November 5, 2002
NASHVILLE, Tenn.—A comprehensive Vanderbilt University study in the wake of the breaking Enron scandal puts a $37.1 million pricetag on the loss of consumer confidence in companies audited by Arthur Andersen, tied directly to their choice of auditors.
As debate rages over the leadership of the board appointed by Securities and Exchange Commission chairman Harvey Pitt to oversee the accounting profession, the Vanderbilt study demonstrates just how costly loss of public confidence in auditors can be.
The study, which examined all 284 of the S&P 1500 public companies audited by Arthur Andersen, is the first to confirm what many had speculated—that the Andersen-Enron scandal caused widespread and immediate loss in the marketplace.
The study, “Shredded Reputation: the Cost of Audit Failure,” found:
· In the three days that followed the announcement that Arthur Andersen shredded audit documents, Andersen’s clients’ market value dropped 2 percent, or $37.1 million.
· Companies audited by the same Andersen Houston office that audited Enron suffered a striking 4 percent loss.
· Public companies could not recover from the Andersen stain after the auditing firm was indicted.
The study by Paul Chaney, associate professor of accounting at the Owen Graduate School of Management at Vanderbilt, and Kirk Philipich of Ohio State University revealed key consumer, company and audit firm lessons.
“On the dates that shredding was found and the Powers Report was made public, Andersen’s other clients experienced an immediate negative market reaction,” Chaney said. “Investors downgraded the quality of the audits, indicating a failure of trust.
“Andersen’s public clients suffered a 2 percent market decline,” Chaney said. “But those audited by Andersen’s Houston office—the office conducting the Enron audit—suffered twice as much damage.
“Two percent may not sound like much, but we’re talking $37.1 million,” Chaney added.
Advice for investors
Chaney urges investors to heed key lessons from the study, and he offers five points to consider when making investment decisions:
· First, determine who audits the company. You can find this in the annual report. Do not invest in companies audited by low quality audit firms.
· Second, determine whether the company restated prior years’ earnings and, if so, why. Was the restatement due to inappropriate accounting approved earlier by the auditors?
· Third, find out whether the audit firm has been fined by the SEC for audit violations in the past five years. If so, find out why.
· Next, always question the nature of the non-audit fees paid to the CPA firm. “Enron paid Andersen millions for both auditing and consulting,” Chaney said. “While we could not document that this combination influenced the public’s punishment of other Andersen clients, it does raise questions about the auditor’s independence.”
· Finally, question any company’s rapid growth. “If a company is reporting rapid growth, as Enron did, find out whether this is because it is using aggressive revenue recognition policies. In short, are they telling the truth?”
Chaney added, “There’s an old saying: ‘If your mother says she loves you, check it out.’ Investors have a duty to themselves to check out corporate claims and auditing practices.”
Advice for companies
Chaney encouraged companies to consider the impact of their auditor’s reputation, including the auditor’s perceived independence. “Remember, the market punishes firms with aggressive reporting strategies who work with a low quality auditor,” he said.
He said it is a company’s duty to constantly monitor and improve the quality of its internal audit function. “Make sure your audit committee members are financially literate,” Chaney advised. “This is vital.”
Advice for audit firms
Chaney urged that audit companies should require mandatory rotation of partners in charge of large audits.
He also recommends that audits remain independent of consulting work by the same firm. “Audit firms must recognize that a lack of independence not only reduces the auditor’s reputation, but it also can reduce their clients’ market value,” Chaney said. “Ultimately, it can result in the audit firm’s disappearing from the universe.” For firms reluctant to pass up the often lucrative consulting work, he warns: “A lost reputation may be lost forever.”
For more news about Vanderbilt, visit the Vanderbilt News Service homepage at http://www.vanderbilt.edu/News.
Contact: Susanne Loftis, 615-322-NEWS, susanne.loftis@vanderbilt.edu