An analysis of multinational “audit failures”

The International

Journal of Accounting

An Analysis of Multinational “Audit Failures” Heather M. Hermanson, Dana R. Hermanson and Joseph V. Carcello Kennesaw State University and the University of Tennessee

KayWords:

Multinational;

audit failure; bankruptcy;

Big Six; risk factors; going concern.

Abstract: The shift toward multinational

corporutions has exposed the auditor to many risks not found on domestic audits, including foreign currency issues, international political risks, international economic risks, greater informution usymmetry, and greuter complexity. As the client base c~fthe lurge accounting firms becomes more multinational, it is important to understund whether multinational risk factors we associated with “audit failures. ” We identified only eight multinational audit failures (multinational client bankruptcy shortly after un unmodified audit opinion) from the period 1988-1992. An examination of these eight failures provided very little evidence thut multinutional risk factors played any role in the failures.

Over the past two decades, the multinational corporation has emerged as a major force in the world economy. Many U.S. companies have expanded their operations overseas in order to capitalize on new opportunities. From the external auditor’s perspective, the growth of the multinational company has brought a new bundle of risks not faced on domestic audits, including foreign currency issues, cultural issues, international political and economic risks, greater information asymmetry, and greater complexity. Spagnola and Brannan state, the rapid increases in international flows of capital, products, and technologies, and the emergence of the multinational enterprise have complicated organization management and accounting to an unprecedented level (1994, p. 34).

Given the globalization of the business environment, it is important to understand whether the new risks faced on multinational audits are likely to produce a greater number of “audit failures” in coming years. Such failures could be very damaging to the intemational accounting firms. The purpose of this exploratory study is to address two questions. First, how many multinational “audit failures” occurred from 1988 through 1992? Second, do the multinational

Direct all correspondence to: Heather M. Hermanson, Kennesaw State University, Michael J. Coles School of Business, Department of Accounting, 1000 Chastain Road, Kennesaw, GA 30144-5591. E-mail: hhermans@ kscmail.kennesaw.edu The International Journal of Accounting, Vol. 31, No. 3, pp. 281-291 ISSN: 0020-7063. All rights of reproduction in any form reserved. Copyright 0 1996 University of Illinois

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“audit failures” identified appear to be due to risks unique to multinational companies? In other words, are these failures caused by multinational factors, or are they simply failures caused by factors that could be found on any domestic audit? When a client declares bankruptcy soon after the issuance of an unmodified audit opinion, financial statement users often perceive that an audit failure has occurred (Berton, 1985; Berton and Ingersoll, 1985; Campbell and Mutchler, 1988; Carmichael and Pany, 1993). Accordingly, the present study defines audit failures in this manner. We examined U.S. based public clients of the Big Eight (Six) that declared bankruptcy from l/1/88 through 12/31/92 and that had in excess of $40 million of revenue (n = 177). Based on a review of each client’s financial statement footnotes, only 21 (12%) of the 177 clients had significant multinational operations. Interestingly, of the 21 multinational clients, only eight (38%) had received an unmodified opinion, indicating that multinational audit failures are rare events during this period. In addition, for these eight multinational clients, a review of the business press provided very little evidence that multinational risk factors played any significant role in these failures. Therefore, even the eight “multinational audit failures” did not appear to be caused by risks unique to multinationals. Based on these results, it does not appear that multinational risk factors are associated with a large number of audit failures during the sample period.

