The Impact of the Audit Failure on Auditor Reputation

The authors in this paper analyze the impact of the audit failure on the auditor’s reputation based on the market reaction that is measured by abnormal returns for AA clients. The authors separated the audit failure in several events that occurred during the audit failure. In so doing, the authors are able to identify which of these events result in questioning the reputation of AA. Accordingly, the result indicates that the abnormal returns of the clients of AA declined when AA announced that a lot of audit documents were shredded. Therefore, due to the separation of the audit failure events, the authors intend to analyze what exactly of these events affected AA’s reputation during the audit failure, what is was that caused investors to lose their trust in Arthur Andersen and why clients tended to leave AA during the audit failure.

Nelson examine whether the decline in the market reaction for AA clients was due to the damaged reputation of AA. This paper extends the study of Chaney and Philipich. However, Nelson isolate the event being studied from other events occurred during that period of the audit failure. According to the authors, other negative news was released in that period. In particularly, news related to the macroeconomics, industry related news, and news related to the energy and information technology sectors. Furthermore, the authors control for these cofounding news with Big 4 clients expecting a more severe decline in the abnormal returns for AA. In so doing, the authors are able to identify whether the market decline was due to damaged reputation of AA, or due to several confounding events surrounding the period of the shredding announcement. According to their analysis, the confounding effects has the major effect on the negative market reaction.

Weber state that both Nelson and Chaney and Philipich focused in their studies on analyzing the impact of auditor reputation around Enron audit failure in US setting. Accordingly, Weber argue that the separation between the reputation effect and the insurance effect in the US setting is problematic, due to the insurance effect in such a country like US where the auditor “legal liability is high”. In contrast Weber clearly distinguish between the reputation theory demonstrated by DeAngelo (1981) and the insurance theory suggested by recent literatures. 

Thereby the authors choose Germany to study audit failure as Germany provides protection to the audit firms from the investors litigation. According to some theory, this would imply that the auditor has less incentives to deliver high audit quality in Germany. With this context, the authors exclude the insurance effect in their analysis. Therefore the authors are able to provide a cleaner results regarding the reputation of the auditor.

The paper shows that the negative market reaction was a reflection of the damaged auditor reputation due to the shredding audit documents announcement. However, the authors did not control for others negative news announced during that period, while this news could contaminate the outcome of the research. Referring to the findings of Nelson who concluded that the decrease of the abnormal returns of AA clients was due to the cofounding news surrounding the shredding announcement. In other words this decrease was due to other negative news announced at the same time to the announcement of shredding the audit documents. Therefore we could argue that there are other factors explaining the decline in the abnormal returns of AA clients.

Nelson demonstrate that the confounding news occurred around the event being studied contaminates the findings of Chaney and Philipich who document that auditor reputation was damaged during the audit failure. However, Nelson did not include all AA clients, they only include the large clients stated in S&P 1500. With this sample the authors only examine the market reaction for the AA largest clients. They ignore other AA clients that are not included in the sample and who might not be affected by the cofounding news. This might be an indication that the research results may be somewhat biased.

Moreover, the authors document that Arthur Anderson’s reputation did not suffer much from the announcement of the shredding event, but rather because of confounding news. However the authors find some supporting evidence for a reputation effect in the information technology sector. More so, given the presence of other negative news in that time, it is difficult to measure auditor reputation. Therefore indicating that AA reputation did not suffer much from Enron failure might not be accurate.

According to the analysis of Weber, investors seek for high audit quality. In other words the investors value the reputation of the auditor. In this study the investors react negatively to ComROAD failure event for KPMG clients. However the authors analyze the market reaction for the KPMG clients and did not control for other auditors’ clients. For instance Chaney and Philipich and Nelson control the abnormal market returns of AA clients with the Big 4 clients. A control group would enable identifying whether KPMG clients experience a more negative market reaction compared to other auditor clients during the event. This means KPMG clients should suffer from more negative abnormal returns than the other group. This would have made the research result more valid.

The selected papers study whether an event during an audit failure could significantly affect the reputation of the auditor. First, auditor reputation is a crucial concept which is not easy to measure. All 3 papers analyze auditor reputation as the market response in a short term event window. It would be interesting to measure how a scandal impacts the reputation on the long term. What are the long-term consequences of a scandal? For example, it would be interesting to know how an event like this changes the operations of the audit firms. Besides that, future research should attempt to analyze the market reaction for a longer period because the market reaction might differ on the long term. The market response could be less or more severe for the following negative news on audit failure.

Furthermore, future research should contribute to the work of Nelson to understand better whether the market reaction is affected by decreased auditor reputation or other events occurring during the same period. It might be interesting to study if these events correlate with the studied event, or have impact on the correlation between the event being studied and the reputation.

Moreover, it would be interesting to focus on the influence of contextual factors like the legal context. Weber, selected Germany as the context of their study to differentiate between the reputation rationale and the insurance rationale. Therefore future research should develop methodologies to measure both rationales to better isolate these effects from each other to demonstrate cleaner results.

The main aim of these studies was to analyze the impact of the audit failure on auditor reputation, which is a very important subject for regulators as well as audit firms. After reviewing the papers, both Weber and Chaney and Philipich, demonstrate that auditor reputation was damaged due to the fraud announcement by measuring the decline in the clients abnormal returns. In contrast, Nelson et al. (2008) conclude that the decline in the clients shares was mostly explained by the confounding effects during that event window. However, Nelson et al. (2008) still recognize a potential reputation effect due to media pressure and the fact that numbers of the clients left their auditor after the announcement.

Even though all papers recognize the reputation effect, it is still unclear how and to what extent auditor reputation is impaired by an audit failure announcement and what the consequences are. Whether a legal context that provides opportunities for litigation is most favorable to investors seeking high audit quality, might depend on the policy context. It remains important that audit failures are earlier discovered. Therefore checks within the audit process, transparency in financial statements and checks and balances within the broader financial policy context are very important as demonstrated by Weber. Moreover, regulators have an important role by increasing the integrity checks to promote ethics and integrity in the audit firms around the world. Besides that, the regulators could respond to the high switching cost imposed on clients to help clients recover from the negative effects of such an audit failure, as the papers show that clients suffer from decreases in abnormal returns.