Auditor Reputation, Auditor Independence, and the Stock-Market Impact of Andersen's Indictment on Its Client Firms
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Auditor Reputation, Auditor Independence, and
the Stock-Market Impact of Andersen’s
Indictment on Its Client Firms*
SRINIVASAN KRISHNAMURTHY, SUNY — Binghamton
JIAN ZHOU, SUNY — Binghamton
NAN ZHOU, SUNY — Binghamton
Abstract
In this paper, we study a broad sample of Arthur Andersen clients and investigate whether
the decline in Andersen’s reputation, due to its criminal indictment on March 14, 2002,
adversely affected the stock market’s perception of its audit quality. Because these reputa-
tional concerns are more of an issue if an auditor’s independence is impaired, we investigate
the relationship between the abnormal market returns for Andersen clients around the time
of the indictment announcement and several fee-based measures of auditor independence.
Our results suggest that when news about Andersen’s indictment was released, the market
reacted negatively to Andersen clients. More importantly, we find that the indictment period
abnormal return is significantly more negative when the market perceived the auditor’s inde-
pendence to be threatened. We also examine the abnormal returns when firms announced
the dismissal of Andersen as an auditor. Consistent with the audit quality explanation, we
document that when firms quickly dismissed Andersen, the announcement returns are sig-
nificantly higher when firms switched to a Big 4 auditor than when they either switched to
non–Big 4 auditors or did not announce the identity of the replacement auditor. Our empir-
ical results support the notion that auditor reputation and independence have a material
impact on perceived audit quality and the credibility of audited financial statements, and
that the market prices this.
Keywords Audit fee; Auditor independence; Auditor reputation; Nonaudit fee
JEL Descriptors G1, M41, M42
* Accepted by Greg Waymire. We thank Greg Waymire (associate editor) and two anonymous referees
for detailed and insightful suggestions that have significantly improved the paper. We also thank
Paul Caster (discussant), Randy Elder, Murali Jagannathan, Kristian Rydqvist, Ute St. Clair, Steve
Wheeler (discussant), and workshop participants at the 2003 American Accounting Association
(AAA) Annual Meeting and the 2003 AAA Northeast Regional Meeting for helpful comments.
Contemporary Accounting Research Vol. 23 No. 2 (Summer 2006) pp. 465–90 © CAAA466 Contemporary Accounting Research
Réputation et indépendance du vérificateur,
et incidence boursière de la mise en accusation
d’Arthur Andersen pour les sociétés clientes du cabinet
Condensé
L’échec de la vérification d’Enron attribué à Arthur Andersen ainsi que d’autres scandales
comptables connexes ayant fait l’objet d’une vaste publicité et qui mettaient en cause Sun-
beam, Waste Management et WorldCom (entre autres) ont amené le Congrès à adopter la
Loi Sarbanes-Oxley de 2002 (Sarbanes-Oxley Act ). Afin de préserver l’indépendance des
vérificateurs, cette loi leur interdit de fournir simultanément à un client des services de véri-
fication et des services de consultation. L’information contenue dans les états financiers
étant précieuse pour les investisseurs, toute nouvelle négative quant à la qualité du travail
des vérificateurs et à leur indépendance risque de créer de l’incertitude en ce qui a trait à
l’exactitude des états financiers vérifiés de leurs sociétés clientes et d’être préjudiciable à ces
sociétés. Les auteurs de la présente étude abordent ces questions en analysant les rendements
anormaux réalisés par un vaste échantillon de clients d’Arthur Andersen au cours de la
période entourant la mise en accusation criminelle d’Arthur Andersen, survenue le 14 mars
2002, et en documentant la relation entre les variables substituts de l’indépendance et de la
réputation des vérificateurs et ces rendements anormaux.
Les travaux précédents semblent indiquer que le maintien d’une réputation de qualité
supérieure est d’une importance primordiale pour les cabinets de services financiers en
général et les cabinets de vérification en particulier. L’hypothèse veut que les vérificateurs
jouissant d’une bonne réputation réalisent des missions de vérification de qualité supérieure et
attestent mieux de la fiabilité de l’information présentée dans les états financiers. Le 14 mars
2002, les procureurs fédéraux des États-Unis ont accusé Arthur Andersen d’entrave à la
justice. Il s’agissait de la toute première accusation criminelle portée contre un cabinet de
vérification d’une telle envergure aux États-Unis, un événement unique ayant pour consé-
quence évidente de ternir la réputation dudit cabinet. Les auteurs posent donc l’hypothèse
selon laquelle l’annonce de la mise en accusation a transmis un message de piètre qualité
potentielle du travail de vérification du cabinet et créé de l’incertitude au sujet de la qualité
de l’information financière produite par les sociétés clientes d’Arthur Andersen. Le cours
des actions de ces sociétés allait donc souffrir de cette mise en accusation, et les conséquences
allaient être plus graves encore si Arthur Andersen se révélait davantage sujette à caution.
Les auteurs examinent le cours des actions des sociétés clientes d’Arthur Andersen au
moment de l’annonce de la mise en accusation, car l’événement est une expérience naturelle
utile à la détermination de la signification économique de la réputation du vérificateur.
Les auteurs analysent d’abord la réaction du cours des actions de 874 sociétés clientes
d’Arthur Andersen dans les jours qui entourent la mise en accusation et constatent que le
marché a réagi négativement. La moyenne (la médiane) du rendement anormal cumulatif
(RAC) ajusté en fonction du modèle de marché au cours de la journée précédant la mise en
accusation et la journée de la mise en accusation est de − 0,80 pour cent (− 0,53 pour cent).
Cette réaction du cours des actions statistiquement significative se traduit par une perte de
valeur agrégée pour les sociétés clientes d’Arthur Andersen de 11,4 milliards de dollars, soit
une perte moyenne de 13,1 millions de dollars par société.
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 467
Les auteurs procèdent ensuite à une analyse transversale visant à déterminer si cette
réaction du marché est associée à des variables substituts de l’indépendance du vérificateur.
