Journal Of Business & Economics Research Volume 1, Number 6

Transcription

1 Th Impact Of Non-Audit Fs Disclosurs On Company Valu Following Th Enron Collaps Marclo Eduardo Mississippi Collg Tao Zhang Univrsity of Mississippi Abstract Invstor confidnc rgarding th rliability of financial statmnts is absolutly critical for publicly tradd companis. Th bankruptcy of Enron has brought to th forfront th issu of auditor indpndnc and financial statmnt rliability. As a rspons to th criticism that th growth in consulting srvics by CPA firms was lading to a conflict of intrst and significantly hindring auditor indpndnc, th SEC approvd nw auditor indpndnc rgulations that rquird publicly tradd firms to disclos th lvl of fs that wr paid to thir xtrnal auditor for non-audit srvics. This papr invstigats th impact that th Enron collaps has had on invstor prcptions about auditor indpndnc and financial statmnt rliability. Using data from proxy statmnts concrning non-audit fs paid to xtrnal auditors, w find vidnc that auditor indpndnc and thrfor financial statmnt rliability ar compromisd by th provision of ths non-audit srvics. Th rsults indicat that in th wak of th Enron rvlations, invstors prciv financial statmnts as bing lss rliabl and thus rquir an additional risk prmium, which translats into lowr stock prics and a loss of firm valu. W also find that thr is ngativ rlationship btwn th xtnt to which firms us non-audit srvics and th ngativ abnormal rturns thy suffrd during th Enron collaps. 1.0 Introduction I n Novmbr 2000, th SEC approvd nw auditor indpndnc rgulations that rquird publicly tradd firms to disclos th lvl of fs that wr paid to thir xtrnal auditor for non-audit srvics. This rquirmnt was part of a rspons to th criticism that th growth in consulting srvics by CPA firms was lading to a conflict of intrst and significantly hindring auditor indpndnc. Th bankruptcy of Enron and th significant xtnt to which its auditor-arthur Andrsn- providd consulting and intrnal auditing srvics has brought to th forfront th issu of auditor indpndnc and financial statmnt rliability. Invstor confidnc rgarding th rliability of financial statmnts is absolutly critical for publicly tradd companis and th impact that th Enron bankruptcy and th rol of its auditor hav had on th prcption of financial statmnt usrs is an issu of significant importanc that can b mpirically xamind. Th purpos of this papr is to xamin th raction of th stock markt to th disclosur of non-audit fs in th wak of th Enron collaps. Th study will xamin whthr th disclosur of non-audit fs and thir proportion to rgular audit fs provids information to th markt and rsults in changs in firm valu. By xamining th bhavior of stock prics around th tim that th Enron accounting irrgularitis took prominnt plac in th nws, w can mak infrncs rgarding th information contnt of th non-audit f disclosurs and its impact on invstor prcptions about auditor indpndnc and financial statmnt rliability. Radrs with commnts or qustions ar ncouragd to contact th authors via mail. 83

2 Th rst of th papr is organizd as follows. Sction II provids th background of th SEC s auditor indpndnc rul and dvlops our hypothsis. Sction III dscribs th data and mthodology w us. Sction IV prsnts th mpirical rsults. Sction V concluds th papr. 2.0 Background And Hypothsis Th collaps of Enron Corp. is on of th most significant businss failurs of our tim. Th failur of th nation s fifth largst corporation and th tangld wb that prcipitatd its collaps has dominatd th hadlins. Th sris of unsttling rvlations coming from th Enron cas smingly hav ld invstors to look skptically at balanc shts across th conomy. Th Enron failur has calld into qustion th cration and analysis of financial statmnts. Considring that financial statmnts ar th foundations upon which th Amrican invstmnt cultur has bn built, finding cracks in this structur has th potntial to undrmin trust in th markts (Tannnbaum, 2002) Th importanc of auditor indpndnc has bn a widly rcognizd issu by rgulators and rsarchrs (Low 1999; D Anglo 1981) Auditors facilitat th rlationship btwn invstors and managmnt by assuring th rliability of financial statmnts. Howvr, this rlationship is built on th assumption auditor indpndnc (Watts and Zimmrman, 1986). Auditor indpndnc can b dfind in th contxt of th ovrall audit quality along with th liklihood that th auditor will discovr and rport problms with th accounting rporting (DAnglo, 1981). Th dbat about auditor indpndnc and financial statmnt rliability has carrid rnwd forc as th rvlations following auditing irrgularitis for Enron Corp. hav bcom widly known. At th cntr of th dbat ar th fforts of auditing firms to sk altrnativ sourcs of rvnu by offring various typs of profssional srvics including intrnal audit, risk managmnt, and a varity of consulting srvics (Swangr, 2001). This has rsultd in accounting firms aggrssivly looking to consulting srvics as a way to maintain growth in th fac of stagnant f rvnu from thir traditional srvics (Low t al, 1999, Elliot and Pallais, 1997). CPA firms hav bn largly succssful in this pursuit as sn by th dramatic incras in th proportion of f rvnus from nonaudit srvics thy hav