After reading the article, draft a two-page paper by explaining what you learned about accounting and finance. You can
include any reflections related to the article; however, address in paragraph form at least the following in your two-page
What specific actions (or lack of) led to Enron’s bankruptcy?
What types of fundamental accounting and auditing practices eventually contributed to the fraud performed by
Briefly describe the ethical environment that led to the fraud.
How did Enron’s bankruptcy impact the financial markets for Enron’s competitors?
Briefly describe what you learned about the importance of the auditing process.
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Purpose – The purpose of this paper is to examine how the Andersen implosion over Enron impacted
Fortune 500 firms that were competitors of Enron and/or audited by Andersen. This event provides an
opportunity to study various contagion effects. Design/methodology/approach – An event study
methodology is used to analyze the immediate financial impact of the Andersen implosion on
competitors of Enron and/or firms audited by Andersen. More specifically, how did the announcement
of the implosion impact these firms? Findings – The results support a strong industry contagion effect
where Enron’s failure benefited the surviving energy/utility firms who could then increase their market
shares. The authors find the energy/utility firms not audited by Andersen, on average, experienced an
astounding 2.5 percent increase in market capitalization when the audit scandal was announced. In
dollar terms, the mean and median market capitalization increases were $226 million and $101 million,
respectively. In the aggregate, the 21 utility/energy firms gained $4.76 billion in market capitalization.
Research limitations/implications – The results show the importance of the auditing process and the
impact of unethical actions on the firm, their auditor, and their competitors. One limitation is the data
are limited to large Fortune 500 firms. Originality/value – This is the first study, to the authors’
knowledge, that evaluates the contagion effect of the Andersen/Enron audit scandal on Fortune 500
firms: in the same industry as Enron; audited by Andersen; and operating in the same industry as Enron
and audited by Andersen.
The whole duty of an auditor may be summed up in a very few words – it is that of verifying balance
sheets (Accountant, editorial, April 23, 1881 as quoted in  Chambers (1995, p. 81)).
[A]uditing, as carried on under the present system, is of no practical concern as evidence of the true
financial position of a company […] auditors’ certificates […] merely certify that the balance sheet is
correctly copied from the books, sometimes with the addition that the auditors have counted the cash
and inspected the bill case and the security box. Audits under such conditions are a delusion and a
snare ( Vanity Fair, October 6, 1883 as quoted in  Chambers (1995, p. 94)).
Fundamentally, an audit is viewed as a process of obtaining evidence that the statements made by
management about the financial facts of their business are true. Indeed, as early as 1895, Worthington,
in a description of the new field of professional accounting, writes that the manager who ( Parker,
[…] fails to adopt this wise precaution against fraud and embezzlement is frequently running as great a
risk as he would do in failing to insure his stock against the ravages of fire (Parker 31).
What then do auditors do? Auditors gather evidence to support the assumption that financial statements
“fairly” (a different assumption than “accurately”) reflect the activities and current status of the firm.
The evidence can be collected by various activities such as examining source documents, observing the
counting of inventory, talking to members of management and other staff, and obtaining confirmation
of transactions from outside the organization. In most cases, the audit also involves making sure those
policies within a firm designed to insure proper reporting of its activities are in place and being
The confusion that arises is in the definition of “true picture”. In essence there are alternative
definitions of “true” varying from fairness (which is what auditors believe) to accuracy (which auditors
do not claim, but which investors assume). When the management of a Securities Exchange
Commission regulated firm issues a report that is believed to be other than a true picture of that firm,
investors leap to sue whomever they can to limit their potential losses. It is, then, within the courts that
the difference between fair and accurate becomes debated and decided as in the case of the public
accounting firm Andersen.
Our study analyzes the contagion effect of the Andersen implosion over Enron on Fortune 500 firms:
– operating in the same industry as Enron – an industry contagion effect;
– audited by Andersen – an auditor contagion effect; and
– operating in the same industry as Enron and audited by Andersen – an industry/auditor contagion
Regarding the industry contagion effect, did the market view the implosion as negative whereas Enron
competitors may have undertaken similar operations, or as positive in that Enron’s likely bankruptcy
would enable competitors to gain market share? Regarding the auditor contagion effect, did the market
view the implosion as negative in that other Andersen audited firms may have audit problems similar to
Enron’s? Regarding the industry/auditor contagion effect, did the market view the implosion as
negative whereas Enron competitors audited by Andersen may have not only undertaken operations
similar to those of Enron, but also have audit problems similar to Enron’s?