Ils prédisent plus précisément qu’au moment de l’annonce, plus l’indépendance du vérificateur
sera discutable, plus le rendement sera négatif. Dans la foulée des travaux précédents, ils
utilisent à la fois le rapport entre les honoraires de vérification et les honoraires totaux (ratio
des honoraires de vérification) et le niveau des honoraires (logarithme naturel et rang fraction-
naire des honoraires de vérification, des honoraires pour services non liés à la vérification ou
des honoraires totaux) comme mesures de l’indépendance du vérificateur, un faible ratio des
honoraires de vérification ou un niveau élevé d’honoraires servant de substitut au manque
d’indépendance. En s’appuyant sur des régressions de séries chronologiques groupées
(comme celles de Sefcik et Thompson, 1986), les auteurs constatent que le ratio des hono-
raires de vérification (le niveau des honoraires totaux) est en relation positive (négative)
significative avec le rendement anormal de la période de l’annonce. Lorsqu’ils subdivisent
les honoraires totaux en honoraires de vérification et en honoraires pour services non liés à
la vérification, le coefficient relatif au niveau des honoraires pour services non liés à la véri-
fication a une valeur négative significative, alors que le coefficient relatif au niveau des
honoraires de vérification est statistiquement non significatif.
Enfin, les auteurs examinent les rendements anormaux enregistrés au moment où les
sociétés annoncent le remplacement d’Arthur Andersen à titre de vérificateurs. Si les
préoccupations relatives à la qualité de la vérification sont significatives, ils s’attendent à ce
que le cours des actions de ces sociétés augmente ou décline moins si elles choisissent un
vérificateur appartenant aux Quatre Grands pour remplacer Arthur Andersen. En d’autres
termes, ils s’attendent à ce que les meilleures sociétés soient davantage susceptibles (et à
même) de choisir rapidement des vérificateurs appartenant aux Quatre Grands et de le faire
à faible coût. Dans le groupe des sociétés qui ont remercié hâtivement Arthur Andersen de
ses services et l’ont remplacé par un autre cabinet appartenant aux Quatre Grands, le RAC
moyen sur trois jours (− 1,1), au cours de la période entourant l’annonce du congédiement, a
une valeur positive significative. De plus, dans ce même groupe, les rendements anormaux
sont notablement supérieurs lorsqu’un autre cabinet appartenant aux Quatre Grands est
choisi, plutôt qu’un cabinet n’appartenant pas aux Quatre Grands ou un cabinet dont
l’appartenance n’est pas précisée. Cet écart n’est pas significatif pour le groupe des sociétés
ayant remercié tardivement Arthur Andersen de ses services.
Pour résumer, la mise en accusation d’Arthur Andersen offre aux auteurs une occasion
unique d’analyser l’incidence de la réputation et de l’indépendance du vérificateur sur l’éva-
luation des actions par le marché. Les résultats compilés semblent indiquer que l’événement
a eu une incidence négative sur le cours des actions des sociétés clientes, et que cette inci-
dence est plus marquée lorsque Arthur Andersen assurait à ces sociétés la prestation d’un
plus grand volume de services non liés à la vérification. De plus, le marché a subséquem-
ment réagi de façon négative lorsque les sociétés ont choisi un cabinet de remplacement
n’appartenant pas aux Quatre Grands.
1. Introduction
Arthur Andersen’s perceived audit failure of Enron and other well-publicized
accounting-related scandals, such as those involving Sunbeam, Waste Manage-
ment, and WorldCom, led the U.S. Congress to pass the Sarbanes-Oxley Act of
CAR Vol. 23 No. 2 (Summer 2006)468 Contemporary Accounting Research
2002. This law restricts auditors from also providing consulting services, in order
to maintain their independence. Because financial statement information is valu-
able to investors, adverse news about an auditor’s quality and independence creates
uncertainty about the accuracy of its client firms’ audited financial statements and
affects these firms negatively. In this paper, we examine these issues by analyzing
the abnormal returns to a large sample of Andersen clients around the time of
Andersen’s criminal indictment on March 14, 2002, and by documenting the rela-
tion between proxies for auditor independence and reputation with abnormal returns.
Prior research suggests that maintaining a reputation for high quality is of
paramount importance for financial services firms generally and auditing firms
specifically.1 Auditor reputation is crucial because the widespread opinion among
companies is that reputable auditors perform higher-quality audits and better cer-
tify the reliability of the information presented in financial statements (e.g., Bal-
vers, McDonald, and Miller 1988; Beatty 1989).
On March 14, 2002, U.S. federal prosecutors charged Arthur Andersen with
obstruction of justice (Craig 2002). This was the first-ever criminal indictment of a
major U.S. auditor, and notably one in which the auditor’s reputation was clearly
tarnished.2 We hypothesize that the indictment announcement signaled potential
low audit quality and created uncertainty about the quality of financial reporting by
Andersen clients. We predict that client firms’ stock prices would be adversely
affected, and this impact would be more severe where Andersen’s independence is
seen as compromised to a greater extent. We examine Andersen clients’ stock
prices when the indictment was announced because this event provides a naturally
occurring experiment useful for identifying the economic significance of auditor
reputation.3
We first analyze the stock price reaction for 874 Andersen clients in the days
surrounding the indictment, and find that the market reacted negatively. The mean
(median) market-model-adjusted cumulative abnormal return (CAR) over the day
before and the day of the indictment (March 14 and 15, 2002)4 is − 0.80 percent
(− 0.53 percent). This statistically significant price response translates to an aggre-
gate value loss for Andersen clients of $11.4 billion, or an average loss of $13.1
million per firm.
We next use cross-sectional analysis to investigate whether this market reac-
tion is associated with proxies for auditor independence. Specifically, we predict
the announcement return to be more negative when auditor independence is
weaker. Following prior literature, we use both the ratio of audit fees to total fees
(audit fee ratio) and the level of fees (the natural logarithm and fractional rank of
audit, nonaudit, and total fees) as measures of auditor independence, where a low
audit fee ratio or a high level of fees proxies for lack of independence.5 Using port-
folio time-series regressions (Sefcik and Thompson 1986), we document that the
audit fee ratio (level of total fees) has a significantly positive (negative) relation to
the announcement-period abnormal return. When we split total fees into audit and
nonaudit fees, the coefficient on the level of nonaudit fees is significantly negative,
whereas the coefficient on the level of audit fees is statistically insignificant.
