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...firm in our sample loses $31.4 million more than non-Andersen client. We do not find any unusual underpricing for these SEOs, which suggests that any accounting concerns about the issuers are resolved before the issue dates.
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When Enron imploded in 2001, it took with it the auditing firm founded in Chicago in 1913 by Arthur Andersen. This was a tragic end for a company with a long and distinguished history. The event provides, nevertheless, some unique research opportunities. What did Andersen's compromised reputation mean to its clients?
Chaney and Philipich (2002) investigate the impact of the Enron audit failure on auditor reputation and on the stock price of other Arthur Andersen clients. They document that the clients experienced significant negative stock returns due to Andersen's worsening reputation. We focus rather on an auditor's certifying and monitoring role. Myers and Majluf (1984) show that equity issuers face an adverse selection problem since managers tend to have better information about firm value than outside investors. Firms experience underpricing at initial public offerings (IPOs) or their stock prices tend to decline when they announce seasoned equity offerings (SEOs).
Firms rely on the reputation of financial intermediaries to mitigate the asymmetric information problem in equity offerings. Slovin, Sushka, and Hudson (1990) find that the quality of auditing mitigates the negative stock price reaction to the announcement of an SEO.
Titman and Trueman (1986) and Datar, Feltham, and Hughes (1991) show that auditor quality also decreases IPO underpricing. Balvers, McDonald, and Miller (1988), Beatty (1989), and Michaely and Shaw (1995) find that firms employing a (then-)Big Eight auditor experience less underpricing.
Because Arthur Andersen lost its reputation as the Enron saga developed, we expect that its clients might have been negatively affected at issue of equities during that time. We examine the effect of Andersen's worsening reputation on its clients making seasoned equity offerings.
We first look at the announcement effect of SEOs. We examine 39 SEOs audited by Arthur Andersen and 124 SEOs audited by other Big Five firms between October 2001 and August 2002. The firms audited by Arthur Andersen experience a two percentage point more decline in stock prices than those audited by the others. This strong negative reaction remains significant after controlling for other determinants of the stock price reaction to the SEO announcements.
The result is both statistically and economically significant; the median firm in our sample loses $31.4 million more when it announces a SEO. We also examine the difference in SEO underpricing between Arthur Andersen clients and other firms at offering dates, and we find no significant difference.
These results indicate investors were concerned about an issuing firm's use of Andersen at the time of SEO announcement. Its clients experienced more negative returns because Andersen could not mitigate adverse selection costs at the announcement of an SEO. However, we do not observe the difference in SEO underpricing at issuance because the clients have time to address any accounting concerns before they issue equity. Firms might have been able to alleviate these concerns through additional effort such as improving the quality of disclosures or making additional disclosures prior to the issue date.
Our research contributes to the literature on the monitoring and certifying role of financial intermediaries in a unique way. An auditor's worsening reputation has a negative effect on its clients issuing equity. Our result for Andersen clients corroborates findings that the reputation of financial intermediaries is especially valuable to firms issuing equity to alleviate adverse selection problems.
I. Literature Review and Hypothesis Development
A major issue in the literature has been the impact of asymmetric information on security offerings. The Myers (1984) and Myers and Majluf (1984) pecking order theory, is based on the idea that insiders know more about their firms' values and future projects than outside investors, and that firms maximize the wealth of current shareholders. Insiders (or managers) avoid issuing equity when they believe the firm is undervalued.
The result is an adverse selection problem when firms issue equities; because investors have incomplete information, they cannot differentiate overvalued firms from undervalued firms, but because they know firms avoid issuing equities when they are undervalued, they assume issuers are overvalued. Firms thus use financial intermediaries to mitigate the adverse selection problem in an equity offering.
The certification and monitoring role of financial intermediaries at an initial public offering (IPO) has been extensively analyzed and the role of auditors is well established. (1) In the IPO market, the reputations of auditing firms tend to mitigate IPO underpricing for clients. In the Titman and Trueman (1986) and Datar et al. (1991) models, audit quality reduces IPO underpricing. Balvers et al. (1988), Beatty (1989), and Michaely and Shaw (1995) report that firms employing a Big Eight auditor experience less underpricing.
In the 1990s, however, it became hard to test the effect of audit quality on IPO underpricing because Big Five firms dominated the auditing market. Another factor is that, when firms go public, they tend to switch to Big Five firms. The deteriorating reputation of Arthur Andersen at the time of the Enron debacle is a good testing environment for the effect of auditing quality on equity issue.
Authors have documented negative announcement effects for firms issuing seasoned equity. (2) External monitors such as underwriters or auditors can mitigate the adverse selection problem associated with seasoned equity offerings. Slovin, Sushka, and Hudson (1990) find that the stock price reaction to the announcement of a seasoned equity offering is a positive function of the quantity of bank debt, the quality of the firm's investment banker, and the quality of the auditing firm. This result indicates that Arthur Andersen's weakening reputation might exacerbate the negative announcement effects for client firms.
Long established as the industry accounting standard...
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