Auditor’s Reputation, Equity Offerings, and Firm Size: The ...well recognized when firms go to external markets to raise capital. In the IPO market, the higher reputation of auditing

Auditor’s Reputation, Equity Offerings, and Firm Size:

The Case of Arthur Andersen

Stephanie Yates Rauterkus Louisiana State University

Kyojik “Roy” Song

University of Louisiana at Lafayette

First Draft: November 5, 2002 Current Draft: December 31, 2003

ABSTRACT We study the impact of Arthur Andersen’s declining reputation on their clients. When

Andersen clients issue seasoned equity, we find that the negative reaction to SEO announcements is two percent worse for SEOs audited by Andersen versus other Big Five firms. A median firm in our sample loses $31.4 million more than a non-Andersen client. This result supports the argument that the certifying and monitoring role of auditors is valuable to clients. We do not find any unusual underpricing for SEOs or for IPO firms audited by Arthur Andersen. However, we do find that Andersen clients suffered significant value losses (approximately two percent) surrounding two key events: the admission of error by Andersen’s CEO and the announcement of the criminal indictment against Andersen. We find that these results are driven by the large firms in our sample implying that only large firms’ stock is affected by the deteriorating reputation of Andersen. JEL classification: G30 Keywords: Reputation; Certification; Equity Offering; Firm Size Corresponding author: Kyojik “Roy” Song Dept. of Economics/Finance University of Louisiana at Lafayette P.O.Box 44570 Lafayette, LA 70504 Email: [email protected] Phone: 337.482.6656 Fax: 337.482.6675 We thank participants the University of Michigan at Flint Research Workshop and the 2003 Midwest Finance Association Meetings for their helpful comments.

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1. Introduction

The impact of a service provider’s reputation on its clients has been a topic of

great interest in the literature. However, the impact of reputational losses of service

providers has not received as much attention. Due to irregularities in their audit

procedures with respect to Enron, Arthur Andersen recently suffered significant

reputational losses that provide a unique opportunity to examine the impact of these

losses on their clients.

A recent paper published by Chaney and Philipich (2002) also investigates the

impact of the Enron audit failure on auditor reputation and specifically the stock price of

other Arthur Andersen clients. Our study differentiates itself from the recent work by

Chaney and Philipich (2002) in two ways. First, we focus on the certifying and

monitoring role of auditors. Myers and Majluf (1984) show that firms issuing equities

experience an adverse selection problem due to asymmetric information between

managers and investors about firm value. The stock prices of firms issuing equities tend

to decline when they announce seasoned equity offerings (SEOs) or experience

underpricing at initial public offerings (IPOs). Therefore, firms tend to employ the

reputation of financial intermediaries to mitigate this problem in equity offerings.

Slovin, Sushka, and Hudson (1990) find that the quality of auditing mitigates the

negative stock price reaction to the announcement of a SEO. Also, Titman and

Trueman (1986) and Datar, Feltham, and Hughes (1991) develop models in which audit

quality reduces IPO underpricing, and Balvers, McDonald, and Miller (1988) and

Beatty (1989) find that firms employing a Big Eight auditor experience less

underpricing. Because Arthur Andersen loses its reputation over the period of the

Enron saga, we expect that the firms audited by Arthur Andersen might be negatively

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affected when they issue equities over the sample period as compared to other firms.

Second, we focus on whether the firm size of Arthur Andersen clients affects the

magnitude of the stock price decline of the clients. Chaney and Philipich (2002) find

that the stock price of Arthur Andersen clients decreases around the Arthur Andersen

events over the period, October 2001 to March 2002, due to the reputational losses of

Arthur Andersen. They investigate the effect of the events on only large firms. Myers

and Majluf (1984) imply that the certifying and monitoring role is of more importance

to young firms with more growth opportunities. Accordingly, we can expect that small

Andersen clients lose more value. However, Chaney and Philipich (2002) argue that a

large firm’s managers have the ability and the incentive to manage earnings. Therefore,

if large firms have reports that are more complex and less transparent, the market

discounts the quality of these reports. They expect that large Andersen clients lose

more value. Small firms rely on the reputation of financial intermediaries because they

tend to have more asymmetric information. Therefore, we need to investigate whether

small firms or large firms are more affected by the events of Enron and Arthur

Andersen.

We first investigate the effect of the declining reputation of Arthur Andersen on

the announcement effect of SEOs. We examine 39 SEOs audited by Arthur Andersen

and 124 SEOs audited by other Big Five firms over the period, October 2001 to August

2002. We find that, when they announce a SEO, firms audited by Arthur Andersen see

a decrease in stock prices that is two percent greater than that experienced by firms

audited by other Big Five firms. The strong negative reaction to the SEO for the

Andersen clients remains significant after controlling for other determinants of the stock

price reaction to the announcements of SEOs. The result is statistically significant, and

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is also economically significant. For a median firm in our sample, the firm loses $31.4

million more when it announces a SEO. In addition, we examine the difference of SEO

underpricing between Arthur Andersen clients and other firms at offering dates, and we

do not find any significant difference. The results mean that the effect of the

reputational loss of an auditor on seasoned equity offering is fully reflected at the

announcement of SEOs.

Second, we examine IPO underpricing in a sample of firms audited by Arthur

Andersen to investigate whether the effect of Arthur Andersen on an equity offering is

present for IPO firms. The importance of this sample is also enhanced by the fact that

the prospectuses that we reviewed cited the use of Arthur Andersen as an auditor as an

additional risk factor in an IPO. We do not find, however, that these firms experience

unusual underpricing.

