We study stock and audit market effects associated with an accounting scandal involving a public company (ComROAD AG) and a large, reputable auditor (KPMG) in a low-litigation country (Germany). Per Klein and Leffler's  model of endogenous quality, reputable firms provide high quality because they earn quasi-rents that they fear losing should they “cheat” by opportunistically providing low quality. DeAngelo[1981, p. 185] applies this logic to the audit market, arguing that larger audit firms have “more to lose” from supplying low audit quality. Our paper is essentially a test of DeAngelo's reputation rationale for audit quality.
A series of papers examining different contexts and international settings conclude that an insurance rationale for audit quality appears to dominate the reputation rationale (Lennox , Willenborg , Khurana and Raman ). In addition, from a policy perspective, studying whether markets discipline auditors that supply low quality is important given today's climate where it is not obvious that, without a litigation incentive, auditors do high-quality work.1 While it stands to reason that “auditor reputation should matter,” recent literature and events suggest that its impact in terms of inducing audit quality is less than that of legal liability.
In Germany it is difficult for investors to sue auditors and there is a longstanding (since 1931) cap on auditor civil liability to shareholders, presently just €4 million per audit.2 These features of the German legal system suggest that auditors are unlikely to be a source of much insurance to investors. Germany therefore facilitates a clean test of the reputation rationale for audit quality, because it helps circumvent the insurance rationale that motivates wealthy auditors to provide quality in high-litigation countries. We use this context to study the response of investors and boards to events that, relatively unambiguously, damage an auditor's reputation.
The accounting scandal we study involves recognizing false revenues. ComROAD AG, a Munich-based company that develops and markets road transport telematics applications (e.g., navigation assistance, mobile Internet, emergency service), went public on Germany's Neuer Markt in November 1999.3 Soon thereafter, ComROAD began reporting fourfold growth in revenues, from DM 4.6 million to DM 20.0 million to DM 85.8 million for calendar years 1998, 1999, and 2000, respectively. However, by Summer 2001 ComROAD began issuing shareholder letters to defend against accusations of accounting manipulations, the most prominent of which was that they had “phantom partners in Asia.” On February 19, 2002, approximately one month before an analyst conference at which ComROAD was to provide its 2001 audited financial statements, KPMG declined its mandate as auditor, thereby effectively resigning. Per a spokesperson, KPMG stated that “there were justified doubts about the trustworthiness of ComROAD.” (Manager Magazin ). ComROAD responded by announcing that they would hire a new auditor to fully investigate. In a press release on April 10, 2002, ComROAD stated that, according to their new auditor, Rödl & Partner, a major Hong Kong-based customer did not exist and, largely as a consequence, 97% of calendar-year 2000 revenues were fictitious. Later, on April 23, 2002, ComROAD announced, again per Rödl, that 86% and 63% of revenues for 1999 and 1998, respectively, were also fictitious. Arguably in “damage-control mode,” just one day later, on April 24, 2002 KPMG announced it would re-audit all of its Neuer Markt–traded clients.
We use the ComROAD scandal as a case study of whether auditor reputation matters. First, to study whether investors value auditor reputation, we analyze the stock market reaction of KPMG's clients to these events. Second, to examine the specifics of when auditor reputation/quality is more or less valuable to investors, we analyze characteristics associated with this market reaction. Third, to examine whether supervisory boards value auditor reputation, we analyze KPMG Germany's market share before, during, and after ComROAD.
We find that KPMG's clients sustain cumulative negative abnormal returns of about 3% around these events. The reaction is especially large at KPMG's resignation, and at ComROAD's announcement that the majority of their revenues were also bogus for 1999 and 1998, followed by KPMG's announcement that they would re-audit their Neuer Markt clients.
These results suggest that German investors value auditor reputation. Since German law makes it difficult for investors to sue auditors and, in most instances, caps auditor liability, the ComROAD scandal does not likely affect KPMG's viability as a source of insurance to investors. Therefore, in contrast to an insurance rationale, the market reaction more likely reflects KPMG's loss of reputation as a high-quality auditor. The reaction is consistent with investors assigning a higher probability that KPMG-audited financial statements contain material errors and, because of this, revising their beliefs downward regarding the quality of KPMG audits and upwards regarding whether KPMG clients incur costs to switch audit firms (DeAngelo ).4
We find that abnormal returns are more negative for distressed companies, those that follow U.S. generally accepted accounting principles (GAAP) or International Accounting Standards (IAS), newer clients of KPMG, smaller companies, and companies with more subsidiaries. Taken together, we interpret these results as consistent with the view that when concerns regarding audit quality are more important investors consider damage to an auditor's reputation to be more costly.
