Auditor Reputation, Auditor Independence and the Stock Market Reaction to Andersen's Clients

Abstract

In this paper, we study a comprehensive sample of Andersen clients and investigate whether the deterioration of Andersen's reputation after its criminal indictment on March 14, 2002 adversely impacted the perceived credibility of their audit quality. Since these reputational concerns are more of an issue if an auditor's independence is impaired, we investigate the relationship between the abnormal market returns around the indictment announcement for Andersen clients and auditor independence. Our results suggest that when news about Andersen's indictment was released, the market reacted more negatively to Andersen clients than to clients of the other Big Four auditors. More importantly, the indictment period abnormal return is significantly higher when auditor independence is perceived to be high, i.e., the audit firm provides fewer non-audit related services to the client. This result is robust when we include size, book to market ratio, ownership structure, sales growth, leverage and proxies for investor losses as control variables. We also document that when firms announce Andersen's replacement with a non-Big Four auditor, the CAR is significantly negative. This is significantly lower than the return to firms that switch to other Big Four auditors. Collectively, our empirical results provide evidence in support of the notion that auditor reputation and independence have a material impact on audit quality and credibility of audited financial statements, and that the market prices this.