Earnings Management by Turnaround Strategy Reported in the Going-Concern Audit Report

This paper investigates earnings management behavior of firms whose proposed turnaround strategies are requested by independent auditors in the going-concern (GC) explanatory paragraph in modified audit reports. Managements' turnaround plans documented by auditors are grouped into three categories: no strategy, operating turnaround strategy and non-operating (long-term) turnaround strategy. Firms reporting no strategy are generally more likely to go bankrupt in the near future due to the lack of remaining viable strategies. We expect that these firms no longer participate in earnings management behavior since prior research indicates that the survival rate of these firms decreases. Firms proposing operating turnaround strategies, such as cost-cutting or asset disposals, are under imminent cash pressure with greater GC uncertainty than firms reporting long-term, non-operating turnaround strategies, such as new business developments, mergers or strategic alliances. Firms suggesting short-term operating turnaround strategies are suspected to have used most of the possible earnings management tools in the past years resulting in few remaining discretionary reporting choices. On the other hand, firms suggesting non-operating turnaround strategies upon auditor's request are still under auditor's substantial doubt regarding GC even though they are not under immediate shortage of cash-flows. Accordingly, they are also in an urgent position to avoid GC modified audit report or, in the least, to provide comfort to investors by persuading auditors that they can get over GC uncertainties soon. Meanwhile these firms are presumed to have more earnings management opportunities remaining. We find empirical evidence that firms suggesting some type of turnaround strategies to auditors have more income-increasing discretionary accruals than those proposing no strategies during the last 11 years ending 2010 in Korea. Moreover, firms suggesting non-operating(long-term) turnaround strategies use more income-increasing accruals to cover up poor performances, high debt-to-equity ratio, etc., by utilizing more remaining choices for discretionary accounting than those firms suggesting operating turnaround strategies to avoid short-term liquidity uncertainties. A key policy implication of this study is the importance of the detailed wording on auditor's review and evaluation of the GC uncertainties in the explanatory paragraph of the audit report. The results in this study provide guidance for policy makers and standard setters such as PCAOB and IAASB who are currently reviewing the modification of the content and format of the existing audit report.