1994 Riesgo de Litigio y Modificación Del Reporte PDF

Accounting Research Center, Booth School of Business, University of Chicago
Wiley
Auditor Litigation and Modified Reporting on Bankrupt Clients

Author(s): Joseph V. Carcello and Zoe-Vonna Palmrose
Source: Journal of Accounting Research, Vol. 32, Studies on Accounting, Financial Disclosures,
and the Law (1994), pp. 1-30
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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Journal of Accounting Research
Vol. 32 Supplement 1994
Printed in US.A.
Auditor Litigation
and Modified Reporting
on Bankrupt Clients
JOSEPH V. CARCELLO* AND ZOE-VONNA PALMROSEt
1. Introduction
This study examines whether modified audit reports issued prior to
bankruptcy protect auditors from certain effects of legal liability, includ-
ing both lawsuits claiming audit failure and payments made to resolve
such suits. Using a sample of 655 public companies that declared bank-
ruptcy between 1972 and 1992 with Big Six (Big Eight) auditors prior to
bankruptcy, we compare auditor reporting among three groups of firms-
those 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 in-
sights on why auditors are (are not) included as defendants in this litiga-
tion; 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.
*University of Tennessee; tUniversity of Southern California. The financial assistance

of the KPMG Peat Marwick Foundation Research Opportunities in Auditing Program and
the Price Waterhouse Foundation, the research assistance of Tom Hill and David Blum-
berg-Colon, and the helpful comments of Mary Barth, Sarah Bonner, Mark Defond, Mike
Duffy, Jennifer Francis, Paul Healy, Pat Hughes, Maureen McNichols, Kurt Pany, Glen
Pfeiffer, Bob Roussey, Amy Sweeney, Bob Trezevant, workshop participants at the Univer-
sity of Southern California, participants in theJAR Conference, and an anonymous ref-
eree are gratefully acknowledged.
Copyright ?, Institute of Professional Accounting, 1995
2 JOURNAL OF ACCOUNTING RESEARCH, SUPPLEMENT 1994
It is widely assumed that unmodified (unqualified) reports before

client bankruptcy lead to litigation against auditors;1 see, for example,
Kennedy and Shaw [1991] and Berton as cited in Carmichael and Pany
[1993]. On the other hand, it is assumed that modified reports prior to
bankruptcy protect auditors from litigation (e.g., see Frost [1994] and
Kinney and Smith [1992]). Some auditors believe that the purpose of
modified reports, such as the going concern, is to protect against legal
liabilities (Mutchler [1984]). One purpose of our analysis is to provide
evidence on whether modified reports prior to bankruptcy protect au-
ditors from litigation.
We examine bankrupt companies, rather than a broader set of finan-
cially distressed companies, for several reasons. First, client bankruptcy
is the primary focus of policymakers' and practitioners' concerns about
auditors' reponsibilities "for warning the public of impending business
failure" (Connor [1985]). Second, bankrupt clients are the primary focus
of practitioners' concerns regarding auditor liability. Lawyers emphasize
that one of the most frequent sources of litigation against auditors is
client bankruptcy (American Bar Association [1987] and Eickemeyer
[1994]). Finally, bankruptcy is a legal event. It objectively identifies non-
going concerns and avoids problems operationalizing financial distress,
an economic condition (Foster [1986]).
By focusing on bankrupt companies, however, we are not able to ex-
amine whether modified audit reports protect auditors from the effects
of legal liability with regard to financially distressed clients that do not
declare bankruptcy. Even so, our analyses provide insights relevant to
such an examination. We recognize that not all bankrupt companies are
equally distressed. Our analyses take advantage of variation in circum-
stances to test for which ones are more strongly associated with litigation.
We find that the majority (76%) of bankrupt companies in our sample
have no litigation; however, auditors are defendants in the majority
(74%) of litigation that occurs. The auditor litigation rate (18%) for
bankrupt clients is higher than an estimated rate (3%) for all public cli-
ents (Palmrose [1988]). Our multivariate analysis indicates that auditor
litigation is more likely for larger clients, for those with SEC enforce-
ment actions, and for those with net income on the last prebankruptcy
financial statements (or the last prelitigation statements when litigation
precedes the audit report date on the last prebankruptcy statements). In
the univariate analysis, the modified reporting rate on the last pre-
bankruptcy (prelitigation) financial statements is significantly greater
for observations with no litigation; in our multivariate analyses, due to
interrelationships among the reporting and significant explanatory vari-
ables, the significance of modified reporting's effect on the likelihood
of litigation depends on the specification.
1As explained in section 2, we use the terms modified and unmodified rather than
qualified (unqualified).
AUDITOR LITIGATION AND REPORTING ON BANKRUPT CLIENTS 3
We focus on the annual financial statements and accompanying audit

reports at issue in auditor litigation (which vary in number from zero to
six per observation in our study). The vast majority (82%) of the reports
at issue in auditor litigation either do not involve or are not limited to
the last prebankruptcy reports. We find that about 10% of our observa-
tions have only modified reports as the subject of auditor litigation; 20%
have some and 70% have no modified reports. Resolution evidence for
auditor litigation reveals that observations with all modified reports
have the highest dismissal rate and the lowest (mean and median) pay-
ments by auditors; observations with no modified reports have the high-
est auditor payments. Overall, our evidence suggests a defensive role for
timely modified reporting. We also find that accounting issues dominate
auditor litigation while disclosure issues-especially disclosures outside
the financial statements-dominate other litigation. The remoteness of
such disclosures from areas with auditor involvement and responsibility
may help explain why auditors are not defendants in other litigation.
Section 2 provides background on the auditor's reporting decision
and research relevant to our study. Section 3 develops the multivariate
model we use to examine whether modified reports issued prior to
bankruptcy protect auditors from the effects of legal liability. Section 4
describes the sample. Section 5 presents results based on analysis of the
total sample, while sections 6 and 7 focus on the auditor and other lit-
igation subsamples, respectively. Section 8 contains a summary and con-
cluding remarks.
2. Background and Prior Research

The auditor's standard (ummodified or unqualified) report states
that the financial statements comply with generally accepted account-
ing principles (GAAP) in all material respects; the auditor expresses
this opinion after performing an audit in accordance with generally
accepted auditing standards (GAAS). The three general conditions that
require modifying the standard report involve auditing restrictions
(e.g., audit scope limitations), accounting deficiencies (e.g., non-GAAP
financial statements), and uncertainties (including substantial doubt
about the entity's ability to continue as a going concern). Until the late
1980s, uncertainty qualifications were recognizable by the phrase "sub-
ject to" in the opinion paragraph of the auditor's report; uncertainty
disclaimers were permitted but not mandatory.2 Statements on Auditing
Standards (SAS) Nos. 58 and 59 eliminated the "subject to" qualification
while retaining a requirement to discuss the matter in an explanatory
2According to Carmichael and Willingham [1987], disclaimers are issued when an un-
certainty is so material as to "overwhelm" the presentation of financial statements and,
therefore, an opinion on the statements "lacks any substance." Generally, disclaimers are
issued for very serious going-concern problems [1987, p. 489].
4 JOSEPH V. CARCELLO AND ZOE-VONNA PALMROSE
paragraph.3 We include in our study as modified reports those with ex-

