Shredded Reputation: The Cost of Audit Failure

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Shredded ReputationThe Cost of Audit Failure

• Paul K. Chaney
• Vanderbilt University
• Kirk L. Philipich
• The Ohio State University

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• Objective Does auditing matter? (i.e. does the
  reputation of an auditor affect how the market
  perceives the firms financial reports?)
• The Event Andersens failed audit of
  Enron
• The Sample Andersens SP 1500 clients
• The Results Average decline in value

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• GAO
• FINANCIAL STATEMENT RESTATEMENTS
• October 2002
• Although a public companys management is
  responsible for the preparation and content of
  the public companys financial statements, the
  independent external auditor is responsible for
  auditing the financial statements in accordance
  with generally accepted auditing standards
  (GAAS).
• The purpose of the audit is to provide reasonable
  assurance that a companys financial statements
  are fairly presented in all material respects in
  accordance with GAAP.
• Independent audits give the public confidence
  that issuers financial statements are reliable
  and contribute to an efficient market for public
  companies securities. This sense of confidence
  can exist only if reasonable investors perceive
  auditors as independent and expert professionals
  who have neither interests in the entities they
  are auditing nor other conflicts of interest.
• Investors and other users expect auditors to
  bring integrity, independence, objectivity, and
  professional competence to the financial
  reporting process, and to prevent the issuance of
  misleading financial statements.
• Page 19

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Credibility
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Andersen Events

• During 2001, Arthur Andersen was fined or paid
  over 100 million to settle law suits for audit
  problems concerning two clients, Waste Management
  and Sunbeam.
• On November 8, 2001, Andersen received a subpoena
  from the SEC for documents related to Enron.
• On December 4, 2001, Joe Berardino, Arthur
  Andersens CEO, writes an op-ed for the Wall
  Street Journal stating that Andersen will
  acknowledge its mistakes if they have been made.
• On January 2, 2002, Deloitte Touche released
  the results of its audit quality peer review of
  Arthur Andersen. In conducting one of the most
  intensive peer reviews in Arthur Andersens
  history, the report concluded that Andersens
  system of accounting and audit quality provided
  reasonable assurance of compliance with
  professional standards.
• On January 10, 2002, Arthur Andersen notified the
  SEC and the Department of Justice that Arthur
  Andersen personnel involved with the Enron
  engagement disposed of a significant but
  undetermined number of electronic and paper
  documents as well as correspondence related to
  the Enron engagement.
• On February 2, 2002, the Powers report was
  released suggesting that the Chicago office of
  Arthur Andersen was well aware of accounting
  problems at Enron.
• On February 3, 2002, Arthur Andersen announced
  that former Federal Reserve Board Chairman, Paul
  Volcker, agreed to chair an Independent Oversight
  Board (IOB).
• On March 15, 2001, The Justice Department
  unsealed a criminal obstruction-of-justice
  indictment against Andersen.

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Dates Examined

• 1. November 8, 2001 Enron announces
  restatements
• 2. December 12, 2001 Andersens CEO admits
  
  Andersen made an error
• 3. January 10, 2002 Andersen announced that
  documents were shredded
• 4. February 3, 2002 Andersen hires Paul Volcker
  to head the IOB. The Powers Report is Released on
  February 2, 2002

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Other Dates

• 5. The date client firms dropped Andersen
  (162/234 have dropped Andersen)
• 6. March 15, 2001 Indictment date
• 7. CEO certification date
• 8. Last earnings announcement date (Andersen as
  auditor)

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Issues Examined

• Did Andersens client experience a negative
  market reaction?
• Did Andersens Houston office clients experience
  a negative market reaction?
• Are Non-audit fees a factor?
• What happened to the values of the remaining
  final four firms clients?

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Audit Fees
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Table 3Mean Cumulative Abnormal ReturnsAndersen
Clients
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Table 5Mean Cumulative Abnormal
ReturnsAndersens Houston Clients
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Tests for Differences Between Andersens BHAR
And the BHARs of the Final Four Auditing Firms
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Estimated Loss in Market Value In the Days
following the Announcement of Document Shredding
( Thousands)
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Variables Related to Changes in Value

• Firms with high sale growth
• Houston Office Clients

Variables Not Related to Changes in Value (?)

• Size
• Non-audit fees
• Leverage

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Other issues

• No Market effect on Indictment date
• No Market effect on client switch date.
• ERCs appear to increase for Andersens clients on
  the last earnings release date.

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Conclusions

• Audits provide the public with confidence that
  issuers financial statements are reliable.
• Auditor reputation does matter.

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