group c nicole fitzmaurice, eric poolman, lisa landon, pang koh & ping zhou

Group CNicole Fitzmaurice, Eric Poolman, Lisa Landon, Pang Koh & Ping Zhou

AgendaThe insurance hypothesis and

market pricesThe power of auditorsGetting the price rightBehind closed doors at

WorldCom:2001

The Insurance Hypothesis and Market PricesKrishnagopal Menon Boston University David D. Williams The Ohio State University

The Insurance Hypothesis and Market Prices

INTRODUCTION:• The literature on the audit market has

suggested that a valued attribute of audits is implicit insurance.

• Investors assign a value to the right to recover investment losses from the auditor.

• Effect on stock prices of Laventhol& Horwath• ( L&H) clients of two related events.


• The "insurance hypothesis.”• Auditors are viewed as having “deep

pockets”1. The Big 6 auditing firms paid $477 million

for settling and defending lawsuits in 1991.

2. There were about $30 billion in damage claims facing the profession as a whole at the end of 1991.


Laventhol & Horwath's Bankruptcy 1. Laventhol & Horwath agreed to file for

bankruptcy in November 1990.2. In a typical auditor change situation,

the investors continue to have rights against the predecessor auditor.

3. Investors in L&H client firms were restricted from recovering any present and potential claims.


Investors ‘ different rights of recovery of damages from auditors in seasoned securities and in IPOs.

1. Seasoned securities2. Initial public offerings


Alternative hypotheses• Security price changes observed at the time of

L&H' s bankruptcy disclosure. The most prominent of these is related to monitoring.

• When L&H announced bankruptcy, two types of monitoring uncertainties were created.

1. First, there was uncertainty introduced about the quality of future monitoring.

2. Second, some firms might have to delay on filing audited financial statements.

Hypothesis H1: L&H client’s security prices declined

relative to the market on the disclosure of the bankruptcy.

H2: L&H clients whose securities sustained recent losses experienced more negative abnormal returns on the disclosure of L&H’s bankruptcy than other L&H clients and these returns were correlated with the magnitude of the previously sustained losses.

Hypothesis cont….

H3: For L&H clients whose securities sustained recent losses, IPO clients experienced more negative abnormal returns on the disclosure of L&H’s bankruptcy than L&H clients with seasoned securities.

Regression model

Conclusion The disclosure of L&H' s bankruptcy was

found to have a negative impact on L&H client stock prices.

There was no corresponding increase in stock prices on announcement of a replacement auditor.

The results of the paper suggest that auditors are viewed by investors as guarantors of financial statements, and as guarantors of investments.

The Power of Auditors

The Power of Auditors Earnings management: a research perspective

Researchers are also interested in less shocking cases where managers act opportunistically

Problem: unlike high-profile cases where fraud is involved, difficult to identify earnings management without knowing management’s true intentions.

Solution: must infer through observable patterns of reported numbers1. First look at context where earnings management is

most likely to occur2. Try to gather large samples of firms to provide

systematic evidence across the sample

The Power of Auditors (cont’d)

Measuring earnings management Focused on total accruals

Since there are estimates and judgments inherent

Measured as difference between net income and cash flows from operations

Decomposed into:(1) non-discretionary(2) discretionary, which will be inferred as earnings management, since they are on average zero

By far the most-commonly used method

The Power of Auditors (cont’d) Motivations for earnings management

Costs:

1. Iron Law of Accruals Reversals2. Impair perceived quality of earnings3. Violation of GAAP (leading to lawsuits and

penalties) Benefits that outweigh the costs (Capital-based)

1. Increase stock prices in secondary offerings (especially with management as the selling shareholders)

2. Meeting different earnings benchmark• In line with Prospect Theory due to Loss Aversion


Are financial statement users misled by earnings management? Economic consequences of earnings

management seem to be offset by investor’s rational expectation (evident by lower ERC); discounting earnings

However, the discounting is insufficient, evident by the underperformance following an offering


How to strengthen the quality of financial reporting? Corporate governance through audit committee

Requiring: 1) (1) majority of the directors be independent2) (2) committee of independent directors to select new member

Recommending:1) Audit committee be composed of outside directors only2) Members of audit committee be financially literate, and at least

one who have accounting expertise Independence of board of directors seems to be insignificant in

curbing earnings management Independence of audit committee is significant; and not

conditioned on a 100% independent audit committee Relationship investing - where large block-holders take active and

interventionist role on the board

The Power of Auditors (cont’d) Role of auditors and auditor independence

Auditors can curb discretionary accruals and lower threshold for issuing a qualified audit report But 56% of earnings management attempt were waived Earnings management relating to unstructured

transactions and imprecise standards is the most difficult to prevent

Auditor independence is the concerning issue In 2001, SEC required firms to disclose their audit and

non-audit fees Non-audit fees, on average, make up half of the total Positive association between fee ratio and absolute

value of discretionary accruals

Getting the Price Right

Getting the Price Right Seeks to investigate the effects of regulations,

monopoly and monopsony on audit fees Initiatives to enhance competition in the audit

market seem to result in reduction in audit fees But more importantly, is whether the premium

charged by the big accounting firms result from monopoly OR brand-name reputation Brand-name reputation derives from the

idea that the Big Five auditors provide a level of assurance that exceeds the minimum required by GAAP.