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 469
Finally, we examine abnormal returns when firms announce their replacement
of Andersen as an auditor. We expect that if concerns about audit quality are signif-
icant, stock prices of these firms will increase, or decrease less, when a Big 4 auditor
is chosen to replace Andersen. That is, we expect higher-quality firms to be more
likely (and able) to select Big 4 auditors quickly and at a low cost. When firms dis-
miss Andersen earlier and the replacement is a Big 4 auditor, the mean three-day
CAR (− 1, 1) around the dismissal announcement is significantly positive. More-
over, for the early dismissal group, the abnormal returns are significantly higher
when a Big 4 auditor is selected than when a non – Big 4 auditor is selected or
when the identity of the replacement auditor is not announced. This difference is
not significant for the late dismissal group.
To summarize, the Andersen indictment allows us a unique opportunity to inves-
tigate the equity valuation impact of auditor reputation and auditor independence.
Our results suggest that this event had an adverse impact on clients’ share prices,
and this impact was more severe when Andersen supplied more nonaudit services.
In addition, we find that the market responds negatively when a firm selects a non–
Big 4 replacement auditor. These findings complement those in Chaney and Philipich
2002, who document negative market reactions when news of the shredding of
documents by Andersen was made public (January 10 and 11, 2002).
The rest of the paper is organized as follows. Section 2 links our work to the
prior literature and develops the hypotheses. Section 3 describes our sample selec-
tion procedure and the sample descriptive statistics. Section 4 describes our results,
and section 5 concludes the paper.
2. Prior literature and hypotheses
Timeline of Andersen events and prior research 6
Below are the main events related to the Enron–Andersen scandal.
October 16, 2001 Enron announces an after-tax write-off of $1.01 billion.
December 2, 2001 Enron files for bankruptcy.
January 10, 2002 Andersen acknowledges that Enron documents were shredded
(hereafter “the shredding date”).
February 2, 2002 The Powers report cites lax oversight by Enron executives and
the auditor.
February 3, 2002 Andersen announces the hiring of Paul Volcker to lead an
independent oversight board to review Andersen’s auditing
policies and procedures.
March 2002 Andersen negotiates with the U.S. Justice Department on
whether criminal charges will be filed against Andersen.
March 14, 2002 U.S. federal prosecutors charge Andersen with obstruction of
justice.
June 6, 2002 The jury renders a guilty verdict.
August 31, 2002 Andersen ceases conducting audits.
CAR Vol. 23 No. 2 (Summer 2006)470 Contemporary Accounting Research
Chaney and Philipich (2002) show that 287 Andersen clients included in the Stan-
dard & Poor’s (S&P) 1500 index experienced significantly negative price reactions
at the document shredding date and that these reactions were unrelated to the ratio
of audit (or nonaudit) fees to total assets. Moreover, the price reaction was more
negative for Andersen’s Houston clients. They also document an insignificant
reaction for these same firms around the subsequent indictment date. Bushman,
Martinez-Jerez, and Smith (2002) find that the abnormal stock returns around five
Enron-related events were more negative for firms with a higher proportion of
nonaudit-related fees. These findings suggest that the provision of significant
nonaudit services reduces investors’ perceptions of auditor independence. How-
ever, their analysis does not include the indictment period.
Our analysis differs from and complements these studies in several ways. The
main focus of Chaney and Philipich 2002 is the shredding-date CARs, whereas we
focus on the indictment-period CARs. Consistent with our conjecture that the
indictment adversely affected Andersen’s reputation and was not limited to its
Houston office, Barton (2005) documents that the rate of client defections was rel-
atively low even after the shredding date, but that it picked up considerably after the
indictment date. We show that our results are robust to using different fee-based
measures of auditor independence that have been suggested in the literature. Also,
our samples are different from those in previous studies because we include a large
cross-section of Andersen’s clients. For example, the sample in Chaney and Philipich
2002 includes only the larger Andersen clients that are in the S&P 1500.
Hypotheses
Auditor reputation and the indictment period abnormal return
Prior research has shown that an auditor’s reputation for quality is valuable. Exter-
nal stakeholders such as investors and regulators use audited financial statement
information in their decision making. Because investors are unable to directly
observe audit quality and determine whether the reported information is an unbiased
indicator of firms’ financial performance, auditor reputation serves as an important
proxy for the quality and accuracy of client financial statements (DeAngelo
1981).7 If Andersen’s indictment highlighted potential problems with the entire
firm of Andersen and adversely affected its reputation, this would negatively affect
the perceived quality of the audited financial statements of its clients. Therefore,
we hypothesize that the indictment-period return will be negative for Andersen’s
clients.
HYPOTHESIS 1. Andersen’s clients experienced negative abnormal returns
when news of Andersen’s indictment was made public.
Auditor independence and the indictment-period abnormal return
An auditor’s ability to credibly attest to financial statement accuracy depends upon
his or her independence. In particular, concerns about the reliability of audited
financial statement information are less likely to arise when the auditor is perceived
to have exercised independent judgement about accounting issues. A compliant
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 471
auditor who passes on questionable accounting practices should lose investors’
trust and his or her reputation should suffer if such breaches are discovered. An
auditor is more likely to compromise his or her independence when the expected
revenues from future client relationships exceed this reputational loss, and exercising
independent judgement risks losing this revenue stream. Thus, a strong economic
bond between an auditor and his or her client can weaken the auditor’s independ-
ence. Because Andersen was most likely considered a reputable auditor before the
indictment, the indictment should raise concerns about Andersen’s independence
and lead investors to revise their estimates of client-firm equity value downward,
and this effect should be most pronounced when a strong economic bond links
Andersen to the client.
Along similar lines, Simunic (1984) suggests that while efficiencies from
knowledge spillovers between auditing and consulting may exist, these effects can
also threaten independence, which can actually make it more difficult and / or
costly for firms to hire a new auditor. Specifically, if a firm’s auditing environment
requires the auditor to be compliant, then, ex ante, a new auditor should charge a
higher level of fees. Thus, when Andersen’s indictment made it more likely that the
client firms would replace Andersen, a negative return may reflect the higher costs
of hiring a new auditor for firms where auditor independence is impaired.
