The Impact of Litigation against an Audit Firm on the Market Value of Nonlitigating Clients

Abstract

This study investigates how litigation against an audit firm affects the market value of its publicly traded clients. We examine the impact of private litigation alleging audit failure on the audit firm's clients not involved in the lawsuit. Our results indicate that clients not involved in the litigation experience significant negative returns at the announcement of litigation against their audit firm. These results suggest that the market interprets litigation against an audit firm as a signal of decreased audit quality and that the market places a value on audit quality when pricing a firm's securities. The results are also consistent with an audit insurance explanation, which views the audit firm as a source of potential financial indemnification to investors and predicts that damage to the auditor's underwriting ability will be reflected in reduced securities prices for the firm's clients. When the analysis was restricted to companies in the same industry where the alleged audit failure occurred, the market response is significantly more negative when the audit firm is considered a specialist in that industry than when the audit firm is not a specialist. Finally, the market response is weaker later in the sample period, consistent with the findings of prior research that the frequency of nonmeritorious suits has increased over time.

An Experimental Test of the Interaction of the Insurance and Information‐Signaling Hypotheses in Auditing*

“…In order to examine possible interactions between the insurance and informationsignaling hypotheses, it is necessary to separate their main effects. Although considerable empirical work has been done in these areas using archival data, evidence consistent with one hypothesis is also generally consistent with the other and with an audit quality explanation (e.g., Baber, Kumar, and Verghese 1995;Franz, Crawford, and Johnson 1998;Willenborg 1999). For example, lack of auditor independence may reduce audit quality, reduce the likelihood that a going-concern opinion will be issued, and work to the plaintiff's advantage in a lawsuit.…”

“…Yet, it can also be argued that Big X auditors are more likely to signal their private information and that they provide more insurance than do non -Big X auditors. Other studies have looked at auditor litigation (Franz et al 1998;Stice 1991); auditor bankruptcy, such as in the case of Laventhol & Horwath (Baber et al 1995;Menon and Williams 1994); and the demise of Arthur Andersen (Chaney and Philipich 2002;Krishnamurthy, Zhou, and Zhou 2002;Krishnan 2004;Callen and Morel 2003). Negative market reactions to events related to auditing firms can frequently be explained using multiple theories; for example, litigation can indicate that problems existed in audit quality, that the auditor failed to provide appropriate signals to the market, or that a drain on the auditor's assets is forthcoming.…”

The market reaction to Arthur Andersen's role in the Enron scandal: Loss of reputation or confounding effects?

“…Some studies suggest this insurance demand for auditing dominates reputation concerns (Lennox, 1999;Khurana and Raman, 2004), while other studies conclude it is difficult to distinguish between reputation and insurance effects (Baber et al, 1995;Franz et al, 1998). Consistent with the latter view, Weber et al (2008) suggests the negative returns CP documents likely reflect not only the market's revised assessment of Andersen's reputation but also the auditor's prospects for survival.…”

“…For example, auditor reputation is positively associated with the value of initial public offerings (Titman and Trueman, 1986;Beatty, 1989;Datar et al, 1991). Conversely, clients experience a decline in equity values surrounding the announcement of information damaging to their auditor's reputation (Franz et al, 1998;Firth, 1990;Weber et al, 2008). Auditor reputation also affects the market's valuation of client earnings.…”

The Influence of Qualified Foreign Institutional Investors on the Association between Default Risk and Audit Opinions: Evidence from the Chinese Stock Market

“…Many of the prior studies have shown that auditing opinions provide a clear signal summarizing information on firms for use by outsider investors (Dye, 1993; Franz, Crawford and Johnson, 1998; Willenborg, 1999; O’Reilly, Leitch and Tuttle, 2006). Lennox (2000) found that highly leveraged companies, who clearly had inherently higher bankruptcy risk, were also more likely to receive modified audit reports, while Haskins and Williams (1990) and Citron and Taffler (1992) also noted that financial distress was an important indicator and a strong reason for auditors to issue modified opinions.…”