We then expand our sample to encompass the German audit market and study KPMG's share before, during, and after ComROAD. Following the reputation literature, we focus on clients that switch from KPMG. We emphasize however, for several reasons, it is not obvious KPMG would suffer a loss of audit clients following ComROAD. For one, Germany neither permits auditors to advertise nor allows direct uninvited solicitation (Vanstraelen ), activities that Chaney, Jeter, and Shaw  find are positively associated with client/large auditor realignments. Such restrictions should limit the extent to which other auditors can poach KPMG's clients. For another, given other stakeholders, a German managers' objective function may not be to maximize shareholder value, and supervisory boards may be less likely to change from KPMG after ComROAD. Lastly, whereas KPMG's response was to re-audit their Neuer Markt clients, models of endogenous quality explicitly do not contemplate such a response.5
Despite these factors, we find that KPMG's rate of attrition (the fraction of their clients that change auditors the next year) doubles in calendar year 2002 (15.7% versus a three-year average of 7.7%). We conduct a multivariate analysis of auditor changes and confirm this increase in the number of clients that change from KPMG Germany for their 2002 audit.6 Partly because of this, for the 1999–2003 period, KPMG is the only major German auditor, other than Andersen, to suffer a net loss of clients. Moreover, the characteristics of companies that change from KPMG are consistent with concerns regarding audit quality. Taken together, our findings are consistent with the view that German supervisory boards chose not to retain KPMG for quality reasons.
The rest of our paper proceeds as follows. Section 2 surveys literature and discusses the German setting and the ComROAD event. Sections 3 and 4 provide our analyses of the stock and audit market effects associated with ComROAD, respectively. Section 5 concludes.
3. Stock Market Reaction
We identify 128 German companies on Worldscope with KPMG as auditor for the 2001 financial statements, of which 92 have stock price information on Datastream for the 252 trading days from November 1, 2001 to October 31, 2002. In section 3.2, we examine the stock price reaction to the ComROAD scandal for these 92 clients of KPMG. Of these 92, 67 have financial statement, market, and other data for our cross-sectional analysis. In section 3.3, we examine the determinants of the stock price reaction to the ComROAD scandal for these 67 KPMG clients.12
3.2 overall stock market reaction
Average market-adjusted returns are significantly negative for all three of our event dates (panel A of table 1). In panel B of table 1, we present the results of Schipper and Thompson's  multivariate regression model (MVRM), for which we estimate abnormal returns using a time series of daily returns to an equally weighted portfolio of KPMG clients. In our context, the MVRM conditions the return-generating process on the occurrence of the ComROAD event(s) by adding an indicator variable to the market model.13 The estimation accounts for possible contemporaneous correlation of residuals and cross-sectional heteroskedasticity. Because the MVRM assumes residuals are independent and identically distributed, if necessary, we adjust for time-series heteroskedasticity (White ).
Market Reaction to ComROAD Events for KPMG Germany's Clients
|Event 1 (−1, February 19, 2002, +1)|
| Raw return||(54 of 92 < 0)||−0.016||−0.008|
|(t-statistic −4.05)***||(rank test −15)***|
| MarketMDAX-adjusted return||(52 of 92 < 0)||−0.012||−0.005|
|(t-statistic −3.22)***||(rank test −5)|
|Event 2 (−1, April 10, 2002, +1)|
| Raw return||(40 of 92 < 0)||−0.005|| 0.000|
|(t-statistic −1.21)||(rank test 1)|
| MarketMDAX-adjusted return||(60 of 92 < 0)||−0.011||−0.006|
|(t-statistic −2.50)***||(rank test −14)***|
|Event 3 (−1, April 23–24, 2002, +1)|
| Raw return||(52 of 92 < 0)||−0.019||−0.009|
|(t-statistic −3.57)***||(rank test −10)**|
| MarketMDAX-adjusted return||(52 of 92 < 0)||−0.018||−0.008|
|(t-statistic −3.40)***||(rank test −6)|
|Event2|| ||−0.00|| |
|Event3|| ||−0.01|| |
Panel B of table 1 presents the results of estimating equation (1). Abnormal returns are negative for the first and third event windows, and a combination of all event windows.14,15,16 The coefficient estimates for Event1 and Event3 are similar to those in Chaney and Philipich  for Andersen's clients of −2% and −1%, at the shredding disclosure and release of a report from Enron's Board and Andersen's hiring Paul Volcker, respectively. However, in contrast to Enron/Andersen, it is less plausible that the negative returns to KPMG's clients at the time of the ComROAD scandal relate to an insurance rationale for audit quality.
3.3 cross-sectional analysis of stock market reaction
In this section, we examine whether the negative stock market reaction to ComROAD is consistent with investors assigning higher probabilities that KPMG-audited financial statements contain material errors. As investors learn of KPMG's role in the ComROAD scandal, we expect them to downgrade their beliefs regarding the quality of KPMG's past and future audits (i.e., increase their expectations that other KPMG-audited financial statements may be materially misstated and, as a result, that some KPMG clients will defect).17 We estimate the association between abnormal returns to KPMG clients at the time of ComROAD and 11 characteristics: bankruptcy probability; the market-to-book ratio; if the company follows U.S. GAAP or IAS; whether the company recently changes to KPMG; size; the ratio of accounts receivable to assets; the number of subsidiaries and foreign subsidiaries; whether the client is a bank, insurer, or other financial company; and Neuer Markt and ADR listings.