planatory paragraphs on uncertainties under SAS Nos. 58 and 59.4
Only modifications for uncertainties are common in financial state-
ments of public companies.5 The Securities and Exchange Commission
(SEC) does not accept financial statements with departures from a
standard (unqualified) report due to audit scope limitations or GAAP
departures. Also, the SECdoes not accept a disclaimer, including a dis-
claimer for uncertainties, as meeting the requirements of the 1933 Act
for certification of financial statements (Carmichael and Pany [1993]).
Our study analyzes a sample of bankrupt public companies, so it fo-
cuses on modifications for going-concern and other uncertainties.
Modified reports may protect auditors from having to defend either
or both their evaluation of the client as a going concern and the ab-
sence of material omissions or misstatements in the client's audited
financial statements (including disclosures). In distinguishing between
these two forms of protection, Kinney [1993] notes that the second in-
volves allegations of both substandard audits and substandard financial
statements prepared by the client. The first may involve substandard
auditing alone if the audited financial statements contain no material
omissions or misstatements; only the auditor's unmodified report is in-
appropriate. Finally, for lawsuits filed against auditors, modified re-
ports may make it easier to defend against allegations of substandard
audits (and substandard audited financial statements).
Several streams of research on auditor reporting, bankruptcy, and
litigation relate to our study.6 Research on the usefulness and con-
sequences of modified reports provides evidence that auditor reports is-
sued prior to bankruptcy are not modified for at least 50% of bankrupt
companies sampled (e.g., see McKeown, Mutchler, and Hopwood
[1991]). While almost 30% to 40% of firms involved in auditor litigation
are bankrupt (Lys and Watts [1994], Palmrose [1987], and St. Pierre and
Anderson [1984]), auditor litigation actually occurs for a minority of
3Among other changes, with SAS No. 59, the auditor has a responsibility to evaluate
whether there is substantial doubt about the entity's ability to continue as a going con-
cern for a reasonable period of time (not to exceed one year beyond the date of the
financial statements being audited). The recoverability of asset amounts and the amount
and classification of liabilities are no longer the deciding factors in whether to modify
the report (Carmichael and Pany [1993]).
4 SAS Nos. 58 and 59 do not preclude an auditor from issuing a disclaimer in cases in-
volving uncertainties.
5For example, Carcello, Hermanson, and Huss [1995] report going-concern modifi-
cation rates of 8-11% for Big Six (Big Eight) auditors during 1987 to 1991 (based on
approximately 12,000 public companies reported in Compact DISEC). Going-concern modi-
fications include qualifications, disclaimers, and explanatory paragraphs.
6Recent reviews of auditor reporting research include Asare [1990], Boritz [1991],
Carmichael et al. [1994], Carmichael and Pany [1993], and Strawser [1991]. Reviews and
summaries of bankruptcy prediction research include Jones [1987], Zavgren [1983], and
Zmijewski [1984].
bankrupt clients (e.g., Palmrose [1987] reports a rate of 21%). Palmrose

[1987] also reports that 56% of auditor litigation cases with client bank-
ruptcy involve management fraud.
Lys and Watts [1994] include audit reports in their investigation of au-
ditor litigation. Their study encompasses auditor litigation from 1955 to
1994 involving both bankrupt (37%) and nonbankrupt (63%) clients. In
univariate but not multivariate analyses, they find qualified (modified)
reports (measured as the type of audit report in the median fiscal year
allegedly misstated) increase the likelihood of auditor litigation. They
interpret this result as evidence that events leading to lawsuits also lead
to qualified reports.
Directly related to our study, Sullivan [1992] furnishes information on
50 nonfinancial institutions with auditor litigation reported to the Qual-
ity Control Investigations Committee (QCIC) (or the Special Investiga-
tions Committee [SIC]) of the AICPA-SECPractice Section.7 Sullivan
reports that of 16 cases involving bankrupt clients, 5 have going-concern
modifications on the last financial statements before bankruptcy. Sulli-
van notes that the plaintiff's attorney in only one of the 11 bankruptcies
not preceded by a modified report alleged failure by the auditor to pro-
vide a "red flag." Sullivan uses these data (along with information that
7 of 34 nonbankrupt entities with auditor litigation had modified opin-
ions) to argue that auditor reports modified for continued existence
have little usefulness.
3. Framework
We use the following multivariate model to examine whether
modified reports issued prior to bankruptcy protect auditors from the
effects of legal liability as regards bankrupt clients.
auditor litigation= f (the presence and persistence of modified

reports, client financial condition, irregu-
larities, client size, and client industry)
Modified reports can signal client difficulties prior to bankruptcy,
thus reducing the likelihood that bankruptcy surprises users. To the
extent that the financial statements and accompanying audit report re-
veal client financial difficulties before bankruptcy, any user losses from
bankruptcy are less likely to be recoverable from auditors (and others)
via lawsuits alleging substandard auditing and/or substandard financial
reporting and disclosure. We expect that the occurrence of auditor
litigation (1 = yes, 0 = no) is inversely related to the presence of a
modified report (1 = yes, 0 = no) on the last financial statements before
7From inception (November 1979) through December 31, 1993, 567 cases were re-
ported to the QCIC/SIC.
bankruptcy. When litigation occurs before the last prebankruptcy audit

report date, we use the last financial statements and accompanying au-
dit report before litigation in our analysis.
We also include a variable for persistent modified reporting. Multiple
modified reports prior to bankruptcy are consistent with long-standing
and well-recognized financial uncertainties. We define persistent modified
reporting as modified reports on the last two (or more) financial state-
ments before bankruptcy (1 = yes, 0 = no); we expect an inverse relation
between this variable and auditor litigation.
To control for other factors that affect the likelihood of litigation
against auditors, our model includes variables for client financial con-
dition, unrevealed irregularities, client size, and client industry. The
client's financial condition as presented in the last financial statements
before bankruptcy is an important element in determining whether
client bankruptcy surprises users. The first client financial condition
variable takes on the value 1 (0) if the last financial statements report
net income (net loss). We expect the reporting of net income to in-
crease the likelihood of auditor litigation.
The second financial condition variable is the Zmijewski [1984]
financial condition index (ZFC); 8 higher values indicate a greater like-
lihood of failure, suggesting an inverse relation between auditor litiga-
tion and the ZFCmeasure. (The ZFCindex is not used for companies in
the financial services industries. To minimize the loss of observations,
we estimate the Sinkey, Terza, and Dince [1987] financial condition in-
dex for some banks; see Bamber, Bamber, and Schoderbek [1993].)
Several studies on auditor litigation argue that the weak client finan-
cial condition increases, rather than decreases, the likelihood of audi-
tor litigation (e.g., Lys and Watts [1994] and Stice [1991]).9 According
to this argument, financial difficulties make errors more likely, create
incentives for management manipulation, and increase the likelihood
of user losses. However, this research does not examine, as we do, au-
ditor litigation using only bankrupt companies.
8
ZFC is computed using the PROBIT coefficients from the 40 bankrupt/800 nonbank-
rupt estimation sample reported by Zmijewski [1984] as follows:
ZFC = -4.336 - 4.513 (ROA) + 5.679 (FINL) + .004 (LIQ)

where:
ROA = return on assets (the ratio of net income to total assets),
FINL = financial leverage (the ratio of total debt to total assets), and
LIQ = liquidity (the ratio of current assets to current liabilities).
The ZFC index is a standard normal variable. In some analyses, we transform the stan-
dard normal ZFC into a probability of bankruptcy (see Bamber, Bamber, and Schoderbek
[1993]).
9 Stice [1991] reports that higher Altman Z-scores are negatively associated with auditor
litigation. Since higher Altman Z-scores indicate a lower likelihood of bankruptcy, stron-
ger client financial condition lessens the likelihood of auditor litigation.
Furthermore, we include in our model a proxy for irregularities in