arnd. From 1993 to 1999, th avrag annual growth rat from rvnus from managmnt advisory srvics was 26 prcnt compard to 9 for audit srvics. In a rcnt study, Frankl t al, (2002) xamin ovr 4000 publicly tradd companis and find that that non-audit f compris approximatly 70% of total f rvnu and 96% of th clints purchas non-audit srvics. Th SEC, concrnd ovr th rapid growth of non-audit srvics by xtrnal auditors has rspondd with Rul S , Rvision of th Commission s Auditor Indpndnc Rquirmnts. In th viw of th SEC, a potntial conflict ariss from what th agncy calls a mutuality of intrst btwn auditor and clint (Lvitt, 1996). Th intnt of th nw SEC rquirmnt has bn to show xtrnal auditors as indpndnt in fact as wll as indpndnt in apparanc givn th nd for th public to maintain its confidnc on th rliability of th auditd financial statmnts (Hussy, 2001). Th nw rul now rquirs a proxy statmnt disclosing th total fs paid to th xtrnal auditor. Ths fs ar to b brokn into thr parts: Fs for audit of annual financial statmnts and quartrly rviw, Fs for financial information systms dsign and implmntation; and All othr fs such as intrnal auditing and consulting. Furthrmor, th firm s audit committ must now indicat in th proxy whthr it considrd th impact of th nonaudit srvics on its auditor s indpndnc. In summary, to th xtnt that th prcption of auditor indpndnc is as important as th actuality of indpndnc (Schutz, 1994), part of th rational bhind th nw rul appars to b to lt invstors dcid whthr th othr srvics providd by th auditor ar th tail wagging th auditing parnt dog (Barlas, 2001). 84

3 3.0 Non-Audit Srvics And Auditor Indpndnc Th assuranc of financial statmnt rliability rsts to a grat dgr on th assumption of auditor indpndnc. Thrfor, th impact that th provision of non-audit srvics by th xtrnal auditor has on th prcption of auditor indpndnc is critical in dtrmining how invstors prciv th financial statmnts of public companis. This impact can b sn in two diffrnt prspctivs. 3.1 Th Viw Against Auditors Providing Non-Audit Srvics Essntially, critics of th incrasd non-audit activity by auditing firms contnd that providing all of ths additional srvics thratns auditor indpndnc (Swangr, 2001). To th xtnt that ths additional srvics rprsnt significant cash flows, th argumnt is mad that ths futur quasi-rnt constitut an conomic bond (DAnglo, 1981; Simunic, 1984). If this is th cas, auditors with an conomic intrst in thir clints may b lss likly to rport brachs in th accounting systm (DAnglo, 1981). That is, xtrnal auditors may b inclind to srv th intrsts of th managmnt tam rathr than th intrst of sharholdrs and invstors (Chny, 1996). Thr is a significant amount of litratur that finds a ngativ impact whn auditors provid managmnt advisory srvics to thir clints. Swangr (2001) found that th provision of consulting srvics by th xtrnal auditor crats a businss rlationship with incrasd fs, maks th clint mor valuabl to th auditor and possibly clouds th auditor s judgmnt for far of losing th clint. A numbr of othr studis also find that financial statmnt usrs bliv indpndnc to b compromisd if th xtrnal auditor prforms consulting srvics for th audit clint (Pany and Rckrs, 1983, 1984; Rckrs and Stagliano 1981, Shockly, 1981). Gul (1991) nots that whn fs ar a significant proportion of th auditors total rvnu, third party prcptions of th auditor s ability to withstand managmnt powr is advrsly affctd suggsting a link btwn rputation and prcivd indpndnc. In th contxt of invstor prcptions, som studis hav found that financial statmnt usrs prciv th highst dgr of indpndnc in an audit whn th consulting and audit prsonnl wr sparat as opposd whn thy wr combind (Low and Pany, 1995, 1996; Pany and Rckrs, 1984). A mor rcnt study suggsts that companis with a high ratio of non-audit fs to total fs ar mor likly to mt or bat th arnings bnchmarksanalysts xpctations. That is, firms with lss indpndnt auditors appar to manag thir arnings mor than firms that hav a low ratio of non-audit fs to total fs (Frankl, Johnson, Nlson, 2002). Finally, rgulatory authoritis and profssional boards hav also wightd-in arguing against dual work. Th Public Ovrsight Board (POB) of th Amrican Institut of crtifid Public Accountants nots that th provision of non-audit srvics rsults in lowr audit quality and incrasd liklihood that th auditor will waiv arnings managmnt attmpts (Frankl, 2002). 3.2 Th Viw In Favor Of Auditors Providing Non-Audit Srvics Th othr prspctiv on th auditor indpndnc dbat holds that providing non-audit srvics dos not compromis indpndnc but actually rinforcs it. A numbr of studis find that in prforming consulting srvics, auditor indpndnc is not significantly affctd (Pany and Rckrs, 1983, McKinly t al, 1985). Arrunada (1999) modld th non-audit srvics impact on audit quality and concludd that th dual function complmnts th audit function and incrass th audit s firm rputation. That is, conomic intrst would b at risk if th firm compromisd its indpndnc sinc any bnfit from unthical conduct would b small compard to th potntial loss of th quasi-rnts from many clints (Low t al, 1999). D Anglo (1981) notd that that th potntial pnalty to th rputation of th firm constraints th bhavior of th auditor. Institutional factors may also play a significant rol in supporting th favorabl viw on th provision nonaudit srvics. Th nhancd potntial lgal liability carrid by CPA firms that also prform consulting or intrnal audits for thir xtrnal audit clints may nhanc thir prcivd objctivity and indpndnc (AICPA 1997). Auditors fac larg lgal sanctions from poor quality audits. Aggrgat claims against th big firms rachd $30 85