We specify the probability of bankruptcy (Pr(Bankrupt)) per Zmijewksi . A negative association between returns and Pr(Bankrupt) supports a quality story (Baber, Kumar, and Verghese ).18
Because auditors are arguably more important when information asymmetry between management and investors is greater (when investment opportunities comprise a larger portion of company value), we examine the association between returns and the market-to-book ratio (Market/Book). We expect the damaging effects of substandard auditing should increase with the market-to-book ratio.
We also consider whether a company follows U.S. GAAP or IAS (USGAAP/IAS). If German investors are less familiar with U.S. GAAP or IAS, then a decrease in audit quality is arguably more costly for companies that follow these accounting principles. Consistent with this, Leuz and Verrecchia[2000, p. 98] find German companies that switch to U.S. GAAP or IAS have lower bid–ask spreads and higher turnover (proxies for the information asymmetry component of the cost of capital) and conclude “a switch to international reporting represents a substantial increase in a firm's commitment to disclosure.” If investors bundle this commitment to disclosure with the auditor's reputation, the negative effects of revelations of faulty auditing should be more severe for companies that adopt international reporting.
We specify an indicator variable (AuditorΔ) for whether a company changes to KPMG during any of the three years prior to 2002, the year of the ComROAD scandal. Several papers document that financial reporting quality is lower, and that audit failures are more likely, during the early years of an audit firm's tenure (e.g., Johnson, Khurana, and Reynolds , Erickson, Mayhew, and Felix ), consistent with auditors being less familiar with the client's business and more likely to make errors or perhaps be fooled by management. A negative coefficient for AuditorΔ is consistent with investors being more suspicious of KPMG's clients having financial misstatements during the first three years of KPMG's tenure as the company's auditor.
We specify company size (Ln(Assets)) because audit failures may be less likely to occur in larger companies, consistent with better corporate governance and less evidence of earnings management (e.g., Myers, Myers, and Omer ). If KPMG is performing substandard audits, they may be more likely to result in audit failures among their smaller clients (e.g., ComROAD).
Given that the ComROAD scandal involved falsification of a large amount of revenues, investors may be suspicious of KPMG clients with large balances in accounts receivable. To consider this, we specify the ratio of accounts receivable to assets (AcctsRec/Assets).
Another factor that could impact the strength of the market reaction to ComROAD is the complexity of the audit. Just as shorter auditor tenure seems likely to increase the chances of an error, so might audit complexity. To consider this, we specify the number of subsidiaries (Ln(1 +#Subsidiaries)) and the number of foreign subsidiaries (Ln(1+#ForeignSubsidiaries)).
We consider whether the company is in banking, insurance, or other financial industries (Financial) and Neuer Markt listing (NeuerMarkt). We expect the negative effects of disclosures of faulty auditing to be more acute for clients in industries where KPMG has substantial market share (panel B, table 3) and the young, equity-oriented companies on this exchange, respectively.
Market Share Analysis: Overall German Audit Market from 1998 to 2003
|German companies on Worldscope 1998–2003||1,018||3,616|
|less: Companies that appear for nonconsecutive years|| 150|| 505|
|less: Companies that change their fiscal year-end|| 52|| 228|
|less: Companies with non-December 31 year-ends|| 118|| 378|
|less: Companies with missing financial statement data|| 29|| 98|
|Sample for German audit market share analysis (tables 4–6)|| 669||2,407|
|AA|| 0|| (0.0)|| 131|| (7.7)|| 0|| (0.0)|| 6|| (2.5)|| 4|| (7.4)|| 2|| (1.8)|| 143|| (6.0)|
|D&T|| 2|| (1.3)|| 42|| (2.4)|| 4|| (3.0)|| 5|| (2.0)|| 1|| (1.9)|| 1|| (0.9)|| 55|| (2.3)|
|E&Y|| 12|| (7.7)|| 237|| (13.9)|| 6|| (4.5)|| 12|| (4.9)|| 2|| (3.7)|| 11|| (10.1)|| 280|| (11.6)|
|KPMG|| 55|| (35.3)|| 367|| (21.4)|| 73|| (55.3)|| 41|| (16.7)|| 1|| (1.8)|| 5|| (4.6)|| 542|| (22.5)|
|PwC|| 47|| (30.1)|| 293|| (17.1)|| 27|| (20.5)|| 39|| (15.9)||27|| (50.0)|| 58|| (53.2)|| 491|| (20.4)|
| Big 5/4||116|| (74.4)||1,070|| (62.5)||110|| (83.3)||103|| (42.0)||35|| (64.8)|| 77|| (70.6)||1,511|| (62.8)|
|BDO|| 11|| (7.0)|| 99|| (5.8)|| 17|| (12.9)|| 15|| (6.1)|| 6|| (11.1)|| 11|| (10.1)|| 159|| (6.6)|
|Other auditors|| 29|| (18.6)|| 542|| (31.7)|| 5|| (3.8)||127|| (51.9)||13|| (24.1)|| 21|| (19.3)|| 737|| (30.6)|