HYPOTHESIS 2. The indictment-period abnormal returns are more negative
for firms where perceived auditor independence is weak.
There are divergent views about how to measure auditor independence,
because the strength of the economic bond between the auditing firm and its clients
is not directly observable. One stream of research suggests that the provision of
nonaudit services compromises auditor independence. For example, profitable
nonaudit services can create an incentive to compromise audit quality if it helps to
preserve the relationship (see Frankel, Johnson, and Nelson 2002).8 Alternatively,
the economic bond between an auditing firm and its client may be stronger when
the total engagement fees are large, whether they derive from nonaudit services or
not. In their discussion of Frankel et al. 2002, Kinney and Libby (2002) suggest
that the threat to auditor independence could be as strong when the audit fee is large
as when the nonaudit fee is large. Given the divergent findings documented in the
literature, we use both the ratio of audit fees to total fees and the level of fees (log
and rank of audit, nonaudit, and total fees) as proxies for auditor independence. In
addition, the Andersen indictment may have a larger impact on the value of firms
where the market has ex ante reasons to be concerned about the veracity and accur-
acy of financial statements. Accordingly, our tests of Hypothesis 2 will need to
control for managers’ incentives and opportunities to manage earnings and other
financial statement variables. Thus, we include the book-to-market ratio, leverage,
prior sales growth, and discretionary accruals to proxy for managers’ use of aggres-
sive accounting. Finally, because investors can sue to recover investment losses
caused by their reliance on misleading or incorrectly audited financial statements,
we control for investor losses in the period prior to the indictment.
CAR Vol. 23 No. 2 (Summer 2006)472 Contemporary Accounting Research
Abnormal returns around auditor-change announcements
Because Andersen’s indictment made it less likely that Andersen would survive as
an independent entity, several of its clients chose to replace Andersen with another
auditor. We expect firms with low audit risk to be more likely (and able) to quickly
select reputable auditors at a lower cost. We expect that firms with high audit risk
would dismiss Andersen as an auditor, but they might not be able to find a Big 4
replacement auditor immediately. These firms would either continue their search for
a Big 4 auditor and defer the announcement of a replacement auditor, or they would
choose a lower-quality, non–Big 4 auditor. Therefore, if concerns about audit qual-
ity are significant, we expect a more negative return when the firm does not select a
Big 4 auditor to replace Andersen and does so relatively late.
If concerns about the lost insurance value were important, we would not neces-
sarily expect this pattern in abnormal returns around the announcement of a
replacement auditor, since the new auditor would not be liable for errors and omis-
sions of the prior auditor. But, if a high-quality auditor provides better insurance
against future claims, then we would expect a higher (less negative or more posi-
tive) return when a Big 4 auditor is selected to replace Andersen.
HYPOTHESIS 3. The abnormal return is more negative when a firm either
replaces Andersen with a non–Big 4 auditor or defers the announcement
of a replacement auditor than when it selects a Big 4 auditor to replace
Andersen.
3. Data and methodology
Sample selection
Our initial sample includes 1,406 Andersen clients identified in COMPUSTAT
(see Table 1).9 We augment this with an additional 54 Andersen clients listed on
Forbes’s website that also have information on COMPUSTAT.10 This gives us a
total of 1,460 Andersen clients. In compiling our final sample, we eliminate 216
firms that cannot be matched with the Center for Research in Security Prices (CRSP)
data base. We exclude 174 firms that are American Depositary Receipts or foreign
firms, retaining only common stocks of domestic U.S. firms. A further 150 firms
are eliminated because they delisted from CRSP on or before March 18, 2002.
We collect stock prices from CRSP and require the firm to have (1) price data
until the indictment date, (2) at least 100 returns during the market-model estimation
period from January 1 through December 31, 2001, and (3) available returns during
the event window from March 14 to 18, 2002 so that the CAR can be calculated.
These criteria eliminate another 23 firms. After imposing these constraints, we
have 897 firms with available return data. We also eliminate 23 firms that dis-
missed Andersen as an auditor between January 2 and March 13, 2002, which
leaves a final sample of 874 firms that were Andersen clients on the indictment
date. For our tests that require fee data, we obtain data on fees paid to the auditor
for the fiscal year ending in the calendar year 2001 from proxy statements filed
with the Securities and Exchange Commission (SEC). We eliminate another 62
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 473
firms for which we are unable to locate fee data, leaving a subsample of 812 firms on
which we base our tests. Ownership data prior to the event period are from the
Compact-D data base. When data are missing, we augment the ownership data
with data from the S&P Stock Guide.
We need the announcement date of Andersen’s dismissal and the identity of
the replacement auditor to test Hypothesis 3. For our sample of 897 Andersen client
firms, we collect the names of the firms that dismissed Andersen as an auditor, the
dates of dismissal announcements, and the names of the replacement auditors from
Forbes’s website. We augment these data with dismissal data from SEC Form 8-Ks
for those sample firms where data were not available from Forbes. We are able to
find dismissal announcements for 882 firms. We are unable to compute CARs at
the dismissal date for 32 firms because of missing returns, leaving us with a sample
of 850 firms for tests of Hypothesis 3. We eliminate another 273 firms that dismissed
Andersen on or after its conviction (June 15, 2002),11 which leaves us with a final
sample of 577 firms that voluntarily dismissed Andersen.12 We verify the accuracy
of the dismissal date for a sample of firms from LexisNexis and find no systematic
discrepancies between the Forbes and the LexisNexis dates.