4 billion in 1992 (Frankl, 2002). Ahlawat (1998) found that du to concrns ovr malpractic litigation, outsourcd xtrnal auditors wr actually mor objctiv than in-hous intrnal auditors. Low t al (1999) xamind th impact that th outsourcing of th intrnal audit has on financial statmnt usr s prcptions of auditor indpndnc. Th rsults of his study suggst that outsourcing th intrnal audit dos not, in itslf, ngativly affct prcptions of auditor indpndnc. Morovr th implmntation of sparat tams to carry out th intrnal and xtrnal audit functions may strngthn public confidnc that th xtrnal audit function is not influncd by othr rlationships (Sullivan, 1995). Finally, th AICPA position has bn that incrasd conomic intrst by th xtrnal auditor may actually rinforc th indpndnc btwn auditor and clints (AICPA 1997). That is, th AICPA s viw is that as long as th rsponsibility of th intrnal audit function rmains with managmnt and th auditor dos not tak on oprational rsponsibilitis, thr is no conflict of intrst. This viw if furthr amplifid by th AICPA hypothsis that intrnal audit functions may actually provid xtrnal auditors with gratr undrstanding of th firm and thus bttr prpar thm to discovr rrors or fraud (Carmichal, 1998). 4.0 Firm Valu Effct And Hypothsis Th nt quity pric raction to non-audit f proxy disclosur can only b assssd mpirically. Th nw SEC rgulation on auditor indpndnc rprsnts a significant rul that allows us to xamin th impact of mandatory audit f disclosur in providing a clarr pictur of auditor indpndnc and thus financial statmnt rliability. Enhancd disclosur lvls of auditor activitis can b ithr bnficial or dtrimntal to auditor indpndnc and thrfor carry important implications about th prcptions of financial statmnt usrs. A ngativ markt raction would imply that invstors rgard th company as bing lss rliabl by having auditors that ar not compltly indpndnt. Th rsult of this raction is that invstors rduc thir xpctations of th futur CF s or intrprt th high fs as signaling poor managmnt quality or som undisclosd difficulty with th company (Frankl, t al 2002). If invstors prciv th financial statmnts to hav a highr probability to b unrliabl, thn thy will rquir a additional risk prmium, which would translat into, lowr stock prics and loss of firm valu- (Simunic, 1984). Morovr, a prcption of lowr audit quality may rsult in lowr stock prics as invstors rvis downwards th firm s arnings stram (Toh and Wong, 1993). Furthrmor, th collaps of Enron, bcaus of its magnitud, th normous amount of covrag that it rcivd and th focus that was placd on its auditor, rprsnts a uniqu opportunity to masur invstors prcption to auditor indpndnc and financial statmnt rliability in th contxt of th nw proxy disclosurs. This study posits that th nw mandatory rporting rquirmnts undr th nw SEC rul provid maningful information about auditor indpndnc and thrfor affct stock prics. Th gratr information disclosur suggsts an nhancd pictur of th firm and motivats th following null hypothsis: H1: Th nw SEC ruls providing disclosur of non-audit fs paid to th xtrnal auditor hav had no impact on stock prics in th contxt of th Enron accounting irrgularitis. 5.0 Data And Mthodology Th study will xamin whthr th nw SEC rul rquiring th disclosur of non-audit fs paid to xtrnal auditors provids information to th markt by xamining th stock pric raction to ths disclosurs in th wak of th Enron collaps. Th nw SEC rul rquirs that rgistrants disclos th non-audit srvics th auditor providd on thir proxy statmnts fild aftr Fbruary Patl (1979) posits that from an invstor s prspctiv, information is any data whos disclosur will altr th probability distribution ovr futur stats of th utility drivd from holding a portion of th firm s dbt or quity. To th xtnt that th nw SEC rul on non-audit f disclosur provids a mor maningful pictur of 86

5 auditor indpndnc and thrfor a clarr pictur of financial statmnt accuracy, such probability distribution will diffr from a distribution that is fr of this disclosur. Givn that th utility probability distribution of an invstor is unobsrvabl, it follows that w ar lft with an oprational tchniqu (vnts study mthodology) in which w analyz stock rturns and tst for significant changs in thm that can t b xplaind by othr vnts. This lads us to infr that th prsnc of abnormal rturns during th vnt priod is du to th non-audit fs disclosurs. Frankl t al (2002) showd in a study that rviwd ovr 4000 proxis that a rlativly small numbr of clints ssntially th largst corporations-account for a disproportionat amount of ach of th Big Fiv s nonaudit f rvnu. Thus, our study focuss on ths larg corporations. Our initial sampl consists of th top 150 U.S. firms as listd by th 2002 Fortun 500 (Amrica s largst corporations) ranking. In