prebankruptcy financial reporting and disclosures. We measure irregu-
larities by the existence of a SECenforcement action against the client,
its officers, or directors (1 = yes, 0 = no) involving material omissions or
misstatements in financial statements and disclosures made before
bankruptcy. SECenforcement actions differ in their nature and severity
(see Feroz, Park, and Pastena [1991]); our dichotomous variable is in-
tended to capture those situations at the irregularities end of a contin-
uum from errors to irregularities. As an aside, our variable also provides
some insight on the association between SEC enforcement actions and
private civil litigation.
Client size is consistently associated with financial reporting and dis-
closure litigation (Francis, Philbrick, and Schipper [1994], Lys and
Watts [1994], Schultz and Gustavson [1978], and Stice [1991]), possibly
because larger companies, even bankrupt ones, are more likely to have
resources (including officers and directors insurance) to pay plaintiffs
(see Dunbar and Juneja [1993] and the WallStreetJournal[1993 ]). In ad-
dition, they tend to have enough insurance to provide adequate fees for
plaintiff attorneys (even after covering the relevant defendants' defense
costs), therefore making it worthwhile for attorneys to file lawsuits.
Firm size and litigation may also be linked through estimated dam-
ages. Client size is related to damages and larger estimated damages at-
tract litigation because damages are related to settlements. Dunbar and
Juneja [1993] and Francis, Philbrick, and Schipper [1994] document a
nonlinear relation between estimated damages and actual settlements.
Client size may affect the exposure to litigation because of disclosure
practices; larger clients have more public disclosures. Francis, Philbrick,
and Schipper [1994] find that, relative to a control sample of firms in
the same industries, more disclosures are made by or about the lawsuit
firms in their sample.
We include two size-related variables in our model: assets (ln total as-
sets), and an indicator of companies listed on the New York Stock Ex-
change (NYSE) (1 = yes, 0 = no). Simonetti and Andrews [1994] report
that 1 of every 8 companies on the NYSE, 1 of every 18 companies on
the ASE, and 1 of every 20 companies on the NASDAQhave recent in-
volvement in securities litigation.
Finally, client industry appears to be a factor in the occurrence of lit-
igation (e.g., see Class Action Reports[1993], Dunbar and Juneja [1993],
and Francis, Philbrick, and Schipper [1994]). Palmrose [1988] reports
that a significant portion of auditor litigation involves clients in the finan-
cial services industries (30%). Our model includes an indicator variable
(1 = yes, 0 = no) for financial services companies.
In summary, our multivariate analysis uses a logistic regression
model with the occurrence of litigation (1 = yes, 0 = no) as the depen-
dent variable; presence and persistence of modified reports as the test
variables; and net income, the ZFC/Sinkey financial condition index,
SEC enforcement actions, (in) client assets, NYSE, and client industry
(financial services) as a control variables.
We also analyze the auditor and other litigation subsamples. First, we
identify all financial statements at issue in auditor litigation and deter-
mine the types of audit reports accompanying these statements. These
analyses recognize that litigation need not allege reporting and disclo-
sure deficiencies in financial statements close in time to bankruptcy,
and litigation can encompass several years' audits. Second, we provide
resolution data by subsample. Even if modified reports do not prevent
the occurrence of litigation, they may reduce its severity. For example,
the likelihood of dismissal (no payments to plaintiffs) may be greater
for litigation involving modified reports. Finally, we compare the audi-
tor and other litigation subsamples using modified reporting rates, res-
olution data, and the stated accounting, reporting, and disclosure
issues in litigation. These analyses provide preliminary evidence on why
auditors are not included as defendants in other litigation.
4. Sample Selection and Description

Our sample consists of 655 public companies that declared bank-
ruptcy between 1972 and 1992. We limit our sample to companies with
Big Six (Big Eight) auditors at bankruptcy and with Big Six (Big Eight)
firms involved in auditor litigation. We primarily obtained the sample
from Predicasts' F&S Index of Corporate Change (Predicasts). Predicasts is a
compilation of data from numerous newspapers and periodicals; we
supplemented this source with the Wall StreetJournal Index, Who Audits
America, and sources listed in Palmrose [1991]. The bankruptcy sample
is limited to companies for which we could locate the last annual report
(or 10-K) issued before bankruptcy to determine the type of audit re-
port.10 Where possible, we reviewed the original audit reports for all
years with financial statements at issue in auditor litigation; in a few in-
stances we relied on secondary sources listed in Palmrose [1991] be-
cause we could not locate the audit reports.11
The sample includes 118 firms with auditor litigation and another 41
with financial reporting and disclosure litigation not involving auditors
(other litigation);12 the remaining firms have no financial reporting/
disclosure litigation. We do not consider a company to be the subject of
10If the bankruptcy filing fell between the financial statement year-end and the date
of the audit report, we used the financial statements and accompanying audit report
from the preceding year. If the company did not publish financial statements in the year
prior to bankruptcy, we used the preceding year's financial statements and accompanying
audit report. Use of these financial statements is subject to the constraint that the audit
report is dated within 15 months of bankruptcy filing. Companies for which there is no
audit report within 15 months of bankruptcy filing are excluded from the sample.
' We used report collections in a number of university libraries. We also searched
databases such as NAARS and CompactD/SEC.
12Auditor litigation was based on a sample of over one thousand litigation observations
for the largest audit firms; about half of the observations have resolution information
litigation if more than three years elapse between the date of the latest
financial statements involved in litigation (or the end of the class period)
and the bankruptcy filing date.13 This criterion excludes 12 companies
from the auditor litigation group and 11 companies from the other lit-
igation group; these 23 firms are included in the no litigation group.
More than 75% (496 of 655) of our sample firms have no financial re-
porting/disclosure litigation; 18% (118 of 655) have auditor litigation;
and 6% (41 of 655) have other litigation. While litigation rates may
seem low, at least relative to anecdotal evidence, auditors are included
in 118 of 159 (74%) of financial reporting/disclosure lawsuits involving
our sample companies. Furthermore, the auditor litigation rate for
bankrupt clients (18%) is higher than an estimated rate (3%) for all
public clients (Palmrose [1988]).
5. Results
5.1 UNIVARIATE ANALYSIS
Table 1 presents selected descriptive characteristics for the total

sample and the three groups-no litigation, auditor litigation, and
other litigation. Panel A reports mean, standard deviation, and median
amounts for company assets, net income (for those observations with net
income), net loss (for those observations with net losses), and the ZFCI
Sinkey financial condition index (expressed as a probability of bank-
ruptcy). The reported amounts are based on the last financial statements
before either bankruptcy or litigation (for those observations where lit-
igation precedes the last prebankruptcy audit report date). Panel B
provides stock price and return characteristics; these data are discussed
in section 5.2.
Comparison among no litigation, auditor litigation, and other litiga-
tion subsamples in table 1 reveals that bankrupt companies with litigation
are significantly larger than those with no litigation. The auditor litiga-
tion subsample has the highest percentage (55%; 60 of 110) with re-
ported net income in the year immediately preceding bankruptcy or
litigation.14 For observations with net losses, the auditor litigation sub-
sample has the largest mean and median net loss amounts.
Although not shown in tables, the litigation groups have higher
frequencies of NYSE companies (38-39% compared to 19% for
the companies with no litigation). The auditor litigation subsample is
(see Palmrose [1991; 1994]). Other litigation was identified from Investor Class Action
Monitors and Securities Class Action Alert (April 1988 to October 1993), legal notices in the
Wall StreetJournal (1985 to 1993), and Dow Jones News Retrieval. These sources are more re-
liable for revealing other litigation during the 1980s and 1990s.
13 For example, one company filing for bankruptcy in 1989 had litigation subsequent to
its 1983 initial public offering that involved the auditor as defendant. We included this
company in the no litigation subsample because litigation was too distant from bankruptcy.
14 Missing data reduce sample sizes for some variables.
(forNet (forNet Total

Stock Stock Panel Panel
B: Loss A:
Price ZFC/Sinkey(n Income Assets
at Return =
Stock (n
for
ruptcy/Litigation = (n=
observations
observations
467, Selected
(n Indexe
= Year with 176,
with 643,
Bankruptcy/Litigation (n 395,
Beginning = 97, Client
(n=of 420, net50, net 492,
Price/Return
570, 60,
Ending 22) 110,
420, 308, 19)
Year 452, losses) Financial
308, 81,with income) 41)d
Selected
80,
81,before 31)
Bank- 38)
31) Characteristics
Characteristics
Characteristicsc
Mean Mean Mean Mean Mean Mean for
Median Median Median Median Median Median
Standard Standard StandardStandard Standard Standard the
Total
Deviation Deviation DeviationDeviation Deviation Deviation