Getting the Price Right (cont’d)Market competition OR brand-name

reputation Craswell, Francis and Taylor (1996) found

that the deregulation of audit market in Australia did not lead to reduction in the Big Six audit fees Evidence that the Big Six audit fee premiums are due to

brand-name reputation, rather than monopoly power

Average real audit fees were mostly higher for the Big Six auditors than for other auditors, both before and after the amendment Supporting that premiums reflect brand-name

reputation

Getting the Price Right (cont’d)

Supply structure (Auditors’ power) Pearson and Trompeter reported that high levels of

auditor concentration led to lower audit fees Auditors share benefits from economies of scale with

clients In contrast, authors of the paper have found

otherwise; high levels of auditor concentration led to higher audit fees

Inconclusive, have to also take into account demand structure


Demand structure (Audit clients’ power) Audit market also characterized by

monopsony theory Where audit clients may exercise influence

over the setting of price to bring it to a level below what would otherwise occur in competitive market

The authors found that audit fees were in fact lower in markets where municipal clients exercise influence over auditors.


Economic Consequences: Supply structure: in relation to

whether the audit premiums that the Big Four charge are due to monopolistic power or brand-name reputation

Demand structure: in relation to whether audit clients have market power over auditors or not

Behind Closed Doors at WorldCom: 2001Kay E. Zekany, Lucas W. Braun and Zachary T. Warder

Behind Closed Doors at WorldCom: 2001

Large telecommunications company

Annual revenues > $30 billionServed > 20 million customersLargest internet carrier

Serving 100 countries in 6 continentsProvider of network services for US

Government


External Environment # of local telephone companies dropped to 150

from 330 in 2000 Long distance carriers lost pricing power and

market share Entrants of many competitors for internet

service in late 90’s

Greater competition and challenging market


CEO – Bernard J. (Bernie) Ebbers Risk-seeking, free-spending, over-zealous

deal maker Orchestrated mergers with 75 companies

Largest MCI

“Our Goal is not to capture market share or be global. Our goal is to be

the No. 1 stock on Wall Street.”


Outside: stock looked to be doing fine Beginning July 2000

Expenses as a percentage of total revenues increased

Declining earning Result in stock price decrease

Pressure to not let stock decrease Bernie’s financial well-being dependant on

stock price Company marked as high-growth company


Corporate Culture Management Leaders

CEO – Bernie CFO and CAP Scott Sullivan

Leaders and managers not to be questioned

Loyalty was compensated Bernie very interested in making sure all

employees add value


Accounting Functions Internal Audit

Only proceeded with operational audits Reported results and proposed audits for

approval to Audit Committee Rest of the time reported to Sullivan

Prepared ERP reports Served no audit purpose Time-intensive


Accounting Functions Revenue Accounting

Monthly Revenue (MonRev) Reports Corporate Unallocated Schedule (CUS)

Sullivan responsible for item booking into CUS Revenue Accounting Group (led by Ronal

Lomenzo) prepared schedule and had principal responsibility for booking entries

Distribution limited and closely guarded Access to CUS was restricted to Bernie, Sullivan

and the Revenue Accounting Group


Accounting Functions Property Accounting

Responsible for tracking assets and inventory Produced Property Plant and Equipment Roll forward Report

Capital Reporting Responsible for approving capital expenditures and reporting

on capital spending Two versions of report

The Monthly Revenue Closing Process Produced “Preliminary MonRev” for review Then “Final MonRev”


Line Cost AccrualsCosts of the use of “off-net” facilities

and connections were estimatedEstimates were booked each month in

an adjusting journal entryAdjustments were made as necessary


Line Cost Accrual Release In 2001 General Accounting was instructed to

reduce line costs by $150 million Vice President of Wireless Finance refused to

make adjustment due to lack of documentation

Sullivan eventually got another member of Accounting to book the entry


Capitalization of Line Costs Line cost E/R ratio increased significantly in

2000 and 2001 Excess capacity was capitalized to reduce

costs Erroneous asset accounts were created to

offset the reversal of expenses These invalid entries brought line costs back

down to prior year levels


Revenue Accounting’s “Close the Gap” Exercise Each quarter a “Close the Gap” Exercise

was conducted This was managements way of

maintaining double-digit revenue growth Difference between budgeted and

preliminary revenue numbers was booked to increase revenue


Arthur Andersen’s Audit of 2001 Audit took place in the midst of the Enron

scandal Acknowledged WorldCom was maximum

risk client and had taken aggressive accounting positions in the past

Signed off on financial statements despite risk identified and documented

QUESTIONSNicole Fitzmaurice, Eric Poolman, Lisa Landon, Pang Koh & Ping Zhou

group c nicole fitzmaurice, eric poolman, lisa landon, pang koh & ping zhou

Documents

sample slide

offering slide

insurance hypothesis

lh clients security

loss aversion slide

regression model slide

market prices introduction

earnings management