The SEC’s Enforcement Record against Auditors

Simi Kedia

Rutgers Business School

skedia@rbsmail.rutgers.edu

Urooj Khan

Columbia Business School

uk2117@columbia.edu

Shiva Rajgopal

Goizueta Business School,

Emory University

shivaram.rajgopal@emory.edu

Comments welcome

August 14, 2014

Abstract:

We investigate the enforcement record of the SEC against auditors over the years 1996-2009 to evaluate

concerns about the alleged lax enforcement effort of the SEC against auditors. Of the 435 enforcement

actions initiated by the SEC against companies for fraudulent financial reporting, the auditor who signed

off on the underlying financial statements during the violation period is specifically named as a defendant

by the SEC in 78 cases. Conditioned on being charged by the SEC, a Big N auditor is less likely to be

named in an AAER relative to a non-Big N auditor, after controlling for the egregiousness of the

reporting fraud and the characteristics of firms that self-select to buy audits from non-Big N firms. A

closer look at the specific sanctions (individual partner or firm charged, administrative or court action,

penalties imposed) suggests that the SEC typically goes easy on auditors, especially the Big N, relative to

fraudulent firms or its managers. Private enforcement is more effective as class action lawsuits against

auditors are relatively more frequent. However, SEC actions against auditors are not associated with a

loss of market share for such auditors, except in extreme circumstances. These findings have implications

for the debate about regulatory and enforcement changes designed to make auditors more accountable and

independent gatekeepers.

We thank our respective schools for financial support. We are thankful to Chang Wook Lee and Haitao Tu for excellent research assistance. The

data on enforcement actions was generously shared by Jonathan Karpoff. Cornerstone Research and Stanford Law School provided the data on securities class actions. We acknowledge helpful comments from anonymous review for the 2014 AAA conference, Monika Causholli, Stephen

Penman and workshop participants at the University of Mississippi and Columbia Business School Brown Bag on an earlier draft. The views

expressed in this paper are ours and do not represent in any way the views of Cornerstone Research or Stanford Law School. Also, all errors are ours.

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The SEC’s Enforcement Record against Auditors

1. Introduction

In this paper, we investigate the record of regulatory oversight, especially that of the SEC’s,

against audit firms and their partners. Steven M. Cutler, then Director of the SEC’s Division of

Enforcement, on Dec 12, 2002, following the collapse of Enron, stated: “while I believe the causes of this

phenomenon [seemingly unprecedented corporate fraud] are multiple, a significant contributing factor

was the laxity of the so-called gatekeepers — the accountants, lawyers, ….. Perhaps foremost among

these is the auditor.” The perceived failure of the auditor in limiting corporate misconduct is often

accompanied by claims about lax regulatory oversight of the audit industry. An influential report issued

by the Project of Government Oversight (POGO) (2011) finds that a substantial number of senior ex-SEC

employees leave the agency to work for audit firms. The possibility of regulatory capture, discussed

extensively in the political economy literature (Dal Bo 2006), raises the concern that the revolving door

between the SEC and audit firms creates incentives for SEC enforcement personnel to go easy on

disciplining audit firms who might be their future employers (Day 2002, McGinty 2010). Furthermore,

several authors have argued that the Big N audit firms, after the demise of Andersen, have become “too

big to fail” (e.g., Benston 2003, Cunningham 2006 and Weil 2012). Because Big N firms audit virtually

all the large public companies in the U.S., a regulatory crackdown on any of these audit firms would

result in the potential disruption in the audit market causing the SEC to look the other way (Nocera 2005).

But, what exactly is the SEC’s enforcement record against auditors and along what dimensions

should the agency strive to improve its enforcement performance? This article presents some of the first

systematic and comprehensive empirical evidence on SEC enforcement by constructing a dataset of all

SEC actions against audit firms and their partners over the years 1996 to 2009. In particular, our sample

consists of 435 SEC enforcement actions against companies that have allegedly engaged in accounting

misrepresentation for whom we can find an associated audit firm that has signed off on the allegedly

irregular financial statements. Using this dataset, we investigate several questions.

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We begin with an investigation of the propensity of the SEC to charge auditors, especially the Big

N audit firms. We find that the auditor who signed off on the financial statements deemed misrepresented

by the SEC in 435 enforcement actions is charged by the SEC as negligent in 78 cases (i.e., in 18% of the

cases). As auditors are unlikely to be complicit in all cases of misconduct, it is difficult to ascertain

whether 18% represents an appropriate level of enforcement against auditors.

Regardless of the SEC’s enforcement rate against auditors in general, one can investigate whether

the SEC is equally likely to go after Big N or non-Big N audit firms. The data show that although the Big

N firms serve 72% of the audit market, they accounted for 44% of the cases where auditors were named

by the SEC. Of course, this statistic could simply imply that Big N firms provide better quality audits

(e.g., DeAngelo 1981, Francis 2004). If the quality of the audits provided by the Big N auditors is indeed

better, one would expect that their client firms would be less likely to be charged by the SEC for

misreporting, irrespective of whether the auditor is charged or not.

We document that during our sample period, clients of Big N audit firms are not less likely to

misreport. Between 1996 and 2009, although Big N audit firms serve 72% of the audit market, their

clients account for a higher, statistically significant, share (76%) of firms charged for financial

misrepresentation by the SEC. We also report multivariate evidence on the likelihood of an auditor being

charged by the SEC for negligent audits after controlling for (i) the severity of the fraud; and (ii) nature of

clients that are likely to choose a Non-Big N auditor. We find that Big N audit firms are less likely to be

named by the SEC for negligent audits.

Having decided to charge an auditor, the SEC faces three key choices when it initiates an

enforcement action: (i) whether to focus on individual partners or pursue corporate liability by charging

the audit firm (ii) whether to pursue an administrative action or civil proceedings; and (iii) what kind of

penalty to impose on the auditor.