Descriptive statistics
The average book value of total assets for Andersen clients is $2,288 million
(Table 2). However, the first quartile is $79 million and the third quartile is $1,165
million, indicating that our sample includes both small and large firms. This is
markedly different from the sample in Chaney and Philipich 2002, who focus on a
subset of Andersen clients that are also part of the S&P 1500. The average total
assets in fiscal year 2000 for firms in their sample of 287 firms is $8,133 million,
and the first quartile is $456 million. Consistent with the fact that our sample also
TABLE 1
Sample selection criteria
No. of firms
Andersen clients from COMPUSTAT 1,406
Additional Andersen clients from Forbes 54
Total Andersen clients 1,460
Less: 216 firms not matched to CRSP, 174 non-U.S. or noncommon stock,
and 150 firms that are delisted on or before March 18, 2002 (540)
Sample available on both CRSP and COMPUSTAT 920
Less: Firms with insufficient or missing return data on CRSP (23)
Sample with available returns 897
Less: Firms that dismissed Andersen as auditor on or before March 13, 2002 (23)
Final sample 874
Less: Firms with missing audit fee (62)
Subsample with available audit fee data 812
CAR Vol. 23 No. 2 (Summer 2006)474 Contemporary Accounting Research
includes larger firms, institutional owners and 5 percent owners constitute a little
more than 40 percent of the firms’ shares.13 The audit fee ratio averages 51 percent
and the median is 50 percent. There is substantial variation in the audit fee ratio,
because the interquartile range is about 37 percent. The average total fee is about
$1.48 million. The mean audit fee (nonaudit fee) is $0.47 million ($1.01 million).
The mean book-to-market ratio of equity is 0.69, and the median is 0.56, suggesting
that these firms could reasonably be classified as glamour or high-growth firms.
The average sales growth is about 40 percent (excluding one outlier firm that has a
sales growth of 884,435 percent); however, the median is smaller at 3.7 percent.
4. Empirical results
We begin our empirical analysis by documenting the announcement-period returns
for Andersen clients around the indictment date. We then investigate whether
proxies for auditor independence are significantly associated with the indictment-
period CAR in a multivariate setting. We also report the results of several addi-
tional robustness checks and tie in our results to those documented in the prior
literature. Finally, we investigate whether the announcement of the selection of a
new auditor to succeed Andersen elicits a predictable market reaction.
Indictment-period CARs: Univariate results
On March 14, 2002, newswires reported that Andersen had been indicted by U.S.
government attorneys for obstruction of justice. We use March 15, 2002 as day 0
for our event study, because the indictment was announced in the afternoon of
March 14, 2002 and widely reported on March 15, 2002. We identify the three-day
event period to be March 14, 15, and 18, 2002. We compute daily market-model-
adjusted abnormal returns for the sample firms using the return on the CRSP
value-weighted index with dividends as the proxy for market returns. We estimate
the market-model parameters using returns from January 1, 2001 to December 31,
2001. The CARs are computed by cumulating the daily abnormal returns over the
period of interest. We use two two-day CARs over (− 1, 0) and (0, 1) and one three-
day CAR (− 1, 1) to measure the impact of Andersen’s indictment on its client firms.
The average two-day CAR (− 1, 0) for the full sample of 874 Andersen clients
is –0.80 percent, which is statistically significant at the 1 percent level (Table 3,
panel A). This result is not driven by outliers, because the median return is similar
in magnitude (− 0.53 percent) and is statistically significantly different from zero at
the 1 percent level.14 However, both of the mean returns over (0, 1) and (− 1, +1)
are not statistically significant at conventional levels. The median two-day CAR
(0, 1) (three-day CAR (− 1, 1)) is − 0.31 percent and is statistically significant at the
5 percent level (− 0.20 percent, p-value = 0.12). We estimate the value loss for each
firm from March 14 to 15, 2002 as the product of the CAR (− 1, 0) and the equity
market value on March 13, 2002. The aggregate loss is $11.4 billion, or an average
loss of $13.1 million per firm.15
Because our market-model estimation period spans the month of September
2001, when the stock market was affected by 9/11, we reestimate the market model
excluding September 2001. Our results in Table 3, panel B are unchanged. We also
CAR Vol. 23 No. 2 (Summer 2006)TABLE 2
Descriptive statistics for dependent and independent variables
Full sample Firms in S&P index Other firms
Variable Mean Median n Mean Median n Mean Median n
SIZE ($ millions) 2,287.9 295.9 874 5,577.5 1,296.2 271 809.5 142.0 603
FIVEPER (percent) 42.26 39.90 841 34.95 31.44 264 45.60 44.32 577
INSTITU (percent) 43.06 40.19 865 66.68 68.59 271 32.29 27.44 594
RATIO 0.515 0.502 812 0.424 0.406 265 0.560 0.557 547
TOTALFEE ($ thousands) 1,481 428 812 3,198 1,212 265 649 293 547
AUDITFEE ($ thousands) 471 201 812 955 440 265 237 158 547
NONAUDITFEE ($ thousands) 1,010 203 812 2,243 690 265 413 113 547
BM 0.692 0.562 873 0.536 0.481 270 0.762 0.611 603
SALESGR 10.635* 0.037 864 0.103 0.061 271 15.449 0.027 593
LEV 0.240 0.198 872 0.266 0.270 271 0.228 0.151 601
ADJROA − 0.063 0.000 871 0.047 0.023 271 − 0.113 − 0.011 600
IPOLOSS − 0.0035 0.0000 874 0.0000 0.0000 271 − 0.0050 0.0000 603
SSLOSS − 0.1585 0.0000 874 − 0.0988 0.0000 271 − 0.1853 0.0000 603
TOTACC − 0.116 − 0.079 816 − 0.080 − 0.067 260 − 0.133 − 0.087 556
MODIFIED JONES ACCRUALS − 0.036 − 0.009 816 − 0.007 − 0.009 260 − 0.050 − 0.010 556
PERFORMANCE-MATCHED
ACCRUALS − 0.022 − 0.010 816 − 0.029 − 0.014 260 − 0.019 −0.006 556
NOA 0.496 0.583 864 0.577 0.613 271 0.459 0.543 593
Auditor Reputation, Auditor Independence, and Andersen’s Indictment
(The table is continued on the next page.)
CAR Vol. 23 No. 2 (Summer 2006)
475476 Contemporary Accounting Research
TABLE 2 (Continued)
Notes:
* One firm, Team America (TMOS, called Team Mucho prior to January 8, 2001),
reported sales of $0.051 million and $451.062 million in 2000 and 2001,
respectively, resulting in a computed sales growth of 884,435 percent. Excluding
this observation, the mean sales growth is 0.401. Our regression results in Tables
4 through 6 are unaffected if we exclude this firm.