Third, we examine a portfolio of firms audited by Arthur Andersen in 2001 and

find that it underperforms the market as the information related to Arthur Andersen is

gradually revealed after Enron reports a third quarter loss on October 16, 2001. The

underperformance of Andersen clients is consistent with Chaney and Philipich’s (2002)

findings. We find that Andersen clients start to lose their value after the first event date,

October 16, 2001. However, Chaney and Philipich (2002) find that Andersen clients do

not lose their value until January, 20021. The information on Andersen’s auditing

failure starts to be revealed in October 2001. Our results show that the market reflects

the new information on Arthur Andersen right away. Then, we divide Andersen clients

into large firms and small firms based on the median of market capitalization of all

CRSP (Center for Research in Security Prices) listed firms. We find that a portfolio of

1 See Figure 1 in Chaney and Philipich (2002).

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large firms underperforms the market, but a portfolio of small firms does not

underperform the market. This result is consistent with Chaney and Philipich’s (2002)

argument that the market reaction might be related to the manager’s incentive to

manipulate the financial statements.

The next section describes the recent history of Arthur Andersen and Enron,

Section 3 reviews the relevant literature and develops hypotheses, Section 4 describes

the data and presents the empirical results, and Section 5 concludes.

2. Enron and Arthur Andersen

Enron began in 1985 due to a merger between Houston Natural Gas and

InterNorth of Omaha, Nebraska and was designed to create the first nationwide natural

gas pipeline system. During the 1990s, Enron entered into utilities trading and became

number seven on Fortune magazine’s list of the 500 largest firms in the United States.

However, during most of the 1990s, Enron executives and directors created a series of

off-book partnerships that they used to hide millions of dollars of debt while allowing

the executives and directors to make substantial profits. All of these partnerships were

approved by Enron’s board of directors and reviewed by Arthur Andersen, the firm’s

external auditor.

Arthur Andersen was founded in 1913 by a Northwestern University professor

of the same name. In 2001, Andersen was the fifth largest auditing firm in the world

(based on worldwide revenue), employing 85,000 people in 84 countries and with

reported revenues of $9.3 billion ($4.3 billion in the United States alone) 2 . The

Appendix details the major events of 2001-2002 related to Enron and Arthur

2 See Chaney and Philipich (2002).

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Andersen’s demise. After Enron reports a $638 million third quarter loss on October 16,

2001, a series of accounting irregularities related to Enron and Andersen is revealed to

the market. Finally, Andersen is barred from conducting business after August 2002.

Enron experiences the downward path of its stock price throughout 2001 from a high at

the end of January of $80 per share to a low at the end of November of $0.26 per share.

3. Literature Review and Hypothesis Development

One of the major issues in the literature has been the impact of asymmetric

information on security offerings. The pecking order theory, developed by Myers

(1984) and Myers and Majluf (1984), is based on the idea that insiders know more

about their firm’s value and future projects than outside investors, and maximize the

wealth of existing shareholders. The insiders or managers avoid issuing equity when

they believe the firm is undervalued. Consequently, firms tend to experience an adverse

selection problem when they issue equities. That is, because investors have incomplete

information, they will not be able to distinguish overvalued firms from undervalued

firms. However, because they know that firms avoid issuing equities when they are

undervalued, investors assume that firms that issue equities are overvalued. Therefore,

firms employ financial intermediaries to mitigate the adverse selection problem in an

equity offering. The certification and monitoring role by financial intermediaries at an

IPO has been extensively analyzed in the literature3. The role of auditing firms has been

well recognized when firms go to external markets to raise capital. In the IPO market,

the higher reputation of auditing firms tends to decrease IPO underpricing for their

3 For example, Beatty and Ritter (1986), Carter and Manaster (1990), and Carter, Dark, and Singh (1998) find that investment banks can certify IPOs. Also, Megginson and Weiss (1991) find that the presence of venture capital reduces IPO underpricing.

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client firms. Titman and Trueman (1986) and Datar, Feltham, and Hughes (1991)

develop models in which audit quality reduces IPO underpricing. Empirically, Balvers,

McDonald, and Miller (1988) and Beatty (1989) find that firms employing a Big Eight

auditor experience less underpricing. However, in the 1990s, it is hard to test the effect

of audit quality on IPO underpricing because Big Five firms dominate the auditing

market. Also, when firms go public, they tend to switch to Big Five firms. The

deteriorating reputation of Arthur Andersen around the Enron saga is a good testing

environment for the effect of auditing quality on IPO underpricing.

Previous literature has documented negative announcement effects for firms

issuing seasoned equity4. The external monitors can mitigate the adverse selection

problem associated with seasoned equity offerings. Slovin, Sushka, and Hudson (1990)

find that the stock price reaction to the announcement of a seasoned equity offering is a

positive function of the quantity of bank debt, the quality of the firm’s investment

banker, and the quality of the auditing firm. The result indicates that the deteriorating

reputation of Arthur Andersen might exacerbate the negative announcement effects of

their client firms.

In the accounting literature, DeAngelo’s (1981b) definition of audit(or) quality -

- the probability that the auditor will both discover and report a breach in the client’s

accounting system – has long been accepted as the industry standard. Further, audit

firm size (i.e. ‘Big Five’ versus non-Big Five) is commonly used as a proxy for audit

quality. The rationale for this standard is that larger audit firms supply higher quality

because they have more to lose than smaller firms with respect to reputation.5 In light

4 For example, see Asquith and Mullins (1986), Masulis and Kowar (1986), Korajczyk, Lucas, and McDonald (1991), and Choe, Masulis, and Nanda (1993). 5 See DeAngelo (1981b)

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of recent events, a particularly interesting study by Reynolds (2000) finds that economic

dependence (within a particular office) does not cause Big Five auditors to report more

favorably. In fact, Reynolds’ findings support the notion that reputation protection

dominates auditor behavior.

