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Academic Writing 1 | Regression Analysis | Audit

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SHREDDED REPUTATION: CONTAGIOUS EFFECT ON ANDERSEN’S CLIENTS IN MALAYSIA (Paper published in the 6th Asian Academy of Management Conference, 2005) Wan Norhayati Wan Ahmad Rohami Shafie Kamil Md Idris ABSTRACT This study examines the impact of Andersen reputation on market prices based on the event of Andersen admission of shredding documents related to the Enron audit in United States. Specifically, in this paper, we extend to the other stock exchange out of United States, namely Bursa Malaysi
  SHREDDED REPUTATION: CONTAGIOUS EFFECT ON ANDERSEN’S CLIENTS IN MALAYSIA (Paper published in the 6 th Asian Academy of Management Conference, 2005) Wan Norhayati Wan AhmadRohami ShafieKamil Md Idris ABSTRACT This study examines the impact of Andersen reputation on market prices based on the event of Andersenadmission of shredding documents related to the Enron audit in United States. Specifically, in this paper, weextend to the other stock exchange out of United States, namely Bursa Malaysia. Is there any contagious impacton Andersen reputation to the Bursa Malaysia? Since the admission announcement shows the issue of independence as the main focus in the Andersen case, this study also document the impact of non-audit fees onmarket reaction surrounding the admission announcement date. Interestingly, the results prevails a contagiousimpact on Andersen’s Malaysia office due to the shredded reputation in the United States. However, Andersen’sMalaysia office only suffered a less severe decline compared to Andersen’s United States and Houston office. Inaddition, there is no evidence that Andersen’s Malaysia independence was questionable.Keywords: Auditor Reputation , Auditor Independence, Market Prices INTRODUCTION Studies on auditor reputation have been discussed frequently in the accounting and auditing literatures. Suchstudies attempted to relate the audit reputation with audit fees, loan pricing and initial public offering (see for example, Francis and Simon, 1987; Betty, 1989; Butterworth and Houghton, 1995; Rose, 1999; Hartini, 2003). Inaddition, it is assumed that a reputable auditor also an independence auditor (De Angelo, 1981). Many peopleassume that larger audit firms, especially the Big Five firms, are more credible than the non-Big Five firms. Thus,they are presumed to perform more quality works than the non-Big Five. This phenomenon pretends to give valueadded to the wealth of companies.However, recently the Enron scandal in the United States caused the reputation and independence of the BigFive to be questionable. The history event happened when the Enron’s auditor, Andersen, was heavily criticizedfor its collapse. After August 2002, Andersen was barred from conducting and reporting on the audits of SEC-registered companies. This is never happens in the history of auditing profession that such big firms are deniedof its quality in that way.The Enron case caused the auditor’s reputation severely tarnish to the extent that many companies’ (Andersen’sclients) share prices significantly dropped simply because investors loss confidence on the auditor’s reports(Chaney and Philipich, 2002). However, Andersen (also known as Arthur Andersen) was a multinational auditfirms. The events occurred in the U.S may contagious to other nations due to the shredded reputation in the UnitedStates. Nevertheless, empirical study has to be carried out to confirm such contention. This paper attempts to carryout such study. LITERATURE REVIEW There were a lot of previous studies that addressed the issue of audit quality for large audit firms. It is suggestedthat large audit firms produce higher audit quality than the smaller audit firms (Lennox, 1999). Such qualities arerecognized as market react positively when a company switches to a larger audit firms from a smaller one(Nicholas and Smith, 1983).Menon and Williams (1994) found that the disclosure of L&H’s bankruptcy had an adverse effect on market prices of L&H clients. He used seasoned securities and initial public offering (IPO) loss as the determinant of Cumulative Abnormal Return (CAR). In addition, Green and Dawkins (2000) found that there was negativeassociation between bankruptcy outcome and price reaction to bankruptcy filings.Similarly, Moreland (1995) in his study of the effects of SEC criticisms (sanctions) of auditors on earning  response coefficients (ERC) of client firms, found that abnormal security returns is negatively affected by earning prices. This is also supported by study by Firth (1990) who found that United Kingdom of Trade (DOT)investigations into the affairs of a specific company and their criticism on the auditors appear to incur economiclosses from the damage of their reputations.Besides concentrating and analyzing the effect of auditor reputation on market reaction of    Andersen’s clients,Chaney and Philipich (2002); Krishnamurthy et al. (2002) studied