† All variable definitions are in the appendix.
use the Schipper and Thompson 1983 methodology, which accounts for event-date
clustering, because the event period is the same for all firms. We estimate this
model over seven years from October 1, 1995 to September 30, 2002, because we
need the number of days to be at least [2 × (number of firms + 1)] and we have 874
firms in the sample (see Schipper and Thompson 1983, 199). Using this approach,
we find that while CAR (0, 1) is statistically insignificant, both CAR (−1, 0) and
CAR (−1, 1) are significantly negative (Table 3, panel C). Overall, our results support
Hypothesis 1, which predicts a negative abnormal return around the indictment-
announcement period for Andersen clients.
Even before the formal announcement, there was considerable speculation in
the media about Andersen’s indictment. The market may thus have downgraded the
prices of Andersen’s clients before our event period.16 To investigate whether there
was any leakage of information before the indictment, we compute the CAR over
the prior one week (March 7 to 13, 2002). The average (median) CAR is 0.65 percent
(0.02 percent), and about 49.5 percent of the returns are negative. Together with
the significantly negative event-period CAR that we have documented, this result
suggests that the market did not fully anticipate the timing and impact of Ander-
sen’s indictment on its client firms.
Indictment-period CARs: Cross-sectional results
In this section, we investigate whether the indictment-period CARs depend upon
the level of auditor independence (Hypothesis 2). Because the event period is the
same for all firms, we use the portfolio time-series regression approach of Sefcik
and Thompson 1986, which corrects for event-period clustering.17 We designate
the three-day period March 14, 15, and 18, 2002 (− 1, 1) as the event period and
estimate the models over the period from January 1, 2001 to September 30, 2002.
In regression model 1 (Table 4), we include the audit fee ratio as the only explana-
tory variable and find that the coefficient on the audit fee ratio is positive but not
significant at conventional levels (t-value = 1.47). However, when we include addi-
tional control variables, the coefficient on the audit fee ratio becomes statistically
significant (t > 2.1). This suggests that the indictment-period CAR is less negative
when audit fees are a higher percentage of the total fees paid. The individual coef-
ficients on the control variables are generally statistically insignificant. We interpret
this evidence as consistent with Hypothesis 2.
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 477
Alternative model specifications
We describe (but do not tabulate) six additional tests that we conducted to verify
that our main result in models 2 and 3 in Table 4 — a significantly positive relation-
ship between the CAR and the audit fee ratio — is robust:
1. In Table 4, the portfolio time-series regressions use returns from January 1,
2001 to September 30, 2002. We reestimate models 2 and 3 (a) using returns
ending on either June 30, 2002 or December 31, 2002; (b) using returns from
October 1, 1995 through September 30, 2002, the same period used in Table 3,
panel C (using the Schipper and Thompson 1983 approach); and (c) excluding
returns during September 2001, November 2001 through December 2001, or
TABLE 3
Market reaction of Andersen client firms around Andersen’s indictment date
Panel A: Market model estimated using all returns from January 1 to December 31, 2001
Mean Median
Two-day CAR (−1, 0)
March 14 and 15, 2002 −0.0080* −0.0053*
Two-day CAR (0, 1)
March 15 and 18, 2002 −0.0017 −0.0031†
Three-day CAR (−1, 1)
March 14, 15, and 18, 2002 −0.0024 −0.0020
Panel B: Market model estimated excluding returns during September 2001
Mean Median
Two-day CAR (−1, 0)
March 14 and 15, 2002 −0.0085* −0.0058*
Two-day CAR (0, 1)
March 15 and 18, 2002 −0.0022 −0.0029†
Three-day CAR (−1, 1)
March 14, 15, and 18, 2002 −0.0033 −0.0017†
Panel C: Abnormal returns estimated using the Schipper and Thompson 1983
regression method
t-value
Coefficient (p-value)
Two-day event period
March 14 and 15, 2002 −0.0204 −2.31 (0.021)
Two-day event period
March 15 and 18, 2002 −0.0046 −0.61 (0.544)
Three-day event period
March 14, 15, and 18, 2002 −0.0109 −1.71 (0.088)
(The table is continued on the next page.)
CAR Vol. 23 No. 2 (Summer 2006)478 Contemporary Accounting Research
TABLE 3 (Continued)
Notes:
This table shows the market-model-adjusted cumulative abnormal return for the sample of
Andersen clients over the two-day and three-day event windows around March 15,
2002, the date that Andersen’s indictment was reported. In panel A, the parameters of
the market model are estimated using returns from January 1 to December 31, 2001.
We require the firm to have at least 100 nonmissing returns during this period. In
panel B, we exclude September 2001 returns in estimating the market-model
parameters. In panel C, we estimate a multivariate regression model (as in Schipper
and Thompson 1983) and report the coefficient estimates and test statistics for the
dummy variable, which takes the value of one during the event period and zero
otherwise. We use t-test for the mean and the Wilcoxon signed rank test for the
median.
* Significant at the 0.01 level (two-tailed).
† Significant at the 0.05 level (two-tailed).
September 2001 through December 2001. Our inferences do not change since
the coefficient on the audit fee ratio is significantly positive.
2. We substitute total assets, equity market value at the end of December 2001,
or natural log of equity market value for the natural log of total assets. We find
that in five out of these six specifications, the coefficient on the audit fee ratio
is positive and significant at conventional levels (t-value = 1.62 in the other
specification).
3. If the indictment induces the market to discount prior positive earnings sur-
prises, this would result in a negative CAR around the indictment period. We
include the CAR around the prior earnings announcement (earnings CAR),
cumulated over days (−1, 0), (0, 1), or (−1, 1) relative to the earnings announce-
ment, as an additional control variable. Because this would be more of a con-
cern if auditor independence is impaired, we also estimate models that include
both earnings CAR and an interaction term (audit fee ratio × earnings CAR).
The coefficient on the audit fee ratio remains significantly positive.
4. We include a dummy variable indicating whether the client firm was audited
by Andersen’s Houston office or not and confirm that our results remain statis-
tically significant.