In finance too, the literature ties quality to reputation. In fact, a firm’s ability to

repeatedly deliver goods and/or services of high quality is the cornerstone of the

reputation building process (Klein and Leffler (1981); Shapiro (1983)). Additionally,

numerous studies have examined the tradeoff between preserving reputation and the

potential gains related to providing a low quality product and found that for firms that

expect continued operations, the benefits do not outweigh the costs.6

Our concern is more specific. We are interested in the effect of reputation when

a professional service provider’s reputation can impact the market value of their client

and the client’s stakeholders rely on the service provider to mitigate the asymmetric

information problem that has been shown to lead to market failure. 7 Carter and

Manaster (1990) find a negative relation between initial public offering (IPO)

underpricing and underwriter reputation. More importantly, Carter and Manaster (1990)

provide evidence that low dispersion issuers signal their low risk characteristics by

engaging prestigious underwriters who, in order to preserve their high reputation,

market only IPOs of low dispersion firms. Megginson and Weiss (1990) find that the

presence of venture capitalists reduces IPO underpricing in a sample of firms in the

period 1983-1987. Similarly, the choice of auditor also provides firms with an

opportunity to signal their value. Thus, the investment bank, the venture capitalist, and

6 See Maksimovic and Titman (1991) for a detailed theoretical treatment of this topic. 7 See Akerlof (1970)

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the auditing firm (i.e. the service providers) assume both a certification and a

monitoring role.

The literature based on asymmetric information implies that the certifying and

monitoring role is more important to small and young firms with more growth

opportunities. It also implies that the reputation of an auditor is more important to IPO

firms. However, Chaney and Philipich (2002) argue that large firms are often viewed as

having the ability and the incentive to manage earnings. Therefore, if large firms have

reports that are more complex and less transparent, the market discounts the quality of

these reports. They predict that the deteriorating reputation of Arthur Andersen affects

larger firms more severely.

As noted previously, prior studies have typically considered the use of a Big

Five audit firm as a proxy for a quality audit.8 However, due to the signaling effect of

engaging a Big Five audit firm, the vast majority of large, publicly traded firms in the

United States engage Big Five firms. Until now, it has been difficult to test the

differences in quality among audit firms and its impact on their clients due to the virtual

oligopoly that these large audit firms enjoy and the minimal variation between them.

With the series of events surrounding Arthur Andersen and their indictment for fraud in

relation to a major audit client, we have the opportunity to examine a service provider

that has experienced a reputational loss. The magnitude of this failure and the existence

of other concurrent failures greatly reduce the probability that Arthur Andersen would

both discover and report a breach in a client’s accounting system. By definition, then,

Arthur Andersen has exhibited a reduction in quality and therefore reputation. When

8 See Becker et al. (1998), DeAngelo (1981a), Francis and Wilson (1988) and Krishnan and Schauer (2000).

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compared to prior empirical evidence suggesting that such an event is not expected, this

loss raises many new empirical questions.

We focus on the impact of auditor failure and the subsequent decline in the

auditor’s reputation on auditee stock performance. We test the relation between an

auditing firm’s (here, Arthur Andersen’s) changing reputation and their client’s stock

returns. We categorize the clients in three ways: 1) firms issuing seasoned equity; 2)

IPO firms; 3) auditing clients in 2001. Specifically, we divide 2001 auditing clients into

small firms and large firms based on market capitalization to investigate the relation

between firm size and auditee stock performance.

If auditors’ reputation is a concern to investors, it may be appropriate to consider

the retention of a disreputable auditor as a risk factor – particularly for a firm issuing

equity. Even some companies mention auditing by Arthur Andersen as a risk factor in

the prospectus. In its SEC filing, Inveresk Research Group Inc. said “if Arthur

Andersen becomes unable to make required representations to us or for any other reason

(including the loss of key members of our audit team from Arthur Andersen), Arthur

Andersen is unable to provide audit-related services for us in a timely manner.” Also, it

said that “certain investors, including significant funds and institutional investors, may

choose not to hold or invest in securities of a company that does not have current

financial reports available.” We examine whether or not this risk is priced in the market

at the time of IPOs. Also, we examine whether the deteriorating reputation of an

auditor affects the reaction to the announcements of SEOs or SEO underpricing.

In summary, we test three main null hypotheses based on the three categories of

audit clients and their related circumstances described above. First, with respect to all

firms audited by Arthur Andersen in 2000, we test the null hypothesis: We investigate

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whether the declining reputation of Arthur Andersen affects stock prices of its clients

around the announcement of a seasoned equity offering. Specifically we test:

H1: The announcement effects for Andersen’s SEO clients are not different from those for other Big Five’s SEO clients.

Second, we test the null hypothesis that issuers that engage Arthur Andersen as

their auditor do not experience any unusual underpricing. Specifically we test:

H2: The underpricing for Andersen’s IPO clients is not different from that for other Big 5’s IPO clients.

Third, we test the null hypothesis that large firms and small firms experience the

same stock performance after their auditor lose its reputation.

H3: The abnormal returns for the small firm portfolio surrounding each event equals those for the large firm portfolio.

4. Sample Selection and Empirical Results

4.1 SAMPLE SELECTION

We use three data sets to test our hypotheses in this research. First, we obtain

seasoned equity offering (SEO) data from Securities Data Corporation (SDC) Global

New Issues Database. We obtain offer prices, proceeds, underwriters, auditors, offering

dates, and filing dates for each offering from SDC. We find 280 SEOs over our sample

period, October 16, 2001 to August 31, 20029 after removing the offerings from closed-

end funds and financial firms with SIC codes of 6000-6999. We remove the offerings

of financial firms because financial firms are strictly regulated by government agencies,

and the certifying and monitoring role of an auditor is of less importance to them. We

check the Business News in Lexis-Nexis to obtain the announcement dates of SEOs. If 9 We use October 16, 2001 and August 31, 2002 as cutoff dates. October 16, 2001 is the first date that the accounting irregularity of Enron is announced. Arthur Andersen stopped its operation in the end of August, 2002.

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we do not find the announcement dates from this source, we use the filing date as the

announcement date. We remove 70 firms because they announced the offerings before

the starting date of our sample period, October 16, 2001. Then, we remove seven firms

because they are audited by non-Big Five auditors. Also, we remove 36 firms that only

offer secondary shares. We match the remaining sample to CRSP to obtain daily return

data, and remove three firms because the firms are not listed on CRSP. In this way, we

are left with 163 seasoned equity offerings.