BACKGROUND When a business fails soon after the auditor’s issuance of an unmodified opinion, the financial community often perceives that an “audit failure” has occurred (Berton, 1985; Berton and Ingersoll, 1985; Campbell and Mutchler, 1988; Carmichael and Pany, 1993). In such situations, costly litigation against the audit firm may follow (St. Pierre and Anderson, 1984; Palmrose, 1987; Stice, 1993). We use the public perception described above to define “audit failures” as situations in which a client’s bankruptcy is preceded by an unmodified opinion on the client’s last financial statements issued before bankruptcy. Consistent with prior studies (Casey, McGee and Stickney, 1986; Menon and Schwartz, 1987), the last audit opinion must fall within 15 months of the bankruptcy date. We recognize that this definition of audit failure is not perfect; however, this definition is used because it is observable. Business failure and audit failure are not synonymous, and it is possible that one or more situations defined as audit failures in this study are cases in which the auditor had no reasonable chance of detecting the going-concern problem. A priori, how likely is it that multinational risk factors have resulted in a substantial number of audit failures? Certainly it seems plausible that the greater number of risk factors on multinational audits could produce an increase in audit failures. Auditors facing greater complexity could find it more difficult to detect going-concern problems. In addition, multinational clients generally are larger than domestic clients. The auditor may be less inclined to modify the opinion of a distressed multinational client: McKeown, Mutchler and Hopwood (1991) found that larger distressed clients are less likely to receive modified opinions than are smaller distressed clients. Conversely, one other study may suggest that multinational audit failures are not very common. Hermanson (1993) found that Big Six multinational auditing experts generally

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focused on non-multinational risk factors as they set the audit scope on multinational audits (planning which locations to visit and what procedures to perform). The risk factors rated as most important by the experts were unusual transactions, subsidiary size, and client expectations. These factors are all common to domestic audits as well. Since these experts did not focus on multinational risk factors as they planned multinational audits, it seems unlikely that the Big Eight/Six firms have experienced many audit failures caused by multinational risk factors. If the l%rns had been “burned” by multinational risk factors, one would expect them to pay close attention to such factors as they planned their audits. Given the exploratory nature of this study and the competing arguments above, no hypotheses are formulated. Rather we simply gather evidence on the number of multinational audit failures and the apparent causes of the failures.

RESULTS Sample Selection The sample was identified in the following manner. Predicasts’ F&S Index of Corporate Change was used to identify company bankruptcy filings from l/1/88 through 121311 92. We referred to the Directory of Companies Required to File Annual Reports with the SEC to identify the public companies. Each public company’s last annual report before bankruptcy was consulted to gather the auditor name, audit opinion, and financial variables. Consistent with previous research (Casey et al., 1986; Menon and Schwartz, 1987), the last audit opinion had to be issued within 15 months of the bankruptcy date. In a few cases, the most recent annual report was not available, and the prior year report was used (as long as the audit opinion was issued within 15 months of the bankruptcy date). As shown in Table 1, the process above yielded 177 Big Eight/Six public clients with revenues of at least $40 million that declared bankruptcy from l/1/88 through 12/31/92. The $40 million threshold was judgmentally set to ensure that the companies in the sample were of reasonable size, so that any multinationals identified would be substantial companies. The following screens reduce the sample size. First, the financial statement footnotes of each of the 177 companies were consulted to determine whether the companies had mate-

Table 1.

Data Screens

Big Eight/Six Public Clients with Revenues of at Least $40 Million that Declared Bankruptcy from l/1/88 through 12/31/92 Less: Clients Without Material Multinational

Operations

Bankrupt Clients With Material Multinational

Operations

Less: Clients Receiving Modified Opinions Multinational

“Audit Failures”

177

-156 21 -13 8

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rial multinational information,

(foreign) operations.

Public companies

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must disclose foreign operations

if revenue from foreign operations is IO percent or more of the combined revenue of all segments of the entity, or if identifiable assets of the entity’s foreign operations are 10 percent or more of the combined identifiable assets of the entity (Dyckman, Dukes and Davis, 1995, p. 13 12).

A large portion of the initial sample (156 companies, 88% of initial sample) did not present a footnote on foreign operations. Therefore, these companies were excluded from the sample. Of the remaining 21 “multinational clients,” 13 received modified opinions on their last financial statements before bankruptcy. Subtracting these 13 clients leaves eight “multinational audit failures,” multinational clients that declared bankruptcy after receiving an unmodified audit opinion. Based on these data screens, the answer to the first research question is apparent. Multinational audit failures are relatively rare during the sample period. The Big Eight/Six firms experienced only eight multinational audit failures over the five-year period. In addition, of the 21 multinationals that declared bankruptcy, 13 (62%) received modified opinions. While the small sample size prohibits drawing any definitive conclusions, this 62% figure is higher than the 50% modification rate typically found for bankrupt U.S. companies in general (e.g., Altman and McGough, 1974; Menon and Schwartz, 1986).