Samplea
and
(n=Total (7) 113$(41) 3 99 $22 $822(n=
52 3,559
Total theTABLE
No,1
4.13
7.63$6.48 -73.6%
98.3%
-59.6%655) 2.2% 21.8%
33.3% 655)
Sample Sample
Auditor,
and
No No
(n= (n= Other
(6) 89 $(30) 1 25 $10 39 1,205
$318
3.13
5.20$4.37 -74.4%-58.1%496)
112.9% 2.5% 22.6%
33.5% 496)
Litigation Litigation
Litigation
(n=Auditor (n=Auditor
$2,861
(19)194$(104)6 50 $21 2447,462 Subsamplesb
10.25
9.56$11.73-72.2%-66.7%118)
30.4% 1.9% 21.8%
34.7% 118)
Other Other
(n= 184$(88) 281
$86 (n=
$1,408
4,334
(13)f 5f 158f
10.91
8.88f $13.62-66.0%9
-55.8%41)
40.8% 12.5%
26.1%
1.0%9
41)
9No 308,
dFor
samples, aThe Stock
precedes
insurance CDollarbBased ruptcy
81,
theon or
Price
eZFC/Sinkey sample 31)
statistical
fMedian/mean the
last
computing
amounts
last
respectively.
companies.
Index are
valuesis consists Preceding
in
means, of
difference
an
Missing financial Immediately
differ 655
prebankruptcy
among millions.
standard Litigation
acrossestimate audit public
the variables statement (n
of
the = Following
three report.
three reduce before
deviations, 420,
companies Bank-
and
some
Zmijewski's
subsamples
at subsamples
[1984]
sample bankruptcy
bankrupt Mean
(p medians,
Median
< when Standard
the
sizes.
between
.01). financial
conventional sample litigation
1972
Deviation
sizes and
condition
are follows
1992,
significance the
index
or noted last
levels. the audited
.88 4.19$2.29
audit
by
Big
Sinkey, report;
Six
parenthetically
Terza,for (Big
based
the on
and
theEight)
total .69 3.20$1.50
Dince last
firms.
sample
[1987]
and financial
the
no,
financial
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2.504.09$3.65
auditor,before
condition
and
index
other litigation
for
when
8.16$6.50
litigation
finance 3.00f
and sub- litigation
distinguished by a high frequency of companies in the finance and in-

surance industries (43 of 118; 36%).15 Finally, SEC enforcement actions
against companies and/or management distinguish the auditor litigation
subsample (38%) from the other litigation (7%) and no litigation (1%)
subsamples.16
From a time-series perspective, the auditor litigation group primarily
consists of bankrupt companies since 1981 (i.e., 85 of 118 [72%] from
1981 to 1992). Auditor litigation rates (not shown in a table) vary from
14% (1984-86 and 1990-92) to 26% (1972-74). We may not have
identified all legal actions against auditors in our sample of bankrupt
companies and actions may yet occur, so that recent time periods in
particular may have more auditor litigation than we report. Even so,
the auditor litigation rates in our sample of bankrupt public compa-
nies, while consistent with some variation among periods, are not con-
sistent with a litigation "explosion."17
Table 2 shows that the auditor and other litigation subsamples have
higher unmodified reporting rates than the no litigation subsample (64-
66% versus 42%). Persistent modified reporting (at least two years of
modified reports) is more frequent in the no litigation subsample (24%
versus 11-12%).18 The presence and persistence of modified reports are
significantly greater in the no litigation subsample, which provides cir-
cumstantial evidence that modified reports protect auditors. 19 Table 2
also provides a breakdown by type of modified report for the total sample
and the three subsamples. Going-concern modifications, whether pre- or
post-SAS No. 59, represent the majority of modifications. Less than 10%
of the total sample and any subsample involve disclaimers.
15 These finance and insurance observations are from a number of different SIC codes
including banks, savings and loans, and credit institutions (n = 17); insurance (n = 9);
real estate (n = 7); holding companies (n= 7); and brokers and dealers (n= 3).
16 Litigation rates do not significantly differ among either Big Six (Big Eight) firms or
firm groupings based on audit structure (Kinney [1986]).
17 The auditor litigation rate is 14% for the period just before SAS No. 59 (1984-86),
21% for the SASNo. 59transition period (1987-89), and 14% in the post-SAS No. 59period
(1990-92). These rates are inconsistent with predictions that SASNo. 59would increase au-
ditor litigation by increasing auditor responsibilities for going-concern reporting. Futher-
more, the majority of auditor litigation in our sample during the post-SAS No. 59 period
involves companies in the finance and insurance industries (16 of 26 observations).
18 Dopuch, Holthausen, and Leftwich [1986] report that 34% of their modified report-
ing sample has multiple-year modifications. The comparable rate for our sample, consid-
ering only observations with modified reports, is 40% (138 of 344). Their sample does not
consist of bankrupt companies.
19There are at most two observations in the auditor litigation suLbsample where a
modified report on the penultimate prebankruptcy financial statements was followed by
an unmodified report on the last prebankruptcy financial statements. The failure to
modify the last report given the modification of the penultimate report was a focus of
auditor litigation. These observations are classified as unmodified in table 2 because they
do not involve uninterrupted multiple-year modifications.
TABLE 2
Type of Audit Report on the Last Financial Statements before Bankruptcy/Litigation
and the Persistence of Modified Audit Reports a
Panel A: Type of Audit Report on the Last Financial Statements before Bankruptcy/Litigation
Number (Percentage) of Observations
Total No Litigation Auditor Litigation Other Litigation
Unmodified (Unqualified) 311 (47%) 208 (42%) 76 (64%) 27 (66%)

Modified
Going Concern:b 175 (27%) 149 (30%) 21 (18%) 5 (12%)
Subject to SAS No. 59
Explanatory Paragraph 83 (13%) 77 (15%) 5 (4%) 1 (2%)
Other Uncertainties: 26 (4%) 16 (3%) 9 (8%) 1 (2%)
Subject to SAS No. 59
Explanatory Paragraph 16 (2%) 9 (2%) 1 (1%) 6 (15%)
Disclaimers 40 (6%) 35 (7%) 4 (3%) 1 (3%)
Other 4 (1%) 2 (1%) 2 (2%) 0 (0%)
Total Modified 344 (53%) 288 (58%) 42 (36%) 14 (34%)c
Total 655 (100%) 496 (100%) 118 (100%) 41(100%)
Panel B: Persistence of Modified Audit Reports

Number (Percentage) of Observations
Total No Litigation Auditor Litigation Other Litigation
Unmodified (Unqualified) 311 (47%) 208 (42%) 76 (64%) 27 (66%)

Last Report before Bankruptcy/
Litigation Modified, Prior Year
Unmodified 206 (32%) 168 (34%) 29 (25%) 9 (22%)
Last Report before Bankruptcy/
Litigation Modified and Prior
Year(s) Modified 138 (21%) 120 (24%) 13 (11%) 5 (12%)
Total 655 (100%) 496 (100%) 118 (100%) 41 (100%)
aThe sample consists of 655 public companies bankrupt between 1972 and 1992, audited by Big Six (Big Eight) firms.
bIncludes reports that are exclusively going-concern opinions as well as reports with both going-concern and other
uncertainties.
CModified reporting rates differ across the three litigation groups (no, auditor, and other litigation) (chi-square =
25.223, p < .0001).
5.2 MULTIVARIATEANALYSIS
Our multivariate analysis uses the model described in section 3. Test

variables include the presence and persistence of modified reports;
control variables include indicator variables for net income (1 = yes,
0 no), SEC enforcement actions (1 = yes, 0 = no), NYSE listing (1 =
yes, 0 = no), and banks (1 = yes, 0 = no) plus variables for the ZFC!
Sinkey financial condition index and (In) assets.
Table 3 reports the logistic regression results. In panel A, the depen-
dent variable is auditor litigation (1) and no litigation (0); in panel B,
it is auditor litigation (1) and other litigation (0).20
20 Table 3 reports the percentage of observations correctly classified based on prior

probabilities similar to the relative subsample frequencies. We examined the misclassified
14 JOSEPH V. CARCELLOAND ZOE-VONNA PALMROSE
TABLE 3
Logistic Regression Results a
Panel A: Auditor Litigation (1) vs. No Litigation (0)

Number of Observations 532
Chi-Square for Model
(8 degrees of freedom) 152.82
p Value .0001b
Percentage of Observations
Correctly Classifiedc 89.5
Predicted Estimated Standard

Independent Variable Relation Coefficients Errors Chi-Square pLeveld
Intercept none -10.47 1.89 30.63 .001
Modified Audit Report - .18 .40 .20 .655
ZFC/Sinkey Index - .03 .05 .53 .469
Financial Reporting Irregularity + 4.14 .62 44.70 .001
Persistence of Modified Reporting - -0.31 .47 .43 .510
Stock Exchange + .10 .39 .07 .790
TotalAssets (ln) + .43 .10 17.94 .001
Presence of Net Income/Net Loss + 1.10 .36 9.05 .003
Bank/Nonbank + .66 .67 .96 .326
Panel B: Auditor Litigation (1) vs. Other Litigation (0)