on the impact of non-audit services to themarket prices. It is presumed that market react negatively to the larger non-audit services purchased byAndersen’s clients, which show that the auditor independence is impaired (Chaney and Philipich, 2002; andKrishnamurthy et al. , 2002). However the results are mixed. Krishnamurthy et al. (2002) found that the abnormalreturn is significantly higher when auditor independence is perceived to be high. This is contrast to Chaney andPhilipich (2002). The reason why this happens is because Krishnamurthy et al. (2002) used the date of Andersencriminal indictment on March 14, 2002 while Chaney and Philipich (2002) focused on the date of Andersen’sadmission that a significant number of documents had been shredded. Also, Chaney and Philipich (2002) usessample which consisted relatively larger firms, whereas Krishnamurthy et al. (2002) sample consisted of manysmaller firms. However, in general, both studies confirm that Andersen reputation was declined even differentdates were used in their analysis. Therefore in this study, the date of Andersen’s admission that a significantnumber of documents had been shredded will be analyzed using the regression analysis to ensure that the resultscan be concluded clearly. HYPOTHESES DEVELOPMENT In the light of the Andersen’s Malaysia case, the negative market reaction might not be seen before theannouncement of Enron’s bankruptcy because probably investors in Malaysia still did not know this news. Infact, the contagious effect would not happen before a bad news is announced. The brand name of Andersen wastarnished around the world after Andersen admitted shredded the Enron’s documents. Later, such brand name hasnot been used outside the United States after Andersen United States was barred from auditing the companies.They then tried to find other Big Four for merging and building a reputable brand name. The brand name andaudit quality represent the reputation of the auditor and is the most important feature of an audit firm (Dopuch andSimunic, 1982). A repetition story of Andersen failure in the news and press worldwide may also portray aneroded reputation because an action was called to be taken to the Andersen by outsiders such as SecuritiesCommission and public. We argued that it may results the investors outside United States to pull out theinvestment in Andersen clients.Study by Callen and Morel (2002) proved that events directly related to Andersen had a larger (negative) impacton stock returns than events directly related to Enron. Therefore, in the case of events directly related toAndersen, it is expected that a negative reaction will be prevailed. In this present study, one event directly relatedto Andersen’ United States that might be effect other Andersen around the world including Malaysia is studied.The date used is the announcement of shredding documents, which Andersen had admitted on Jan 10, 2002. Thisannouncement is the bad news to Andersen’s clients. Event on Jan 10, 2002 was unexpected and was met withshock in the business community due to the fact that normally when audit firms paid damages to lawsuit claimantsor penalties to the SEC, they are careful not to admit guilty (Chaney and Philipich, 2002). Subsequently, thiswill tarnish the Andersen reputation. As a result of the bad news, the Andersen’s clients also affected. It isargued that the contagious impact will happen in Malaysia due to the fact that Malaysia is an open market nationand Andersen established its branches over here. However, the contagious impact would not spread to other BigFour because it only involved Andersen’s reputation (Krishnamurthy et al., 2002). Therefore the followinghypotheses are derived as follows (in alternate form):H1a: Andersen’s clients in Malaysia will experience a negative market reaction to the announcement of news that Andersen admitted shredded documents related to the Enron audit, is made public.H1b : Andersen’s clients in Malaysia will experience a negative market reaction to the announcement of news that reflects negatively on the Andersen’s reputation.In addition, the negative abnormal returns could be driven by the Andersen independence. It is argued that auditfirms provided other services rather the audits to some extend impair their independence. In the Andersen’s case,the event that Andersen admitted shredded documents related to the Enron audit are likely impaired Andersenindependence. This will be more prominent if Andersen perform more on other services rather than audit services.As the consequences, the reliability and validity of Andersen audit of their companies could be denied and  questionable. Investors will belief that Andersen did not give the best opinion as “true and fair view” to their clients. Thus, the negative abnormal return would be larger if the auditor independence perceived to be impaired.H2 : There is a positive relationship between audit fee ratio and abnormal return for events that perceivedAndersen not to be independence. METHODOLOGY The sample comprised