The implementation of the Financial Accounting Standards Board's (FASB) Accounting Standards Codification Subtopic 205-40 (ASC 205-40) in 2016 brought significant changes to how going-concern issues are evaluated and reported. While auditors have long been responsible for assessing a client’s ability to continue as a going concern, the new standard requires management to conduct formal going-concern assessments and disclose any substantial doubts, along with plans to address those concerns.
This shift increases management's responsibility and affects auditors' duties and potential liability, as the interaction of auditing and financial reporting standards can confuse users about a company’s bankruptcy risk. This was evident when Sears Holding Corp.’s management disclosed substantial doubt under ASC 205-40, yet its auditor, Deloitte, issued a standard unqualified opinion. After Sears filed for Chapter 11 bankruptcy in 2019, it raised important questions about how management disclosure changes impact auditor liability, particularly when auditors issue unqualified opinions before a company's failure, known as a Type II going-concern reporting error.
A recent study led by Assistant Professor Joel Owens of Portland State University explores these dynamics using two mock juror decision-making experiments to assess how jurors view an auditor’s blameworthiness when a Type II going-concern reporting error occurs. “Assessing how likely jurors would assign blame in a hypothetical case of auditor negligence allows us to peer inside the minds of the jurors to better understand why auditor liability is affected by changes in management disclosure practices,” said Professor Owens.
The research found that when management discloses substantial doubt about a company’s future, auditors are viewed as more blameworthy for investor losses than when management does not disclose. This heightened blame stems from the belief that, if management has disclosed the doubt, the auditor should have foreseen the failure. Moreover, even when management does not disclose substantial doubt, auditors are still seen as more culpable under ASC 205-40 compared to previous standards, as they are now responsible for auditing management’s going concern evaluations and ensuring adequate disclosures.
The study also examined whether including a Critical Audit Matter (CAM) related to going concern in the audit report could reduce auditor liability. The findings indicate that when relevant CAMs are disclosed, users are less likely to blame auditors for negative outcomes. This shift is due to the belief that the auditor took the necessary steps to address potential risks during the audit.
Professor Owens explains, “For auditing professionals, these findings have several important implications.” The shared responsibility between management and auditors under ASC 205-40 requires auditors to be more vigilant in evaluating management’s assessments and disclosures related to going concern issues. Including going concern-related CAMs in audit reports can serve as a strategic tool to reduce liability exposure by clearly communicating the auditor’s role in the risk assessment process. Lastly, practitioners should recognize that inadequate disclosures or actions can lead to greater perceptions of auditor liability, with severe reputational and financial consequences.
“As financial reporting standards evolve, it is crucial for auditors to stay informed about the potential implications for liability. By embracing stronger disclosure practices and using CAMs proactively, auditors can better manage the complexities of their responsibilities and safeguard against liability exposure,” said Professor Owens.
This research was coauthored by K. Kelli Saunders (University of Nebraska-Lincoln), Samantha Schachner (St. Bonaventure University) and Todd A. Thornock (University of Nebraska-Lincoln) and accepted for publication in Auditing: A Journal of Practice and Theory in 2024.