Question

In 2002, the audit frm Arthur Andersen collapsed following charges brought against it in the United

States relating to the failure of its client, Enron. Some other clients announced that they would be

dismissing Arthur Andersen as their auditor even before it was clear that Arthur Andersen would not

survive.

Required

Using the theories outlined in this chapter on the demand for audits, explain some reasons why these

clients took this action.

Answer 1

The three theories discussed in the chapter are agency theory, the information hypothesis and the insurance hypothesis.

Agency theory suggests that there are incentives to hire an auditor to assess the fair presentation of the information contained in the financial statements. The auditor reports to the members on the fair presentation of the financial statements prepared by the manager. The good quality managers are willing to have the audit of their reports because it allows them to distinguish themselves from poor quality managers. Shareholders are willing to pay the audit fee (i.e. the audit fee is paid by the company, reducing the profit available to distribute to the shareholders) to monitor the managers (who are their agents). Good quality auditors are more highly valued for this monitoring function than poor quality auditors. Andersen’s lowered their quality through their involvement with Enron, leading some companies to prefer another auditor. It has been suggested that companies taking early action to dismiss Enron could have protected their share price by retaining their financial reporting credibility. Ultimately, all Andersen’s clients had to find another auditor.

The information hypothesis suggests that financial statement users value higher quality information. Higher quality auditors are associated with higher quality financial statements.

Therefore, when Andersen’s quality was called into question by their association with Enron, their client companies that valued higher quality auditors switched to another auditor.

The insurance hypothesis suggests that investors insure against their losses from company failure by purchasing an audit. When Andersen’s credibility was damaged by the Enron affair, there was doubt about their ability to survive and provide the insurance for such losses. The insurance factor is ‘impounded’ into share prices, so when the insurance cover is lost the share price should fall. This means that companies that were more sensitive to the loss of the insurance cover were more likely to dismiss Andersen early.