Second, we also obtain IPO data from SDC. We obtain the data for 73 firms

that went public from October 16, 2001 to August 31, 2002 after removing ADRs,

closed-end funds, REITs, unit issues, and spinoffs. Out of 73 firms, Arthur Andersen

audits 9 firms at the time of IPO. We get offer dates, offer prices, filing price ranges,

proceeds, lead underwriter’s name, initial returns, the names of the venture capitalists

who invested in the firm and the auditor’s name for each IPO from SDC. Because there

are occasional inaccuracies in SDC IPO initial return data, we verify the initial returns

using data from CRSP. To control for underwriter’s reputation, we obtain each

underwriter’s rank from Jay Ritter’s web site.

Third, we obtain a sample of 1,222 firms audited by Arthur Andersen for the

fiscal year of 2000 from Research Insight. We also obtain market value of equity and

book value of assets for each firm from Research Insight. After removing 37 ADRs,

118 financial firms with SIC code of 6000-6999, 48 regulated firms with SIC code

4900-4939, and Enron, we are left with 1,018 industrial firms. We remove financial

firms and regulated firms because the certifying and monitoring role of an auditor is

limited to these firms. Then, we match those firms with the firms in CRSP, and lose 61

firms in the process. We remove the 173 firms that are not traded in the whole year of

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2001 and are not traded by our last event date, March 15, 2002. Also, we check auditor

changes in 2001 using Audit Trak10. We remove 17 firms that dismiss Arthur Andersen

before our first event date, October 15, 2001. Finally, we obtain 768 Arthur Andersen

audit clients for the year, 2001. This approach is in contrast to Chaney and Philipich

(2002) who use only firms included in the S&P 1500. This restriction reduces the size

of their sample to 287 firms versus our 768. Out of 768 firms, 251 firms are traded on

NYSE, 63 firms are traded on AMEX, and 454 firms are traded on NASDAQ. From

CRSP, we obtain daily returns for each firm and CRSP value-weighted index returns for

2001 and 2002.

4.2 EMPIRICAL RESULTS

We compare 39 SEOs audited by Arthur Andersen and 124 SEOs audited by

other Big Five firms. Panel A of TABLE 1 presents the comparison of SEO

characteristics between the two sub-samples. It reports the mean offer price, the mean

stock price run-up during the estimation period (day –170 to day –21), the mean

proceeds, the mean market capitalization on the announcement date, the mean

underwriter’s ranks, and the mean difference test results for each variable between the

two sub-samples. The mean offer price for SEOs audited by Arthur Andersen is $24.13

and the mean offer price for SEOs audited by other Big Five firms $21.71, but these

mean offer prices are not significantly different. The stock prices of both samples

increase about 40 percent over the estimation period, which means firms tend to issue

equities when they are overvalued. The mean proceeds, the mean market capitalization,

and the mean of underwriters’ reputation measures of both samples are not significantly

different.

10 We thank Don Deis for providing us with the Audit Trak data.

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We estimate two-day cumulative abnormal returns (CARs) around SEO

announcements (over day 0 and day 1) using a single factor market model. We use the

CRSP value-weighted index as a market index. Panel B of TABLE 1 reports the mean

and median CARs of the two sub-samples, the mean difference test result, and the

nonparametric median difference test result. As expected, the firms experience a

negative stock price reaction when they announce seasoned equity offerings. The firms

audited by Arthur Andersen experience more significant negative reaction (- 4.64

percent), compared to the reaction (- 2.45 percent) of other firms. The median CAR

for SEOs audited by Arthur Andersen is – 4.55 percent and the median CAR for SEOs

audited by other Big Five firms is – 2.51 percent. The chi-square test statistic (2.71)

shows that the median CARs are marginally significantly different. Previous literature

finds that stock prices decline two to three percent on average when firms announce

SEOs11. The firms audited by Andersen lose their value much more, compared to other

normal SEOs. This result supports our argument that the deteriorating reputation of

Arthur Andersen affects equity offerings of their clients negatively.

[TABLE 1 about here]

TABLE 2 presents the results of multivariate regressions examining two-day

cumulative abnormal returns around SEO announcements after controlling for other

determinants. The dependent variable is the two-day abnormal returns. Model 1

includes the log of proceeds, stock price run-up, CRSP value weighted index run-up

over the day –170 to –21 (market run-up), a dummy variable for SEOs which includes

secondary shares, and underwriter’s reputation measure as controlling variables. We

expect the coefficient on the log of proceeds to be positive because large offerings tend

11 For instance, see Masulis and Korwar (1986).

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to suffer less from adverse selection. The coefficient is negative and insignificant which

is not consistent with what we expect. Stock price run-up before the issuance is

significantly negatively related to the reaction to the SEO announcement. This result is

consistent with Choe et al.’s (1993) timing argument that firms with greater stock price

rises experience larger negative reaction because firms tend to issue stock when they are

overvalued. Also, Choe et al. (1993) find that SEO firms experience less of a negative

announcement reaction in up markets than in down markets. The coefficient on market

run-up, which controls for market condition, is insignificantly positive. The

insignificant result may come from our short sample period, which means the market

condition does not change much over the short period. Even though we remove the

SEOs consisting of only secondary shares, we have some SEOs that have a portion of

secondary shares. The secondary shares might affect the stock price reaction due to

inside information. The coefficient on the dummy variable for secondary shares, which

controls for inside information, is positive and insignificant. This result is inconsistent

with our expectation. Also, the coefficient on the underwriter’s reputation measure is

negative and insignificant. Our key variable, a dummy variable for auditing by Arthur

Andersen, is significantly negative with a t-statistic of –2.18. The dummy variable

indicates that the stocks audited by Arthur Andersen lose two percent more compared to

other firms when they announce seasoned equity offerings. In model 2, we use the log

of market capitalization on the announcement date as a firm size measure instead of the

log of proceeds. The results are qualitatively the same as in model 1. The coefficient

on the log of market capitalization is positive and insignificant.


