and this is

quite similar to the bankruptcy wave in the 1980s US downturn of economy. Most of

bankruptcy filings of listed industrial firms are clustered in the years 1997–2002, as

uncertainties emerged as an important issue for revising accounting and auditing

standards in 1999. For details, Misawa (2005) analyzed the Japanese government's

positions and makes comments on the problems and issues indicated in the MOF

(Ministry of Finance) Memorandum entitled "Adoption of International Accounting

Standards in Japan".

The Accounting Standards Board of Japan enacted a requirement for both

management disclosure and audit opinions about going concern uncertainties since

March 1st 2003^2 .. After that, the top management of a list company has been required

to disclose its going concern status. And the auditors assess the top management’s

disclosure on going concern uncertainties. In 2002, the JICPA (Japanese Institute of

Certified Public Accountants) Audit Standard Committee Report 74 provides detailed

guidance regarding adverse conditions and events that may raise substantial doubt

about an entity’s ability to continue as a going concern. Management should disclose

going concern uncertainties in financial statement notes with proposed solutions if

adverse conditions and events exist and continue. Besides going concern note, related

information is also required to be adequately disclosed in the parts of “risks of business,

(^2) Without any audit standards on going concern uncertainties, auditors had to issue

special notes to express doubt about a client’s business continuance ability. Till 1999, the Japan Corporate Accounting Principles placed importance on the profit and loss calculation for a particular period, assuming that the particular period and the particular corporation was of on-going concern, as augured in Misawa (2005).

etc.” and “analysis of financial position, operating results, and cash flows" under the

"business condition" section in the Annual Securities Report if a firm is at the risk of

adverse conditions and events. This is also mandatory requirement in accordance with

the Security Exchange Law.

The Report 74 also provides specific going concern risk indications related to (1)

financial ratios, (2) financial difficulties, (3) operating activities, (4) others as follows.

First, the management should consider the risk of the validity of the going concern

assumption by examining warning signs from the financial statements, such as,

substantial decline in sales, consecutive operating losses or consecutive negative

operating cash flow, substantial operating losses, ordinary losses or net losses,

substantial negative operating cash flow, total liability exceeding assets. Regarding

financial difficulties, management should assess going concern risk if it is difficult to

repay operating debt, to meet covenants of loans, to pay off corporate bonds, to raise

new money, to sell major asset as scheduled, or, to pay dividends. Also, a firm should

evaluate its ability to continue operations in cases of the termination of transactions or

withdrawing trade credits by the main suppliers, substantial losses of market share or

favorite customers, lapses of indispensable patents, losses of core personnel, damages,

losses, or, disposal of indispensable assets, or, substantial regulatory imposition on

as a means to force extreme poor performing firms to downsize or to exit. Along the line

of this, we investigate the effects of management going concern note on downsizing and

exit.

3. Methodologies and Hypotheses

Now we turn to our econometric methodologies and hypotheses. Some firms issue

financial statement notes about going concern uncertainties and the rest do not issue

going concern notes. We would like to know the likelihoods of exit for firms with

financial statement going concern notes. However, it is not possible to observe what

would have happened to firms that disclosed going concern uncertainties if had they not

disclosed them. Moreover, management going concern uncertainty disclosures are

endogenously determined. In this paper, we employ methodologies which estimators are

robust in an environment with endogeneity and omitted variables as follows.

Treatment-effects estimation

It would be ideal for us to observe the bankruptcy probability when a firm issues a

going concern financial statement note (which we denote as P gcn), and the bankruptcy

probability conditional on no going concern financial statement note (which we denote

as P clean). We could then average the difference between P gcn and P clean across all the

sample firms to obtain a measure of the average impact of going concern notes.

Unfortunately, it is impossible to observe a specific firm having a going concern note and

having a clean note. Also, it is impossible to observe the firm’s bankruptcy probability

under both circumstances.

We employ the treatment-effect estimators to estimate the efficacy of going concern

notes using observational data. Consider firm 𝑖 which has a clean note so that we

observe outcome y clean,i. What would y gcn,i be for the same firm if it issues a note on going

concern uncertainties? We call y gcn,i the potential outcome or counterfactual for that firm

with a clean report. For firm j with a going concern note, we observe y gcn,j , so y clean,j would

be the counterfactual outcome. Treatment-effect methods can account for this

missing-data problem.

We estimate three parameters. The potential-bankruptcy means (POmeans) are the

means of y gcn and y clean. The average going concern note effect (ATE) is the mean of the

difference (y gcn - y clean ). Finally, the average conditional effect on bankruptcy of a going

concern note (ATET) is the mean of the difference (y gcn - y clean ) among the firms that

actually report a going concern note.

y gcn or y clean is the observed outcome variable, t (1 for a going concern note, 0 for a clean

to either x or z. p(z, t, γ) denotes the conditional probability model for the probability

that a firm has a going concern note conditional on covariates z. The functional form is

the normal cumulative distribution function Φ(zγ).

