Modeling the Audit Opinions Issued to Bankrupt Companies: A Two-Stage Empirical Analysis

Abstract

Many observers are dissatisfied with the accounting profession?s ability to warn the public of upcoming bankruptcy filings. The Chairman of the SEC recently reminded auditors that "they are the public?s watchdog in the financial reporting process" and that "we rely on auditors to put something like the Good Housekeeping seal of approval on the information investors receive" (Levitt, 1998). Since regulators and users tend to treat an unmodified audit opinion as a "clean bill of health", they do not expect the business to fail in the near future. Research has shown that more often than not, auditors end up letting users down when it comes to predicting bankruptcy filings with audit opinions.

Although auditors assert they are not responsible for predicting future events, it is very clear that their opinion decision is evaluated, at least in part, based on events that occur after the audit report date. The interesting and logical next step is to find out how companies exit bankruptcy. Do they liquidate or reorganize? Successful reorganization may, in the end, exonerate auditors and preserve their role as an early warning device. Is there any evidence to suggest that auditors end up being correct? The opinion prediction model developed in the paper introduces a new bankruptcy resolution variable that proxies for the auditor?s prognosis of the ultimate disposition of the soon-to-be-bankrupt company. Using a sample of bankruptcy filings between 1982 and 1992, we find that auditors do not seem to be able to predict filings or resolution. Instead, the model suggests that auditors are less likely to issue a modified opinion when the financial prospects of the company are not clear and when auditors are faced with incentives to delay or avoid a modified opinion. Our tests of bankruptcy resolution support what auditors have been arguing for years: that they are not clairvoyant with respect to a client?s future. The results of the research are not encouraging for those who rely on audit opinions as an early warning device.

JEL Classification: M49, G33