2.1 Literature review
 Aharony and Swary (1983) in their seminal paper examined the contagion effects of three
prominent bank failures on the banking industry using an event study model. Two of the three banks
suffered from activities specific to the bank. For example, one bank failure was due to fraud and
internal irregularities while the other bank failure was due to illegal channeling of loans from a
subsidiary to the bank which was an activity specific to the bank. They concluded that if the bankruptcy
was due to events specific to the affected bank, then there was no contagion effect. However, if the
events were associated with problems that were correlated across all banks in the industry, then a
negative contagion effect could be expected. In this case the bank failure was due to large losses related
to risky foreign exchange transactions. Since many banks also engaged in risky foreign exchange
transactions, the market assumed those banks may likely suffer large losses.
 Lang and Stulz (1992) study a sample of 59 bankruptcies in 41 industries and found that bankruptcy
announcements could have both a positive and a negative effect on competitors’ equity. They found
that bankruptcies have moderate contagion effect on competitors in the same industry. Furthermore, the
impact increases with stronger competition, higher industry leverage, and similarity of cash flow
characteristics between the failed firm and competitors. In general, they found a negative contagion
effect with a 2.87 percent decline in market capitalization in highly leveraged industries, while the
impact for low leveraged industries was slightly positive. Competitors with high leverage and a high
degree of competition had a 3.2 percent decline in market capitalization as a response to bankruptcy in
their industry. They also found a significant competitive effect where both leverage and the degree of
competition are low.
 Fenn and Cole (1994) studied the contagion effect associated with announcements of asset writedowns by two life insurance companies in 1990 by examining the impact on 54 competing insurance
companies. They found evidence of a significant contagion effect for companies with an asset
composition similar to that of the announcing firm. The results also supported the hypothesis that
investors are relatively uninformed regarding the asset composition of life insurance companies due to
high monitoring costs, but that an announcement of asset restructuring leads the market to reevaluate
the asset composition of all insurance companies.
 Cheng and McDonald (1996) studied seven airline and five railroad industry bankruptcy
announcements between 1962 and 1991. They found a competitive effect in the airline industry with an
abnormal return of 2.80 percent and a contagion effect in the railroad industry with an abnormal return
of -0.59 percent. These results conclude the industry’s market structure will determine the bankruptcy
announcement’s impact on the stock prices of the surviving firms. For example, the positive
competitive effects in the airline industry can be attributed the failure of one firm gives more market
power to the competitors.
 Polonchek and Miller (1999) examined the effect of 69 equity offerings by insurance companies
between 1977 and 1993. They conclude that equity offerings are market indicators of management
belief that the company’s stock is overvalued. As such, the offerings reveal information about the
quality of both the announcing firm’s portfolio and the quality of rival firms’ portfolios. Therefore, the
market is induced to draw inferences about the future prospects of the entire industry.
 Chaney and Philipich (2002) use an event study methodology to study 284 of the 287 Andersen
clients included in the S&P 1500 to examine the stock market reaction to various events surrounding
Andersen’s Enron audit. They employ a market model to calculate abnormal returns and examine four
event windows ranging from two days to four days. The first event window is November 8, 2001 when
Enron announces restatements. They find other clients of Andersen experience a mean cumulative
abnormal return (CAR) of +0.94 percent over the four-day event window surrounding the restatement
of Enron’s earnings. This suggests there was no downgrading of other companies audited by Andersen
and this was treated as an isolated event. The third event window is January 10, 2002 when Andersen
announces documents were shredded. Contrary to the first event, they find other Andersen clients
experience a statistically negative mean CAR of -2.10 percent over the four-day event window
surrounding Andersen’s admission. This suggests that investors downgraded companies audited by
Andersen on the basis of a decline in the perceived quality of the Andersen audits.