With respect to the first question related to personal vs. corporate liability, the data show that the

SEC tends to favor charging individual partners, as opposed to the audit firm. In 69% of the cases, only

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the partner was named as opposed to 4% of the cases where only the audit firm was charged.1 It is

unclear whether personal liability or firm wide liability leads to more effective enforcement. The second

dimension of SEC enforcement relates to whether to bring an administrative proceeding or a more

onerous civil litigation, or both against the auditor. Administrative proceedings are heard by an

administrative law judge who issues a decision that includes recommended sanctions. In contrast, in a

civil action, the SEC files a complaint with a U.S. District Court and asks the court for a sanction. We

find that the SEC predominantly relies on administrative actions against auditors. In 78% of the cases the

auditor/audit firm was subject to an administrative action only. This is significantly higher than the usage

of administrative actions by the SEC in related enforcement against corporate offenders. Specifically,

only 15% of the client firms charged by the SEC for misconduct were subject to administrative action.

The most common penalty sought by the SEC under administrative proceedings is a denial of

privilege that bars, either temporarily or permanently, the accountant from practicing before the SEC.

These penalties are targeted at partners not the audit firms, in general. Censure, the mildest punishment,

was the most commonly employed penalty imposed on an audit firm. Disgorgement awards against

auditors are uncommon.

In general, penalties against Big N auditors are smaller than those levied on non-Big N auditors.

Big N auditors are subject to milder penalties such as censure and signing of undertakings to reform audit

processes whereas non-Big N auditors are more likely to be sanctioned with denial of privilege to practice

and cease and desist orders. No Big N audit firm has been denied the privilege of practicing auditing in

our sample. This is despite observing no material difference between Big N and non-Big N auditors in

the nature of violations brought by the SEC. However, the frequency of sanctions imposed by courts in

civil proceedings, as opposed to those decided by the SEC, are more evenly balanced between non-Big N

and Big N auditors. In summary, we believe that the evidence is consistent with the charge that the SEC

is lax at charging auditors, especially the Big N firms.

1 In the remaining 27% of the cases, both the partner and the audit firm were charged.

4

We turn next to an examination of private channels of enforcement such as class action lawsuits

and the loss of market share for an audit firm charged by the SEC. Not surprisingly, class action lawsuits

against auditors are filed less frequently relative to analogous lawsuits against their clients. Over the

1996 to 2009 time period, auditors are sued in 27% of the cases where class action lawyers accuse client

firms of GAAP violations. However, this is much higher than the analogous SEC’s propensity to charge

auditors (18% mentioned on the first page). Unlike the SEC, class action lawyers are more likely to target

Big N auditors, perhaps because of their deep pockets.

Finally, we examine the efficacy of private enforcement against the auditor via the product

market. In particular, we investigate whether auditors who are charged by the SEC subsequently lose

market share. Except for audit firms associated with the most frequent (top decile) SEC sanctions, we

find no evidence suggesting that clients defect in abnormally large numbers after the audit firm is

identified as negligent by the SEC. Moreover, the clients that do defect are not the bigger and the more

visible ones, limiting the reputational damage stemming from such defection. This evidence contrasts

with (i) audit firms’ claims that reputational mechanisms are sufficient for them to function effectively

(U.S. Treasury, 2008); and (ii) the reputational penalties suffered by culpable managers when they are

accused of filing fraudulent financial statements (e.g., Srinivasan 2005; Desai et al. 2006 Karpoff et al.

2008b).

Our work contributes to the sparse academic literature examining disciplinary actions by

regulators against auditors (e.g., Feroz et al. 1991) and the growing literature on the effectiveness of

public regulators such as administrative and enforcement agencies and of private enforcement via class

action lawsuits (e.g., Coffee 2002; Cox, Thomas and Kiku 2003; Siegel 2005; La Porta, Lopez-de-Silanes

& Shleifer 2006; and Jackson and Roe 2007). Our paper provides perhaps the first detailed account of the

SEC’s enforcement activity against a significant set of gatekeepers: the auditors. Our key findings are (i)

that Big N auditors are less likely to be named in SEC actions; (ii) when named, the SEC is more likely to

pursue administrative proceedings against auditors rather than the more onerous court action; and (iii)

although the nature of violations brought against Big N and non-Big N auditors are similar, non-Big N

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auditors have been subjected to more severe penalties. We interpret such evidence as consistent with

allegations of lax enforcement by the SEC against auditors, especially the Big N.

Private enforcement mechanisms are somewhat more effective. Class action litigation is more

vigorous than the SEC at charging auditors, especially the Big N audit firms. However, the product

market does not appear to impose losses in market share on auditors tainted by SEC sanctions. The

apparent absence of a reputation penalty against tainted audit firms is consistent with the “too big to fail”

allegation given that companies, even if they want to switch auditors, would prefer another Big N audit

firm. Moreover, the threat of failure of the prospective Big N audit firm that the client might switch to,

due to regulatory intervention, is no different from that of the existing Big N firm that currently audits

that client.

We acknowledge that evaluating whether the SEC’s enforcement record against auditors is

inherently complex and our evidence should be viewed as suggestive not definitive. In particular, we

view our evidence as a starting point for the literature to comprehensively assess whether the SEC is

lenient towards auditors. We cannot directly test for the mechanism underlying such tilt, especially with

the revolving door concern. This is because the names of clients for whom the auditors, who are ex-

employees, lobby the SEC are redacted from publicly available documents. Moreover, audit reports in

the U.S. are not signed by individual partners. Hence, we cannot link ex-SEC audit partners to

questionable financial reporting outcomes. Similarly, it is not obvious how one should directly test the

claim that Big N audit firms are “too big to fail.”

The remainder of the paper is organized as follows. Section 2 discusses the background and

conjectures we expect to see borne out by the data. Section 3 outlines the research design. Section 4

describes the data and presents the evidence. Section 5 explores the role of the other enforcement activity

against the auditors such as PCAOB action and class action lawsuits. Section 6 studies the potential loss

of reputation and consequent discipline by the audit market. Section 7 concludes.