ordr to b includd in our sampl, firms hav to hav a dfinitiv proxy statmnt fild btwn Fbruary 5, 2001 and Sptmbr 1, 2001 in th EDGAR databas. Also, firms wr not chosn if thy had changd auditors during th yar. Th final sampl siz givn ths rstrictions was 115 firms. Bcaus of thir siz and markt valus, firms includd in this list rciv substantial scrutiny and ar closly followd by a significant numbr of analysts. All 115 of th firms sampld rportd fs for non-audit srvics, on avrag ths fs amountd to narly $16 million and rprsntd about 69% of a firm s total fs. Panl A of Tabl 1 shows dscriptiv statistics of th diffrnt fs disclosd by th proxis. TABLE 1: Dscriptiv Statistics of Auditor Fs and CONSULTRATIO Disclosd in th Proxy Statmnts This tabl prsnts th summary statistics of auditor fs and CONSULTRATIO disclosd in th Proxy Statmnts. Th sampl includs 115 companis that fild a dfinitiv proxy statmnt btwn Fbruary 5, 2001 and Sptmbr 1, 2001 in th EDGAR databas and wr listd as 150 largst Amrican corporations by Fortun. Panl A rports th dscriptiv statistics of auditor fs. Panl B rports th dscriptiv statistics of variabl CONSULTRATIO. Avrag is th man of stimatd cofficints of dummy variabls. Std is th standard dviation of stimatd cofficints of dummy variabls. Max is th maximum valu of variabls. Min is th minimum valu of variabls. % of Total Fs is th ratio of ach f on th total fs. Panl A: Dscriptiv Statistics of Auditor Fs Variabls Avrag Std % of Total Fs Auditor Fs $5.101 $ % IS Fs $2.779 $ % Othr Fs $ $ % Panl B: Dscriptiv Statistics of CONSULTRATIO Variabls Avrag Std Max Min CONSULTRATIO 68.8% 15.8% 94.2% 22% Panl B of Tabl 1 provids summary statistics on th xtnt to which th firms non-audit fs compar to thir total fs paid. This ratio, which is th ratio of all non-audit srvics (IS Fs plus Othr Fs) to th total fs paid by th corporation to its xtrnal auditor, srvs as a proxy for auditor indpndnc and is calld CONSULTRATIO. Th vnts rlatd to th Enron accounting scandal ar idntifid from th Wall Strt Journal Indx and th Wall Strt Journal. In this study, w considr two critical vnts: th initial disclosur of accounting 87

6 irrgularitis with Enron and th invstigation of Arthur Andrsn by th SEC. Evnt 1 is considrd a significant vnt as it is th watrshd announcmnt concrning Enron s accounting problms and brings to th forfront issus rgarding auditor ffctivnss. This vnt rprsnts th announcmnt by th firm that its financial statmnts wr inaccurat and ld to a rstatmnt involving a $1.2 billion quity writ-off that was a front-pag story in th Wall Strt Journal and providd invstors with th bginning point of th Enron saga. Evnt 2 rprsnts th announcmnt of th SEC s formal invstigation of Arthur Andrsn. This vnt is significant for it rprsnts anothr critical point in th dbat about auditor indpndnc. As rvlations about th rol that Andrsn playd in providing consulting srvics to Enron wr systmatically disclosd, this dat marks an idntifiabl point in invstor skpticism towards auditor indpndnc. Tabl 2 brifly illustrats th two vnts studid. TABLE 2: Evnts Rlating to Enron Accounting Scandal Evnt Disclosur Dat by WSJ Brif Dscription 1 Octobr Accounting irrgularitis with Enron wr disclosd-$1.2 billion quity writ-off was undrtakn 2 Novmbr Arthur Andrsn was put undr invstigation by SEC Th papr uss daily stock rturn data from th CRSP tap from January to Dcmbr To tst th robustnss of our rsults, w choos two markt bnchmark indics from th CRSP tap: CRSP valuwightd NYSE/AMEX/NASDAQ Indx and th S&P 500 Indx. Thr ar two diffrnt statistical approachs to tst th impact of crtain vnts on th scurity prics. On is th FFJR modl proposd by Fama, Fishr, Jnsn and Roll (1969) that analyzs th cumulativ abnormal rturns and avrag abnormal rturns. This approach first computs th markt modl from an stimation priod in ordr to calculat th prdictd normal rturns. Th mthod thn calculats th abnormal rturns for th sampl firms by subtracting thir actual rturns from th prdictd normal rturns during th vnt window. Th altrnativ mthodology is Multivariat Rgrssion Modl (MVRM) first suggstd by Gibbons (1980). Th MVRM adds a zro-on dummy variabls for multipl vnts into th markt modl, so it is popular in rsarch tsting th significanc of diffrnt vnts on scurity prics. Th stimatd cofficint of th dummy variabl rprsnts th ffct of a spcific vnt on th scurity prics. In this study, w us this dummy variabl approach. Th rgrssion modl is th following: R ir (1) it i Mt i t it whr: E 1 D R it = th daily rturns of th stock i on day t; R Mt = th daily rturn of S&P 500 Indx or CRSP valu-wightd NYSE and AMEX/NASDAQ Indx on day t; = th ffct of th th vnt on th pric of stock i; i D t = E = 88 u dummy variabls that qual on during th thr-day vnt window (th disclosur dat by WSJ and bfor and aftr on trading day) and zro othrwis; numbr of vnts studid (qual to two in this study). Following Espahbodi t al (1995), w st th dummy variabls to on during th disclosur dat by WSJ as wll as on trading day bfor and aftr, and to zro othrwis. Th purpos of slcting thr-day vnt window is to account for th unknown xact timing of information rlas. Th modl is stimatd ovr th priod from January 2, 2001 to Dcmbr 31, 2001.

