TOWARDS AN EXPLANATION OF AUDITOR FAILURE TO MODIFY THE AUDIT OPINIONS OF BANKRUPT COMPANIES

This research examines auditors' failures to modify their opinions for companies that go bankrupt. First, a 'hidden fraud' variable is added to a bankruptcy estimation model and is significant when the model is applied to nonstressed companies, but not when applied to stressed companies. Second, auditors' opinion decisions for stressed companies are analyzed by testing four hypotheses: auditors are less likely to qualify the opinions of (1) bankrupt companies with ambiguous probabilities of bankruptcy, (2) larger bankrupt companies, and (3) companies for which there is a shorter time period between their fiscal year-ends and their audit opinion dates. Each of these hypotheses is supported. The fourth hypothesis, that auditors do not qualify bankrupt companies that have hidden fraud, is not supported; but the likelihood of undiscovered fraud is much higher for the nonstressed companies, suggesting that additional audit effort may produce gains. The inverse relationship between client size and the going-concern qualification, after controlling for the relationship between size and bankruptcy, indicates that pressures related to client size may influence the opinion decision.