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In summary, univariate and multivariate test results support our hypothesis that

the deteriorating reputation of Arthur Andersen exacerbates the negative reaction to

SEO announcements compared to SEOs audited by other Big Five firms. The results

show that the firms audited by Arthur Andersen experience a decrease in stock prices

two percent more when they announce SEO compared to the firms audited by other Big

Five firms. These results are statistically significant and are also economically

significant. For a median firm in the sample, the firm loses $31.4 million more when it

announces SEO.

TABLE 3 presents univariate test results on SEO underpricing. Corwin (2003)

finds that SEO underpricing is positively related to offer size, price uncertainty, and the

magnitude of pre-offer returns. We examine whether the deteriorating reputation of

Andersen affects the underpricing as well as the announcement reaction. The

underpricing is measured as the return of offer price to close price on the offering date.

We find that the underpricing of SEOs audited by Andersen is not significantly different

from that of other firms. This result indicates that the effect of Andersen’s deteriorating

reputation on SEOs is fully reflected at the announcements of SEOs.


To investigate the effect of the declining reputation of Arthur Andersen on

equity offering further, we examine IPO underpricing. TABLE 4 compares IPOs

audited by Arthur Andersen with IPOs audited by other Big Five firms. Our IPO

sample consists of 73 firms going public from October 16, 2001 to August 31, 2002.

Out of 73 firms, Arthur Andersen audits 9 firms and other Big Five firms audit the other

64 firms. The mean initial return (the ratio of the first day closing price to the offer

price) of IPOs audited by Arthur Andersen is 12.08 percent, which is slightly higher

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than that (11.62 percent) of other IPOs. The mean of offer prices for both samples is

close to $15. The mean proceeds ($289.03 million) of IPOs audited by Big Five firms

appear to be much higher than those ($176.66 million) of IPOs audited by Arthur

Andersen, but the difference is not significant. Also, the mean proceeds of IPOs audited

by Big Five firms are highly skewed to the right, and the median proceeds of both

samples are not much different. The mean of the standard deviation of daily stock

returns of IPOs audited by Arthur Andersen is significantly lower than that of other

IPOs, which means that Arthur Andersen has audited less risky firms for the sample

period. Even though the clients of Arthur Andersen are less risky, they experience

slightly higher underpricing. The adjusted tombstone ranks, which measure

underwriter’s reputation, are similar for both samples. Basically, the univariate test

results show that the two sub-samples have similar characteristics except the standard

deviation of daily stock returns.


TABLE 5 reports multivariate regression results for the IPO sample. In model 1,

initial returns are regressed on offer size (natural log of the proceeds), standard

deviation of daily stock returns during day +21 to day +120 after IPO, underwriter’s

reputation (natural log of adjusted tombstone ranks), and a dummy variable for venture

capital backed IPOs. The coefficient on offer size is positive and insignificant, which is

not consistent with Beatty and Ritter (1986) who argue that a smaller offering is more

speculative than a large offering. The coefficient on the risk measure, standard

deviation of daily stock returns, is negative and insignificant, even though we expect a

positive coefficient. The coefficient on underwriter’s reputation is significantly

negative, which means that prestigious underwriters tend to mitigate the adverse

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selection problem of IPOs. The dummy variable for a venture capital backed IPO is

positively significant, which is not consistent with Megginson and Weiss (1991).

In model 2, we consider the partial adjustment phenomenon. Hanley (1993)

argues that investment banks can have a strong bargaining position when there is high

demand for the issue. We introduce the interaction term

AboveRange*UnderwriterReputation, which indicates that the offer price is higher than

the initial filing range, and underwriter’s reputation measure. As expected, the

coefficient on the interaction term is significantly positive. Also, we introduce the

interaction term VCBacked*UnderwriterReputation for venture capital backed IPOs and

underwriter reputation measure because venture capital backed IPOs tend to employ

more prestigious investment banks. The coefficient on the interaction is insignificantly

positive, and the coefficient on dummy variable for venture capital backed IPOs is now

negative.

In model 3, we add our key variable to the model -- a dummy variable which

indicates whether an IPO is audited by Arthur Andersen. The coefficient on the dummy

variable is positive and insignificant. We expect that the deteriorating reputation of

auditor’s reputation should have a negative effect on the IPOs of their client firms.

However, we don’t find any significant result in univariate and multivariate tests. We

think that the results might come from our limited sample size, or small and young

firms might not be affected by the reputational losses of Andersen. We have only nine

IPOs audited by Arthur Andersen in the sample period.


To investigate the relation between firm size and excess returns for Andersen

clients, we divide 768 clients into 310 small firms and 458 large firms using the median

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market capitalization of all CRSP firms as of October 15, 2001. Then, we construct a

small firm portfolio and a large firm portfolio to use event study methodology. Of the

major Enron and Andersen-related events in Appendix that took place from October

2001 through March 2002, we consider those that could have the greatest impact on

other Andersen clients. We also review newspaper coverage and the events used in

Chaney and Philipich (2002) to ensure that we choose dates that receive the greatest

reaction. Specifically, we examine November 8, 2001 when Enron revises its financial

statements for the previous five years; December 12, 2001 when the CEO of Arthur

Andersen testifies before congress; January 10, 2002 when Andersen announces that

they shredded documents; February 3, 2002 when Andersen announces the creation of

an independent oversight board and March 15, 2002 when the criminal indictment

against Andersen is unsealed12.

We compare firm characteristics between small firms and large firms and

present the results in TABLE 6. Firms in a small firm portfolio have much smaller

market capitalization and total assets by construction. Specially, we are interested in the

market to book ratio of equity and the research and development expense to sales ratio

(R&D)13. Myers and Majluf (1984) show that firms with high growth opportunities

have more asymmetric information. These firms need to rely more on the certifying and

monitoring role of auditors. We proxy growth opportunities using the market to book

ratio of equity and the research and development expense to sales ratio. Interestingly,

the mean growth opportunities are not significantly different between the two portfolios.

12 Compared to Chaney and Philipich (2002), we have one more event date, March 15, 2002 when the criminal indictment against Andersen is unsealed. 13 R&D expense to sales ratio is available for only 181 small firms and 246 large firms from Research Insight.

