Auditor Litigation and Modified Reporting on Bankrupt Clients

Abstract

This study examines whether modified audit reports issued prior to bankruptcy protect auditors from certain effects of legal liability, including both lawsuits claiming audit failure and payments made to resolve such suits. Using a sample of 655 public companies that declared bankruptcy between 1972 and 1992 with Big Six (Big Eight) auditors prior to bankruptcy, we compare auditor reporting among three groups of firmsthose with auditor litigation, those with reporting and disclosure litigation not involving auditors (other litigation), and those with no reporting and disclosure litigation. The first two groups provide evidence on the overall level of reporting and disclosure litigation against bankrupt companies and the extent of auditors' involvement in such litigation. We provide insights on why auditors are (are not) included as defendants in this litigation; of particular interest is the role of modified reporting. Finally, we identify and discuss a number of empirical regularities regarding auditor reporting for those bankrupt clients with litigation against auditors.