The Demise of Arthur Andersen

With the revelation to the investing public of fraud and misrepresentation in the presentation of Enron’s financial statements--fraud and misrepresentation in which the accounting firm of Arthur Andersen appears to have been complicit--at least 143 corporate clients, out of 2,311, have left Andersen, and Andersen itself has been forced to lay off about 7,000 of its 26,000 employees.

The firm has been reported in search of a white knight, and--in the absence of one--may be forced into even more severe retrenchment, if not liquidation. Why such a severe reaction to one mistake?

While an unqualified report by a company’s independent auditor does not guarantee the accuracy of a firm’s financial statements, it does indicate that the financial statements were compiled based on generally accepted accounting principles (GAAP). This means that outsiders can have some confidence in the numbers they are reading.

In this country, public corporations (i.e., those whose shares are owned by more than a handful of investors) are required by the Securities and Exchange Commission (SEC) to have their financial statements independently audited and, thus, based on GAAP. Many private (or closely held) corporations and proprietary businesses elect to have their financial statements independently audited, as that facilitates credit analysis by suppliers, banks, and other lenders, and is appreciated by a variety of other outsider investors such as limited partners and venture capitalists.

In truth, the quality of an audit is unobservable. An audit conducted by a small and relatively unknown accounting firm, therefore, may not be worth much. It may be a function of observable "proxies" for quality, such as investor lawsuits. A variety of research has shown that the value of the stock of public corporations audited by non-Big 5 accounting firms reflects such proxies for audit quality. However, the value of stock of Big 5-audited public corporations seemed immune to such events. That is, it seemed immune, until the demise of Andersen.

Several events stand out in Andersen's demise. Probably the first serious news that Andersen might have been criminally involved in the Enron scandal occurred on December 1, 2001, when the SEC issued a subpoena to Andersen for its documents in the case. It appears that this subpoena temporarily spooked the stock market.

Then, on January 28, 2002, the Wall Street Journal reported that the Department of Justice (DOJ) would seek a criminal obstruction-of-justice charge against Andersen, for its shredding of documents in the Enron case. Clients had already started leaving Andersen, but it appears that this news proved to be the nail in the coffin.

Following this, Andersen-audited firms appear to be discounted by about 6 percent relative to non-Andersen-audited firms, and clients started leaving Andersen in droves. The company was actually indicted on March 14, but by then the indictment was old news as far as the stock market was concerned.

To track the stock market’s discount of Andersen-audited firms, Andrew Knipe--one of my MBA students--and I constructed two portfolios, one of Andersen-audited firms and the other of non-Andersen firms, matched by industry and size. For none of the firms included in this analysis was there a convoluting event such as a major merger and acquisition announcement during the time period of the study. A total of 40 firms, 20 in the Andersen-audited group and 20 in the non-Andersen-audited group, was selected. These companies are listed in the table below.

From Yahoo.com, Andrew and I downloaded the daily adjusted closing prices of the stocks of these companies (the adjustment taking into account splits and dividends). I then constructed portfolios based on an equal dollar investment in the stocks of each of the companies and tracked the performance of the two portfolios from August 1, 2001, to March 1, 2002. Indexes of the values of these portfolios are juxtaposed in Figure 1.

From August 1, 2001, to November 30, 2001, the values of the two portfolios are very highly correlated. In particular, the values of the two portfolios fell following the September 11 terrorist attack on our country and then quickly recovered. You would expect a very high correlation in the values of truly matched portfolios. Then, two deviations stand out.

In early December 2001, a wedge temporarily opened up between the values of the two portfolios. This followed the SEC subpoena. Then, in early February, a second and persistent wedge opened. This followed the news of the coming DOJ indictment. It appears that an Andersen signature (relative to a "Final Four" signature) costs a company 6 percent of its market capitalization. No wonder corporate clients--including several of the companies that were in the Andersen-audited portfolio Andrew and I constructed--are leaving Andersen.

Prior to the demise of Arthur Andersen, the Big 5 firms seemed to have a "lock" on reputation. It is possible that these firms may have felt free to trade on their names in search of additional sources of revenue. If that is what happened at Andersen, it was a big mistake. In a free market, nobody has a lock on anything. Every day that you don’t earn your reputation afresh by serving your customers well is a day you risk losing your reputation. And, in a service-oriented economy, losing your reputation is the kiss of death.