Client security price reactions to accounting firms' bankruptcy

Baber et al. (1995) study the effect of the disclosure of the bankruptcy of Laventhoal and Horwath (LH) on the equity prices of the clients of LH. At the time, LH was the seventh largest auditor in the U.S. before its bankruptcy. In November 1990, under a burden of litigation, LH unexpectedly filed for chapter 11. The news about the bankruptcy was available in a period of four days. Speculation about the firm’s solvency was reported in a Chicago Tribune article on November 16, 1990, and the decision to file for bankruptcy was reported by most newspapers on November 19, 1990.

The disclosure of the bankruptcy of LH may have sent signals about the audit quality of LH and its ability to fulfill its insurance role; consequently, the disclosure may have had a negative impact on the value of its clients. A rational auditor makes audit quality decisions to minimize the costs associated with an audit, including the effort costs and the costs associated with a potential audit failure. Since audit quality is positively associated with audit efforts and negatively associated with the probability of audit failure, there exists an optimal quality that minimizes the total expected costs. Furthermore, the probability of audit failure is affected by both the benefits from an ongoing relationship with the clients and the wealth of the firm partners. Since the bankruptcy of an auditor would lower both future benefits associated with the current clients and the total wealth of its partners, the bankruptcy would also lower the level of the optimal audit quality. As stated by Baber et al. (1995), solvent auditors, concerned about their reputations (Simunic and Stein 1987) or about client-specific quasi-rents (DeAngelo 1981a), have incentives to preserve audit quality. In contrast, financially distressed auditors, overly concerned about their short-run financial prospects (or less concerned about their long-run reputations), lack incentives to undertake the costly audit procedures required to detect financial statement errors and omissions. Furthermore, financially distressed auditors may be more likely than financially sound auditors to compromise their independence in order to retain clients—that is, they may be less likely to report errors or omissions that are detected. Rational investors can anticipate these incentives; therefore, confidence in the audit process depends on the perception of the auditor as a going concern. Disclosure of the auditor’s bankruptcy, to the extent that it is not completely foretold, increases perceptions that unreported errors or omissions exist, which in turn induces client security price declines.

The bankruptcy of an auditor also reduces the gross audit insurance value that is derived from the auditor liability for damages from engagements. When an auditor is bankrupt, as mentioned in Baber et al. (1995), the costs of recovering damages from partners in the bankrupt firm both discourage actions against partners and reduce plaintiffs’ returns from lawsuits that are filed. Thus, in the case of the auditor’s bankruptcy, security payoffs are affected to the extent that the bankruptcy impedes the recovery' of investment losses. The gross audit insurance value is highly correlated with the financial health of the client firms since insurance is related to investment losses. If a client firm is financially sound, the insurance value is negligible. Therefore, the consequences of an auditor bankruptcy are more substantial for shareholders of financially distressed than financially sound clients. Given that the auditor may be the sole defendant with an ability to pay in most business failure cases, investors often turn to auditors to recover losses in the event of the client’s bankruptcy (Simunic 1980; Mednick 1987).

Baber et al. (1995) document the following results. The risk-adjusted returns for LH clients during the LH bankruptcy disclosure (November 16—19, 1990) are significantly negative for all LH clients. The negative return is mainly for financially distressed clients but not for healthy clients and the difference between the returns of financially distressed and healthy clients is significant. Baber et al. (1995) conclude that such results are consistent with either or both of the insurance and quality explanations. The first explanation is that the LH bankruptcy compromised the insurance value of the LH audit which was initially incorporated in the clients’ pre-bankruptcy security prices. The second explanation is that the LH bankruptcy disclosure caused investors to reconsider the LH audit quality, defined in terms of the probability that client financial statements are fairly stated.

The results documented in Baber et al. (1995) provide strong support that an audit has insurance value since the disclosure of the LH bankruptcy indeed significantly lowered the investors’ expected compensation from LH through litigations, particularly relating to the clients with financial distress. Baber et al. do not find a significant negative reaction in the equity price of the financially healthy firms to the bankruptcy announcement, which may suggest that the LH bankruptcy does not lower the investors’ perceived quality of LH audits in general. Since financially healthy firms are not likely to go under in the near future, the auditor’s insurance value impounded in the price of these firms should be trivial. If the equity price reacts negatively to the disclosure of LH’s bankruptcy, it would certainly suggest that the reaction is triggered by the belief that the LH’s quality is lower than initially assessed. Since the price of the equity of the financially healthy firms does not react significantly to the bankruptcy disclosure, the perceived quality of LH may not be affected by the bankruptcy disclosure.