2.0 Background and conjectures

2.1 Extant literature

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Individual investors rely on auditors to ensure that financial statements were, in fact, produced

and audited in accordance with Generally Accepted Accounting Principles (GAAP) and Generally

Accepted Accounting Standards (GAAS), respectively. If managers engage in misreporting or

malfeasance and the audit firm is negligent at identifying such behavior, it seems reasonable to expect

that the SEC and other regulatory institutions will effectively protect investors by bringing regulatory

action against such audit firms. Moreover, even if the SEC is less able or willing to pursue negligent

auditors vigorously, we might expect private class action litigation or the product market (the market for

audit services) to act as a deterrent to audit firm negligence.

Indeed, a large literature examines SEC enforcement actions against public firms (e.g., Feroz et

al. 1991; Dechow et al. 1996; Karpoff et al. 2008a) and the consequences of such actions on boards (e.g.,

Srinivasan 2005) and culpable managers (e.g., Desai et al. 2006; Karpoff et al. 2008b). However, little

attention has been paid to studying the enforcement patterns of the SEC against audit firms, who are

arguably one of the most important gatekeepers in financial reporting (e.g. Feroz et al. 1991). We provide

some of the first systematic empirical evidence on (i) the SEC’s enforcement practices against auditors;

and (ii) supplementary evidence on the efficacy of private enforcement via class action lawsuits and the

product market.

Critics have alleged that the actual enforcement of securities laws by the SEC against audit firms

is less aggressive than desirable for two key reasons: (i) the revolving door phenomenon; and (ii) the

“too-big-to-fail” phenomenon. These are discussed in greater depth below.

2.2 Revolving doors

The first reason for potential laxity towards audit firms is the revolving door phenomenon.

Several Congressmen and the press have expressed concerns that the revolving door results in potential

regulatory capture whereby the enforcement staff at the SEC goes easy on potential employers such as

law firms and audit firms (e.g., Perino 2004; Grassley 2010). A widely cited report published by the

Project on Government Oversight (POGO) finds that, for the period 2006-2010, the three top accounting

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firms were among the 11 most frequent employers of ex-SEC staff.2 Of the 131 recruiters from the SEC

that were identified by POGO, Deloitte and Ernst &Young (E&Y) rank as the second and the third most

frequent recruiters. Moreover, ex-SEC officers from Deloitte and E&Y were the most active in

representing clients before the SEC, as evidenced by the number of post-employment conflict of interest

letters filed by ex-SEC employees.

The fact that regulators can come from practice or end up there has been long recognized as a

source of bias in regulatory decisions in the political economics literature (Dal Bo 2006). The concern is

that regulators might bias their decisions to be lenient to industry in return for future employment in

industry. Even if ex-regulators are hired purely for their skill, firms may prefer hiring employees who

have the industry’s interests at heart. This incentive, in turn, might make regulators signal their leniency

towards industry. Che (1995) models the revolving door phenomenon and argues that if firms employ

former regulators because of their connections and usefulness at political lobbying, as opposed to pure

skill, revolving doors can have a detrimental effect on the nature of regulation.

However, empirical evidence on this question is sparse and mixed. In the broadcasting industry,

Gormley (1979) and Cohen (1986) find that prior industry-experience makes FCC commissioners more

supportive of industry’s interests. Spiller (1990) finds that regulators who preside over more lenient

regulatory periods are more likely to get jobs in industry. Vidal et al. (2012) find evidence consistent

with revolving door lobbyists selling access to powerful politicians. In contrast, Glaeser et al. (2000) and

DeHaan et al. (2014) argue that the career prospects of enforcement officials are strengthened by

cultivating a reputation for aggressive enforcement and not by pandering to potential target-employers.

We posit that the revolving door between the SEC and auditors potentially reduces the vigor with which

SEC enforces sanctions and penalties against auditors.

It is worth noting that a direct test of the revolving door phenomenon is difficult, if not impossible

in our context, because we cannot tie back the names of audit partners who worked for the SEC to the

2 Over this period, Deloitte and Touche hired nine officers, Ernst and Young hired eight officers and KPMG five

officers.

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names of the clients, whose audit reports they signed or for whom they lobbied the SEC. This is because

(i) the names of the clients the auditors advocate for are redacted in the statements (known as CFR Title

17 letters) that the SEC requires former employees to file when they expect to appear before the agency

on behalf of outside parties after leaving the SEC; and (ii) partners’ names do not appear on audit reports

in the U.S. Hence, we can only rely on indirect evaluation of the “revolving door” pressure by examining

the SEC’s enforcement record against auditors.

2.3 The too-big-to-fail phenomenon

The second potential reason for the SEC’s alleged laxity is the contention that Big N accounting

firms have become too big to fail. The GAO (2003) found that Big N firms audit over 78% of all U.S.

public companies and 99% of all public companies, when the sales of such companies are considered. In

the large public company audit market, the Big N audit over 97% of all public companies with sales over

$250 million. The GAO (2003) notes that small audit firms find it increasingly hard to compete with the

Big N in terms of reputation, staff, reach, scale and resources. Cunningham (2006) points to the

government’s decision to not pursue a criminal indictment against KPMG in the 2005 case involving

illegal tax shelters despite little evidence to suggest that KPMG was not guilty of misconduct. The

regulators were allegedly worried about disrupting the audit market if a large audit firm were to dissolve

on account of a criminal indictment. When the Government did let Andersen fail, the Big Five were

reduced to arguably the “Final” Four because four big auditors is a historically low number to support the

audit demands of U.S. public companies.

