The market reaction to Arthur Andersen's role in the Enron scandal: Loss of reputation or confounding effects?☆
Introduction
A recent widely cited study by Chaney and Philipich (2002) (hereafter CP) utilizes damaging revelations regarding Arthur Andersen's role in the accounting fraud at Enron to assess the client valuation implications of a loss of auditor reputation. The study finds that Andersen clients experienced significant negative stock market reactions over a 3-day period beginning January 10, 2002, the date Andersen publicly acknowledged its employees had destroyed documentation related to the Enron audit. Moreover, clients of Andersen's Houston office, where the alleged incidents at Enron occurred, suffered a larger stock price drop than the firm's non-Houston clients. The evidence suggests the cumulative loss of Andersen clients was in excess of $10 billion in market capitalization during this 3-day window, which CP interprets as the client valuation effect attributable to Andersen's damaged reputation.1 However, CP does not control for concurrent negative news events that could explain these results.
As with any event study analysis, it is imperative to isolate the effect of the event being studied (e.g., Dyckman et al., 1984). Our review of several major news sources reveals that negative macroeconomic and industry-related news was released during the event window. In particular, a number of news sources (see Appendix) attributed the decline in equity prices during this period to concerns about the prospects for economic recovery and upcoming disappointing earnings reports, as well as a substantial oil price drop in the Energy sector and overvaluation in the Information Technology sector. We test whether these confounding events, coupled with differences in the industry composition of Andersen's clients relative to clients of the other big auditors (which we refer to as the Big 4 auditors), produce the pattern of stock returns documented by CP.
Consistent with CP, we find Andersen clients experienced an average abnormal return of approximately −2% in the (0, +2) event window surrounding the shredding announcement, a market response that is significantly more negative than that of Big 4 clients. However, we show that the results are strongly influenced by the Energy sector, where Andersen clients experienced an abnormal return of −5.70%, nearly twice as large in absolute terms as the return in any other sector. Although this return is not significantly different from the −6.55% abnormal return for Big 4 Energy clients, Andersen audited a disproportionate share of the companies in this sector. We show that these confounding factors help to produce a more negative abnormal return for the portfolio of Andersen clients as a whole and for the energy-heavy Houston office in particular.
Furthermore, the abnormal returns of Andersen and Big 4 clients are not significantly different in nine out of ten industry sectors, inconsistent with the notion of a widespread client market reaction attributable to a decline in Andersen's reputation. Only in the Information Technology sector do we find that Andersen clients experienced more negative returns, on average, than Big 4 clients. On the one hand, this evidence is consistent with a reputation effect; on the other hand, there is no a priori reason to expect this reputation effect to be isolated to this sector. It is possible that the single statistically significant difference out of ten industry sectors is simply random. Moreover, when we control for differences in size by matching each Andersen client to a Big 4 client in the same sector that is closest in terms of market value of equity, there is no longer a statistically significant difference in abnormal returns for this sector. Nevertheless, we are unable to rule out the possibility that the results in this sector are related to Andersen's damaged reputation, although the evidence taken as a whole is not consistent with the shredding announcement having a significant reputation effect on the stock prices of Andersen's clients.
We also examine the market reaction to two related events – the February 2, 2002 release of the Powers Report suggesting Andersen was complicit in Enron's accounting maneuverings and the March 15, 2002 indictment of Andersen for obstruction of justice. Consistent with CP, we find the market reaction surrounding the release of the Power's Report was significantly negative for Andersen clients, but not as pronounced as on the shredding date. In contrast to CP, however, we also examine the stock price reaction of Big 4 clients. The results show that abnormal returns for Andersen clients are not significantly different from Big 4 clients, inconsistent with the notion the market was reacting to a differential loss of auditor reputation.
Prior research reports mixed findings regarding the indictment date. CP finds an insignificant market reaction for their sample of S&P 1500 firms while Krishnamurthy et al. (2006) finds some evidence of a small effect for a broader sample of Andersen clients. We replicate both of these findings, and conclude there was a marginal reaction, statistically and economically, around the indictment date for Andersen's smaller clients not in the S&P 1500. Because the market response is limited to small clients, however, the indictment date evidence is inconsistent with a loss of auditor reputation. Overall, the findings reported in this study show there is no consistent evidence of a reputation effect surrounding any of the information events examined.
Our final set of tests examines earnings response coefficients (ERCs) of Andersen and Big 4 clients. If the shredding announcement affected the market's perception of audit quality, we would expect to observe lower ERCs for Andersen clients following the announcement. However, we find no evidence that the market reaction to earnings surprises of Andersen clients was lower following the shredding announcement compared to the same period in the preceding year or to Big 4 clients, as would be expected if damage to Andersen's reputation was impounded in the market's valuation of client earnings.
Taken together, our results indicate that the significant market decline for Andersen clients in the days following the shredding announcement is not a reflection of the auditor's damaged reputation. To the extent a loss of auditor reputation triggered a market response, it appears to be limited to the Information Technology sector. However, even in this sector, confounding effects make it difficult to attribute any stock price effect to Andersen's sullied reputation. Similarly, the market reaction to other Enron-related events and to earnings surprises offers no systematic evidence of a response indicative of a reputation effect. Nevertheless, we caution that our study does not suggest that auditor reputation is unimportant to the capital markets; rather, our analysis highlights the difficulty of identifying and quantifying a reputation effect in the context of an event study contaminated by confounding factors.
Section 2 provides background and motivation. 3 Abnormal returns, 4 Earnings response coefficients describe the research methods and present the empirical findings. Section 5 summarizes and concludes.
Section snippets
Research on auditor reputation
Audits are a mechanism to enhance the credibility of financial statements and reduce the client firm's agency costs. The assurance value of the audit is thus directly related to the reputation of the auditor (Watts and Zimmerman, 1983). Consistent with this view, prior research demonstrates that the value of an auditor's reputation is impounded in the stock prices of its clients. For example, auditor reputation is positively associated with the value of initial public offerings (Titman and
Shredding announcement
Following CP, our sample consists of companies in the S&P 1500. We obtain the listing of the S&P 1500 as of October 31, 2001 from the Standard & Poors website, and from this sample exclude Enron and companies without the necessary security price data on CRSP. To identify the auditor for each company in our sample, we extract the audit opinion from 10-K filings in 2001 and 2002, and also search 8-K filings to determine if there was a change in auditors prior to the shredding announcement. Table 1
Earnings response coefficients
In this section, we present evidence from an alternative empirical approach to assess whether the reputation effects of Andersen's shredding announcement had a negative impact on its other audit clients. Specifically, prior research suggests that an auditor's reputation lends credibility to the earnings reports of its clients that is reflected in higher ERCs (Teoh and Wong, 1993). Conversely, situations that damage an auditor's reputation result in lower client ERCs (Moreland, 1995; Francis and
Discussion of results and conclusion
Prior research finds that in the 3 days following Andersen's admission they shredded Enron-related documents, Andersen's other audit clients, particularly those in the Houston office, experienced a statistically significant negative stock market reaction (Chaney and Philipich, 2002). This finding has been widely interpreted as evidence that the damage to Andersen's reputation caused by this admission was impounded in the equity prices of other Andersen clients. In this study, we provide new
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Cited by (0)
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We appreciate the helpful comments and suggestions of Jerry Zimmerman (the editor), Michael Willenborg (the referee), Jennifer Blouin, Gustavo Grullon, Wayne Landsman, James Weston, and workshop participants at Southern Methodist University and Texas Tech University. Srinivasan Krishnamurthy, Jian Zhou, and Nan Zhou generously provided some of the data for this study.