Group C
Nicole Fitzmaurice,
Eric Poolman, Lisa Landon,
Pang Koh & Ping Zhou
insurance hypothesis and
market prices
The power of auditors
Getting the price right
Behind closed doors at
The Insurance
Hypothesis and
Market Prices
Krishnagopal Menon
Boston University
David D. Williams
The Ohio State University
The Insurance Hypothesis and
Market Prices
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 and
Market Prices
The "insurance hypothesis.”
Auditors are viewed as having “deep
The Big 6 auditing firms paid $477 million for
settling and defending lawsuits in 1991.
There were about $30 billion in damage
claims facing the profession as a whole at
the end of 1991.
The Insurance Hypothesis and
Market Prices
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.
The Insurance Hypothesis and
Market Prices
Investors ‘ different rights of
recovery of damages from
auditors in seasoned securities
and in IPOs.
1. Seasoned securities
2. Initial public offerings
The Insurance Hypothesis and
Market Prices
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.
 H1:
L&H client’s security prices declined relative
to the market on the disclosure of the
 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
Regression model
 The
disclosure of L&H' s bankruptcy was found
to have a negative impact on L&H client stock
 There was no corresponding increase in stock
prices on announcement of a replacement
 The results of the paper suggest that auditors
are viewed by investors as guarantors of
financial statements, and as guarantors of
The Power of
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 numbers
First look at context where earnings management is most
likely to occur
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
Iron Law of Accruals Reversals
Impair perceived quality of earnings
Violation of GAAP (leading to lawsuits and
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
The Power of Auditors (cont’d)
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
The Power of Auditors (cont’d)
 How
to strengthen the quality of financial reporting?
Corporate governance through audit committee
(1) majority of the directors be independent
(2) committee of independent directors to select new member
 Recommending:
Audit committee be composed of outside directors only
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
Auditors can curb discretionary accruals and lower
threshold for issuing a qualified audit report
of auditors and auditor independence
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 nonaudit 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
Craswell, Francis and Taylor (1996) found that
the deregulation of audit market in Australia
did not lead to reduction in the Big Six audit
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
Pearson and Trompeter reported that high levels of
auditor concentration led to lower audit fees
structure (Auditors’ power)
Auditors share benefits from economies of scale with
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
Getting the Price Right (cont’d)
 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.
Getting the Price Right (cont’d)
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: 2001
Kay E. Zekany, Lucas W.
Braun and Zachary T.
Behind Closed Doors at
WorldCom: 2001
 Large
 Annual revenues > $30 billion
 Served > 20 million customers
 Largest internet carrier
 Serving
 Provider
100 countries in 6 continents
of network services for US
Behind Closed Doors at
WorldCom: 2001
 External
# 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
Behind Closed Doors at
WorldCom: 2001
– Bernard J. (Bernie) Ebbers
Risk-seeking, free-spending, over-zealous
deal maker
Orchestrated mergers with 75 companies
 Largest
“Our Goal is not to capture market share or
be global. Our goal is to be the No. 1 stock
on Wall Street.”
Behind Closed Doors at
WorldCom: 2001
 Outside:
stock looked to be doing fine
 Beginning July 2000
Expenses as a percentage of total revenues
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
Behind Closed Doors at
WorldCom: 2001
Corporate Culture
 Management Leaders
CEO – Bernie
CFO and CAP Scott Sullivan
 Leaders
and managers not to be
 Loyalty was compensated
 Bernie very interested in making sure all
employees add value
Behind Closed Doors at
WorldCom: 2001
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
Behind Closed Doors at
WorldCom: 2001
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
Behind Closed Doors at
WorldCom: 2001
Accounting Functions
 Property Accounting
Capital Reporting
Responsible for tracking assets and inventory
Produced Property Plant and Equipment Roll forward Report
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”
Behind Closed Doors at
WorldCom: 2001
Line Cost Accruals
 Costs of the use of “off-net” facilities and
connections were estimated
 Estimates were booked each month in an
adjusting journal entry
 Adjustments were made as necessary
Behind Closed Doors at
WorldCom: 2001
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
 Sullivan eventually got another member of
Accounting to book the entry
Behind Closed Doors at
WorldCom: 2001
Capitalization of Line Costs
 Line cost E/R ratio increased significantly in 2000
and 2001
 Excess capacity was capitalized to reduce
 Erroneous asset accounts were created to
offset the reversal of expenses
 These invalid entries brought line costs back
down to prior year levels
Behind Closed Doors at
WorldCom: 2001
Revenue Accounting’s “Close the Gap”
 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
Behind Closed Doors at
WorldCom: 2001
Arthur Andersen’s Audit of 2001
 Audit took place in the midst of the Enron
 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
Nicole Fitzmaurice,
Eric Poolman, Lisa Landon,
Pang Koh & Ping Zhou

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