Descriptive Statistics Table 2 presents descriptive statistics on the 21 multinational bankruptcies, partitioned by those clients receiving modified opinions and those clients receiving unmodified opinions. Despite the very small sample sizes, it appears that the audit failure clients may be slightly smaller, have smaller losses, and have a greater percentage of their operations overseas. The smaller losses could make it more difficult for the auditor to detect a going-concern problem, and the greater percentage of overseas operations could increase the complexity of these audits.

Multinational Audit Failures This section presents a brief “case study” analysis of each of the eight multinational audit failures. The analysis is based on a review of the business press around the time of each company’s bankruptcy filing. The purpose of the analysis is to determine whether Table 2.

Variable Medians ($ in thousands) Modified

Vuricrblr

(n = 13) Multinutionul Clirnls

Assets

$298,883

Revenues

$331,541

Net Income

-$I37,069

(n = 18) Multinutiond “Audit Fui1urr.s” $203,106

$199,325 -$26,945

% of Foreign Assets

15.7%

30.3%

% of Foreign Revenues

15.5%

40.8%

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any evidence suggests that multinational risk factors may have led to these bankruptcies. Note that the business press focuses on the causes of the business failure (i.e., why did the company go bankrupt). We can only assume that these same factors are the cause of the audit failure, for we have no access to the audit workpapers or to the decision process used by the auditors. Please refer to Table 3 for a summary of each of the failures. Aancor Holdings, Inc. Aancor Holdings Inc. (Aancor) was the parent company of National Gypsum Co., a wallboard manufacturer. Aancor declared bankruptcy in October of 1990. The company was quite large, with assets and revenues each near $1.5 billion. Approximately 7% of the company’s assets and 12% of its revenues were foreign. Aancor declared bankruptcy after Citibank refused to renew its line of credit. In addition, other potential lenders were frightened away by declining prices for wallboard, fears that the construction market was turning softer, and concerns about National Gypsum’s asbestos-liability lawsuits (WSJ, Oct. 30, 1990, p. A12).

Wallboard prices had dropped from $125 per 1,000 square feet in 1986 to $80 in 1990. The company had been involved in asbestos litigation for many years. In addition, the company had a large debt load from its 1986 leveraged buyout (KU, Oct. 30, 1990). Based on this information, it does not appear that Aancor’s failure was caused by multinational risk factors. The company simply failed because of industry conditions, litigation, and high leverage. Alliant Computer Systems Corp. Alliant Computer Systems Corp. (Alliant) was a small manufacturer of mini-supercomputers. Alliant declared bankruptcy in May of 1992. The company had assets and revenues of approximately $40 million each. Foreign operations accounted for 35% of assets and 38% of revenues. According to the Wall Street Journal, [Alliant’s] problems were attributed to technical difficulties in making a transition from its traditional supercomputers to a new line of computers using a ‘massively parallel’ design (WSJ, May 27, 1992, p. B4).

The company had suffered losses because the market for mini-supercomputers “was eclipsed by increasingly powerful workstations” (p. B4). Overall it appears that Alliant failed to keep up with market shifts and then had problems changing its product line. These factors are not multinational in nature. Basix Corp. Basix Corp. (Basix) was a diversified company with operations in oil drilling, toll systems, printing, computer leasing, traffic control systems, power line construction, and security systems (Giltenan, 1989). Basix declared bankruptcy in February of 1988. The company had assets and revenues of approximately $200 million each. As of 1986, only about 5% of the company’s operations were foreign (the company was above the 10% threshold in earlier years). Basix faced a number of setbacks from 1985 through 1987. Oil prices fell in 1985, and the company sold its drilling subsidiary at a loss. The next year Basix “had to take a $21 million writedown on its offshore oil reserves in Greece” (Giltenan, 1989, p. 70). In 1986, the printing business was cut in half by changes in the municipal bond industry. In addition, the printing operation’s spending was not controlled effectively. Finally, the toll business and traffic control operations experienced significant problems. One director

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Table 3.