7 Whn w assum that th cofficints in th quation (1) ar diffrnt for ach company, w hav th Smingly Unrlatd Rgrssion modl (SUR). Following Grn (2000), th FGLS rgrssion is usd to account for th unknown covarianc matrix of th disturbanc. As th first stp of FGLS rgrssion, w obtain th OLS rsiduals to stimat th consistnt cross-sctional covarianc matrix. Th first null hypothsis is that th avrag abnormal rturn during ach of vnt priod quals zro: (2) 0 H : 0 i whr i is th numbr of companis in th sampl, and is th th vnts in th study. H 0 is similar to th analysis of avrag abnormal rturn in Fama t al s modl. Bsids, w considr two joint linar hypothss: (3) : 1 (4) : 2 H 0 i, i H 0 i i whr i is th numbr of companis in th sampl, and is th th vnts in th study. H 1 tsts whthr both vnts hav a significant impact on th stock prics, whil H 2 tsts th impact from only on of th vnts. Bindr (1985) argud that th main advantag of MVRM ovr Fama t al s markt modl approach is that MVRM can asily handl th joint linar hypothsis tst bcaus MVRM xplicitly incorporat cross-sctional corrlations in th paramtr stimation and hypothsis tsting. Our study will also masur th impact on firm valu of th non-audit srvic fs disclosur by focusing on th magnitud of ths fs compard to th total audit fd paid by ach firm. In ordr to do this, a proxy for th xtnt to which th firm ngags its auditors for non-audit srvics is computd. This proxy is th ratio of non-audit fs (th sum of IS and othr fs) to total audit fs and w call it CONSULTRATIO. Th ratio of ths two fs has bn usd as a proxy for auditor indpndnc bfor (Firth 1997, Barknss and Simntt 1994). Givn that w posit that stock prics will ract to th information disclosur, w us th CONSULTRATIO variabl as a proxy for th dgr to which th markt viws auditors as bing indpndnt and thus viws th financial statmnts as bing rliabl. W tst th impact that th lvl of non-audit fs has had on th abnormal rturns by stimating th following rgrssion: D *( CONSULTRATIO) (5) whr: D = stimatd cofficint of th dummy variabl (abnormal rturns) from quation (1) CONSULTRATIO = th ratio of all non-audit srvics (IS fs plus Othr fs) to th total fs paid by th firm to its xtrnal auditor Th stimat of rprsnts th ffct of non-audit fs on invstor raction to ach of th vnts. To th xtnt that th markt viws high lvls of non-audit fs as hindring auditor indpndnc and financial statmnt rliability, w would xpct th stimat of to b ngativ i. 89

8 6.0 Rsults Tabl 3 prsnts th xcss rturns rsulting from quation (1) for th priod from January to Dcmbr Th stimatd cofficints of th dummy variabls masur th impact on th stock prics of diffrnt vnts associatd with th Enron rvlations. Panl A and B us th CRSP valu-wightd NYSE/AMEX/NASDAQ indx and SP500 Indx rspctivly. Th rsults indicat th prsnc of significant ngativ abnormal rturns from Evnt 1,.g. th avrag abnormal rturn is whn compard to th CRSP valu-wightd NYSE/AMEX/NASDAQ Indx with significanc at th lvl of 1%. Th avrag abnormal rturn is whn compard to th S&P500 Indx with significanc at th lvl of 5%. On th othr hand, th rsults show that Evnt 2 has a rlativly smallr impact on firm valu: th avrag abnormal rturn is only significantly diffrnt from zro at th 10% lvl whn compard to th CRSP valuwightd NYSE/AMEX/NASDAQ Indx. As Panl C of Tabl 3 shows, th F-statistics of th stimatd cofficints for dummy variabls rjct th null hypothsis that all th abnormal rturns from all vnts ar not significantly diffrnt from zro. Panl D rports th tsting rsults of null hypothsis H 2. Th F statistics show that th abnormal rturns from ithr of two vnts ar significantly diffrnt from zro at th lvl of 1%. Ths findings suggst th prsnc of significantly ngativ abnormal rturns accompanying th announcmnt of Enron accounting irrgularitis. Th rsults provid vidnc consistnt with th argumnt that invstors rducd thir valuations as a compnsation