| Non–Big 5/4|| 40|| (25.6)|| 641|| (37.5)|| 22|| (16.7)||142|| (58.0)||19|| (35.2)|| 32|| (29.4)|| 896|| (37.2)|
|AA|| 17|| (4.8)|| 20|| (5.8)|| 55|| (10.8)|| 45|| (9.6)|| 6|| (1.5)|| 0|| (0.0)|| 143|| (6.0)|
|D&T|| 6|| (1.7)|| 6|| (1.7)|| 7|| (1.4)|| 6|| (1.3)|| 16|| (3.9)|| 14|| (4.3)|| 55|| (2.3)|
|E&Y|| 27|| (7.6)|| 20|| (5.7)|| 41|| (8.1)|| 50|| (10.7)|| 75|| (18.3)|| 67|| (20.9)|| 280|| (11.6)|
|KPMG|| 97|| (27.3)|| 94|| (26.9)||105|| (20.7)||100|| (21.5)|| 76|| (18.6)|| 70|| (21.8)|| 542|| (22.5)|
|PwC|| 71|| (20.0)|| 74|| (21.2)||102|| (20.1)|| 93|| (20.0)|| 83|| (20.3)|| 68|| (21.2)|| 491|| (20.4)|
| Big 5/4||218|| (61.4)||214|| (61.3)||310|| (61.1)||294|| (63.1)||256|| (62.6)||219|| (68.2)||1,511|| (62.8)|
|BDO|| 26|| (7.3)|| 23|| (6.6)|| 30|| (5.9)|| 30|| (6.4)|| 29|| (7.1)|| 21|| (6.6)|| 159|| (6.6)|
|Other auditors||111|| (31.3)||112|| (32.1)||167|| (32.9)||142|| (30.5)||124|| (30.3)|| 81|| (25.2)|| 737|| (30.6)|
| Non–Big 5/4||137|| (38.6)||135|| (38.7)||197|| (38.9)||172|| (36.9)||153|| (37.4)||102|| (31.8)|| 896|| (37.2)|
Lastly, we control for whether the company trades ADRs (ADR). While we argue that German investors are unlikely to sustain a loss in auditor insurance coverage as ComROAD unfolds, shares of companies that trade ADRs may reflect an insurance effect. Also, given that Leuz  shows that foreign listing is the major determinant of whether a German company adopts U.S. GAAP or IAS, ADR helps control for selectivity associated with the USGAAP/IAS variable.
To study the association between these characteristics and abnormal returns, we follow Sefcik and Thompson's  portfolio weighting procedure. The primary advantages of this procedure are that it accounts for cross correlation between characteristics and adjusts standard errors for cross correlation of residuals (Bernard ). Of the 92 companies in the MVRM estimation, 67 have the necessary data for the Sefcik and Thompson  estimation.
We take the following steps. We first form a matrix F=[1 X2…Xj], which has a column of ones and J−1 columns of firm characteristics. In matrix F, Xj is an N×1 vector for the jth firm characteristic, where N denotes the number of firms in the analysis. We then create a portfolio weight matrix W and calculate J sets of weighted portfolio returns, as we define below.
J×N matrix of portfolio weights ( J= 11 firm characteristics and N= 67 firms)
N×J matrix defined in the first step
N×1 vector, the jth row of portfolio weight
return on portfolio j on day t
individual firm's return on day t
Panel A of table 2 provides descriptive statistics, which we partition by whether a company's event-day raw returns are at or above the sample median. KPMG clients that sustain a below-median reaction are more likely to follow U.S. GAAP or IAS and have more subsidiaries. With regard to size, because both Deutsche Bank and Allianz (the two largest companies in our sample, by four orders of magnitude) are among the 33 with below-median returns, no descriptive difference is evident. If we exclude these companies, the mean (median) Assets for the remaining 31 decreases to 18,171 (1,114) million DM. Panel B presents the results of estimating equation (2). The coefficients on the event-date variables measure the association between each company/security characteristic and the abnormal returns to the three events. The adjusted R2 provides a measure of the extent to which the events of interest explain the variation in the weighted return matrix associated with each particular characteristic.
Cross-sectional Analysis of Market Reaction to ComROAD Events for KPMG Germany's Clients
|Pr(Bankrupt)||Mean|| 0.22|| 0.25|| 0.19||0.38|
|Median|| 0.09|| 0.11|| 0.07||0.44|
|Market/Book||Mean|| 1.02|| 1.03|| 1.01||0.94|
|Median|| 0.69|| 0.84|| 0.62||0.15|
|USGAAP/IAS||Mean|| 0.46|| 0.32|| 0.61||0.02|
|AuditorΔ||Mean|| 0.13|| 0.09|| 0.18||0.27|
|AcctsRec/Assets||Mean|| 0.17|| 0.18|| 0.16||0.48|
|Median|| 0.17|| 0.18|| 0.14||0.05|
|Financial||Mean|| 0.27|| 0.29|| 0.24||0.64|
|NeuerMarkt||Mean|| 0.18|| 0.12|| 0.24||0.19|
|ADR||Mean|| 0.16|| 0.12|| 0.21||0.31|
|Panel B:Sefcik and Thompson regressions|
|Variable||E[sign]||Coefficient (t-statistic)||Adjusted R2|
The negative stock reaction to KPMG clients at the time of ComROAD is more severe for stressed companies, those following U.S. GAAP or IAS, those recently switching to KPMG, smaller companies, and those with more subsidiaries. These results suggest that as the events at ComROAD unfold, investors assign higher probabilities that KPMG-audited financial statements contain material errors. We interpret this as support for the reputation rationale for audit quality.
