Auditor Differentiation, Mitigating Management Actions, and Audit-Reporting Accuracy for Distressed Firms

Abstract

SUMMARY: In this paper we examine whether there is auditor differentiation through industry specialization and audit methodology in judging the adequacy of mitigating management actions as implemented by financially distressed companies. Using a sample of U.S. companies from manufacturing industries (SIC 20–39) that went bankrupt between 1999–2002, we find evidence that specialist auditors are more likely to issue a going-concern opinion for soon-to-be bankrupt companies when management undertakes strategic turnaround initiatives, relative to non-specialist auditors. Interestingly, and counter to our expectations, we find that audit firms that use a business risk audit methodology are less likely to issue a going-concern opinion for a firm that subsequently goes bankrupt if the client has undertaken operating initiatives to mitigate financial distress. Finally, we also find very strong evidence that all auditors, irrespective of type, are less likely to issue a going-concern opinion for clients that subsequently go bankrupt when the client has plans to raise cash in the short term.