 Barton (2005) examined the defections of Andersen’s clients after the Enron bankruptcy case in
order to determine whether firms act upon changes in an audit firm’s public reputation. They reviewed
the defection rate of 1,229 Andersen’s clients, finding that 95 percent of them did not switch their
auditing firm until after Andersen was indicted for criminal misconduct regarding its Enron audit.
Findings further show that the firms that left earlier were those more visible in the capital markets.
These results suggest that public firms that are visible in capital markets and are closely followed by
the press are more concerned about using a highly reputable public accounting firm.
2.2 The Big Five accounting firms
The term Big Eight originated in the 1970s when the ranking by size of US public accounting firms
showed that there was a significant difference between the top eight and the ninth largest firm. By the
late 1990s, mergers had reduced the number of such public accounting firms to five and had increased
the difference between the top five and the firm that ranked sixth. By 2000 the Big Five firms
(Andersen, Deloitte & Touche, Ernst & Young, KPMG Peat Marwick, and PricewaterhouseCoopers)
had cornered the market on audits for most major publicly traded firms. In 2001 the Big Five audited
almost 90 percent of the Fortune 500 firms and maintained 523 global offices which generated $63
billion of global revenues with $26 billion generated within the USA. In 2001 Andersen operated 81
offices which generated over $9 billion of global revenue, of which over $4 billion was generated
within the USA. At that time, Andersen audited 91 of the Fortune 500 firms. Upon the collapse of
Andersen, the majority of their clients were absorbed by other public accounting firms. Table I [Figure
omitted. See Article Image.] reports each Big Five’s market shares of the Fortune 500 firms along with
revenues and offices.
2.3 Event date
The first major Wall Street Journal announcement regarding the Andersen/Enron audit scandal
appeared on November 5, 2001: “Enron transaction raises new questions.” This announcement reported
inconsistencies in the financial reports of Enron and explained how, in order to minimize reported debt,
Enron created companies which would bring in equity and allow borrowing to occur without the debt
being reflected on Enron’s balance sheet. It was at this time that it became clear that Andersen might
face scrutiny regarding Enron’s financial reports. Later in November, Enron released its restated
financial results, lowering reported earnings for the prior four years by $586 million. Over the
following months it became clear that Andersen auditors had failed to fulfill their responsibilities in
their oversight of Enron.
Figure 1 [Figure omitted. See Article Image.] reports the calendar dates of the seven-day event window
from November 2-12, 2001. The announcement date of November 5 is labeled (event day 0), the first
trading day prior to the announcement is labeled (event day -1), the first trading day following the
announcement is labeled (event day +1), and so forth with the fifth trading day following the
announcement labeled (event day +5).
To be included in the study, a firm must:
– have been ranked as a Fortune 500 firm at least once from 1997 through 2000;
– have been publicly traded with daily stock returns and a beta reported for the event window
on Compustat(North America) data definition; and
– have not had a major news announcement in the Wall Street Journal within a ten day window from -5
to +5 to avoid contaminating the daily returns in the seven-day event window.
Three samples of firms were created and are shown in Figure 2 [Figure omitted. See Article Image.]
with the firms identified in the Appendix. The first sample includes energy/utility firms that were
audited by a non-Andersen Big Five firm from 1997 to 2000. The second sample includes nonenergy/non-utility firms that were audited by Andersen from 1997 to 2000. The third sample includes
energy/utility firms that were audited by Andersen from 1997 to 2000. The energy/utility industry
included primary SIC codes of 1311, 1389, 2911, 4911, 4922, 4923, 4931, 4932, and 5172.
An event study methodology is utilized to examine the contagion effect of the Andersen and Enron
audit scandal on other Fortune 500 companies ( Brown and Warner, 1985;  Peterson, 1989; 
Wells, 2004). The three contagion effects examined as described in Table II [Figure omitted. See
An event study is used to measure abnormal returns in the stock prices of publicly traded firms as a
reaction to an announcement of an event. The fluctuation of stock prices caused by an event can be
isolated because of two unique characteristics of stock prices. One, a firm’s stock price is a function of
the firm’s expected future earnings. Two, a firm’s stock price reacts to an event announcement quickly
and effectively under the efficient markets hypothesis. Therefore, any announcement of an event that
has an impact on future earnings of a firm should be reflected rapidly in the stock price. The changes in
stock return can be attributed to two components: the normal return (the change in a stock return that
results from overall stock market movement) and the abnormal return (the change in a stock return that
results from a specific event).
