Predicting {Impending} {Bankruptcy} {Using} {Audit} {Firm} {Changes}

Abstract

Unlike prior research, we investigate the incremental explanatory power of auditor changes beyond the information conveyed by traditional financial statement ratios in predicting bankruptcy. We find that auditor changes are important in predicting impending bankruptcy and convey important information not reflected in traditional financial statement ratios alone. In fact, we find compelling evidence that directional knowledge regarding auditor changes such as changing from large accounting firms to small accounting firms provide incremental explanatory power in predicting impending firm failure beyond what is conveyed traditional financial statement ratios and auditor changes considered jointly. 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 smaller audit firms may be as a strategic response to manifestation of the financial statement effects of bankruptcy.