for th prcivd rduction in audit quality. Ths rsults may also indicat ngativ prcptions by invstors concrning th quality of th xpctd futur cash flows. TABLE 3: Estimation of Dummy Variabls in MVRM/SUR Modl Summary statistics for th stimation of dummy variabls in th MVRM/SUR modl from January to Dcmbr Thr ar total 115 companis and 248 trading days. Panl A uss th CRSP valu-wightd NYSE/AMEX/NASDAQ Indx as markt bnchmark. Panl B uss th SP500 Indx as markt bnchmark. Evnt 1 and 2 ar th vnts dscribd in Tabl 2. Avrag is th man of stimatd cofficints of dummy variabls. Std is th standard dviation of stimatd cofficints of dummy variabls. Max is th maximum valu of stimatd cofficints of dummy variabls. Min is th minimum valu of stimatd cofficints of dummy variabls. Mdian is th mdian valu of stimatd cofficints of dummy variabls. t-statistics of man of th stimatd cofficints of th dummy variabls is in th parnthsis. Panl C and D rport th tst of th two jointly linar hypothsis of H1and H 2. Panl A: CRSP valu-wightd NYSE/AMEX/NASDAQ Indx as markt bnchmark Evnt Avrag Std Max Min Mdian (-2.355)*** (-1.365)* Panl B: SP500 Indx as markt bnchmark Evnt Avrag Std Max Min Mdian (-2.135)** (-1.080) 90

9 Panl C: Tst of jointly linar hypothss of H 1 CRSP valu-wightd NYSE/AMEX/NASDAQ Indx SP500 Indx F statistic p-valu Panl D: Tst of jointly linar hypothss of H 2 Evnt CRSP valu-wightd NYSE/AMEX/NASDAQ Indx SP500 Indx 1 F statistic p-valu F statistic p-valu *** Significant at th 1% lvl basd on a on-taild t-tst ** Significant at th 5% lvl basd on a on-taild t-tst * Significant at th 10% lvl basd on a on-taild t-tst Tabl 4 blow shows th rsults for th rgrssion btwn th abnormal rturns and th ratio of consulting fs to total audit fs. Th dpndnt variabl is th dummy variabl cofficints of diffrnt vnts, whil th indpndnt variabl is th firm charactristic rflcting th indpndnc and accuracy of financial statmnts th ratio of non-audit fs ovr total fs paid to xtrnal auditors. Panl A rports th OLS rgrssion of quation (5). Gnrally, th rlationship btwn th cofficints of dummy variabls and th ratio of non-auditing f is ngativ for Evnt 1 with significanc at th lvl of 5%. But th sam rlationship for Evnt 2 is not significantly diffrnt from zro. Ths finding ar consistnt with th rsults found in th Tabl 4 whr Evnt 2 has smallr abnormal rturns than Evnt 1. Panl B shows that thr is no vidnc of significant positiv and ngativ AR (1) and AR (2) autocorrlation among OLS rsidus. And Panl C indicats that OLS rsidus for Evnt 1 and 2 hav fw sign of htroscdasticity. But w still rport th t-statistics adjustd by htroscdastic-consistnt standard rrors in Panl A. Ovrall, Tabl 4 shows strong vidnc that th abnormal rturns of Evnt 1 ar ngativly rlatd with th ratio of non-audit f. This rsult suggsts that invstors rassssd thir prcptions of auditor indpndnc and financial statmnt rliability whn th first big shock nws from Enron took plac. Th subsqunt official invstigation of Arthur Andrsn by th SEC has no impact on firm valus. That is, th influnc of Evnt 2 on th lvl of abnormal rturns is minimal and w posit can b undrstood in th contxt of old nws from th prspctiv of invstors. TABLE 4: Paramtr Estimats for th Rgrssion btwn Abnormal Rturns And Consulting F Ratio Panl A rports th OLS stimation of quation (5): D *( CONSULTRATIO) Whr D is th stimatd cofficint of dummy variabl from quation (3), CONSULTRATIO is th ratio of all non-audit srvics (IS Fs plus Othr Fs) to th total fs paid by th corporation to its xtrnal auditor. Panl B rports th Gnralizd Durbin-Watson statistics of autocorrlation for OLS rsidus for Evnt 1 and 2 compard to CRSP valu-wightd NYSE/AMEX/NASDAQ Indx and SP500 Indx. Panl C rports th rsults of Whit tsts for htroscdasticity of OLS rsidu for Evnt 1 and 2 compard to CRSP valu-wightd NYSE/AMEX/NASDAQ Indx and SP500 Indx. t-statistics calculatd by th htroscdasticity-consistnt standard rrors ar in th parnthsis. 91