19

The leverage of firms in a large firm portfolio is marginally higher, and the mean

earnings per share (EPS) are not significantly different.


We examine the stock price performance of 768 client firms around each event

date to confirm Chaney and Philipich’s (2002) results. We combine client firms into a

single portfolio. Excess returns are the mathematical difference between observed

returns and predicted returns. We use a single factor market model to predict market-

conditional returns. In this model, portfolio returns are regressed on CRSP value-

weighted index returns over a 150 day estimation period from t = -170 to –21. Because

there are multiple events in our analysis, the estimation period differs across events. In

unreported tests, we use the CRSP equally-weighted index returns as market returns,

and obtain qualitatively similar results. Our results do not appear to be driven by the

choice of market index. Because the event dates are common for all clients, there is

cross-sectional correlation in their respective returns. Forming portfolios of all firms in

the sample incorporates any cross-sectional correlation in returns. Chaney and Philipich

(2002) recognize that contemporaneous correlation exists, but they try to correct for it

by forming portfolios by industry. However, the events affect the firms across each

industry and therefore, cross-sectional correlation continues to exist in their industry

portfolios. We report two-day CARs (day –1 and day 0) and the corresponding z-

statistics in TABLE 714. Andersen clients lost their value by 2.02 percent and 1.75

percent on two event dates, December 12, 2001 (Andersen’s CEO admits Andersen

made an error at a Congressional testimony) and March 15, 2002 (Criminal indictment

against Andersen is unsealed). The results are somewhat different from Chaney and

14 Degree of freedom of z-statistics depends on the number of days in the estimation period.

20

Philipich’s (2002) results. They find that Andersen clients do not underperform the

market until January 10, 2002. However, because the information on accounting

irregularities related Enron and Andersen began to be revealed to the market starting

October 16, 2001, it is reasonable that Andersen clients should start to lose their value

before January 10, 2002. We report CARs over the period, October 16, 2001 to

December 31, 2002 in Figure 1. We find that Andersen clients start to lose their value

as the information on accounting irregularities is gradually revealed to market after

October 16, 2001, which is different from Chaney and Philipich’s (2002) results. It is

likely that the different results come from our larger sample size and the event study

methodology.

[TABLE 7 and Figure 1 about here]

We report two-day cumulative abnormal returns of a small firm portfolio and a

large firm portfolio, and report difference test results around each event date in TABLE

8. We report CARs based on a single factor market model using the CRSP value

weighted index returns or CRSP equally weighted index returns as market index returns.

The results are qualitatively similar regardless of the choice of market index, which

implies that the results are not driven by the size effect. Consistent with our previous

results, we find the significant value loss on two event dates, December 12, 2001

(Andersen’s CEO admits Andersen made an Error) and March 15, 2002 (Criminal

indictment against Andersen is unsealed). Around December 12, 2001, large firms

underperform the market significantly while small firms do not underperform the

market. Also, the difference in the CARs between the two portfolios on the event date

is statistically significant. These results are also similar around March 15, 2002. The

results are consistent with Chaney and Philipich’s (2002) argument that because large

21

firms’ financial statements tend to be more complex and less transparent, the market

discounts the quality of these statements.


5. Conclusion

In this research, we examine the impact of Arthur Andersen’s declining reputation on

their clients. When Andersen clients issue seasoned equity, we find that the negative reaction to

SEO announcements is two percent worse for SEOs audited by Andersen versus other Big Five

firms over the sample period, October 2001 to August 2002. The result is statistically and

economically significant. For a median firm in our sample, the firm loses $31.4 million more

when it announces SEO compared to other firms. However, we do not find any unusual SEO

underpricing for Andersen clients, which implies that the effect of the deteriorating reputation of

Andersen is fully reflected at the announcements of SEO. We also do not find any unusual

underpricing for IPO firms audited by Arthur Andersen.

We find that a large firm portfolio audited by Andersen underperforms the market

during the period from October 2001 to March 2002 while a small firm portfolio does not

underperform the market, which is consistent with Chaney and Philipich’s (2002) argument

that the market discounts the quality of large firm’s more complex and less transparent

financial statements. The result that only large firms are affected by Andersen’s

deteriorating reputation is also consistent with the results from equity offering samples.

The auditor’s reputational losses affect seasoned equity issues that tend to be offered by

large and established firms, but do not affect new equity issues that tend to be offered

by small and young firms.

22

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Balvers, R., B. McDonald, and R. Miller. 1988. Underpricing of New Issues and the Choice of Auditor as a Signal of Investment Banker Reputation. The Accounting Review 63: 605-22.

Beatty, R. P. 1989. Auditor Reputation and the Pricing of Initial Public Offerings. The Accounting Review 64: 693-709.

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———. 1981b. Auditor Size and Audit Quality. Journal of Accounting and Economics 3: 183-99.

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24

TABLE 1 Univariate test results on SEO sample

Panel A presents the number of seasoned equity offerings audited by Arthur Andersen and other Big Five firms during 10/16/2001-8/31/2002, the mean offer price, the mean stock price run-up during the estimation period (day –170 to –21), the mean proceeds (in million dollars), the mean market capitalization (in million dollars) on the announcement date, and the mean of adjusted tombstone ranks of underwriters. Also, it shows the test results about whether the means of each variable between two-subsamples are different from each other.

Panel B presents the mean and median of two-day cumulative abnormal returns of SEOs audited by Arthur Andersen and other Big Five firms, and the mean difference test result and the nonparametric median difference test result.

Panel A. Difference tests on SEO characteristics

N Offer

price

Stock price run-up

Proceeds Market capitalization

Underwriter

Reputation

SEOs audited by Arthur Andersen

39 24.13 41.56% 138.53 1222.65 8.33

SEOs audited by other Big 5 firms

124 22.71 44.46% 157.93 1824.07 8.53

Difference tests (t-statistics)

- 0.72 -0.18 -0.64 -1.17 -0.84

Panel B. Difference tests on two-day cumulative abnormal returns around announcement dates of SEOs

Two-day CARs

N

Mean Median


39 - 4.64% - 4.55%


124 - 2.45% - 2.51%

Difference tests

t = -2.22** χ 2 = 2.71*

*, ** and *** indicate statistical significance at the 10%, 5% and 1% levels respectively.

