Auditor Reputation, Auditor Independence, and the Stock‐Market Impact of Andersen's Indictment on Its Client Firms*

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 reputational 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 independence 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 significantly 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 empirical 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.

Auditor Independence and Audit Quality

“…However, most evidence are consistent with the negative market reaction to the level of non-audit service in various circumstances, e.g. the fee disclosure date (Frankel, Johnson and Nelson, 2002), quarterly earnings announcement (Francis and Ke, 2006), key events leading up to the passage of Sarbanes-Oxley Act (Jain and Rezaee, 2006;Zhang, 2007), Arthur Andersen's clients around the indictment period (Krishnamurthy, Zhou, and Zhou, 2006).…”

Review of empirical research on rotation and non-audit services: auditor independence in fact vs. appearance

“…The list of companies facing similar issues is quite long, including Parmalat in Italy in 2003, the Austrian company Yline in 2003, andPhilipp Holzmann andComroad in Germany in 2002. In response, regulating bodies in the United States and the European Union each issued major pieces of legislation: in the United States, the Sarbanes-Oxley Act in 2002, and in the European Union, the revised 8th Directive (2006). These regulations include more severe penalties and larger enforcement budgets to protect financial markets from fraud (see, e. g., Krishnamurthy, Zhou, and Zhou 2006).…”

Should PCAOB Disciplinary Proceedings Be Made Public? Evidence from Sanctions against a Big 4 Auditor

“…Damage to an audit firm's reputation can impair investors' perceptions of audit quality, leading to negative stock market effects for the audit firm's clients (Rauterkus and Song 2005;Krishnamurthy et al 2006;Weber et al 2008). Barry Melancon, President of the American Institute of Certified Public Accountants (AICPA), testified that the Board already has the ability to make disciplinary proceedings against a firm public simply by referring the matter to the SEC for enforcement.…”