10 Panl A: OLS rgrssion of dummy against ratio of non-audit f CRSP valu-wightd NYSE/AMEX/NASDAQ Indx SP500 Indx =1(Evnt 1) =2(Evnt 2) =1(Evnt 1) =2(Evnt 2) (-2.34)** (-0.64) (-2.32)** (-0.65) 2 R ***: Significant at th 1% lvl basd on a two-taild t-tst **: Significant at th 5% lvl basd on a two-taild t-tst *: Significant at th 10% lvl basd on a two-taild t-tst Panl B: Gnralizd Durbin-Watson tst for AR (1) and AR (2) autocorrlation of OLS rsidus Evnt 1 Evnt 2 Ordr CRSP valu-wightd NYSE/AMEX/NASDAQ Indx Positiv Ngativ DW Autocorrlation P Autocorrlation P valu valu DW SP500 Indx Positiv Ngativ Autocorrlation Autocorrlation P valu P valu Panl C: Whit tst for htroscdasticity of OLS rsidus CRSP valu-wightd NYSE/AMEX/NASDAQ Indx 2 P valu 2 SP500 Indx P valu Evnt Evnt Summary And Conclusions Th qustion of whthr th provision of non-audit srvics by th xtrnal auditor impacts invstor prcptions about auditor indpndnc and thus prcptions about financial statmnt rliability is a critical issu to th financial markts and th ovrall conomy. Th SEC, concrnd ovr th rapid growth of non-audit srvics by xtrnal auditors nactd Rul S that rquirs a proxy statmnt disclosing th total fs paid to th xtrnal auditor. Using a sampl of 115 larg U.S. firms, w tstd th proposition that th non-audit f disclosurs hav no significant ffct on thir stock prics. Th impact on firm valu was spcifically tstd against two important vnts in th Enron dbacl. Th first vnt was th initial announcmnt of th accounting irrgularitis at Enron that rsultd in a $1.2 billion dollars quity writ-off. Th scond vnt involvd th announcmnt that Enron s auditor-arthur Andrsn-was bing invstigatd by th SEC. Th rsults suggst th prsnc of significantly ngativ abnormal rturns for vnt 1. Morovr, th xtnt to which th firms in th sampl usd non-audit srvics from its xtrnal auditor (a proxy for auditor indpndnc) is ngativly and significantly rlatd to th abnormal rturns for th vnt announcing th accounting irrgularitis at Enron. Ths rsults ar consistnt with th argumnt that non-audit srvics ar dtrimntal to auditor indpndnc and financial statmnt rliability prcptions. Th rlationship btwn auditor 92

11 indpndnc and abnormal rturns undr th announcmnt of th SEC invstigation of Andrsn ar lss robust and not significant. W argu that this announcmnt is viwd as old nws for invstors and that thy hav alrady pricd th auditor indpndnc ffct during th initial announcmnt of accounting irrgularitis at Enron. In summary, th rsults of th study suggst that auditor indpndnc and thrfor financial statmnt rliability ar compromisd by th provision of non-audit srvics by th xtrnal auditor. Th rsults also indicat that in th wak of th Enron rvlations, invstors prciv financial statmnts as bing lss rliabl thus rquir a additional risk prmium, which translats into lowr stock prics and a loss of firm valu. Rfrncs 1. Ahlawat, S. S Outsourcing of th Intrnal Audit Function: Implications for Auditor Objctivity. Working papr, Rutgrs Univrsity. 2. Amrican Institut of Crtifid Public Accountants (AICPA) Srving th Public Intrst: A Nw Concptual Framwork for Auditor Indpndnc, Nw York, NY: AICPA. 3. Arrunada, B Th Economics of Audit Quality: Privat Incntivs and th Rgulation of Audit and Non-Audit Srvics. Norwll, MA: Kluwr Acadmic Publishrs. 