Number of Observations 118
Chi-Square for Model
(8 degrees of freedom) 17.58
p Value .0246b
Percentage of Observations
Correctly Classifiedc 67.8
Predicted Estimated Standard
Independent Variable Relation Coefficients Errors Chi-Square pLeveld
Intercept none 0.03 2.75 .00 .992
Modified Audit Report - -0.03 .60 .00 .965
ZFC/Sinkey Index - .24 .13 3.29 .070
Financial Reporting Irregularity + 1.97 .70 7.84 .005
Persistence of Modified Reporting - -0.11 .74 .02 .885
Stock Exchange + .09 .56 .03 .870
Total Assets (In) + .03 .14 .05 .821
Presence of Net Income/Net Loss + .28 .50 .31 .576
Bank/Nonbank + .29 .98 .09 .765
aThe sample consists of 655 public companies bankrupt between 1972 and 1992, audited by Big Six (Big Eight)
firms. Missing variables reduce the multivariate samples.
bOLS regression results were substantially similar to those reported; the adjusted R2 was 35% in panel A and
7% in panel B.
cBased on prior probabilities similar to the relative subsample frequencies of 20%/80% in panel A and 75%/
25% in panel B.
dThe significance tests are two-tailed.
The test variables' coefficients are not significant at conventional lev-

els in either regression. The significant control variable coefficients are
for In assets, net income, and SEC enforcement actions in panel A; as
observations. In panel A, auditor litigation observations with no SEC enforcement actions

are classified as no litigation (these represent the vast majority of misclassifications); no
expected, the signs for these coefficients are all positive.21 In the audi-
tor/other litigation logistic regression (panel B), only the coefficients
for SEC enforcement actions and ZFC/Sinkey financial condition index
are significant; the latter has an unexpected positive sign. In part, this
latter result may reflect, on average, higher leverage in the auditor
litigation subsample (.36 versus .26, based on total long-term debt ex-
cluding deferred taxes) and the magnifying effect of leverage on the
ZFC/Sinkey measure.22
We conducted a number of additional analyses, with no/auditor liti-
gation as the dependent variable, to gain some insight into the in-
significant test variable results and to address some other issues related
to auditor litigation involving bankrupt clients. For example, we de-
leted the observations with SEC enforcement actions to assess whether
modified reports have greater protective value in situations without ir-
regularities, as proxied by SEC enforcement actions. The results were
substantially similar to those reported in table 3.
The correlation matrix (table 4) suggests some potential interrela-
tionships among the test and control variables. To address these issues,
we used the test variables and then each of the significant control vari-
ables (In assets, net income, and SEC enforcement actions) individually.
We ran a series of regressions beginning with three regressions; (1) and
(2) had each of the test variables as the only variable; (3) had both test
variables as the only variables. Next, to each of these three regressions
we added one control variable in turn, either in assets, net income, or
SEC enforcement actions. (This procedure yielded nine more regres-
sions.) As the only test variable included, the coefficient of the presence
of a modified report variable was negative and significant except when
net income was included. As the only test variable included, the
coefficient of the persistent modified reporting variable was always nega-
tive and significant. With both test variables included, the persistence
litigation observations with SEC enforcement actions are classified as auditor litigation.
SEC enforcement actions, for the most part, occur after the initiation of private civil liti-
gation against auditors. In panel B, misclassifications are entirely other litigation classified
as auditor litigation.
21 We computed the ZFC index using hand-collected data that included amounts for
total long-term debt (excluding deferred taxes) not total debt (including short- and long-
term notes) as defined by Compustat. Zmijewski [1984] developed his index using total
debt as defined by Compustat. We recomputed the ZFC index and ran the regression for
the portion of the no litigation and auditor litigation subsamples available on Compustat
(n = 220). The results are substantially similar to those reported in panel A of table 3. The
mean bankruptcy probabilities are 19% and 33% using total long-term debt (excluding
deferred taxes) and Compustat debt, respectively.
22 For example, we ran the regression deleting four auditor litigation observations
with leverage ratios of .80 or greater. The ZFC/Sinkey coefficient was not significant at
conventional levels (only the SEC enforcement action coefficient was significant). Debt-
holders are among the plaintiffs in three of the four deleted observations.
I.~~~~c
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coefficient was never significant; the modified report coefficient was

negative and significant in regressions which included the persistence
variable and In assets. From these results, we conclude that the modified
report variable swamps the persistence variable and that the net income
variable swamps the modified report variable.23 This analysis suggests a
role for modified reporting in protecting auditors from litigation, while
recognizing the interrelationships among the reporting and significant
explanatory variables.
We added a stock return variable to the full logistic regression model
to address the proposition that lawsuits are attracted by large price de-
clines, even within bankrupt companies. The stock return variable is
measured over the year ending either just before the initiation of liti-
gation or after the declaration of bankruptcy for those observations
available on CRS1 This variable was not significant at conventional levels
in the regression. Table 1 (panel B) shows that while the median one-
year returns are similar for the no litigation and auditor litigation sub-
samples (-74.4% and -72.2%, respectively), stock prices for the auditor
litigation subsample are at least twice those for the no litigation sub-
sample. Results (not reported in the table) show 72% of the no litigation
subsample has beginning stock prices of $5.00 or less compared to 25%
of the auditor litigation subsample. These results suggest that larger es-
timated (common stock) damage computations characterize the auditor
litigation subsample.
5.3 ANALYSIS OF DEGREE OF FINANCIAL DISTRESS
To analyze the role of financial distress in our model, we partitioned

the sample using the ZFC/Sinkey index into most and least distressed
quartiles, as indicated in panel A of table 5. Total litigation rates are
highest (28%; 40 of 143) in the least distressed quartile and lowest
(15%; 21 of 143) in the most distressed quartile. Panel B presents the
type of report (modified or unmodified) on the last financial statements
before bankruptcy (litigation) for the observations in the most and least
distressed quartiles for each subsample. In the least distressed quartile,
the modified reporting rate is only 18% (7 of 40 reports) for the two
litigation subsamples compared to 47% (48 of 103 reports) for the no
litigation subsample. Auditor litigation, however, precedes bankruptcy
for most of the least distressed observations with auditor litigation and
unmodified reports (results not reported). (The timing of auditor liti-
gation is among the issues pursued in the next section.) To address con-
cerns that the least distressed observations might unduly influence the
multivariate results, we ran the full logistic regression, with no/auditor
litigation as the dependent variable, deleting the bottom quartile of
least distressed observations. The results were substantially similar to
those reported in table 3.
23 We thank Maureen McNichols for suggesting this analysis.
TABLE 5
Degreeof Financial Distressa and Typeof Audit Reportb (for the Most/LeastDistressedQuartiles):
No, Auditor, and OtherLitigation Subsamples
Panel A: Subsamples Classified by ZFC/Sinkey Indexc
Number of Observationsd
Most Distressed Least Distressed Neither
Total (Top Quartile) (Bottom Quartile) (Interquartile Range)
No Litigation 452 122 103 227
Auditor Litigation 80 18 27 35
Other Litigation 38 3 13 22
570 143 143 284
Panel B: Subsamples Classified by Type of Report on the

Last Financial Statements before Bankruptcy/Litigation
Number of Observations
Most Distressede (Top Quartile) Least Distressedf (Bottom Quartile)
Unmodified Modified Unmodified Modified
Total Report Report Total Report Report
No Litigation 122 28 94 103 55 48
Auditor Litigation 18 5 13 27 22 5
Other Litigation 3 0 3 13 11 2
143 33 110 143 88 55
aThe sample consists of 655 public companies bankrupt between 1972 and 1992, audited by Big Six (Big
Eight) firms. Some observations were lost due to missing variables.
bBased on the last financial statement before bankruptcy when litigation follows the last audit report; based
on the last financial statement before litigation when litigation precedes the last prebankruptcy audit report.
c7FC/Sinkey Index is an estimate of Zmijewski's [1984] financial condition index or the Sinkey, Terza, and
Dince [1987] financial condition index for finance and insurance companies.
dFinancial distress (quartile) and litigation status are not independent (chi-square = 11.05, p < .05).
CLitigation status is independent of report type for the most distressed quartile of observations (chi-
square = 1.13, p= .57).
fLitigation status is not independent of report type for the least distressed quartile of observations (chi-
square = 10.35, p< .01).
6. Auditor Litigation Subsample