Empirical research on claims related to the “too big to fail” auditor is sparse. Brown, Shu and

Trumpeter (2008) find that KPMG’s clients’ stock price increased on the days surrounding the

announcement of their settlement with the Government in the tax shelter case. Allen, Ramanna and

Roychowdhary (2013) argue that, as the oligopoly in audit markets tightened, auditors’ comment letters to

the FASB seek more reliability in accounting measurement to avoid litigation and political visibility. The

authors interpret this data as inconsistent with audit firms’ perception that they are “too big to fail.” If the

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SEC indeed believes that Big N audit firms have become “too big to fail,” we would expect to observe

laxer enforcement against these firms, ceteris paribus.

2.4 The resource constraints counter argument

Even if we were to find lax enforcement activity against the Big N audit firms, a critic could

counter argue that such evidence merely points to the resource constraints faced by the SEC. That is,

because the SEC has limited resources, it is likely to pursue cases where there is a high probability of

success. Given that Big N audit firms have more resources to fight back, the SEC may be less likely to

target them. It may be more difficult for the SEC to bring cases against auditors when the auditor can

demonstrate that they followed the standard of “due care.” Alternately, the SEC may gain more political

capital by focusing on executives or directors who orchestrated a fraud than the auditor. These

arguments, prima facie, seem to be consistent with our inference in the paper that the SEC’s enforcement

record against Big N audit firms is indeed less vigorous than it could otherwise be.

However, we believe that the resource constraints hypothesis, in our context, appears untenable

for two reasons. First, we are unsure why limited resources should constrain the SEC from pursuing Big

N firms but not other prominent fraudulent companies and their officers. Second, if resource constraints

were indeed the key motivator, we would expect the SEC to pursue targets that have greater deterrent

value to prevent negligent behavior among other auditors. Given that the Big N firms collectively audit a

substantial portion of corporate America, actions against them, as opposed to those against a small CPA

firm, would be expected to have greater deterrent effects. In conclusion, these arguments, at the very

least, motivate the need for a comprehensive empirical assessment of the SEC’s enforcement record

against auditors.

3.0 Research Design

An empirical evaluation of whether the SEC’s regulatory oversight against the auditors is lax is

complicated. This is because we cannot observe the counter-factual i.e., in how many cases did the SEC

pass on prosecuting the auditors despite knowing of their negligence or wrongdoing? So, we benchmark

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the SEC’s enforcement against audit firms by comparing the (i) SEC’s activity against corporate firms

and managers on the same underlying cases of misreporting; and (ii) the incidence of class action

lawsuits, which represents a private mode of enforcement. In particular, we examine several enforcement

decisions taken by the SEC: (i) whether they name an auditor, and if yes, a Big N auditor (section 3.1);

(ii) do they charge the audit firm or the partner (section 3.2); (iii) do they pursue an administrative or a

more stringent civil action (section 3.3); and (iv) do they impose stiff penalties and sanctions (section

3.4). A detailed discussion follows.

3.1 Naming the auditor

We begin by investigating the likelihood that an audit firm is named by the SEC for a negligent

audit. Both the revolving door and the “too big to fail” arguments suggest that the SEC is likely to be

biased in favor of the Big N audit firms. As these firms are the likely future employers of SEC staff as

well as the largest players in the audit market, a favorable SEC bias implies that the Big N audit firms

should be less likely to be targeted by the SEC. The hypothesis of no (favorable) bias towards Big N

audit firms therefore implies that the share of the Big N audit firms in SEC enforcement cases against

auditors should be similar to (less than) their share of misrepresenting clients. In other words, if the Big

N client firms account for 80% of all firms targeted by SEC, then 80% of all cases against auditors should

be against Big N audit firms under the “neutral SEC” hypothesis.3

An obvious concern with the above test is that if Big N auditors provide higher quality audits

(DeAngelo 1981; Francis 2004), then they may be found to be negligent in fewer cases, which, in turn,

would result in a lower likelihood of being charged by the SEC. Because we do not have data on the

negligence of the auditor, it is hard to examine this claim directly. However, we can investigate this issue

indirectly. One implication of the assertion that Big N audit firms provide better audits is that their client

firms should be less likely to be targeted by the SEC for financial misrepresentation. In other words, if

3 Note that this argument holds irrespective of whether the incidence of SEC enforcement against auditors is high or

low. In other words, whether the SEC names auditors in 15% of the cases or 40% of the cases, the unbiased

hypothesis tests whether the proportion targeted by the SEC is the same for Big N and other auditors.

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the share of Big N audit firms charged with misconduct is significantly lower than their share of the audit

market, better quality audits may have potentially reduced the likelihood of financial misrepresentation.

We entertain this alternate explanation in our empirical tests. We also control for (i) the characteristics of

clients that choose Big N versus other auditors; and (ii) the severity of the misconduct perpetrated by the

client firm.

3.2 Corporate or individual liability

The SEC has the discretion to bring enforcement actions against individual partners for their role

in the financial misrepresentation or against their employers, the audit firm, or against both the partner

and the audit firm. However, it is unclear whether actions against the individual partner or the audit firm

can be considered a sign of aggressive enforcement. On the one hand, actions against an individual

partner can be considered aggressive enforcement because (i) absence of personal liability is likely to

limit the potential deterrence effect of securities litigation (see Arlen and Carney 1992; Coffee 2007;

Klausner 2009, Gadinis 2009); (ii) sanctioning the whole firm can result in penalizing other clients and

colleagues who may be lacking in culpability (Margolis 1978); (iii) penalizing an individual partner in a

local audit firm with one or two partners is tantamount to sanctioning the entire firm.

On the other hand, one could counter argue that an aggressive enforcement policy should target

the audit firm because: (i) targeting the individual partner, who is likely to have fewer resources to fight

back the SEC compared to the audit firm, enables the SEC to record more wins to appease the public and

Congress; (ii) naming individuals, rather than the firm, allows audit firms to potentially scapegoat a few

“bad apples” and thus isolate the audit firm from reputational damage; and (iii) as SEC Commissioner

Stephen Cutler (2002) points out, “audit work supplied by an accounting firm is very much a product of

that firm's culture, personnel, systems, training, supervision, and procedures. If that product is defective,

the causes may well be found in the firm.” These arguments point towards the importance of naming the

audit firm in the SEC enforcement action.