4. Barlas, Stphn, Jan Corporat Audit Committ Must Gar Up. Stratgic Financ, Volum 82, Issu 7, Barkss, L., and R. Simntt Th Provision of Othr Srvics by Auditors: Indpndnc and Pricing Issus. Accounting and Businss Rsarch 24: Bindr, J. J., Spring On th Us of th Multivariat Rgrssion Modl in Evnt Studis, Journal of Accounting Rsarch, Vol. 23, pp Carmichal, D. R A Concptual Framwork for Indpndnc. Th CPA Journal (March): Chny, G Intrnal Auditors Push AICPA on Outsourcing Ethics. Accounting Today (May 20-Jun 2): 14, DAnglo, L Auditor Siz and Audit Quality. Journal of Accounting and Economics 3: Elliott, R. K., and D. M. Pallais Ar You Rady for th Nw Assuranc Srvics? Journal of Accountancy (Jun): Espahbodi, H., P. Espahbodi, and H. Thranian Equity Pric Raction to th Pronouncmnts Rlatd to Accounting for Incom Taxs, Th Accounting Rviw, Volum 70 Numbr 4, p Fama, E., Fishr, L., and Jnsn, M. C., Th Adjustmnt of Stock Prics to Nw Information, Intrnational Economic Rviw, pp Firth, M Th Provision of Non-audit Srvics by Accounting Firms to thir Audit Clints. Contmporary Accounting Rsarch 14: Frankl, Richard, M. Johnson, and K. Nlson, 2002, Th Rlation Btwn Auditors Fs for Non-Audit Srvics and Earnings Quality. Working papr, Sloan School of Businss. 15. Gibbons, M. R., Economtric Modls for Tsting a Class of Financial Modls- An Application of th Nonlinar Multivariat Rgrssion Modl., Ph.D. dissrtation, Univrsity of Chicago. 16. Grn, W.H Economtric Analysis, Uppr Saddl Rivr, NJ, Prntic Hall 17. Gul, E.A. 1991, Siz of Audit Fs and Prcptions of Auditors Ability to Rsist Managmnt Prssur in Audit Conflict, ABACUS, Hussy, Rogr and Gorg Lan. Jul An Examination of Auditor Indpndnc Issus from th Prspctivs of U.K. financ dirctors. Journal of Businss Ethics; Dordrcht,Volum 43, Issu 2, pp Lvitt, A Rmarks givn at th 24 th Annual National Confrnc on Currnt SEC Dvlopmnts, Washington D. C., Dcmbr spch122.txt. 20. Low, D. J., and K. Pany CPA Prformanc of Consulting Engagmnts with Audit Clints: Effct on Financial Usrs Prcptions and Dcisions. Auditing: A Journal of Practic & Thory (Fall): Low, D. Jordan, Marshall A. Gigr, and Kurt Pany Th Effcts of Intrnal Audit Outsourcing on Prcivd Extrnal Auditor Indpndnc. Auditing; Volum 18, pp McKinly, S., K. Pany, and PM.J. Rckrs An Examination of th Influnc of CPA Firm Typ, Siz, and MAS provision on Loan Officr Dcisions and Prcptions. Journal of Accounting Rsarch (Autumn): Pany, K., and P.M. J. Rckrs, Auditor Indpndnc and Non-audit Srvics: Dirctor Viws and thir Policy Implications. Journal of Accounting and Public Policy 2 (1): Pany, K., and P.M. J. Rckrs, Non-audit Srvics and Auditor Indpndnc, Auditing: A Journal of Practic & Thory, (Fall): Patl, Jams Th API and th Dsign of Exprimnts. Journal of Accounting Rsarch (Autumn):

12 26. Rckrs, P. M. J., and A. J. Stagliano Non-audit Srvics and Prcivd Indpndnc: Som Nw Evidnc. Auditing: A Journal of Practic & Thory (Spring): Scuritis and Exchang Commission Final Rul: Rvision of th Commission s Auditor Indpndnc Rquirmnts. Washington, D. C. 28. Schutz, W. P. 1994, A Mountain or a Molhill? Accounting Horizons 8, Simunic, D Auditing, Consulting, and Auditor Indpndnc. Journal of Accounting Rsarch 22: Shockly, R. A Prcptions of Auditors Indpndnc: An Empirical Analysis. Th Accounting Rviw (Octobr): Sullivan, J.D. 1995, Lttr of Jun 14 th to Hrbrt Finkston, Dirctor of Profssional Ethic (AICPA). Stamford, CT: Public Ovrsight Board. 32. Swangr, Susan L.and Eugn G. Chwning Jr. Sp Th Effct of Intrnal Audit Outsourcing Financial Analysts Prcptions of Extrnal Auditor Indpndnc. Auditing; Sarasota, Volum 20, pp Toh, S. H., and T. J. Wong Prcivd Auditor Quality and th Earnings Rspons Cofficint. Th Accounting Rviw 68: Tannnbaum, Carl R. Th Auditor as Enablr. Amrican Bankrs Association. ABA Banking Journal. Nw York, April 2002, Volum 94, pg Watts, R. L., and J. L. Zimmrman Positiv Accounting Thory. Englwood Cliffs, NJ: Prntic-Hall Inc. Endnot i During stimation of quation (5), w tstd for autocorrlation and htroscdasticity in th cross-sctional OLS rsidus. First, w us th gnralizd Durbin-Watson statistics to tst for first- and scond-ordr autocorrlation, thn w us th Whit tst to idntify th htroscdasticity. W also calculat th Eickr-Whit htroscdasticityconsistnt varianc and covarianc from OLS stimation to gt th htroscdasticity-adjustd t statistic for th stimatd cofficints. 94