25

TABLE 2 The effect of the deteriorating reputation of Arthur Andersen on abnormal returns

of SEOs The table shows whether the deteriorating reputation of Arthur Andersen influences the announcement effects of SEOs over the period, 10/16/2001-8/30/2002. The dependent variable is the two-day cumulative abnormal returns (day 0 and day 1), which are measured by a single factor market model. Log of proceeds indicates the natural log of proceeds from the SEO, and log of market capitalization indicates the log of market capitalization on the announcement date. Stock price run-up is the holding period return of each stock during the estimation period (day –170 to –21), and market run-up is the holding period return of CRSP value-weighted index during the estimation period. Dummy for secondary shares is a qualitative variable indicating that the SEO includes some portion of secondary shares among equities offered. Underwriter’s reputation is measured as the adjusted tombstone ranks. Dummy for auditing by Arthur Andersen is a qualitative variable indicating that SEO is audited by Arthur Andersen. T-statistics based on White’s (1980) consistent covariance are given in parentheses.

Expected Sign Model 1 Model 2

Intercept

.15 (1.27)

.001 (.02)

Log of proceeds

(+) -.006 (-.82)

Log of market capitalization

(+) .004 (.97)

Stock price run-up

(-) -.01** (-2.04)

-.01** (-2.01)

Market run-up

(+) .04 (.64)

.02 (.42)

Dummy for secondary shares

(-) .0003 (.03)

.0009 (.09)

Underwriter’s reputation

(+) -03 (-1.10)

-.05 (-1.59)

Dummy for auditing by Arthur Andersen

(-) -.02** (-2.18)

-.02** (-2.26)

N

161 161

Adjusted R 2

.03 .03


26

TABLE 3 Univariate test results on SEO underpricing

The table presents the univariate test results on seasoned equity offerings (SEOs) underpricing between SEOs audited by Arthur Andersen and SEOs audited by other Big Five firms over the period, October 16, 2001 to August 31, 2002. SEO underpricing is measured as the return of an offering price to the closing price on offering date. The table presents the number of SEOs, the mean and median underpricing, the mean difference test results, and the median difference test results.

SEO underpricing N Mean Median


39 3.26% 1.61%


124 2.77% 1.89%

Difference tests

t = - 0.52 χ 2 = 0.02

27

TABLE 4

Univariate Test Results on IPO Sample This table shows the number of IPOs audited by Arthur Andersen and by other Big Five firms, the mean offering price, the mean proceeds from IPOs (in million dollars), the mean standard deviation of daily stock returns during +21 through +120 trading days after IPO, and the mean of adjusted tombstone ranks of underwriters. Also, the table presents t-test results showing whether the means of each variable between two sub-samples are different.

N Initial returns

Offer price Proceeds Standard deviation

Underwriter reputation

IPOs audited by Arthur Andersen

9 12.08% 15.5 176.66 3.04% 8.21

IPOs audited by other Big 5 firms

64 11.62% 15.38 289.03 4.36% 8.25


0.09 0.07 -1.09 -3.28*** -0.07


28

TABLE 5

The effect of the deteriorating reputation of Arthur Andersen on IPO underpricing

This table shows whether the deteriorating reputation of Arthur Andersen affects the initial returns of IPOs audited by the firm during 10/16/2001-8/31/2002. The dependent variable is initial returns. Offer size indicates the natural log of proceeds, and standard deviation of daily stock returns indicates standard deviation of daily stock returns during +21 through +120 trading days after IPO. Underwriter’s reputation is measured as the adjusted tombstone ranks. Above range is a qualitative variable indicating that the offer price is higher than initial filing range. VC-backed is a qualitative variable indicating that IPO is backed by venture capitalists. Dummy for auditing by Arthur Andersen is a qualitative variable indicating that IPO is audited by Arthur Andersen. T-statistics based on White’s consistent covariance are given in parentheses.

Expected Sign

Model 1 Model 2 Model 3

Intercept

-.40 (-.94)

-.30 (-.94)

-.35 (-1.13)

Offer size

(-) .04 (1.55)

.04* (1.92)

.04** (2.11)

Standard deviation of daily stock returns

(+) -.48 (-.30)

-1.03 (-.94)

-.77 (-.73)

Underwriter’s reputation

(-) -.03* (-1.82)

-.04*** (-2.74)

-.04*** (-2.92)

Above range* underwriter’s reputation

(+) .03*** (4.02)

.03*** (4.09)

VC-backed

(-) .08* (1.77)

-.14 (-.75)

-.23 (-1.00)

VC-backed* underwriter’s reputation

(+) .03 (1.07)

.04 (1.27)

Dummy for auditing by Arthur Andersen

(+) .05 (.87)

N

73 73 73

Adjusted R 2

.02 .34 .34


29

TABLE 6

Comparison of firm characteristics between a small firm portfolio and a large firm portfolio of 2001 Arthur Andersen clients

This table presents the comparison of firm characteristics between a small firm portfolio and a large firm portfolio. The table presents the number of firms in each portfolio, and the mean market capitalization (Market CAP), the mean total assets, the mean market to book ratio of equity, the mean research & development expense to sales ratio (R&D), the mean long-term debt to assets ratio (Leverage), and the mean earnings per share (EPS) of the firms for the fiscal year, 2001. Also, the table presents the mean difference test results. Market capitalization and total assets are in millions of dollars. R&D expense to sales ratio is available for 181 small firms and 246 large firms from Research Insight.

