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

Agenda The insurance hypothesis and market prices The power of auditors Getting the price right Behind closed doors at WorldCom:2001

The Insurance Hypothesis and Market Prices Krishnagopal 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 and Market Prices 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 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 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.

Hypothesis H1: L&H clients 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&Hs 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&Hs 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

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 managements true intentions. Solution: must infer through observable patterns of reported numbers 1. First look at context where earnings management is most likely to occur 2. Try to gather large samples of firms to provide systematic evidence across the sample

The Power of Auditors (contd) 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 (contd) Motivations for earnings management Costs: 1. Iron Law of Accruals Reversals 2. Impair perceived quality of earnings 3. 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

The Power of Auditors (contd) Are financial statement users misled by earnings management? Economic consequences of earnings management seem to be offset by investors rational expectation (evident by lower ERC); discounting earnings However, the discounting is insufficient, evident by the underperformance following an offering

The Power of Auditors (contd) How to strengthen the quality of financial reporting? Corporate governance through audit committee Requiring: 1) (1) majority of the directors be independent 2) (2) committee of independent directors to select new member Recommending: 1) Audit committee be composed of outside directors only 2) 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 (contd) 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

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 (contd) 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 (contd) 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

Getting the Price Right (contd) 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 (contd) 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: 2001 Kay E. Zekany, Lucas W. Braun and Zachary T. Warder

Behind Closed Doors at WorldCom: 2001 Large telecommunications company Annual revenues > $30 billion Served > 20 million customers Largest internet carrier Serving 100 countries in 6 continents Provider of network services for US Government

Behind Closed Doors at WorldCom: 2001 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 90s Greater competition and challenging market

Behind Closed Doors at WorldCom: 2001 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.

Behind Closed Doors at WorldCom: 2001 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 Bernies 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 questioned 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 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

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 documentation 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 costs 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 Accountings 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

Behind Closed Doors at WorldCom: 2001 Arthur Andersens 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

QUESTIONS Nicole Fitzmaurice, Eric Poolman, Lisa Landon, Pang Koh & Ping Zhou