Going-Concern Opinion Makes Investors Feel Comfortable With Decisions To Invest In IPO

Going-Concern Opinion Makes Investors Feel Comfortable With Decisions To Invest In IPO

Contrary to conventional wisdom, an audit opinion expressing substantial doubt about the ability of a private company to continue in existence may actually make investors feel more comfortable about their decision to invest in that company's initial public offering.

"A going-concern opinion represents an auditor's uncertainty that a company will be able to continue in the future. However, these opinions help investors evaluate IPO securities, specifically by narrowing their estimate of the dispersion of an IPO's value," explains James C. McKeown, interim chair of the Department of Accounting in Penn State's Smeal College of Business Administration. "In other words, the private information conveyed by the going-concern opinion helps outside investors make a more precise estimate of the distribution of a firm's value."

McKeown recently co-authored a study on the topic, Going-Concern Initial Public Offerings, with Michael Willenborg of the University of Connecticut. The study will appear in the Journal of Accounting & Economics and examines the role of going-concern opinions in initial public offerings of equity securities. The study, which focused on micro-cap IPOs raising $10 million or less, provides insights into the relation between auditing reports and the capital-raising activities of small businesses.

Outside investors considering an IPO are concerned about the gap between the information available to them and the insiders' information. The issuing company must pay investors to assume this risk by setting the issue price lower than the expected value of the stock. This is referred to as underpricing and is commonly estimated by the amount the stock rises on the opening day it trades--the larger the perceived information gap, the larger the required underpricing. One of the study's major findings is that going-concern (GC) IPOs suffer less first-day underpricing. This means that outside investors perceive a smaller information gap when the IPO prospectus contains financial statements with a going-concerned-modified audit report.

Between January 1, 1993 and December 31, 1994, approximately 1,000 domestic commercial companies went public in the U.S. in firm-commitment IPOs. Of these, 28 percent raised $10 million or less, and approximately one-quarter of those small-deal IPO companies went public despite their auditor having rendered a going-concern-modified opinion on their financial statements.

McKeown notes that in accordance with professional standards, an auditor must evaluate whether there is a substantial doubt concerning a firm's ability to continue as a going concern, and, in the presence of such doubt, the auditor must then evaluate management's detailed plans to deal with the adverse conditions. If the auditor concludes that such doubt remains, then the auditor must issue a going-concern (GC) opinion.

"The GC opinion represents a mandated revelation of otherwise private information and reflects doubt about a firm's future. In fact, we also find that a GC opinion indicates lower expected long-run performance. However there is less variance around the lower expectation because investors believe that with the GC opinion they have received more of the available information about the company," says McKeown.