Description

of Multinational

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“Audit Failures”

Aancor Holdings (National Gypsum Co.) Bankruptcy Date Last Financial Statements Assets (000s) Revenues (000s) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code Primary cause of bankruptcy: Falling price of wall board: weak construction lack of financing.

1o/90 1213 l/89 $1,458,325 $1,364,070 -$40,330 7% 12% 3270

market; asbestos litigation;

Alliant Computer Systems Corp. 5192 12/31/91 $40,739 $43,824 -$9,483 35% 38% 3571

Bankruptcy Date Last Financial Statements Assets (000s) Revenues (000s) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code Primary cause of bankruptcy: Shift away from mini-supercomputers;

technical problems with new market.

Basix Corp. Bankruptcy Date Last Financial Statements Assets (000s) Revenues (000s) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code

2/88 12/31/86 $224,598 $175,532 -$13,559 4% 6% 2750

Primary cause of bankruptcy: Lack of control; lack of synergy; oil price drop; problems in several industries. D.R. Holdings (Prime Computer) Bankruptcy Date Last Financial Statements Assets (000s) Revenues (000s) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code Primary cause of bankruptcy: Collapse of minicomputer market; high leverage.

8192 12/31/91 $1,149,563 $1,382,444 -$537,926 66% 62% 7373

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Floating Point Systems Inc. 10/91 10/3 l/90 $62,273 $46,886 -$9,202 18% 49% 3571

Bankruptcy Date Last Financial Statements Assets (000s) Revenues (Ooos) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code Primary cause of bankruptcy: Declining sales of attached processors and mini-supercomputers; engineering and testing problems; other market factors. Siliconix Inc. Bankruptcy Date Last Financial Statements Assets (000s) Revenues (000s) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code Primary cause of bankruptcy: Unfavorable patent infringement TIE Communications

4190 12/31/88 $157,125 $128,526 $1,221 41% 43% 3674 verdict.

Inc. 419 1 12/31/89 $181,614 $223,118 -$69,825 25% 32% 3661

Bankruptcy Date Last Financial Statements Assets (000s) Revenues (000s) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code Primary cause of bankruptcy: Management issues; heavy debt load; tiled prepackaged emerged from bankruptcy after three months. Wang Laboratories

bankruptcy

plan:

Inc. 8/92 6/30/9 1 $1,417,900 $2,091,500 -$385,500 48% 55% 3570

Bankruptcy Date Last Financial Statements Assets (000s) Revenues (000s) Net Income (000s) % Foreign Assets % Foreign Revenues SIC Code Primary cause of bankruptcy: Collapse of minicomputer market; product development management team problems.

issues;

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of the company described the situation: “It was like Murphy’s Law. If something could go wrong, it did” (p. 71). In summary, Giltenan writes: What is the lesson in this sad story? Beldock [the company founder] likes to think Basix victim of circumstance--falling oil prices, an untrustworthy manager or two, congressional ity to follow through on road rebuilding, and so on. There is some truth in that, but particularly relevant. More acute is a former Basix director who says: “There wasn’t any in the various companies. Everybody was an entrepreneur, and there weren’t the proper from Beldock” (Giltenan, 1989, p, 71).

