Predicting Impending Bankruptcy From Auditor Qualified Opinions And Audit Firm Changes

Abstract

<p class="MsoBlockText" style="margin: 0in 0.6in 0pt 0.5in;"><span style="font-style: normal; font-size: 10pt; mso-bidi-font-style: italic;"><span style="font-family: Times New Roman;">Unlike prior research, we investigate the incremental explanatory power of both auditor qualified opinions and auditor changes beyond the information conveyed by traditional financial statement ratios in predicting bankruptcy. We find that qualified auditor opinion and auditor changes are both important in predicting impending bankruptcy and that auditor changes convey important information not reflected in auditor qualified opinions alone.<span style="mso-spacerun: yes;">  </span>In fact, we find compelling evidence that auditor changes provide incremental explanatory power in predicting impending firm failure beyond what is conveyed by auditor qualified opinions and traditional financial statement ratios considered jointly.<span style="mso-spacerun: yes;">  </span>Although the existing relevant literature provides no empirical evidence in this regard to our knowledge, this result is intuitive as one motivation for clients to change audit firms is to seek less conservative professional auditors as a strategic response to manifestation of the financial statement effects of bankruptcy.</span></span></p>

The change of auditor: The Portuguese case

“…The selection of independent variables allows for the realization of to what extent the entities in the sampling have changed their auditors, for having received a qualified opinion, which is considered as relevant and the object of international acknowledgement by the scientific community, by Ball, Walker, and Whittre (1979), Ballesta and García-Meca (2005), Brío González (1998), Gómez-Aguillar and Ruiz Barbadillo (2000Barbadillo ( , 2003 and Senteney, Chen, and Ashok (2006).…”

Predicting Material Weaknesses In Internal Control Systems After The Sarbanes-Oxley Act Using Multiple Criteria Linear Programming And Other Data Mining Approaches

“…We follow Ge and McVay (2005) to measure Segnm as the number of operating segments disclosed in the Form 10-K. 3 In addition to Size, using Ohlson's (1980) definition of the log of the ratio of total assets to gross domestic products, we use another variable used by Ge and McVay (2005) to proxy for size, BV (book value of assets from Form 10-K). We have two return-on-asset variables, NI/TA as in Ohlson (1980), Senteney et al (2006), and Hogan and Wilkins (2008) and CRE/TA (earnings before extraordinary items divided by total assets) as in Ge and McVay (2005). We included CRE/TA in our study because many firms reported significant losses after the September 11, 2001 terrorist event.…”

“…4 Auditor Ch is an indicator variable equal to one if the auditor changed for the year, and Auditor Ch5 is an indicator variable equals to one if a firm changed auditors within five years. Both auditor change variables are included because Ettredge et al (2007) find an association between auditor dismissals and internal control problems and Senteney et al (2006) document that auditor changes are associated with an increasing probability of bankruptcy. Table 1 shows the descriptive statistics for material weakness firms (Panel A) and non-material weakness firms (Panel B).…”

“…Because our study focuses on prediction of firms with material weaknesses in internal controls, prior bankruptcy prediction studies provide support for our approach in this paper. Using the log-linear logistic regression model, Senteney et al (2006) empirically document that qualified auditor opinions and auditor changes are associated with increasing probability of bankruptcy in addition to six common financial ratio variables (covering three dimensionsliquidity, leverage, and return on assets) previously used by other firm bankruptcy prediction studies such as Altman et al (1977) and Zmijewski (1984). Ohlson (1980) used a logit model that does not require any assumptions about the prior probability of firm financial distress with nine independent variables, including five financial ratios, for predicting bankruptcy, and six of the nine variables had statistically significant coefficients.…”

A New Methodology for Estimating Internal Credit Risk and Bankruptcy Prediction under Basel II Regime

“…The loglinear models make the differences between large values less important and those between small values more important. They are employed in (McLeay et al 2002;Ashton et al 2004) to assume proportionate growth in accounting variables that may be restricted to firm growth and are employed in (Senteney et al 2006) for predicting the impending bankruptcy. We first transform the financial ratios utilizing the nonlinear function given in Equation 4 and then compute the new Z-score, Z M as (5) in which λ 1 .…”