The Effect of Going-Concern Diagnosticity on Market Prices

Abstract

The market effects of high profile corporate failures have led to increased interest by investors and regulators on the quality, or diagnosticity, of auditors’ going-concern opinions. Extant research suggests that going-concern opinions are moderately diagnostic at best, as only fifty to sixty percent of financially distressed firms actually receive going-concern opinions prior to bankruptcy. What remains unexplored is whether uncertainty created by moderate diagnosticity systematically influences investor behavior. Using an experiment, we investigate the effects of going-concern diagnosticity on stock price judgments. Results suggest that in a market with moderately diagnostic going-concern opinions, investors penalize the prices of firms receiving clean opinions and overvalue firms receiving going-concern opinions as compared to a market with highly diagnostic opinions. Interestingly, we also show that pricing behavior in a moderately diagnostic market is no different than a market without any going-concern signals. These findings have implications for regulators who are interested in understanding how the quality of going-concern opinions influences market price behavior and, in turn, investor wealth

Keywords: going-concern opinions, diagnosticity, investor confidence, bankruptcy