To calculate the normal return, we employ a modified market model where the normal return is equal
to market return multiplied by the average beta of the firms in the sample. Thus, when the systematic
risk of the sample is low as with energy and utility firms, then there will be smaller adjustment to the
daily return. The abnormal return is then calculated by subtracting the normal return from each firm’s
daily return. Thus, the daily abnormal return, AR it , for each firm i on day t is defined as: Equation 1
[Figure omitted. See Article Image.] where Rit is the stock return of firm i on day t, Bsample is the
average beta of the sample, and Rmt is the stock market return of the S&P 500 Index on day t.
The CAR for each firm is calculated for a seven-day window. Since information about an event may
leak prior to the public announcement, a one-day return prior to the public announcement is included in
the CAR. For example, when the Wall Street Journal learned of the inconsistencies in Enron’s financial
statements, the Wall Street Journal would have published the news as soon as possible. This means
the Wall Street Journal had to learn of the inconsistencies prior to November 5 which may have been
on Friday. Likewise, there is a reasonable chance that investors learned of the inconsistencies on Friday
as well and then traded on that information. Similarly, the impact of an event on a firm could linger
over several days as the market evaluates the potential influence of the event on the firm’s future
earnings. Thus, the five-day return after the public announcement is included in the CAR. The
cumulative abnormal return, CAR i , for each firm i for the seven-day window, day -1 through day +5,
is defined as: Equation 2 [Figure omitted. See Article Image.] where ARit is the abnormal return for
firm i on day t.
The average CAR summarizes the CARs of all the firms in the sample. The average CAR is used to
eliminate unique individual stock returns that may not be a result of the event studied. While some
stocks will have random positive returns, other stocks will have random negative returns so summing
the returns will offset these random positive and negative returns. The average cumulative abnormal
return (ACAR), for the sample is defined as: Equation 3 [Figure omitted. See Article Image.] where
CAR i is the CAR for firm i over the seven-day window, and N is the number of firms in the sample. If
the public announcement of the Andersen/Enron audit scandal had a contagion effect on the sample of
firms, then the event should result in an ACAR that is significantly different than zero.
The first set of results will evaluate the industry contagion effect. The second set of results will
evaluate the auditor contagion effect and the third set of results will evaluate the combined
industry/auditor contagion effect.
5.1 Industry contagion effect
We examined the energy/utility firms that were not Andersen audited and find an ACAR of 2.51
percent which is significant at the 1 percent level. We also find that 90 percent of the firms in the
sample experience a positive return over the seven-day event window which is also significant at the 1
percent level. Table III [Figure omitted. See Article Image.] reports both results along with the sample
beta. It is clear that the market did not perceive the announcement as negative news and was not
concerned with other energy/utility companies undertaking operations similar to Enron. On the
contrary, the market perceived the announcement as positive news where there was a competitor effect.
It is likely the market perceived Enron as moving toward bankruptcy and surviving firms in the
industry would benefit with the elimination of Enron, a large competitor .
5.2 Auditor contagion effect
We examine the non-energy/non-utility firms that were audited by Andersen and find an ACAR of 1.14
percent while the percent of positive CARs was 41 percent. Neither figure is significant at even the 10
percent level. Thus, we conclude there is no auditor contagion effect on other non-energy firms audited
by Andersen. Table III [Figure omitted. See Article Image.] reports the ACAR and percent of CARs
that are positive.
Given the independent structure of audit firm offices and the tendency within public accounting firms
for offices of a firm to specialize in a particular industry, there appears to be no market perception that
the failure of one office contaminates the results of other offices. Thus, from an auditing perspective, it
appears that the market is unaware of the similarity in the manner of conducting an audit among
auditing fi …
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