Was audit quality of Laventhol and Horwath poor?

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Abstract

Laventhol and Horwath (L&H), the then seventh largest accounting firm in the US, declared bankruptcy in November 1990. The firm claimed that its bankruptcy was due to the perception of it being a deep pocket rather than inherent deficiencies in its performance. In this study, we examine whether the audit quality of L&H was lower than other auditors. Results do not show that L&H is associated with lower quality audits either in terms of lower likelihood of issuing modified audit opinion, higher levels of discretionary accruals for its clients, or lower predictability of discretionary accruals for future non-discretionary net income for its clients than for clients of other auditors. Results of additional tests also do not suggest that auditors that take up clients of L&H report differently from L&H. This evidence does not support the proposition that L&H’s audit quality was less than audit quality of other audit firms during the period leading up to the bankruptcy.

Introduction

In this paper, we examine whether Laventhol and Horwath (L&H) provided poor quality audits. In November 1990, L&H declared bankruptcy and was then the seventh largest public accounting firm in the United States. The main reason cited for its bankruptcy was large settled and pending lawsuits against it (Business Week, 1990). In addition, L&H claimed that there were more than 100 pending lawsuits with total claims amounting to $2 billion (Pae, 1990). The then CEO, Robert Levine, further claimed that L&H fell because of its “deep pocket” and not due to incompetent professional performance (Arthur Andersen et al., 1992). In fact, the fall of L&H occurred in the midst of high incidences of litigation against auditors. As expected, audit firms lobbied for law reform that would significantly curtail the incentives of bringing class-action lawsuits and for new forms of business practices that would shield partners’ personal assets from the wrong-doings of other partners. These lobbying efforts eventuated in the passage of the Private Securities Litigation Reform Act in 1995 and the creation of limited liability partnerships or corporations in the mid-1990s.

An interesting point to note in the above developments is that the claim of L&H has been taken for granted. This is evident from the use of the L&H case by the then Big 6 auditors in their open letter in which they alleged that escalating liability from litigation was threatening the survival of the profession (Arthur Andersen et al., 1992). In addition, prior studies involving L&H do not examine audit quality of L&H compared to other auditors.1 These studies fall into two categories: (1) examination of the insurance hypothesis2 (Menon and Williams, 1994, Baber et al., 1995) and (2) choice of new auditors by former L&H clients upon L&H’s bankruptcy (Wootton and Tonge, 1993, Reed et al., 2000). Whether L&H offers lower audit quality is an important question because it has implications. First, if L&H provided poor quality audits, then the use of the L&H case by the accounting profession to support the massive lobbying efforts to curtail litigation exposure may be inappropriate. Second, prior studies that examine the insurance hypothesis are not able to attribute the negative stock price reaction solely to the bankruptcy of L&H because of the confounding effect of L&H’s audit quality. If the audit quality of L&H is not different from the quality of other auditors, the results of prior studies are more compelling.

We measure audit quality in terms of (a) the likelihood of issuing modified audit opinions by auditors, (b) the levels of discretionary accruals of their clients and (c) the relationship of audited discretionary accruals with future non-discretionary net income, a measure of the quality of discretionary accruals. If L&H is not associated with lower audit quality relative to other auditors, then L&H is not likely to be a poor professional performer.

Our results do not support the proposition that L&H is associated with lower audit quality than other auditors: Big 6 (now Big 4) firms, other non-Big 6 (now non-Big 4) firms, large national firms and small regional firms. Specifically, L&H does not have a lower likelihood of issuing modified audit reports to their clients or allow their clients higher discretionary accruals than other auditors. In addition, the predictive ability of discretionary accruals of clients of L&H is not lower than the predictive ability of discretionary accruals of other firms. Lastly, results from further tests do not suggest that new auditors report differently from L&H. Overall, our evidence does not suggest that L&H provided poorer quality audits.

This paper contributes to the literature in three ways. First, it provides evidence that suggests that L&H was not professionally incompetent. Second, the results in this paper are supportive of the profession’s attempt to curtail litigation exposure at the time. Last, this paper contributes to the literature by suggesting that results of prior studies on the insurance hypothesis using L&H’s bankruptcy are not likely to be due to poor audit quality of L&H.

The next section of the paper develops the hypothesis. The research method is then discussed, followed by a description of the sample selection. The last two sections discuss the results, including sensitivity analyses and limitations, and the conclusions of the paper.

Section snippets

Hypothesis

When companies fail, auditors are often named as one of the defendants in lawsuits brought by parties who allege to have incurred financial losses due to the reliance on audited financial statements. Although there may be various reasons for this happening, in the case of L&H, it was claimed that litigation arose because the auditor was a “deep pocket” rather than a poor professional performer (Arthur Andersen et al., 1992). Hence, L&H claimed that one reason (deep pocket consideration) and not

Research method and sample

First, we estimate the following logistic specification to test whether L&H is more or less likely to issue modified opinion to its clients (first test for H01).MODIFY=a0+a1LTA+a2CATA+a3QUICK+a4DE+a5ROI+a6PLOSS+a7PMODIFY+a8LHwhere5

  • MODIFY = 1 if the firm receives a modified audit opinion in year t, or 0 otherwise

  • LTA = natural logarithm of total assets

  • CATA = ratio of current assets to total assets

  • QUICK = ratio of current

Modified opinion

To test whether L&H is more or less likely to issue modified audit opinion to its clients, we collected the necessary data for expression (1) from COMPUSTAT. After deleting observations with missing value and observations that were more than four standard deviations from the means of the variables, we had a sample of 14353 observations. In this sample, there are 4871 observations for 1988, 4744 observations for 1989 and 4738 observations for 1990. In addition, there are 222 observations for

Conclusion

In this paper, we investigate the audit quality of L&H because the firm claimed that it fell not because of poor professional performance. We define audit quality in terms of the likelihood of issuing modified audit opinion, the provision of discretionary accruals and the predictability of discretionary accruals for future earnings. We report that L&H is more (instead of less) likely to issue modified audit opinion to its clients and its clients do not have higher or lower discretionary

Acknowledgement

We acknowledge helpful comments from two anonymous reviewers, MarkBliss, Jere Francis and seminar participants of the City University of Hong Kong.

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    Data availability: Data are publicly available from sources identified in the paper.

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