Research Summary 18: The 1995 Reform Act and Auditor Litigation

When—and when not—to issue early bankruptcy warnings.

reduction in early warnings of bankruptcy could be costly to the profession because of increased public and legislative scrutiny, especially since the Private Securities Litigation Reform Act of 1995 elevated going-concern reporting to the status of law. On the other hand, false alarms of impending bankruptcy also could harm auditors’ reputations. Our study focused on whether—after enactment—auditors less frequently issued going-concern modified audit opinions to companies that later went belly-up.

The act, which codified as law the reporting requirements under Statement on Auditing Standards no. 59, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, provided auditors with litigation relief. It became difficult for plaintiffs’ attorneys to successfully bring class-action suits against auditors. And, in cases where auditors had not issued modified reports to companies that went under, damage awards provided only for proportionate liability. The results of our study indicated that, after the 1995 act, auditors were less worried about litigation and less likely, therefore, to issue going-concern modified audit reports.

We examined reports from audits conducted just prior to bankruptcy for 383 publicly traded companies that filed for bankruptcy between 1991 and 1998. We controlled for financial stress, company size, default status, audit report lag and bankruptcy filing lag. A company was stressed if it exhibited at least one of these “stress criteria”: negative working capital or, in any of the three years prior to bankruptcy, operating losses, negative retained earnings or a bottom-line loss. Auditors issued fewer modified reports for bankrupt companies that had low levels of financial stress because they had more leeway in determining the type of opinion to render.

Despite the passing of the act, the Auditing Standards Board may need to update guidance on how auditors determine whether a company requires such opinion.

For the full text of the research paper, see Auditing: A Journal of Practice & Theory, Spring 2001, vol. 21, no. 1.

MARSHALL A. GEIGER, CPA, PhD, is associate professor, E.C. Robins School of Business, University of Richmond, Virginia. His e-mail address is . K. RAGHUNANDAN, CPA, PhD, is professor of accounting, College of Business Administration, Texas A&M International University, College Station.

This series is based on work published in Auditing: A Journal of Practice & Theory. The intent is to bridge the gap between researchers and practitioners by offering concise practice summaries of cutting-edge research in the field of auditing.


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