In this section, we pursue the potential economic significance of
modified reports. We focus on the auditor litigation subsample and dis-
cuss four issues: (1) the sequence of events relative to the audit report
date, the date of the first lawsuit filed against the auditor, and the bank-
ruptcy filing date; (2) the financial statements at issue in litigation; (3) the
types of audit reports at issue in auditor litigation; and (4) the role of
modified reporting in resolutions.
6.1 MODIFIED REPORTING AND THE TIMING OF AUDIT REPORTS, LITIGATION, AND
BANKRUPTCY
Table 6 (panel A) classifies the auditor litigation subsample by the se-

quence of events relative to the last audit report, client bankruptcy, and
the first lawsuit filed against the auditor.24 The sequence of events: audit
24 Five observations have litigation filed, but not against the auditor, before the audit
report date; auditors are added as defendants after the report date (either before the
AUDITOR LITIGATIONAND REPORTING ON BANKRUPT CLIENTS 19
TABLE 6
Sequence of Events (Audit Report, Bankruptcy, Litigation) for Auditor and
Other Litigation Classified by Type of Auditor Report
Last Financial Statements before
Bankruptcy/Litigation
Unmodified Modified
Sequence of Events Total Report Report
Panel A: Auditor Litigation
Audit Report-Bankruptcy-
Auditor Litigation 53 22 31
Audit Report-Auditor Litiga-
tion-Bankruptcy 37 30 7
Auditor Litigation-Audit
Report-Bankruptcy 28 24 4
Totala 118 76 42
Panel B: Other Litigation

Audit Report-Bankruptcy-
Other Litigation 10 7 3
Audit Report-Other Litiga-
tion-Bankruptcy 14 8 6
Other Litigation-Audit
Report-Bankruptcy 17 12 5
Totalb 41 27 14
aChi-square = 22.154, p < .0001.
bChi-square = .718, p = .698.
report-bankruptcy-litigation, is consistent with the notion that users

incur losses with client bankruptcy which in turn precipitates litigation
(St. Pierre and Anderson [1984]). However, as shown in panel A, this se-
quence actually occurs in only 45% of the observations (53 of 118). Au-
ditor litigation precedes bankruptcy for the remaining observations; 28
of 118 (24%) firms have litigation prior to the last prebankruptcy audit
report date and 37 firms have litigation between the audit report date
and bankruptcy.
One difference (not shown) among the three sequences is in the rate
of fraudulent financial reporting (fraud is alleged in 54 of the auditor lit-
igation observations).25 The fraudulent financial reporting rate is 28%
bankruptcy filing [n = 2] or after the bankruptcy filing [n = 3]). All five of the last audit
reports before bankruptcy (which coincide with the last reports before auditor litigation)
are modified; all five of the last reports before litigation against other defendants are un-
modified. Our analyses use the date that the auditors become defendants in litigation.
Changing the reports from modified to unmodified (to utilize the last report before liti-
gation against other defendants) does not change the multivariate results.
25 We add criminal convictions of management for fraudulent financial reporting,
internal investigations that confirm fraudulent financial reporting, and regulatory en-
forcement actions against companies and their management along with SECenforcement
(15 of 53) for the audit report-bankruptcy-litigation sequence, 62% (23

of 37) for the audit report-litigation-bankruptcy sequence, and 57% (16
of 28) for the litigation-audit report-bankruptcy sequence.
6.2 PREBANKRUPTCY FINANCIAL STATEMENTS AT ISSUE IN AUDITOR LITIGATION
In this section, we initially classify the financial statements at issue in au-

ditor litigation relative to the last statement before bankruptcy. Litigation
can be limited to the last prebankruptcy statement; it can involve only prior
financial statements; or it can include both the last statement and prior
statements. The summary in table 7 (panel D) reveals that the latter occurs
in 55 of the 118 cases (46%); litigation not involving the last statement
occurs in 42 cases (36%); and litigation confined to the last prebankruptcy
statement occurs with the lowest frequency (18%; 21 of 118).26
Table 7 combines information on financial statements at issue in lit-
igation, the last prebankruptcy audit report, and the sequence of events
for auditor reporting, bankruptcy, and litigation. The table includes
the last prebankruptcy financial statement, so the number of modified
reports exceeds the number reported in previous tables. The increase
occurs because auditor litigation precedes the audit report date on the
last prebankruptcy statement; 20 observations have modified reports on
the last prebankruptcy statement (table 7, panel C) but unmodified re-
ports on the last preauditor litigation statement (table 6).
There are six observations in table 7 (panel C) where auditor litigation
occurs before the audit report date on the last prebankruptcy statement
yet the litigation involves that statement (along with prior statements).
There are several reasons for this result. One reason is that the initial
legal action defines the sequence of litigation-audit report-bankruptcy,
but the classification of financial statements involved in litigation con-
siders all legal actions against the auditor. Thus, subsequent legal ac-
tions can encompass different financial statements and disclosures than
the initial action. As a result, the audit of the last prebankruptcy financial
statement is not irrelevant even when initial legal actions against audi-
tors precede that audit report date.
6.3 TYPES OF AUDIT REPORTS INVOLVED IN AUDITOR LITIGATION
This section describes the types of reports for all the financial state-
ments involved in auditor litigation. The number of annual audit re-
ports involved in litigation ranges from zero to six per observation.
(Zero occurs on one observation because allegations involve omissions
only in a comfort letter.) Most observations (70%; or 82 of 118) have
actions against companies, management, officers and directors, and auditors. This in-
creases the number of observations to 55 of 118 (47%) in the auditor litigation sub-
sample. Of these, 54 involve financial reporting irregularities; one is an SECenforcement
action limited to the auditor for independence problems.
26 In at least eight of these observations, the financial information involved in auditor
litigation also includes subsequent interim statements along with the annual financial
statements.
TABLE 7
Financial Statements at Issue in Auditor Litigation Classified by Event Sequence
(Audit Report, Bankruptcy, Auditor Litigation) and Type of Report (on Last
Financial Statement before Bankruptcy)
Type of Audit Report

Last Financial Statement before
Bankruptcy
Total Unmodified Modified
Panel A: Audit Report-Bankruptcy-Auditor Litigation
Financial Statements at Issue in Litigation:
Only the Last Statement
before Bankruptcy 11 4 7
Only Statements Prior to the
Last Statement before
Bankruptcy 14 3 11
Both the Last Statement
before Bankruptcy and
Prior Statements 28 15 13
53 22 31
Panel B: Audit Report-Auditor Litigation-Bankruptcy

Bankruptcy 6 4 2
37 30 7
Panel C: Auditor Litigation-Audit Report-Bankruptcy

Bankruptcy 22 1 21
28 4 24
118 56 62
Panel D: Summary
Bankruptcy 42 8 34
118 56 62
only unmodified reports as the subject of auditor litigation;27 another