4. KPMG's German Audit Market Share—before, during, and after ComROAD
Following DeAngelo , a high-quality auditor caught “cheating” by providing low quality should be “punished” by their clients. In this section, we study KPMG's market share before, during, and after ComROAD. We begin by providing descriptive statistics for the German audit market (section 4.1) and for changes in KPMG's share (section 4.2.1). We then analyze the likelihood that a KPMG client changes auditors, and whether this likelihood increases at the time of ComROAD (section 4.2.2). Lastly, we examine the characteristics of KPMG clients that change auditors following ComROAD versus those that do not (section 4.3).
4.1 sample and descriptive statistics
Panel A of table 3 details the sample for our market share analysis. We identify 1,018 German companies (3,616 company-years) on Worldscope with financial statement information for any of the years from 1998 to 2003. Because of our focus on changes in KPMG's share of the audit market around the time of ComROAD, we exclude certain observations. We eliminate 150 companies (505 company-years) because they do not appear consecutively on Worldscope and, therefore, we cannot reliably discern whether they change their audit firm. Because of the timing of ComROAD (February–April 2002), we exclude 52 companies (228 company-years) that change their fiscal year-end and 118 companies (378 company-years) with non–calendar year-ends.19 We eliminate 29 companies (98 company-years) with missing financial statement information to compute the control variables for the equation (3) regression. The audit market sample for our descriptive analysis is 669 companies and comprises 2,407 company-years.
Panels B and C of table 3 provide a descriptive analysis of these 2,407 company-years by audit firm/industry and by audit firm/year, respectively. We break out the Big 5 firms and BDO, due to its substantial presence in the German audit market (Ashbaugh and Warfield ). To ease comparison, the market share analyses accord retroactive treatment to the 1999 merger between Coopers & Lybrand and Price Waterhouse (PwC). For the 1998–2003 time period, KPMG is the market leader, auditing 22.5% of total observations, with PwC the runner-up, auditing 20.4% (panel B). KPMG's leadership dips sharply in 2000, when the number of companies in our sample increases 45% (panel C). By 2003, the sample shrinks to pre-1998 levels and the German market is a three-firm race between KPMG and PwC and Ernst & Young (E&Y). We focus in on the year-to-year changes in the KPMG row in panel C of table 3 (see table 4).
Market Share Analysis: KPMG Germany from 1998 to 2003
|1998–2002|| 36|| || 9||(25.0)|| 36||+0||−2|| 7||(19.4)|| 36||+0||−1|| 6||(16.7)|| 36||+0||−1|| 5||(13.9)||36||+1||−1|| 5||(13.9)|| |
| || || |
|1998–2001|| 39|| || 8||(20.5)|| 39||+0||−0|| 8||(20.5)|| 39||+0||−0|| 8||(20.5)|| 39||+0||−1|| 7||(17.9)||190|| ||49||(25.8)|| |
| || || |
|1998–2000|| 32|| || 6||(18.8)|| 32||+0||−0|| 6||(18.8)|| 32||+0||−2|| 4||(12.5)||229|| ||57||(24.9)|| |
| || || |
|1998–1999|| 48|| ||17||(35.4)|| 48||+0||−1||16||(33.3)||261|| ||65||(24.9)|| |
| || || |
|1998 only|| 46|| ||11||(23.9)||309|| ||83||(26.9)|| |
| || |
|355|| ||97||(27.3)|| |
|1999–2003|| ||19|| ||5||(26.3)||19||+1||−0||6||(31.6)||19||+1||−2||5||(26.3)||19||+0||−2||3||(15.8)|| 19||+0||−0|| 3||(15.8)|
|1999–2002|| || 3|| ||0|| (0.0)|| 3||+0|| 0||0|| (0.0)|| 3||+0||−0||0|| (0.0)|| 3||+0||−0||0|| (0.0)|| |
| || || |
|1999–2001|| || 0|| ||0|| (0.0)|| 0||+0||−0||0|| (0.0)|| 0||+0||−0||0|| (0.0)||22|| ||3||(13.6)|| |
| || || |
|1999–2000|| || 6|| ||0|| (0.0)|| 6||+0||−0||0|| (0.0)||22|| ||5||(22.7)|| |
| || || |
|1999 only|| ||12|| ||6||(50.0)||28|| ||6||(21.4)|| |
| || |
|40|| ||11||(27.5)|| |
|2000–2003|| ||125|| ||18||(14.4)||125||+2||−1||19||(15.2)||125||+1||−4||16||(12.8)||125||+2||−0||18||(14.4)|
|2000–2002|| || 30|| || 6||(20.0)|| 30||+2||−1|| 7||(23.3)|| 30||+0||−3|| 4||(13.3)|| |
| || || |
|2000–2001|| || 25|| || 6||(24.0)|| 25||+0||−0|| 6||(24.0)||155|| ||20||(12.9)|| |
| || || |
|2000 only|| || 38|| || 4||(10.5)||180|| ||32||(17.8)|| |
| || |
|218|| ||34||(15.6)|| |
|2001–2003|| ||13|| ||1|| (7.7)||13||+1||−0||2||(15.4)|| 13||+0||−0|| 2||(15.4)|
|2001–2002|| ||10|| ||1||(10.0)||10||+0||−0||1||(10.0)|| |