5. We identify confounding events from the Wall Street Journal Index (earnings
announcements, spin-offs and merger announcements, debt and / or equity
issuances, etc.) just prior to and during the indictment period (March 13, 14,
15, and 18, 2002). Using these screens, we exclude seven firms with confound-
ing events. We also repeat the analysis after including 23 firms that dismissed
Andersen as an auditor between January 2 and March 13, 2002. The coeffi-
cient on the audit fee ratio is significantly positive.
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 479
6. We replicated the analysis in Table 4 using proxies for earnings management
in lieu of prior sales growth, book-to-market ratio, and leverage. In these tests,
we use net operating assets deflated by beginning total assets and three accrual
measures — total accruals, modified Jones model discretionary accruals, and
performance-matched discretionary accruals — as measures of earnings man-
agement.18 None of the four earnings-management measures is statistically
significant. Most importantly, we find that the coefficient on the audit fee ratio
is positive and significant in all four regression models at the 5 percent level.
Because prior research has also used the absolute value of accruals to proxy
TABLE 4
Portfolio time-series regressions
(1) (2) (3)
Coefficient Coefficient Coefficient
Variable (t-value) (t-value) (t-value)
Intercept −0.004 −0.014 −0.014
(−0.98) (−1.48) (−1.56)
RATIO 0.008 0.012 0.013
(1.47) (2.15)* (2.34)*
LOG(SIZE) 0.001 0.001
(0.85) (0.58)
BM 0.003 0.003
(1.41) (1.59)
SALESGR × 103 −0.159 −0.140
(−0.42) (−0.37)
LEV 0.001 0.002
(0.19) (0.36)
ADJROA 0.007 0.007
(0.96) (0.94)
IPOLOSS −0.015 −0.014
(−0.75) (−0.69)
SSLOSS 0.000 −0.001
(0.02) (−0.05)
FIVEPER × 103 0.020
(0.47)
INSTITU × 103 0.045
(0.75)
Notes:
All variable definitions are in the appendix. The portfolio time-series regressions are
estimated over the period January 1, 2001 to September 30, 2002, using a three-day
event period (−1, 1).
* Significant at the 0.05 level (two-tailed).
CAR Vol. 23 No. 2 (Summer 2006)480 Contemporary Accounting Research
for earnings management (e.g., Gul, Chen, and Tsui 2003), we replicate the
analysis using the absolute value of accruals. As an additional check, we use
the rank of these accrual measures, rather than their magnitude. Finally, we
also deflate net operating assets using sales (instead of total assets). In all
cases, our results are robust to these alternative specifications.
Results using different fee-based measures of auditor independence
We have reported results using the audit fee ratio to measure auditor independence.
However, as discussed in section 2, a high level of total fees could also strengthen
the economic bond between the audit firm and its clients and weaken auditor inde-
pendence. We thus use the natural log of the amount of total fees and expect auditor
independence to be more likely impaired at higher levels of fees. Further, we split
total fees into audit fees and nonaudit fees and investigate whether the indictment-
period CAR is related to these two components of fees. As alternative measures,
we also use the rank of these fees, rather than the levels, in our regressions.
In Table 5, we report the results of replicating Table 4, model 3, after substitut-
ing these alternative fee-based measures of auditor independence for the audit fee
ratio. In model 1, we include the log of total fees as the main explanatory variable.
Consistent with the evidence in Table 4, the coefficient on log of total fees is nega-
tive and significant (t-value = − 2.52). In model 2, we include the log (audit fees)
and log(1 + nonaudit fees), instead of total fees. We use (1 + nonaudit fees) because
some firms report zero nonaudit fees. We find that while the coefficient on nonaudit
fees is significantly negative, the coefficient on audit fees is not significant. This
evidence suggests that the provision of significant nonaudit services is associated
with more negative stock returns at the announcement date.19
Reconciliation with Chaney-Philipich 2002
As stated earlier, Chaney and Philipich (2002) find a significantly negative CAR
around the document shredding date and a positive but insignificant CAR around
the indictment date. They estimate multivariate regressions using the shredding-
period CAR and show that the market reaction was more severe for clients of
Andersen’s Houston office and for firms with high prior sales growth. They do not
find that the audit fee or nonaudit fee (deflated by total assets) is significantly
related to the abnormal return. In contrast, we document that the indictment-period
CAR is cross-sectionally related to the audit fee ratio (deflated by total fees). Because
our results for the fee variables differ from theirs, we investigate why this may be so.
First, the primary focus of their multivariate tests involves the shredding-date
CARs, whereas we focus on the CARs around the indictment period. It is likely
that on the shredding date the market perceived the problems to be limited to client
firms audited by Andersen’s Houston office. However, a criminal indictment may
have had an impact on all of Andersen’s clients, rather than just on clients of the
Houston office. We thus include a dummy variable indicating whether the client
firm was audited by Andersen’s Houston office or not in models 2 and 3 of Table 4.
Consistent with this interpretation, in untabulated results, the Houston office dummy
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 481
variable is not significantly related to the indictment-period CARs, whereas the
audit fee ratio remains significantly positive.
Second, our sample includes all Andersen clients with available CRSP and
COMPUSTAT data, whereas the Chaney-Philipich sample includes only Andersen
clients that were in the S&P 1500. Out of the 897 Andersen client firms that sur-
vive the CRSP and COMPUSTAT filters in our sample, 285 (32 percent) firms are
also in the S&P 1500, which is very close to the Chaney-Philipich sample of 287
Andersen S&P 1500 clients.20 Our final sample includes 271 S&P 1500 firms,
because 14 of the 285 S&P 1500 Andersen client firms dismissed Andersen before
March 14, 2002.21
To compare the two results, we replicate the indictment period analysis in
models 2 and 3 of Table 4 and models 1 and 2 of Table 5 on the subsample of
Andersen clients that are also S&P 1500 firms. In untabulated results, we find that
the coefficient on the audit fee ratio is positive, but is not significant at conven-
tional levels. The coefficients on the log (or rank) of audit, nonaudit, and total fees
are negative, but are not statistically significant. Because Chaney and Philipich
(2002) use ordinary least squares (OLS) regressions, we also replicate this analysis
using OLS regressions. The coefficients on the fee-based variables are statistically
significant in the predicted direction.22 Further, we estimate Table 4, models 2 and
3 around the shredding-date window (January 10, 11, and 14) for the full sample of
897 Andersen clients with available data.23 The coefficient on the audit fee ratio
(deflated by total fees) is significantly positive, with t-values of 2.03 and 1.76. The
OLS regression results are similar. In sum, this evidence suggests that the lack of
results concerning auditor independence in Chaney and Philipich 2002 is likely
due to their focus on a subset of Andersen clients that are part of the S&P 1500
firms and/or their focus on the shredding date rather than the indictment date.