The three parameters of interest are

(1) the potential-bankruptcy mean (POmean) 𝛼 0 = 𝐸(𝑦 0 )

(2) the average going concern note affect (ATE) τ = 𝐸(𝑦 1 − 𝑦 0 ) ; and

(3) the average going concern note effect conditional on going concern note (ATET)

δ = 𝐸(𝑦𝑡|𝑡 = 1).

The potential bankruptcy estimators and the average going concern note effect

estimators use normalized inverse probability weights. The unnormalized weights for

firm i and going concern disclosure t are 𝑑𝑖(𝑡) = 𝑡𝑖(𝑡)/𝑝(𝑧𝑖, 𝑡, 𝛾̂), and the normalized

weights are 𝑑̅𝑖 (𝑡) = 𝑁𝑡𝑑𝑖(𝑡)/ ∑ 𝑁𝑖 𝑑𝑖(𝑡). Here, 𝑁𝑡 is the number of observations in going

concern disclosure t, and 𝑡𝑖(𝑡) = 1 𝑖𝑓 𝑡𝑖 (𝑡) = 𝑡; 𝑡𝑖(𝑡) = 0 𝑖𝑓 𝑡𝑖 (𝑡) ≠ 𝑡.

The unnormalized conditional inverse probability weights are 𝑓𝑖 = 𝑝(𝑧𝑖, 𝑡̃, 𝛾̂)/𝑝(𝑧𝑖, 𝑡, 𝛾̂)

, and the normalized conditional inverse probability weights are 𝑓̅𝑖 = 𝑁𝑓𝑑𝑖/ ∑ 𝑁𝑖 𝑓𝑖. The

normalized conditional inverse probability weights are used to estimate the average

going concern note effect conditional on disclosing going concern uncertainties.

The downsizing functional forms conditionally on going concern disclosures are.

where 𝛽 0 and 𝛽 1 are coefficients to be estimated, 𝜖 0 and 𝜖 1 are error terms that are

not related to x or z. This potential-outcome model separates each potential outcome

into a predictable component, 𝑥′𝛽𝑡, and an unobservable error term, 𝜖𝑡. We let μ(x, t, 𝛽𝑡)

denote a conditional-mean downsizing E(y|x, t) conditional on covariates x and going

concern disclosure t.

We implement inverse probability weighted regression-adjustment (IPWRA)

estimators for the effects of going concern notes on exit and downsizing as described

above. The IPWRA estimators are known as “Wooldridge’s double-robust” estimators

(Wooldridge, 2007, 2010). Our estimators are robust in an environment with

endogeneity and omitted variables.

Hypotheses: downsizing effects of going concern notes

According to mandatory management going concern disclosure requirement in Japan,

the top manage should also work out a restructuring plan to mitigate adverse events

and conditions that may influence the likelihood of business survival in addition to

going concern note. This means that the management disclosing going concern problems

management was not necessarily wrong to disclose doubt about its ability to continue as

going concern. Such subsequent viability is an outcome of successful downsizing and

debt restructurings rather than a wrong management going concern disclosure. The

point is that whether management going concern disclosures not only provide early

warnings but also inform investors by working out solutions for going concern problems.

In this paper, we examine subsequent corporate restructuring activities as well as

subsequent viability status of firms following going concern notes. We develop our

hypotheses as follows.

If a firm is facing with extreme poor performance such as substantial decline in sales,

consecutive operating losses or consecutive negative operating cash flow, total liability

exceeding assets, the management has to disclose going concern issues in accordance

with the Report 74 as mentioned above. Otherwise, the management would risk civil

liability and criminal responsibility for inappropriate disclosures according to the

Security Exchange Law. Our first hypothesis is on the relationship between firm

performance and going concern disclosures.

H1: Extreme poor performing firms are more likely to disclose going concern

uncertainties in financial statement notes.

Facing costs of civil liability and criminal responsibility, the management still has

incentives not to or delay to disclose its ability to continue as going concern. Going

concern problems also mean that assets in place are of exposure to high risks but low

return. Therefore, the asset substitution agency problem (Jensen and Meckling,1976) is

much more severe for firms with going concern uncertainties. The management may

choose to risk creditors’ interests if managerial ownership level is high. For perverse

incentives, banks may exercise control over management to delay going concern

disclosures. Our second hypothesis is on effects of managerial ownership and financial

institutional ownership on decisions to disclose going concern issues as follows.

H 2 : Firms with high managerial ownership and high financial institutional

ownership are less likely to disclose doubts about going concern.

In the literature of corporate finance^3 , extreme poor performance implies needs to

downsize, to restructure debt or to exit. To regain viability, the firm fist needs to

downsize and restructure debt. Also, it is possible that the firm is forced to exit

regardless of downsizing efforts. For going concern note firms, it is required for the

(^3) As mentioned above, extreme poor performing firms are more likely to file for

bankruptcy. Empirical studies on bankruptcy resolution and private debt restructurings all show that downsizing and debt restructurings in distressed firms to regain viability. For details, see Gilson ( 1989 , 1990), Gilson et al. (1990), Weiss (1990), Franks and Torous(1994) and Xu(1997).