was the inabilit’s not synergy controls

Based on the information above, it does not appear that multinational risk factors played a major role in the Basix failure. The only multinational factor cited above was the oil reserves in Greece ($21 million), but this loss would have occurred regardless of where the oil was located because oil prices fell worldwide. D.R. Holdings (Prime Computer). D.R. Holdings owned Prime Computer, a large manufacturer of minicomputers. D.R. Holdings declared bankruptcy in August of 1992. The company was quite large, with assets and revenues each in excess of $1 billion. Over 60% of the company’s assets and revenues were foreign. Prime Computer faced two problems, over $1 billion of debt and plummeting sales of minicomputers. “Prime has been hurt by business’ rapid switch from minis to desktop workstations” (McWilliams, 1991, p. 98). An earlier article by Sivula (1990) discussed Prime Computer’s lack of new products, a major problem in a fast-changing market. Ultimately Prime was unable to maintain its market share, and the company failed. Although the majority of its operations were foreign, it does not appear that multinational risk factors account for the failure of D.R. Holdings. The company was not able to survive the decline of the minicomputer industry. Floating Point Systems Inc. Floating Point Systems Inc. (Floating Point) was a small manufacturer of mini-supercomputers. Floating Point declared bankruptcy in October of 1991. The company had assets of approximately $60 million and revenues of approximately $45 million. The company’s assets were 18% foreign, while 49% of its revenues were foreign. Floating Point “had increasing difficulty finding a market for its outmoded processors and has been plagued with troubles in engineering and deploying new products” (WSJ, October 8, 1991). Earlier WSJ articles cited problems with new products and shipping delays (July 22, 1991) as well as competition, economic conditions, and reduced demand in Europe (June 11, 1991). Overall this failure is nearly identical to Alliant. Neither company could survive the decline of the mini-supercomputer market, for they could not introduce new products quickly enough. Other than the role of European demand, it does not appear that multinational risk factors played a major part in this failure. Siliconix Inc. Siliconix Inc. was a manufacturer of semiconductor products. The company declared bankruptcy in April of 1990. Siliconix had assets of approximately $160 million and revenues of approximately $130 million. Over 40% of the company’s assets and revenues were foreign. Siliconix filed for bankruptcy “partly because of an unfavorable verdict in a patent infringement suit” (WSJ, April 12, 1990, p. A2). The lawsuit was filed by International Rectifier Corp. and had been in process for several years. The two companies subsequently agreed that Siliconix would pay $12 million over two years and would pay

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royalties to International Rectifier (WSJ, May 22, 1990). At the time of the bankruptcy filing, the company also was in technical default on some of its debt. The primary cause of this failure was the unfavorable patent infringement verdict. No multinational risk factors were cited. Inc. (TIE) was a manufacturer of TIE Communications Inc. TIE Communications telephone systems for small offices. The company filed for bankruptcy in April of 199 1. TIE had assets of approximately $180 million and revenues of approximately $220 million. Approximately 30% of the company’s business was foreign. TIE entered a prepackaged bankruptcy plan in which it traded stock for the debt held by its largest creditor (WSJ, April 9, 1991). According to an investor seeking control of the company, TIE’s major problems were “ineffective management and a crushing debt load” (WSJ, March 27, 1991, p. A.5). Shortly after the bankruptcy filing, the company sold its equipment distribution channels to a Japanese firm, and the company emerged from bankruptcy after three months (WSJ, July 3, 1991). TIE’s bankruptcy was short-lived, and there is no evidence that multinational risk factors played any role in this failure. Wang Laboratories Inc. Wang Laboratories Inc. (Wang) was a large producer of computers. The company filed for bankruptcy in August of 1992. Wang had assets and revenues in excess of $1.4 billion. Approximately 50% of the company’s operations were foreign. Wang.. revolutionized offices around the world with its minicomputers. But as the industry began to shift to personal computers in the mid- 198Os, Wang was left behind (Miller and Rosenberg, 1992, p. 72).

Another factor was Mr. Wang’s choosing his son to succeed him in the business: The inexperienced Fred [son of the founder] failed to spruce up the firm’s product line and loaded its balance sheet with almost $1 billion of debt (The Economisr, August 22, 1992, p, 58).

One consultant

concluded,

[Wang] fell prey to the enormous success of the PC. They simply did not react fast enough to compete in the workplace (Miller and Rosenberg, 1992, p. 72).

Wang’s failure appears quite similar to that of D.R. Holdings. The company did not survive the fall of the minicomputer market. The only discussion of any multinational factor was the sale of Wang Austria, a small, unprofitable foreign subsidiary (WSJ, Sept. 1, 1992). This multinational factor appears quite minor in the overall failure.