Variable N Market Cap

Total assets

Market to book

R&D Leverage EPS

Small firm portfolio

310 42 219 2.08 3.57 0.18 - 1.88

Large firm portfolio

458 3,661 2,615 2.45 0.78 0.21 - 1.79


- 5.36*** -6.98*** - 0.81 0.99 - 1.92* - 0.08


30

TABLE 7

Cumulative abnormal returns of Arthur Andersen 2001 audit clients portfolio This table presents two-day cumulative abnormal returns (CARs over day – 1 to day 0) around each event date for a portfolio constructed of 768 audit clients of Arthur Andersen for 2001. The abnormal returns are measured using a single factor market model, and the estimation period is day – 170 to day – 21. We use the CRSP value-weighted index returns as market index returns.

Events

CAR z-statistics

November 8, 2001 – Enron restates income back to 1997

0.41% 0.73

December 12, 2001 – Andersen’s CEO admits Andersen made an error at a Congress testimony

- 2.02% - 3.77***

January 10, 2002 – Andersen announces documents were shredded

0.19% 0.37

February 3, 2002 – Andersen announces independent oversight board

- 0.50% - 0.95

March 15, 2002 – Criminal indictment against Andersen is unsealed

- 1.75% - 3.66***

*** indicate statistical significance at 1% level.

31

TABLE 8 Cumulative abnormal returns for Arthur Andersen 2001 Audit clients based on

market capitalization (size) This table presents the two-day cumulative abnormal returns (CARs over day – 1 to day 0) around each event date for two portfolios constructed by 768 audit clients of Arthur Andersen for 2001. Based on the median market capitalization of all CRSP listed firms on October 15, 2001, we divide the sample into 310 small firms and 458 large firms. The abnormal returns are measured using a single factor market model, and the estimation period is day – 170 to day – 21. EW indicates that we use the CRSP equally-weighted returns as market returns, and VW indicates that we use the CRSP value-weighted returns as market returns.

Panel A. November 8, 2001 – Enron restates income back to 1997 CAR (EW) z-statistics CAR (VW) z-statistics Small firm portfolio

-.69% -1.04 -.33% -.31


.07% .07 .42% .73

Difference (Small firm-large firm)

-.76% -.62 -0.76% -0.62

Panel B. December 12, 2001 – Andersen’s CEO Admits Andersen Made an Error CAR (EW) z-statistics CAR (VW) z-statistics Small firm portfolio

.22% .33 .56% .56


-2.45%** -2.51 -2.05%*** -3.77


2.66%** 2.25 2.63%** 2.26

Panel C. January 10, 2002 – Andersen Announces Documents Were Shredded CAR (EW) z-statistics CAR (VW) z-statistics Small firm portfolio

.44% .64 .61% .61


-.05% -.05 .18% .35


.48% .42 .43% .38

Panel D. February 3, 2002 – Andersen Announces Independent Oversight Board CAR (EW) z-statistics CAR (VW) z-statistics Small firm portfolio

.03% .04 .09% .09


-1.26% -.1.39 -.51% -.96


1.29% 1.13 .61% .53

32

Panel E. March 15, 2002 – Criminal Indictment Against Andersen is Unsealed CAR (EW) z-statistics CAR (VW) z-statistics Small firm portfolio

-.38% -.54 -.42% -.43


-1.52%* -.1.86 -1.77%*** -3.64

Difference (Small firm-Large firm)

1.14% 1.06 1.35% 1.25

*, ** and *** Indicate statistical significance at the 10%, 5% and 1% levels respectively.

33

Figure 1. Cumulative abnormal returns (CARs) of 768 Arthur Andersen clients

-0.04

-0.035

-0.03

-0.025

-0.02

-0.015

-0.01

-0.005

010/16/01 10/26/01 11/5/01 11/15/01 11/25/01 12/5/01 12/15/01 12/25/01 1/4/02

Date

CA

R

34

Appendix This table describes the major events related to Enron and Arthur Andersen.

Date Description of Event October 16, 2001 Enron reports a $638 million third quarter loss and discloses a $1.2

billion reduction in shareholder equity, partly related to partnerships run by chief financial officer Andrew Fastow. Andersen’s audit practices are immediately questioned after it is revealed that Enron had outsourced some internal audit functions to Andersen (with SEC approval).

October 24, 2001 Fastow is removed. November 1, 2001 Enron announces the SEC’s formal investigation. November 8, 2001 Enron files documents with the SEC revising its financial statements

for the past five years reducing profits by $586 million and increasing debt by $2.5 billion. Also, Andersen receives a subpoena from the SEC.

November 28, 2001 Dynegy, Inc. backs out of a proposed deal to buy Enron after Enron’s credit rating is downgraded to junk bond status. As a result, Enron’s stock price falls below $1.

December 3, 2001 Enron files for Chapter 11 bankruptcy protection marking the largest bankruptcy petition in United States history. The filing is followed by massive layoffs in both the U.S. and Europe.

December 12, 2001 The CEO of Arthur Andersen testifies before Congress. January 10, 2002 The Justice Department confirms that it has begun a criminal

investigation of Enron and that Arthur Andersen LLP, admits to destroying some of Enron’s documents. In response, Andersen dismisses the lead partner, David Duncan, at the Houston, Texas office responsible for the Enron audit.

January 16, 2002 Enron discharges Andersen and begins the process of locating a new auditor.

February 3, 2002 A special investigative committee set up by Enron’s board of directors reports that an elaborate scheme involving multiple partnerships allowed top Enron executives to inflate earnings by one billion dollars and channel millions of dollars of the proceeds to their personal accounts.

February 4, 2002 Enron’s chief executive officer, Kenneth Lay, resigns from the board of directors.

March 14, 2002 A federal grand jury indicts Arthur Andersen for obstruction of justice for “knowingly, intentionally and corruptly” persuading employees to shred Enron-related documents.

March 15, 2002 The United States government suspends new business dealings with Enron and Andersen, citing evidence of misconduct by the energy marketer and the criminal indictment of the auditor.

June 15, 2002 A federal jury convicts Andersen of one count of obstructing justice. Andersen is barred from conducting and reporting on the audits of SEC-registered companies after August 2002.