3.3 Court action or administrative action

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When the SEC initiates a regulatory action against the firm, it can choose to bring an

administrative proceeding or a civil litigation, or both. Administrative proceedings are heard by an

administrative law judge, who is independent of the SEC and issues a decision that includes

recommended sanctions. In contrast, in a civil action, the SEC files a complaint with a U.S. District

Court and asks the court for a sanction. Stronger sanctions, such as banning the individual from

practicing in the industry, are more likely to need civil actions (Gadinis 2009). Further, if the SEC

decides to initiate administrative proceedings, it can close the matter quickly as any proposed settlement

does not need the approval of the administrative law judge. In civil proceedings, any settlement needs the

judge’s approval. This implies that administrative proceedings not only take less time but also involve

less negative publicity for the defendant firm. In summary, civil actions suggest stronger enforcement by

the SEC against auditors. Hence, we test whether the SEC’s use of administrative versus civil

proceedings differs between Big N audit firms and others. Under the “neutral SEC” hypothesis, there

should be no difference in the frequency of court or civil actions against Big N audit firms and others.4

3.4 Nature of violations and penalties imposed

Another observable outcome of the enforcement process relates to the nature of the penalty

imposed by the SEC. The SEC can seek three main types of penalties against auditors: (i) orders

prohibiting similar violations in the future; (ii) monetary sanctions, such as fines, disgorgement orders,

and interest penalties; and (iii) orders suspending or expelling defendants from the auditing industry. In

theory, all sanctions are available against both audit firms and individual audit partners. The SEC, via an

administrative action, can also impose cease-and-desist orders, which largely represent a reprimand for

the auditor’s conduct. The SEC can also seek an undertaking by the defendants to introduce reforms in

their compliance process. In a court action, the SEC can seek to obtain an injunction prohibiting the

defendant from violating securities laws in the future. An enforcement process that goes easy on the

4 Of course, the unbiased hypothesis assumes that we account for the nature of the violations between Big N and

non- Big N firms before testing for a similar frequency of civil actions between Big N and non-Big N firms. We do

not find major differences in the nature of the violations levied against the Big N and non-Big N firms in Table 8

(discussed later).

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auditors, or towards the Big N auditors, is likely to be associated with milder alleged violations and

penalties. To control for differences in the underlying fraudulent reporting, we benchmark the penalties

imposed on Big N and non-Big N auditors against the nature of violations with which the SEC charges

them.

4.0 Data

Our initial sample comprises of all enforcement actions initiated by the SEC and Department of

Justice (DOJ) from January 1, 1977 to September 30, 2009.5 We access these enforcement actions on the

SEC’s website and collect information regarding whether the audit firm and/or auditors are also named in

the SEC action.6 As the SEC’s website reports data from 1996, we study 592 enforcement actions issued

by the SEC between January 1, 1996 and September 30, 2009. Details provided in the enforcement action

and COMPUSTAT allow us to identify an audit firm for 544 cases. In 109 of these cases, we find a

change in audit firm during the violation period. To avoid ambiguity about which auditor is potentially

responsible for the tainted financial statements, we exclude these 109 cases to obtain a final sample of 435

cases. Of these, in only 78 cases (about 18%), the audit firm and/or the auditor were also named in the

SEC enforcement action. 7 The sample selection process is summarized in Table 1. A list of all audit

firms whose clients were named defendants in SEC actions is provided in Appendix A. And, a list of the

audit firms that were specifically named as parties in an SEC action is provided in Appendix B.

4.1 SEC actions against auditors and Big N audit firms

5 The data have been collected, described and analyzed in Karpoff, Lee and Martin (2008 a,b). We thank Jonathan

Karpoff, Scott Lee and Gerry Martin for sharing this data with us. 6 By opting for this design, we have assumed that the SEC’s decision of which company or officer to pursue for

fraudulent reporting is exogenous to the question we are interested in. That is, within the set of actions taken by the

SEC against fraudulent firms and managers, we investigate what proportion of these actions also results in actions

against auditors. We believe that our research design, while not perfect, at least helps us benchmark the SEC’s

enforcement behavior against auditors relative to companies and officers. 7 An SEC action is considered to be an auditor related action if an audit firm or an employee of the audit firm is

named as a defendant in the enforcement. When an enforcement action names an individual associated with an audit

firm as a defendant, in most cases that individual happens to be the engagement partner on the audit. However,

there are some cases in which an employee of the audit firm other than the engagement partner is named as a

defendant. We do not make a distinction between whether an engagement partner or some other employee of the

audit firm is named and collectively refer to them as partners.

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We begin by examining the auditor choice of all firms with available data on COMPUSTAT. As

expected, Big N audit firms have a large market share – they audit about 72% of all firm years over our

sample period (see Table 2, panel A). The remaining 28% of firm years are audited by other auditors,

referred to as non-Big N firms. During our sample period (i.e., 1996-2009) the Big N client firms account

for 76% of all SEC actions in our sample, which is significantly higher, at the 5% level, than 72%, which

is the Big N’s share of the audit market.8 However, as seen in Table 2, Big N audit firms account for only

44% of cases where the SEC charged the auditor for negligence. The lower share of Big N audit firms

among SEC actions where the auditor is named, in comparison to their share of misreporting firms, is

significant at the 1% level. In contrast, clients of non-Big N audit firms account for 24% of the

misreporting cases although the SEC accuses non-Big N auditors of negligent audits in 56% of cases.