20% have a mixture of modified and unmodified audit reports. For most
of the observations with a mixture of reports, the last report before
bankruptcy is one of a number of reports at issue in auditor litigation;
usually the last report is the only modified report involved in auditor lit-
igation. Only 12 of the 118 observations exclusively involve modified re-
ports as the subject of litigation. For 8 of these 12 observations, the last
prebankruptcy financial statements are the only statements involved in
litigation.
The low rate of modified reports as the only reports at issue in litiga-
tion suggests that such reports reduce but do not eliminate the likeli-
hood of litigation where plaintiffs allege substandard audits and auditor
responsibility for substandard financial reporting and disclosures. How-
ever, 24% (28 of 118 in table 7) of auditor litigation in our sample oc-
curs beforeissuance of the last prebankruptcy report; 82% (97 of 118) of
auditor litigation is either not limited to or does not involve the last pre-
bankruptcy report.28
We next analyze the role of modified reports in auditor litigation by
examining plaintiffs' rationales for including auditors as defendants for
the 12 observations with only modified reports as the subject of litiga-
tion. Except for two observations about which we have little information
(we classify these as having only modified reports at issue), the obser-
vations fall into two categories. First, plaintiffs allege auditors failed
to provide the appropriate audit report even though the report was
modified (n = 6). Most commonly plaintiffs argue that the financial
statements contain material omissions or misstatements in spite of a
modified report. In one case, the auditor subsequently withdrew the
modified report stating that users should no longer rely on the financial
statements. In another case, plaintiffs claim that the auditor inappro-
priately used an uncertainty modification rather than a modification for
departures from GAAP (or rather than require that the client change
reported amounts and footnote disclosures).
27 Six unmodified reports were subsequently withdrawn by the auditors. Two unmodified
reports were retroactively modified.
28 Our evidence, that other (more) than the last financial statements before bank-
ruptcy are the subject of auditor litigation, reinforces the relevance of a current imple-
mentation issue under SAS No. 59 called the "15-month" problem. "This situation arises
when the client is not expected to have any financial difficulties for the next 12 months,
but the auditor knows that difficulties will exist within the following few months" (Car-
michael and Pany [1993, p. 46]). Auditors adopt a practical solution to this problem by in-
cluding an emphasis of matter paragraph. We classify emphasis of matter paragraphs
(which differ from explanatory paragraphs) as unmodified reports; there are at least four
in our sample, all before or during the transition to SAS No. 59. While our evidence im-
plies that unmodified penultimate (and prior) reports preceding bankruptcy may indeed
increase litigation exposure, the absence of any unmodified reports with emphasis of mat-
ter paragraphs post-SAS No. 59 provides some very limited evidence that the practical so-
lution is effective.
A second category involves questions of auditor responsibility and

conduct for events or information outside the annual financial state-
ments (n = 4). We conservatively classify these observations as litigation
that involves only modified reports because plaintiff allegations appear
conditioned on (or related to) the auditor's association with annual
financial statements containing modified audit reports. To illustrate, one
suit over financial statements used in an acquisition focuses on com-
ments made by individual auditors during acquisition-related meetings;
plaintiffs alleged that these comments tempered information in the
financial statements (with modified reports).
In summary, based on the accumulated evidence it is clear that un-
modified reports are not necessary for the occurrence of litigation, and
modified reports are not sufficient to prevent it. However, the small num-
ber of observations with modified reports as the only reports at issue in au-
ditor litigation and the nonroutine nature of plaintiffs' allegations about
these reports suggest a defensive role for timely modified reporting.
6.4 AUDITOR LITIGATION RESOLUTIONS
Table 8 (panel A) presents data on auditor resolutions in terms of

amounts paid by auditors and the number of modified reports at issue
in litigation. Resolution amounts are not inflation adjusted.
The auditor dismissal (no payment) rate is 33% (16 of 49); 14% (7 of
49) are payments less than $1 million; 16% (8 of 49) are between $1 and
$5 million; and 37% (18 of 49) exceed $5 million. Comparable rates for
all types of auditor litigation (i.e., not just litigation involving bankrupt
public clients) generally are about 44% (dismissals and no payments),
28% (payments less than $1 million), 18% (payments between $1 and
$5 million), and 10% (payments of $5 million or more) (Palmrose
[1994]). There are several possible explanations for these differences.
First, claims against auditors could be more meritorious for observa-
tions in this study than observations in other studies. Second, client
bankruptcy disadvantages defendants with resources such as auditors
(i.e., resolutions and merits may be disconnected, thereby increasing
amounts paid by deep-pocket defendants). As table 8 indicates, mean
amounts (in panel A) for auditor payments ($7.5 million) and total res-
olutions on auditor litigation ($34.5 million) exceed the average total
payment for other litigation ($4.9 million in panel B).29
The lowest payments and the highest dismissal rate are associated
with reports that are all modified; the highest auditor payments are on
observations where no reports are modified (panel A of table 8). These
results are consistent with modified reports providing some protection
29 The average auditor payment and total resolution amounts (panel A) are also larger
than the inflation-adjusted averages reported in Palmrose [1994] of $4.6 million and
$23.11 million, respectively.
TABLE 8
Litigation Resolutions for Auditor and Other Litigation
(Auditor Resolutions Classified by Type of Report)

Audit Reports at Issue in Litigation
Total None Modified All Modified Some Modified
Auditor Payment Amounts
None (Dismissed) 16 9 3 4
Under $1 million 7 4 1 2
$1 up to $5 million 8 6 0 2
$5 up to $10 million 10 6 1 3
Greater than $10 million 8 6 0 2
Total 49 31 5 13
Auditor Payments (in Millions)
Mean $7.5 $9.5 $1.2 $5.2
Median $0.7 $2.0 $0 $1.3
Maximum $168.6 $168.6 $6.0 $32.0
Total Resolutions on Auditor
Litigation (in Millions)
Mean $34.5
Median $7.8
Maximum $383.0

Total Resolutions
No Payments by Any Defen-
dants (Dismissed) 1
Noncash Settlement 1
Under $1 million 7
$1 up to $5 million 11
$5 up to $10 million 3
Greater than $10 million 5
Total 28
Mean $4.9
Median $1.8
Maximum $30.0
for auditors from the consequences (effects) of litigation. However,

the number of observations is small, particularly in the category with
only modified reports at issue in auditor litigation.30
30 We also ran a multivariate regression with auditor payments (including zero) as the
dependent variable using the model outlined in section 3 (but excluding the financial
condition variable to maintain a sufficient sample size). No significant results emerged;
in fact, the model was not significant.
7. Analysis of Other Litigation

As indicated in panel B of table 6, other litigation tends to precede
bankruptcy; litigation following bankruptcy has the lowest occurrence
rate of any sequence. Table 6 shows that 34% of audit reports are
modified for the last financial statements before bankruptcy (or before
litigation if it precedes the date of the last prebankruptcy audit
report). The modified reporting rate (not shown) is similar for the
specific audit reports at risk for auditor litigation based on the finan-
cial statements both preceding and during class periods (rather than
just the last statements before bankruptcy [litigation]).
These low modified reporting rates (along with the results reported
in table 3) indicate that other factors may be important in explaining
why auditors are not defendants in other litigation. Resolution evi-
dence available for other litigation (table 8, panel B) provides some in-
sights. The mean (median) resolution amount is $4.9 million ($1.8
million) and amounts range from zero to $30 million. These means
(medians) are less than those reported in other studies.31 With the ex-
ception of one dismissal, these resolutions occur through settlements.
A few settlement notices gave company bankruptcy and defendants'
lack of resources as reasons for low settlement amounts. Alternatively,
low settlements may just reflect weak claims (Palmrose [1994]). Either
explanation raises the question-why not sue the auditors too? Weak
claims, combined with auditors' possible disincentives to settle weak
claims (Palmrose [1991; 1994]), may explain why auditors are not in-
cluded as defendants in this other litigation.
To analyze why claims in other litigation might be viewed as weak with
respect to auditors, we consider the accounting, reporting, and disclo-
sure issues in auditor litigation and other litigation; these are summa-
rized in table 9. We tried to use the focus of plaintiffs' allegations to
describe the issues. A limitation of this approach is that it condenses
often complex allegations into single issues, potentially obscuring im-
portant insights. For example, a lawsuit with allegations of overstated
assets, overstated revenues and income, irregularities in accounting for
related party transactions, waste of corporate assets, and weaknesses in
internal control is classified simply as overstated assets.
The information in panels A and B of table 9 reveals that accounting
issues dominate auditor litigation and disclosure issues dominate other
litigation. In fact, many allegations in other litigation do not involve
31 For example, Francis, Philbrick, and Schipper [1994] report a mean (median) set-
tlement of $6.3 million ($3.8 million) and a range from zero to $25.2 million. About 10%
of our other litigation companies involve the SIC codes (3500-3599 and 7300-7399)
used in their study. Based on a sample of 343 securities resolutions from 1988 to 1993,
O'Brien and Hodges [1993] report an average cash settlement of $7.25 million.
TABLE 9
Accounting, Reporting, and Disclosure Issues: Auditor Litigation and Other Litigation
Adequacy of Disclosures Regarding:
Financial condition, financial position, business pros-
pects (including accounting issues) 19
Other disclosures (e.g., cost overruns, financing, etc.) 7
Accounting Issues:
Overstated: Assets 18
Revenues 17
Earnings 10
Understated: Loan loss reserves and allowances for bad
debts 12
Insurance reserves 6
Other (e.g., losses, liabilities) 3
Non-GAAPAccounting
Various 9
Junk bonds 5
Illegal Acts 3
Failure to Comply with GAAS 2
Unknown 7
Total 118