| || || |
|2001 only|| ||12|| ||4||(33.3)||23|| ||3||(13.0)|| |
| || |
|35|| ||6||(16.7)|| |
|2002–2003|| || 8|| ||1||(12.5)|| 8||+0||−0|| 1||(12.5)|
|2002 only|| ||11|| ||0|| (0.0)|| |
| || |
|19|| ||1|| (5.3)|| |
|2003 only|| || || 2|| || 0|| (0.0)|
|Total||355|| ||97||(27.3)||349|| ||94||(26.9)||507|| ||105||(20.7)||466|| ||100||(21.5)||409|| ||76||(18.6)||321|| ||70||(21.8)|
|KPMG clients continuing|| ||86||(of 97 in 1998)||72||(of 94 in 1999)||97||(of 105 in 2000)||83||(of 100 in 2001)|| 66||(of 76 in 2002)|
|KPMG rate of attrition (%)|| ||8.1%||(i.e., 7 of 86)||6.9%||(i.e., 5 of 72)||8.2%||(i.e., 8 of 97)||15.7%||(i.e., 13 of 83)||1.5%||(i.e., 1 of 66)|
4.2 changes in kpmg's share
4.2.1. Descriptive Statistics. Table 4 provides a descriptive analysis of changes in KPMG's share of the German audit market for the period 1998–2003. For KPMG, 1999 is a stable year; while 11 of its 1998 clients drop out of the sample, KPMG gains 11 of the 40 companies that are new to the sample. Of the 355 companies for 1998, 309 continue in the sample through (at least) 1999. Of these 309, KPMG picks up 4 and loses 7 clients. These 7 are out of KPMG's 86 (97 minus 11) clients that continue in the sample from 1998 to 1999, for an 8.1% rate of attrition. Overall, KPMG's share goes from 27.3% (97 of 355) for 1998 to 26.9% (94 of 349) for 1999.
In contrast to the stability of 1999, KPMG's share drops to 20.7% in 2000 (105 of 507), mostly because it gains just 34 of the 218 (15.6%) new companies to the sample, many of which were Neuer Markt IPOs. As for companies that continue in the sample from 1999 to 2000, KPMG adds 4 and loses 5 clients. These 5 are out of KPMG's 72 (94 minus 16 minus 6) clients continuing from 1999 to 2000, for a 6.9% rate of attrition.
For 2001, the calendar year-end prior to when they resign the ComROAD audit, KPMG adds 5 and loses 8 clients. These 8 are out of KPMG's 97 (105 minus 4 minus 4) clients that continue on from 2000 to 2001, for an 8.2% rate of attrition. For the 1999–2001 period, KPMG loses an average of 6.67 clients per year, an attrition rate of 7.8% (20 of 255).
For 2002, the calendar year of the ComROAD scandal, KPMG audits just 5.3% (1 of 19) of the new companies to the sample. As for companies that continue in our sample from 2001 to 2002, KPMG picks up 5, 2 of which are former Andersen clients (SAP and SAP Systems Integration). KPMG's attrition rate for 2002 is double their three-year average, as they lose 13 clients in 2002, in contrast to a yearly average of 6.67 clients for 1999–2001. These 13 are out of KPMG's 83 (100 minus 7 minus 6 minus 4) clients that continue from 2001 to 2002, or a 15.7% rate of attrition. A test of the change in proportions from the 7.8% attrition rate for 1999–2001 to the 15.7% attrition rate for 2002 yields a Z-statistic of 2.09, significant at 5% (two-tailed). This increase in client attrition does not occur for KPMG in the United States.
For 2003, KPMG adds five clients and loses one. This 1 is out of KPMG's 66 (76 minus 5 minus 4 minus 1) clients that continue in the sample from 2002 to 2003, for a 1.5% rate of attrition. A test of the change in proportions from the 15.7% attrition rate for 2002 to the 1.5% attrition rate for 2003 yields a Z-statistic of 2.94, significant at 1% (two-tailed).
Table 5 provides a zero-sum descriptive analysis that frames KPMG's gains and losses of continuing companies from table 4 in the context of the overall German audit market. The bottom (far right) of the KPMG column (row) shows their client gains (losses) among the companies in the sample that continue on for the next year. That is, the bottom (far right) of the KPMG column (row) depicts the 4, 4, 5, 5, and 5 (7, 5, 8, 13, and 1) new clients (lost clients), for 1999, 2000, 2001, 2002, and 2003, respectively, that we discuss above. With regard to Andersen, table 5 shows that of the 40 clients they lose in the 2002–2003 period, E&Y gains 32 and KPMG gains just two. KPMG's loss of 13 clients in 2002 is noteworthy, both in terms of KPMG's time series and that of its rivals (e.g., it is double PwC's largest year of client attrition). Of note, per the bottom row of table 5, other than Andersen, KPMG is the only major German audit firm to sustain a net loss of continuing clients for this time period.