This evidence raises the initial possibility that the SEC is biased in favor of the Big N audit firms.9

Our sample period, ranging from 1996 to 2009, is characterized by the passage of SOX. SOX not

only increased the regulatory oversight of the SEC but also led to the establishment of the PCAOB, an

institution specifically set up to monitor the auditing industry. We examine whether these regulatory

changes had an impact on the SEC’s propensity to charge Big N audit firms. SEC enforcement actions

are classified as pre SOX if the first SEC regulatory action is dated before July 30, 2002. As can be seen

in panel B of Table 2, there are significant differences between the pre and the post SOX period. In the

pre SOX period, Big N audit firms serviced a larger proportion of the market (80%).10

However, the

8 Another potential area of inquiry is to investigate a tilt in favor of auditors and Big N firms in a sample of Wells’

notices, which represent letters sent by the SEC to firms or individuals against whom the SEC is planning to bring

an enforcement action. Unfortunately, Wells notices are not publicly available. We have filed a FOIA (Freedom of

Information Act) request with the SEC to obtain these notices and we await the SEC’s action in this regard. As an

aside, we were told that the SEC did not have a formal process of tracking such notices before the year 2011.

Hence, we are unlikely to obtain these notices in a timely manner to allow a meaningful analysis.

9 Alternatively, the SEC has been unsuccessful at proving that Big N auditors were negligent in audits or were

complicit in the misreporting by the client. However, if the SEC is systematically less successful at implicating Big

N auditors, it could simply suggest that the Big N can out-spend the SEC in their defense.

10

Note that the Big N audit firms in the pre SOX period include Arthur Anderson.

15

clients of Big N audit firms have a significantly lower share (67%) among firms accused of

misrepresentation during this period. This is consistent with the evidence in Lennox and Pittman (2010a)

who also find that clients of Big N audit firms had a lower incidence of alleged fraud in the pre SOX

period.11

Conditional on misrepresentation by client firms, we continue to find that the SEC was less

likely to name Big N audit firms in the pre SOX period. Specifically, Big N audit firms were named in

only 38% of cases against auditors even though they audited 67% of misreporting firms and this

difference is significant at the 1% level.

In the post SOX period, although Big N audit firms account for 64% of all audits, their share of

the audits of misreporting firms is significantly higher at 82%. Big N firms account for only 52% of all

cases against auditors, which is significantly lower at the 1% level relative to their share (82%) of

misreporting firms. In summary, the post SOX period saw a decline in the market share of Big N audit

firms and in the quality of their audits, as captured by the likelihood of their client firms being charged for

financial misrepresentation by the SEC. More important, after the passage of SOX a greater proportion of

SEC actions against auditors are directed towards Big N auditors. However, the SEC is less likely to

target Big N audit firms relative to non-Big N firms, both before and after the passage of SOX.

4.2 Multivariate analysis

In our analysis thus far, we have not controlled for confounding factors that influence whether an

auditor is named in the SEC enforcement action. In this section, we discuss relevant factors that point to

the potential culpability of the auditor and control for them. The dependent variable, referred to as

AUDITOR_NAMED, is an indicator variable that takes on the value of one when the auditor is named in

the SEC enforcement action. The variable, AUDITOR_NAMED, is set to zero for SEC enforcement

actions against corporate offenders where the auditor has not been specifically named as a culpable party

by the SEC.

11

Using a sample spanning the years 1981 to 2001, Lennox and Pittman (2010a) find a negative association between

audits by Big Five firms and incidence of alleged fraud. However, they do not examine the post SOX period.

16

All auditors, and especially Big N auditors, are more likely to discover larger and more egregious

misreporting. We consider several proxies for the magnitude and severity of the misreporting.

Specifically, we include the length of the violation period (VIOLENGTH) as identified by the SEC in the

enforcement action. The greater the violation period, the longer was the fraud perpetrated by the

defendant firm. The average VIOLENGTH in our sample is 34 months, as shown in Table 3. SEC

actions that are also accompanied by class action litigation are likely to be more severe. Hence, we

include an indicator variable to identify whether the SEC action was accompanied by class action

litigation against the defendant firm (TARGET_LIT). Table 3 reports that about 64% of the SEC actions

were accompanied by class action litigation. Another indication that the violation was severe is whether

the target firm is required to restate its financial statements. We find that in 76% of the cases, target firms

restated and the indicator variable TARGET_RESTATE takes the value of one. Finally, we identify

whether SEC action against the defendant company involves an administrative action and/ or a court

proceeding. Court proceedings indicate tougher action by the SEC and are hence more likely to indicate

severe violations. Court actions are brought against the target firm or its managers in 85% of the cases

and are captured by the indicator variable, TARGET_COURT. Finally, we include the three day stock

price reaction of the defendant company on the trigger date when news about the wrongdoing is revealed

(EWCAR). The more egregious the violation, the greater is the stock price decline on the announcement

of the violation. The average announcement return for our sample firms is -21%.

We also include controls for the client firm’s characteristics. Following Lawrence, Minutti-Meza

and Zhang (2011) who find that firm size (MKTCAP), asset turnover (SALES/AT), current ratio

(CA/CL), leverage (DEBT/AT), and performance (NI/AT) are likely to explain a company’s choice of a

Big N auditor, we include these variables in our estimation as control variables. The main variable of

interest is BIG N which takes the value of one if the target firm is audited by one of the Big N audit firms.

We also include an indicator variable, POST SOX, that takes the value of one for all SEC enforcement

actions that were initiated after July 2002. Further, we introduce interactions of these variables with

17

POST SOX to ascertain whether the SEC’s targeting policy changed after the passage of SOX. In

summary, we estimate the following probit model:

AUDITOR NAMED = f (BIG N, POST SOX, EWCAR, VIOLENGTH, TARGET_LIT,

TARGET_RESTATE, TARGET_COURT, MKTCAP, SALES/AT,

CA/CL, DEBT/AT, NI/AT, INTERACTIONS WITH SOX) (1)

Results drawn from the estimation of the model are reported in Table 4. The usable sample falls

considerably from 435 cases to 244 cases when we constrain the sample to firms with all available data on

COMPUSTAT and CRSP. Hence, we report a version of the model without firm characteristics (model

1) and with all available data (model 2). In model 1, the coefficient on BIG N is negative and significant

(coefficient = -0.3282, p < 0.001) suggesting that Big N auditors are less likely to be named in SEC

actions. The coefficient on POST SOX is not significant and neither is its interaction with BIG N,

suggesting that the SEC’s likelihood of naming a Big N auditor does not change after the passage of

SOX. The severity of the violation, as captured by VIOLENGTH, is positively associated with the

likelihood of the auditor being named (coefficient = 0.0036, p = 0.03). However, this factor is less likely

to matter after the passage of SOX as the interaction of VIOLENGTH and POST SOX is negative and

significant.