Adequacy of Disclosures (failure to disclose, timeliness of
disclosures, misleading disclosures, etc.):
Optimistic disclosures about prospects (or misleading
information about operating problems and financial
condition) 12
Cash flow, operating, and liquidity problems 4
Risks and other information 3
19
Accounting Issues (along with adequacy of disclosures
about prospects, financial condition, and risks):
Adequacy of Allowances (loan losses and doubtful
accounts) 4
Obligations 4
Revenue and contracts 2
Compliance with GAAP 2
12
Breach of Fiduciary Duty 1
Merger and Restructuring Terms and Conditions 3
Unknown 6
Total 41
financial statement (including footnote) disclosures.32 To the extent

that other litigation focuses on financial reporting and disclosures more
remote from those with auditor involvement and responsibility, audi-
32 It appears that at least one other litigation observation primarily focuses on quar-
terly statements which were restated during the year-end audit. There are at least four no
tors may be excluded from this litigation because they are not appro-
priate defendants.33
8. Summary and Conclusions

Our study examined whether issuing modified reports prior to client
bankruptcy protects auditors from the effects of legal liability. Our
study included three groups of bankrupt companies-those with audi-
tor litigation, those with reporting and disclosure litigation not involv-
ing auditors (other litigation), and those with no financial reporting
and disclosure litigation. We found that the majority (76%) of the 655
bankrupt public companies in our sample had no litigation; but audi-
tors were defendants in the majority of litigation that occurred.
Consistent with prior research, we found that litigation was more likely
to involve larger clients. Other variables associated with an increased
likelihood of auditor litigation included net income (on the last pre-
bankruptcy or prelitigation financial statements) and SEC enforcement
actions. The latter result is consistent with SEC enforcement activities
facilitating civil litigation. Modified reporting rates were significantly
higher for the companies with no litigation in our univariate analysis;
however, in multivariate analyses, the significance of variables for
the presence and persistence of modified reports depended on the
specification.
We found that litigation preceded bankruptcy in most cases, and
some of this litigation also preceded the last prebankruptcy report.
This result is inconsistent with anecdotal evidence that describes client
bankruptcy as the primary event inducing litigation, and it indicates
that modifying only the last report before bankruptcy does not in and
of itself protect auditors from litigation. In fact, most auditor litigation
in our sample was not limited to or did not involve the last report be-
fore bankruptcy. However, we also found a low rate (10%) of only
modified reports at issue in auditor litigation.
Resolution evidence for auditor litigation revealed that observations
with only modified reports had the highest dismissal rate and the lowest
(mean and median) payments; observations with no modified reports had
the highest auditor payments. While small sample sizes make these results
very preliminary, this resolution evidence suggests that observations with
only modified reports have weaker claims. If so, one inference is that
modified reports serve to weaken plaintiffs' claims against auditors.
litigation observations with similar events within two years of bankruptcy. See Kinney and
McDaniel [1989] for a discussion of this area.
33 In auditor litigation, stockholders and debtholders are the most common plaintiffs
(appearing in 96 of 115 cases for which we have data) and the company, officers, and di-
rectors are the most common defendants (appearing in 107 of 113 cases). Stockholders
dominate as plaintiffs in other litigation; companies, officers, and directors dominate as
defendants.
Relative to results reported elsewhere, auditor litigation in our study

had lower dismissal rates and higher average (median) payments, and
other litigation in our study had lower mean (median) payments. One
explanation for these differences is that merits tend to be stronger for
auditor litigation and weaker for other litigation in our study. Alterna-
tively, client bankruptcy may disadvantage "deep-pocket" defendants
such as auditors in the resolution process, while company bankruptcy
may reduce the resources available to plaintiffs in other litigation.
However, this raises the question of why auditors are not defendants in
other litigation; our resolution results for other litigation indicate that
adequate payments from nonauditor defendants cannot be the reason
for excluding auditors from this litigation. Auditors may be excluded
from other litigation because these suits involve disclosures outside the
financial statements, that is, disclosures remote from those with audi-
tor involvement and responsibility.
Because our sample consists entirely of bankrupt public companies,
our results may not generalize to auditor reporting and litigation in
other settings, including bankrupt nonpublic companies and nonbank-
rupt companies. However, our study does provide evidence useful for
future auditor litigation research in these settings, in particular, a set-
ting of financially distressed but not bankrupt companies.
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Accounting Research Center, Booth School of Business, University of Chicago

Auditor Litigation and Modified Reporting on Bankrupt Clients

*University of Tennessee; tUniversity of Southern California. The financial assistance

Copyright ?, Institute of Professional Accounting, 1995

It is widely assumed that unmodified (unqualified) reports before

We focus on the annual financial statements and accompanying audit

2. Background and Prior Research

paragraph.3 We include in our study as modified reports those with ex-

bankrupt clients (e.g., Palmrose [1987] reports a rate of 21%). Palmrose

auditor litigation= f (the presence and persistence of modified

bankruptcy. When litigation occurs before the last prebankruptcy audit

ZFC = -4.336 - 4.513 (ROA) + 5.679 (FINL) + .004 (LIQ)

Furthermore, we include in our model a proxy for irregularities in

4. Sample Selection and Description

Table 1 presents selected descriptive characteristics for the total

(forNet (forNet Total

Deviation Deviation DeviationDeviation Deviation Deviation

and sub- litigation

distinguished by a high frequency of companies in the finance and in-

Unmodified (Unqualified) 311 (47%) 208 (42%) 76 (64%) 27 (66%)

Panel B: Persistence of Modified Audit Reports

Total No Litigation Auditor Litigation Other Litigation

Unmodified (Unqualified) 311 (47%) 208 (42%) 76 (64%) 27 (66%)

Our multivariate analysis uses the model described in section 3. Test

20 Table 3 reports the percentage of observations correctly classified based on prior

Panel A: Auditor Litigation (1) vs. No Litigation (0)

Predicted Estimated Standard

Panel B: Auditor Litigation (1) vs. Other Litigation (0)

The test variables' coefficients are not significant at conventional lev-

observations. In panel A, auditor litigation observations with no SEC enforcement actions

~~~ CC.CSC> C)C

coefficient was never significant; the modified report coefficient was

To analyze the role of financial distress in our model, we partitioned

Panel B: Subsamples Classified by Type of Report on the

6. Auditor Litigation Subsample

Table 6 (panel A) classifies the auditor litigation subsample by the se-

Panel B: Other Litigation

report-bankruptcy-litigation, is consistent with the notion that users

(15 of 53) for the audit report-bankruptcy-litigation sequence, 62% (23

6.2 PREBANKRUPTCY FINANCIAL STATEMENTS AT ISSUE IN AUDITOR LITIGATION

In this section, we initially classify the financial statements at issue in au-

6.3 TYPES OF AUDIT REPORTS INVOLVED IN AUDITOR LITIGATION

Type of Audit Report

Panel B: Audit Report-Auditor Litigation-Bankruptcy

Panel C: Auditor Litigation-Audit Report-Bankruptcy

only unmodified reports as the subject of auditor litigation;27 another

A second category involves questions of auditor responsibility and

6.4 AUDITOR LITIGATION RESOLUTIONS

Table 8 (panel A) presents data on auditor resolutions in terms of

Panel A: Auditor Litigation

Panel B: Other Litigation

for auditors from the consequences (effects) of litigation. However,

7. Analysis of Other Litigation

Panel B: Other Litigation

financial statement (including footnote) disclosures.32 To the extent

8. Summary and Conclusions

Relative to results reported elsewhere, auditor litigation in our study

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