of all Andersen’s clients in Malaysia in the year of 2000 and must still maintainengagement with Andersen until 2002. Total sample is 101 companies. For descriptive analysis, the date thatAndersen admitted shredding the documents on January 10, 2002 is used. Ten trading days on stock prices of Bursa Malaysia (Main and Second board) are gathered (see Menon and Williams 1994).This study used previous established event study model. Fama, Fisher, Jensen and Roll (1969) pioneered theevent study. Later, in 1980s, the researchers introduced the cross sectional studies using abnormal returns andfirm specific variables of size and leverage (see Leftwich, 1981). Thus, this study replicates the established modelof cumulative abnormal return from previous studies in market reaction of audit quality that is used worldwide inauditing literature (see for example, Menon and Williams, 1994; Chaney and Philipich, 2002; Krishnamurthy et al., 2002 in the United States; and in Asia, Gul, Sun and Tsui, 2003) and extended to accommodate the Malaysianenvironment. Several variables such as size and risk are control in the Ordinary Least Squares Regressions, are possible to influence market returns (see for example Menon and Williams, 1994; Chaney and Philipich, 2002;and Krishnamurthy et al., 2002 in the United States; and in Asia Gul, Sun and Tsui, 2003). Both variables arewell specified in the model (Leftwich, 1981).This study uses one sample t-test and the regression analysis (OLS) to analyze the data. The research models areas follows:Andersen admitted shredding documentsCAR = α + β 1 FEERATIO + β 2 LOGASSETS +β 3 SALESGROW + β 4 LEV+ β 5 AA + β 6 FYR+ ewhere,CAR=The Cumulative Mean Abnormal Return for Andersen client over the two, three and five days aroundadmitted of shredding documents by Andersen.CAR  T  ΣAR  it  t  =0where,AR  it    = R  it     – (α + β i R  mt    )AR  it    = Abnormal ReturnR  it  = Observed return on security IR  mt    = Return on the KLSE Composite Index (KLCI) for the t  th periodα = Interceptβ i = Beta for firm  I  1 FEERATIO = The ratio of audit fee to total fees paid to AndersenLOGASSETS = Log 10 of total assetsSALESGROW = Percentage growth in sales from 19999-2000LEV=The ratio of long-term debt plus short-term debt to total assetsAA =Indicator variable having a value of 1, if the name of auditor is Andersen and 0, if HanafiahRaslan MohamadFYR =Indicator variable having a value of 1, if the fiscal year-end between December 31 andJanuary 31, and 0, if otherwiseα =constant (i = 0) 1 Betas were estimated using a 100-day estimation period that ended December 31, 2001 (refer to Menon andWilliams, 1994). Composite Index of Bursa Malaysia was used to compute market returns.  β = Coefficients=i=1,2,3,4,5 RESULTSDescriptive Analysis Table 1 shows that how the sample is gathered. As suggested by Menon and Williams (1994), the companiesmust meet all the following criteria; first, the companies should have stock return data. Second, additional data inthe analyses should be available; third, the trading price should at least RM0.25, and lastly, the companies shouldnot make a dividend or earnings announcement on the ten trading days. In addition, all Practice Note 4 companiesare eliminated to ensure no compounded effect and also meet the Menon and Williams (1994) requirements. Table 1: Sample Selection: Andersen’s clients in Bursa Malaysia Total Andersen’s Clients Less Delisting companiesPractice Note 4 companiesEarning AnnouncementDividend Announcement No Return Data No Annual ReportTrading price below RM0.25 Total Sample 15433235613 101 Companies that purchased Non-Audit Services (NAS)Companies that did not purchase NAS and disclose it inthe annual reportsTotal Sample for regression analysesCompanies that are silent on NAS (assumed did not purchase NAS) Total sample 28265447 101 Table 2 and Table 3 confirms that CARs for Andersen clients are significantly negative for two and three eventwindows. However, both abnormal returns and CARs are less severe compare to Andersen’s counterpart inUnited States and Houston (see Chaney and Philipich, 2002). For example, on January 11 average abnormalreturns for Andersen’s clients in Malaysia are only -.3547 % compare to Andersen’s clients in United States with –0.78%. Similarly, in Malaysia, CAR for two event windows (0, +1) is only –.7043%, while United States andHouston office are –1.17% and –3.16% respectively. Again, it is shows that Andersen’s Malaysia office is lesssevere decline on this date. Overall, the results from Table 2 and Table 3 support Hypothesis 1 (1a and 1b). Table 2: Effect of Andersen Admitted Announcement of Shredded Documents on Security Prices of AndersenClients in Malaysia-Abnormal Returns for Ten days Around Disclosure Period  DateAverage Abnormal Return (%)t-testJan 7-0.3366-1.593Jan 8-0.3603-1.7*Jan 9-0.3148-1.493Jan 10-0.3496-1.647Jan 11-0.3547-1.676*Jan 14-0.3674-1.730*Jan 15-0.3609-1.704*Jan 16-0.3624-1.711*Jan 17-0.3506-1.654Jan 18-0.3516-1.654
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