In model 2, we also control for firm characteristics and their interactions with the POST SOX

variable. However, as mentioned above, these additional data demands further reduce the sample size.

Inclusion of firm level characteristics in the model does not materially impact our results. The coefficient

on BIG N continues to be negative and significant (coefficient = -0.2416, p- value = 0.04) suggesting that

Big N auditors are less likely to be named in SEC actions. Although the coefficient on POST SOX is not

significant, the coefficient on its interaction with BIG N is positive and significant (coefficient = 0.2867,

p-value = 0.02) suggesting that the likelihood that a Big N auditor is named by the SEC increases after

SOX. Overall, results from this smaller sample indicate that although there is a significant enforcement

tilt in favor of the Big N audit firms, such tilt attenuates after the passage of SOX. In sum, the evidence

18

suggests that SEC is significantly less likely to charge Big N auditors for culpability in financial

misrepresentation.

4.3 Actions against individuals or firms

Table 5 reports data on whether the partner or the audit firm was targeted by the SEC. Given the

ambiguity in interpreting this data to evaluate the aggressiveness of SEC enforcement, we merely present

the data for completeness. We find that the audit firm is named in 31% of all cases (24 out of 78 cases)

against auditors, suggesting a significant preference for naming the individual partner instead. Gadinis

(2009), in his study of SEC actions against broker dealers, finds that the SEC files charges of corporate

liability in 40% of the cases against big brokers and in only 10% of the cases against small brokers. In

contrast, the SEC does not appear to discriminate between Big N and the non-Big N when naming audit

firms. The SEC names the Big N firm 27% of the time (9/34 cases) as opposed to 34% of the time when

non-Big N firms are involved (15/44 cases). Given the ambiguity in assessing whether the naming the

audit firm or the partner is indicative of more aggressive enforcement, we do not take a strong stand on

the evidence presented.

4.4 Administrative or court actions

Details on whether the SEC chooses administrative or civil action against auditors are provided in

Table 6. Sixty one of the 78 cases (78%) against the auditors involve exclusive administrative actions.

This is significantly lower than the analogous proportion for SEC actions against the client firms. For

client firms, only 67 of the total 435, i.e., 15% of the cases involve administrative actions. The greater

use of civil proceedings against client firms relative to auditors is highly significant. This evidence

suggests that the SEC appears to go easier on auditors relative to corporate defendants, which can

partially be attributed to the fact that the corporate defendants are more likely to be the main perpetrators

of the alleged fraud. However, that argument does not fully account for the overwhelming tilt in favor of

administrative actions against auditors (78% v/s 15%). Although SEC enforcement for auditors appears

19

to be milder relative to those against client firms, there is no significant difference in such enforcement

between Big N and non-Big N auditors.

4.5 Nature of the penalties

Table 7 reports data on (i) the penalties sought; and (ii) the distribution of these penalties across

Big N auditors relative to other auditors. A detailed description of the penalties can be found in Appendix

C. The data reveal four interesting patterns. First, temporary denial of privilege is the most popular

penalty as it accounts for about 72% of penalty events (56/77 events) sought under administrative

proceedings. The SEC imposes the more onerous permanent denial of privilege in only 26% of the cases

(20/77 events). Another potential penalty is a disgorgement award that forces the defendant to give up

profits obtained by acts deemed illegal or unethical. As can be seen from Table 7, there are eight

instances of disgorgement awards, with the most common disgorgement award being less than $100,000

(five cases). The data suggest that the SEC rarely imposes disgorgement awards against auditors and

when imposed, it is usually a slap on the wrist.

Second, most of the penalties are imposed on individual partners and not on audit firms. For

instance, 56 (19) individual partners and only nine (four) audit firms have been subject to temporary

(permanent) denial of privilege. 12

Censure, the mildest penalty that involves an expression of strong

disapproval or harsh criticism, was the commonly employed penalty against the audit firm (43% of all

penalties on audit firms: 10/23 cases).

Third, penalties against audit firms are usually targeted at the non-Big N firms. For instance, all

the nine cases of the temporary denial of privilege have been imposed on a non-Big N audit firm. A Big

12

There are four cases where a non-Big N firm has been subject to permanent denial of privilege. These are 1) Eli

Buchalter Accountacy Corporation with details at http://www.sec.gov/litigation/admin/3437702.txt 2) Michael,

Adest, & Blumenkrantz PC with details at http://www.sec.gov/litigation/admin/34-41284.txt, 3) Schnitzer &

Kondub PC with details at http://www.sec.gov/litigation/admin/34-42979.htm and 4) BDO Cyprus with details at

http://www.sec.gov/litigation/litreleases/lr17776.htm

20

N audit firm has never been subjected to either a temporary or a permanent denial of privilege in our

sample. Only small and local audit firms have been sanctioned with permanent denial of privilege. 13

Four, cease and desist orders are more likely to be imposed on non-Big N auditors (17/25

instances). However, less onerous sanctions such as censures and signing an undertaking to introduce

reforms are more likely to be levied on Big N auditors (9/11 censures and 7/10 undertakings). Turning to

the data on civil proceedings, where punitive actions are decided by the courts and not the SEC, we find

that the distribution of penalties between Big N and non-Big N firms and partners is more balanced (7/15

for Big N auditors).