Market Share Analysis: German Auditor Changes from 1999 to 2003
4.2.2. Multivariate Analysis. Of the 2,407 (669) company-years (companies) in tables 3–5, there are 121 observations representing just one year of data for a company. Because we cannot discern an auditor change, we eliminate these companies, leaving 2,286 observations for 548 companies. We also eliminate the first year for each company, leaving 1,738 observations for 548 companies. Of these 1,738, Worldscope shows 259 auditor changes20, of which we exclude 96 relating to mergers, acquisitions or dissolutions (i.e., 51 that relate to the PwC merger, 5 to Deloitte & Touche's acquisition of Wollert-Elmendorff, and 40 to Andersen).21 As such, 1,642 company-years comprise the sample for our multivariate analysis, of which 163 change auditors.
Using these 1,642 observations, we estimate equation (3) via probit. This regression examines the likelihood a KPMG client switches in the subsequent year. We control for size, leverage, changes therein (DeFond , Francis and Wilson ), profitability, financial health, and industry. Our variable of interest, KPMGt−1*Year2002, is equal to one if KPMG is the auditor for calendar 2001 and the year is 2002, the first audited financial statement after ComROAD. A positive coefficient for this variable (β8) is consistent with the notion that clients “punish” a high-quality auditor caught “cheating” by providing low quality.
- AuditorChange =
1 if a change in the company's audit firm and 0 otherwise
- Ln(Assets) =
Natural logarithm of total assets
- %ΔAssets =
Percentage change in Assets
- Leverage =
Total liabilities/total assets
- ΔLeverage =
Change in Leverage
- ROA =
Net income/total assets
- Loss =
1 if net income is negative and 0 otherwise
- KPMG =
1 if KPMG is the (prior year) audit firm and 0 otherwise
- KPMG *Year2002 =
1 if KPMG is the audit firm for 2001 and current year is 2002 and 0 otherwise
Table 6 presents the results of estimating equation (3). The pseudo-R2 (likelihood ratio index) is 3.7%. With respect to controls, our findings indicate that auditor changes are more common for smaller, unprofitable companies. Consistent with the descriptive statistics in tables 4 and 5, the coefficient on our variable of interest, KPMGt−1*Year2002, is positive and significant at 5% (two-tailed).22,23 The marginal effect of KPMGt−1*Year2002's coefficient is 0.074, implying a 7.4% increase in the likelihood of an auditor change in calendar 2002 for those cases where KPMG is the incumbent for the December 2001 audit.
Auditor Change Probit Regressions: Changes Away from KPMG Germany
|KPMG t −1||−0.18|
|Industry indicator variables||Included|
|Psuedo-R2 (likelihood ratio index)||3.7%|
Because German audit fees are confidential, we cannot directly quantify the losses that KPMG sustains due to abnormal client attrition following ComROAD. However, given that extant literature demonstrates that company size is (by far) the primary determinant of audit fees (e.g., Menon and Williams ), we can use assets to proxy for audit fees. The 13 KPMG clients for 2001 that change auditors for 2002 (see tables 4 and 5) represent 3.4% of client total assets for the 83 KPMG clients for 2001 that continue in our sample for 2002. Moreover, the total assets of these 13 companies is about 10 times the total assets of the 20 clients that change from KPMG during the three-year period 1999–2001 (see also tables 4 and 5). In addition to this, as table 4 shows, during 2002 KPMG audits just 5.3% (1 of 19) of the companies new to Worldscope, versus 16.7% and 15.6% for 2001 and 2000, respectively.24
4.3 characteristics of companies that change from/stay with kpmg
We take a closer look at KPMG's 83 calendar year-end clients for 2001, 13 of which change auditors for their 2002 audit. While significant and consistent with our prediction, the attrition we find may not be as large as some may expect (e.g., given a failure so severe that it is associated with a 3% drop in investor wealth, some may expect an exodus from KPMG).25
One barrier to auditor–client realignment is that Germany bans direct solicitation and advertising by audit firms, making it difficult for rival audit firms to lure KPMG's clients after ComROAD. To the extent these restrictions impede client–auditor realignments, an unintended consequence is that audit markets may not adequately adjust to revelations of declines in quality.
Another factor likely to hinder auditor switching is that the objective function of German managers may not be to maximize shareholder value. European companies in code-law countries such as Germany are subject to the demands of a broad set of stakeholders, including labor and banks. This means that there is likely to be cross-sectional variation in the demand for audit quality (e.g., some supervisory boards may choose to stay with KPMG because the costs to investors of retaining KPMG are offset by the benefits KPMG brings to other stakeholders). Following this, companies with less board representation by labor unions or banks and that recently raise public equity seem more likely to have stronger incentives to change from KPMG.