DISCUSSION AND CONCLUSION The results above suggest the following. First, multinational audit failures appear to be quite rare during the sample period, with only eight in the five-year period. Moreover, only three of the eight failures involved very large companies. Aancor, D.R. Holdings, and Wang were the only multinational audit failures with revenues in excess of $1 billion. Second, the majority (62%) of the bankrupt multinational clients received modified opinions. Therefore, the Big Eight/Six as a group generally provided early warning of multinational bankruptcies.

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Finally, a “case study” analysis of the eight multinational audit failures suggests that multinational risk factors did not play a major role in any of the failures. Articles discussing Basix, Floating Point, and Wang mentioned multinational factors, but these factors did not appear to be primary causes of the failures. Based on the results found in this one context, it does not appear that multinational auditing is inherently different than domestic auditing. The factors that lead multinationals to fail appear to be the same types of factors that destroy domestic companies--primarily adverse market conditions, high debt, product development problems, litigation, and poor planning. We encourage researchers to further explore the issues of multinational audit failures and multinational auditing in general. The present study is exploratory, has a very small sample size, relies heavily on the business press, and is purely descriptive in nature. This area of research is in its infancy, and a great number of multinational auditing issues deserve our attention. The central question to examine is how the auditing profession will be affected

by the globalization

of the economy.

Acknowledgements: We gratefully acknowledge the research assistance of Jenny Cai and Jennifer Shull. The authors’ names are listed in reverse alphabetical order.

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Miller, Annetta and Debra Rosenberg. 1992. “Blinded by the Future: Wang Falls Victim to the Personal Computer,” Newsweek, (August 3 1): 72. Palmrose, Zoe-Vonna. 1987. “Litigation and Independent Auditors: The Role of Business Failures and Management Fraud,” Auditing: A Journal of Practice & Theory, (Spring): 90-103. Sivula, Chris. 1990. “Prime Users Still on Hold,” Datamation, (September 1): 61-63. Spagnola, Bob and Rodger Brannan. 1994. “International Joint Ventures: A Perspective on Organizational and Accounting Implications of Global Partnering for US Multinationals,” The International Journal of Accounting, 29: 34-45. Stice, James D. 1993. “Reading the Warning Signs,” The National Public Accountant, (March): 22-25. St. Pierre, Kent and James A. Anderson. 1984. “An Analysis of the Factors Associated With Lawsuits Against Public Accountants,” The Accounting Review, (April): 242-263. The Economist. 1992. “Wang: An American Tragedy,” (August 22): 56,58. The Wall Street Journal. 1990. “Business Brief--Siliconix, Inc.: Chapter 11 Reorganization Filed by California Concern,” (April 12): A2. The Wall Street Journal. 1990. “International Rectifier, Siliconix Settle Suit,” (May 22). The Wall Street Journal. 1990. “National Gypsum and Parent Seek Chapter 11 Status,” (October 30): A12. The Wall Street Journal. 1991. “TIE / Communications, Inc.,” (March 27): A5. The Wall Street Journal. 1991. “TIE Will Swap $35 Million in Debt to HCR Partners,” (April 9): All. The Wall Street Journal. 1991. “Technology: Floating Point Posts Loss of $7.2 Million for its Second Quarter,” (June 11). The Wall Street Journal. 1991. “Business Brief: TIE / Communications, Inc. Sale of Distribution Rights tod Nitsuko is Completed,” (July 3). The Wall Street Journal. 1991. “Business Brief: Floating Point Systems Inc. Work Force to be Cut 25% and Salaries to be Frozen,” (July 22). The WaZZStreet JournaZ. 1991. “Floating Point Files for Reorganization Under Chapter 11,” (October 8). The Wall Street Journal. 1992. “Business Brief: Alliant Computer Files for Chapter 11, Trims its Work Force by Two-Thirds,” (May 27): B4. The Wall Street Journal. 1992. “Wang to Liquidate Austria Unit,” (September 1): B8.