Auditor reputation and the insurance hypothesis: The information content of disclosures of financial distress of a major accounting firm

Abstract

It is obvious that the rapid demise of Andersen LLP (Limited Liability Partnership) has significant implications for its clients. However, even less dramatic events affecting an auditor may influence the client and its management. For example, evidence supports the assertion that certain events impacting a CPA firm are reflected in its publicly traded clients' security prices. In one study, Firth (1990) finds that auditor criticisms by the British Department of Trade resulted in statistically significant negative returns for audit-firm clients traded on British exchanges. Moreland (1995) documents that Security and Exchange Commission (SEC) enforcement actions directed towards a CPA firm resulted in a reduction in clients' earnings response coefficients (ERCs). Baber et al. (1995) (henceforth BKV) and Menon and Williams (1994) (henceforth MW Schwartz and Menon, 1985). De-Angelo (1981) asserts that larger audit firms supply a higher level of audit quality because such firms have more extensive investments in brand name reputations. Davidson and Neu (1993) document that larger auditing firms are associated with higher audit quality audits. In a study of 164 not-for-profit entities, Krishnan and Schauer (2000) find a positive association between audit firm size and audit quality. Larger CPA firms are also viewed differently with regard to the amount of resources available for potential claimants (Schwartz and Menon, 1985). The perceived difference in the ability of the large CPA firms to serve as insurers was noted by a Shearson Lehman accounting analyst the day after Laventhol's bankruptcy filing. The analyst remarked that the medium-sized accounting firms such as Laventhol are most financially vulnerable to lawsuits, while the Big 6 do not appear to be in financial trouble (Cooney, 1990: 67). Thus, given that the Big 4 are in a different class from smaller audit firms, one contribution of this study is to examine the extent to which events impacting a Big 4 firm affect its clients. We assess the client share price effects of litigation-related bankruptcy rumors reported in the financial press about Ernst & Young (henceforth E&Y) in late November and early December, 1990 (see Appendix A). The potential demise of a top-tier accounting firm has serious implications for client firm management. First, a client firm's cost of capital may increase due to a rise in information risk (i.e., the likelihood of unreliable financial statement information). A decrease in both the quantity and quality of information increases information asymmetry between management, shareholders, and creditors. Another implication is the increased cost associated with additional management time and effort devoted to providing shareholders, creditors, and regulators with timely, reliable information on corporate activities. A third implication is the increased stress or burden placed on internal corporate governance mechanisms to compensate for the loss (albeit temporary) of a firm's independent auditor. If litigation-related share price effects exist for a Big 4 firm's clients, then a critical issue not previously explored is whether efforts by that CPA firm to temper negative market reactions may prove successful. Successful mitigation of any negative client firm market reaction would reduce the severity of the managerial consequences noted above. …