Lastly, auditor industry expertise and the severity of event-day returns could be factors that help explain why some KPMG clients change while others do not. Prior research finds evidence consistent with auditors who are industry leaders providing higher quality audits, where industry leadership is captured by client industry concentration (Francis, Reichelt, and Wang ). This suggests that the propensity for a client to switch from KPMG may be a function of whether KPMG is the industry leader, although the direction of this impact is difficult to predict. For example, if KPMG is the industry leader, even a drop in the level of perceived audit quality in KPMG may still be higher than the quality of alternative auditors. This would suggest that there would be less switching away from KPMG when KPMG is the industry leader. On the other hand, clients with industry leaders may be particularly sensitive to drops in audit quality and be more likely to switch from KPMG as a result of a breach in providing the level of quality they expect. In addition, it seems likely that the larger the costs suffered by shareholders as a result of KPMG's audit failure, the stronger the incentives for managers to replace KPMG.
To investigate these rationales, we estimate equation (4a) and equation (4b) via probit, which examines the likelihood that a December 2001 KPMG client changes to a different auditor for their December 2002 audit. As with equation (3), we control for company size, leverage, and profitability. Because German companies with more than 500 employees must reserve 50% of the seats on their supervisory board for employee representation (Ashbaugh and Warfield ), company size can proxy labor union representation on the board. We specify leverage to proxy for firms with debt financing, and hence creditor representation on the board. To proxy for companies that recently raise public equity, we include an indicator variable for whether a company is new to Worldscope since 1999, the year of ComROAD's IPO. As with equation (2), to proxy for industry specialization, we specify an indicator variable for whether the client is in the banking, insurance, or other financial industries. To consider the association between event-day returns and the likelihood a KPMG client changes auditors, we add the event-period returns in equation (4b). Because returns are not available for all KPMG's calendar 2001 clients, sample sizes for the equation (4a) and equation (4b) estimations are 83 and 64, respectively. Panel A of table 7 presents descriptive statistics and regression results for the sample of 83 KPMG calendar 2001 clients, whereas panel B presents the same for the sample of 64 clients.
KPMG Germany's Calendar-Year 2001 Clients by Whether They Changed Auditor in 2002
|Median|| 527|| 1,730||0.09|
|Psuedo-R2 (likelihood ratio index)||14.2%|
|Median|| 527|| 1,824||0.04|
|Returns1 (Event 1)||Mean||−0.042||−0.013||0.13|
|Returns2 (Event 2)||Mean||−0.010||−0.007||0.73|
|Returns3 (Event 3)||Mean||−0.025||−0.018||0.70|
|Psuedo-R2 (likelihood ratio index)||22.7%|
1 if a change in the company's audit firm (i.e., from KPMG) and 0 otherwise
Natural logarithm of total assets
Total liabilities/total assets
Net income/total assets
1 if company is new to Worldscope in 1999, 2000, or 2001 and 0 otherwise
1 if a bank, insurer, or other financial company and 0 otherwise
Returns for the three-day window around February 19, 2002
Returns for the three-day window around April 10, 2002
Returns for the four-day window around April 23–24, 2002
Table 7 presents the results. Consistent with the descriptive statistics, the coefficients on Ln(Assets) and IPO are negative and positive at 10% (two-tailed), respectively, suggesting smaller, recently public companies are more likely to leave KPMG after ComROAD. As per panel B, the coefficient on Returns1 is negative and significant at 10% (two-tailed). This is consistent with the view that the larger the costs that shareholders sustain from ComROAD, the stronger the incentives for supervisory boards to replace KPMG. Among the companies that change from KPMG, those with the most negative Returns1 are smaller, recent IPOs (similar to ComROAD). This is consistent with the view that German supervisory boards more attuned to maximizing shareholder value are more likely to change from KPMG.
In a recent article, DeFond and Francis[2005, pp. 6, 13]“encourage researchers to address issues regarding the role and importance of litigation in maintaining high audit quality.” We examine the stock and audit market effects associated with an audit failure involving a public client of KPMG in Germany, a country that provides auditors with substantial protection from investor litigation. Our findings suggest that German investors and supervisory boards react to revelations of substandard audits by a firm with a reputation for high quality. From a stock market standpoint, investors appear to respond negatively to events relating to ComROAD, manifesting in cumulative negative returns of 3% for KPMG's other German clients. From an audit market standpoint, supervisory boards appear to respond by dropping KPMG, as KPMG's rate of attrition by their calendar-year clients doubles in the year of the ComROAD scandal.
Our findings are important because research has difficulty isolating the value of audit reputation to investors. We believe this difficulty is somewhat attributable to the research setting. By focusing on auditor reputation in relatively high shareholder litigation risk countries, it is difficult to separate reputation effects from insurance effects. In general, extant studies conclude the insurance effect dominates. By conducting our study in Germany, a major industrialized country with very low shareholder litigation risk, we abstract from the insurance rationale and are able to conduct a cleaner test of the reputation rationale for audit quality. We provide evidence that markets discipline auditors that deviate from providing high quality.
Given present-day calls for auditor litigation reform (see Scannell ), policymakers may find our results of some interest. Though we emphasize that a caveat for our paper is that our findings and inferences, because they pertain to a severe audit failure in a country where auditor liability to shareholders is quite low, may be subject to limitations on external validity.