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Shredded Reputation: The Cost of Audit Failure

Objective: Does auditing matter? (i.e. does the reputation of an auditor affect how the market perceives the firm's financial reports?)The Event: Andersen's failed audit of EnronThe Sample: Andersen's S

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Shredded Reputation: The Cost of Audit Failure

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    1. Shredded Reputation: The Cost of Audit Failure Paul K. Chaney Vanderbilt University Kirk L. Philipich The Ohio State University

    2. Objective: Does auditing matter? (i.e. does the reputation of an auditor affect how the market perceives the firm’s financial reports?) The Event: Andersen’s failed audit of Enron The Sample: Andersen’s S&P 1500 clients The Results: Average decline in value

    4. GAO FINANCIAL STATEMENT RESTATEMENTS October 2002 Although a public company’s management is responsible for the preparation and content of the public company’s 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 company’s 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

    6. 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 Andersen’s 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 Andersen’s history, the report concluded that Andersen’s 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 Power’s 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.

    7. Dates Examined 1. November 8, 2001: Enron announces restatements 2. December 12, 2001: Andersen’s 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

    8. 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)

    9. Issues Examined Did Andersen’s client experience a negative market reaction? Did Andersen’s Houston office clients experience a negative market reaction? Are Non-audit fees a factor? What happened to the values of the remaining final four firm’s clients?

    11. Audit Fees

    12. Table 3 Mean Cumulative Abnormal Returns Andersen Clients

    13. Table 5 Mean Cumulative Abnormal Returns Andersen’s Houston Clients

    14. Tests for Differences Between Andersen’s BHAR And the BHARs of the Final Four Auditing Firms

    15. Estimated Loss in Market Value In the Days following the Announcement of Document Shredding

    17. Variables Related to Changes in Value Firms with high sale growth Houston Office Clients

    18. Other issues No Market effect on Indictment date No Market effect on client switch date. ERCs appear to increase for Andersen’s clients on the last earnings release date.

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

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