Collectively, the results documented thus far suggest that the market reacted
more negatively for those firms for which Andersen provided a higher level of non-
audit services. This is consistent with Hypotheses 1 and 2, that adverse shocks to
an auditor’s reputation lead the market to reevaluate the perceived reliability of
financial statement information and that this is more of an issue where auditor
independence is perceived as more likely impaired.
Selection of a successor auditor
Following Andersen’s indictment, several firms announced that they had dismissed
Andersen and selected an alternative auditor. We compute market-model-adjusted
CARs for the days around the dismissal announcement and stratify our sample
based on the announcement timing and whether the replacement auditor is a Big 4
auditor. We report the results for two different time periods that include dismissal
announcements made on or before April 30, and between May 1 and June 14,
2002.24
We find that when firms announce the replacement of Andersen with a Big 4
auditor, the CAR is significantly positive if the dismissal was announced early and
negative if the announcement was made relatively late (Table 6). For the full sample,
the mean three-day CAR (−1, 1) equals 0.84 percent (significant at the 10 percent
CAR Vol. 23 No. 2 (Summer 2006)482 Contemporary Accounting Research
level) for firms that dismissed Andersen on or before April 30, 2002, and − 1.29
percent (significant at the 1 percent level) for firms that dismissed Andersen
between May 1 and June 14, 2002.25
We further stratify the firms based on the identity of the replacement auditor.
For the early dismissal group, we find that both the mean and median CAR (−1, 1)
are significantly positive (1.46 percent and 0.19 percent, respectively) when the
firm selected a Big 4 auditor to replace Andersen. The market reaction is negative
TABLE 5
Portfolio time-series regressions using alternative fee measures
(1) (2)
Coefficient Coefficient
(t-value) (t-value)
Intercept 0.032 0.018
(2.30)* (1.04)
LOG(TOTALFEE) −0.004
(−2.52)*
LOG(AUDITFEE) −0.001
(−0.82)
LOG(1 + NONAUDITFEE) −0.001
(−1.74)†
LOG(SIZE) 0.002 0.001
(1.52) (1.03)
BM 0.003 0.003
(1.61) (1.63)
SALESGR × 103 −0.141 −0.109
(−0.37) (−0.29)
LEV 0.002 0.002
(0.38) (0.34)
ADJROA 0.006 0.006
(0.77) (0.83)
IPOLOSS −0.012 −0.010
(−0.59) (−0.51)
SSLOSS −0.001 0.000
(−0.09) (0.01)
INSTITU × 103 0.048 0.045
(0.77) (0.73)
Notes:
All variable definitions are in the appendix. The portfolio time-series regressions are
estimated over the period January 1, 2001 to September 30, 2002, using a three-day
event period (−1, 1).
* Significant at the 0.05 level (two-tailed).
† Significant at the 0.10 level (two-tailed).
CAR Vol. 23 No. 2 (Summer 2006)Auditor Reputation, Auditor Independence, and Andersen’s Indictment 483
when the firm either did not name a replacement auditor or selected a non–Big 4
auditor to replace Andersen. The difference in mean (median) CAR (−1, 1) is sta-
tistically significant at the 1 percent level (5 percent level). For the late dismissal
group, the mean and median CAR (− 1, 1) are both significantly negative (− 1.29
percent and − 0.86 percent, respectively) if the firm selected a Big 4 auditor to
replace Andersen, and negative but insignificant (−1.29 percent and −0.87 percent)
if the firm did not name a replacement auditor or selected a non–Big 4 auditor to
replace Andersen. The differences are insignificant for late dismissals.
We have used April 30, 2002 as the cutoff date because it equally divides the
time between the indictment date on March 14, 2002 and the conviction date on
June 15, 2002. If we stratify the firms based on the dismissal timing into two
equal-sized groups using May 10, 2002 as the cutoff date, the results are similar to
those reported in Table 6. When we classify the dismissal events into four groups
(on or before March 31, 2002, April 2002, May 2002, and between June 1 and June
14, 2002), our results are qualitatively similar to those reported in Table 6. The dif-
ferences in means (“Big 4” versus “Others”) remain significant for dismissals
announced on and before March 31, 2002 and in April 2002, whereas the differ-
ence in median is significant only for April 2002. None of the differences (“Big 4”
TABLE 6
Announcement return around the selection of a replacement auditor
(1) (2)
Dismiss Andersen on or before Dismiss Andersen between
April 30, 2002 May 1 and June 14, 2002
Mean Median n Mean Median n
CAR (− 1, + 1)
All firms 0.84* 0.01 221 −1.29‡ −0.86‡ 356
Big 4 1.46‡ 0.19* 183 −1.29‡ −0.86‡ 306
Others −2.11* −0.31 38 −1.29 −0.87 50
t- and z-values for
(Big 4 − Others) 3.03‡ 2.06† −0.01 −0.72
Notes:
This table shows the percentage market-model-adjusted CAR around the announcement of
the selection of a replacement auditor. We also separately report results for firms that
selected a Big 4 auditor and either where a non–Big 4 auditor was chosen or where
the replacement auditor was not announced. The last row in each panel reports the
t-values (z-values) testing whether the mean (median) return for “Others” is different
from the return when a Big 4 auditor is selected to replace Andersen.
* Significant at the 0.10 level (two-tailed).
† Significant at the 0.05 level (two-tailed).
‡ Significant at the 0.01 level (two-tailed).
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