Familiarity Bias and the Propensity to Issue Going Concern Opinions

Abstract

This study examines the association between familiarity bias and audit firm judgements using going concern opinion modifications. We conjecture that familiarity bias is highest when an audit firm is least familiar with its clients. We measure familiarity bias using auditor changes because familiarity bias is likely to be the highest on the initial year of an audit relationship. We find the propensity to issue a going concern modification to be much higher during this initial period, even after controlling for a multitude of factors known to be determinants of going concern modifications. Our findings also suggest the phenomenon appears to slowly dissipate over a five-year auditor client tenure. Supporting our theoretical prediction, further results find that as the auditor is more familiar with the client’s industry (e.g. industry expertise) the main effect is moderated. Our results are also strongest when the successor auditor is located in a different locale than the previous auditor, situations leading an even more pronounced lack of familiarity. We also examine SOX 404 internal controls impact, finding auditors are more likely to deem internal controls ineffective when they are unfamiliar with clients.