A plausible explanation for this pattern is that Big N audit firms are charged with less severe

violations relative to the non-Big N audit firms. To evaluate this conjecture, we tabulate the nature of

violations that the SEC charges the audit firms with. A detailed explanation of the violations can be

found in Appendix D. As reported in Table 8, the most common violation, about 46% (79 of 173 cases)

stems from unethical or improper professional conduct. The other two common violations, accounting for

another 27% each (48/173 cases) relate to periodic filing regulations and anti-fraud provisions. More

relevant for our purpose, columns 2 and 3 report the distribution of the violations for Big N audit firms

and others. We also report statistical differences, if any, between the frequency of violations leveled

against Big N and non-Big N groups. As can be seen, of the three most frequently observed violations,

only one violation and that too the most infrequent of the three (anti-fraud provisions), is weakly different

between the two groups. Thus, there appears to be little material difference between the Big N and other

audit firms in the distribution of the alleged violations. This, in turn, suggests that there should not be a

major difference in the penalties on the Big N auditors relative to the other auditors. In sum, we believe

this analysis indicates that the SEC imposes relatively laxer penalties on auditors, in general, and on Big

N firms and partners, in particular.

13

A potential explanation for this pattern could be that the SEC is hesitant to sanction a Big N audit firm with a

temporary denial of privilege because such an action may penalize several thousand clients of the firm who were not

involved in the alleged fraud and lack culpability (Margolis 1978). On the other hand, denial of privilege to small

and local firms is likely to impact fewer clients. To us, that explanation seems consistent with the “too big to fail”

hypothesis.

21

To conclude, we believe our evidence is consistent with the lax SEC enforcement against auditors

hypothesis with a tilt in favor of Big N auditors because (i) the SEC is less likely to pursue Big N audit

firms relative to the smaller audit firms, even after controlling, as best as we can, for the severity of the

fraud and the inherent firm characteristics of firms that choose to buy audits from Big N firms; (ii) the

SEC is disproportionately more likely to pursue relatively lenient administrative actions rather than civil

actions against auditors; (iii) the overall nature of penalties imposed by the SEC against auditors appear

relatively mild but after considering the frequency of the alleged violations between Big N and non-Big N

auditors, the SEC seems to impose harsher penalties on the non-Big N auditors.

In the following section, we consider the role of supplementary enforcement, either by public

regulators (the PCAOB) or private bodies (class action lawyers and the product market for audit services).

5.0. Other enforcement activity against auditors

The SEC is not the only regulatory body that can potentially bring disciplinary action against

auditors. In this section, we examine the role of other agencies and their record in monitoring auditors.

Benston (2003) notes that the state accountancy boards and the American Institute of Certified Public

Accountants (AICPA) can but rarely discipline wayward auditors. 14

In particular, Benston (2003) claims

that the AICPA closed the vast majority of ethics cases without taking disciplinary action or publicly

disclosing the results, but instead issued confidential letters directing the offenders to undergo training.

Moreover, he cites an investigative report by the Washington Post (2001) of a decade of SEC

enforcement action which finds: “The state of New York, which had the most accountants sanctioned by

the SEC, as of June had disciplined [only] 17 of 49 New York accountants.” Consistent with these

criticisms, Lennox and Pittman (2010b) find that PCAOB’s inspection reports are not valuable in

signaling audit quality and less is known about audit firm quality since the PCAOB began conducting

inspections.

5.1 PCAOB actions

14

AICPA is the national professional organization of Certified Public Accountants (CPAs) in the United States with

more than 394,000 members. It sets the ethical standards for the profession and U.S. auditing standards for audits of

private companies, non-profit organizations, federal, state and local governments.

22

The PCAOB was set up by SOX to protect the interest of investors and further the public interest

in the preparation of informative, accurate and independent audit reports (U.S. Congress 2002).

Importantly, the PCAOB was expected to take up any regulatory slack left by the SEC in disciplining

auditors. To examine whether that is indeed the case, we collect data on PCAOB actions against auditors

over the period May 24th 2005 to September 24

th 2009. As seen in Table 9, panel A, the PCAOB has

initiated 26 cases against audit partners or their firms. The pattern of the PCAOB’s enforcement is

similar to that of the SEC’s enforcement in that they are directly predominantly against non-Big N

auditors. In 21 instances, the PCAOB initiated an enforcement action against non-Big N auditors in

contrast to only five cases against Big N auditors. Though the PCAOB is more likely to charge partners

(24 cases) rather than firms (19 cases), it appears to be much less biased towards audit firms relative to

the SEC. Specifically, based on Table 5, we find that only 30% of the SEC cases (24/78 cases) charge an

audit firm while 73% of PCAOB enforcement events name the audit firm.

Panel B details the nature of the penalty imposed by the PCAOB. The vast majority of penalties

fall in two categories of disbarment from practice: (i) revocation of the registration with the board; and

(ii) barred from being an associated person of a registered public accounting firm. These industry bans

constitute a very serious punishment for auditor misconduct. Similar to the SEC, however, these industry

bans are targeted at non Big N firms and partners. In particular, all the 13 revocations are imposed on

non-Big N firms and 17 of the 21 partner bans are targeted at non-Big N partners. The third penalty

(censure) is also targeted predominantly at non Big N firms (six of the seven cases). In general, the data

seem somewhat sparse to draw conclusions about the efficacy of the PCAOB in disciplining auditors.

5.2 Private legislative action

Auditors can be privately sued in class action litigation for their complicity in the company’s

misconduct. Coffee (2002), among others, has argued that the Private Securities Litigation Reform Act

(PSLRA) passed in 1995 made it more difficult for class action plaintiffs to sue public firms for

accounting abuses. Moreover, the Securities Litigation Uniform Standards Act of 1998 abolished state

23

court class actions alleging securities fraud, increasing plaintiffs’ difficulty in suing accounting firms. In

particular, Coffee (2002) points to two court cases that made bringing lawsuits against auditors more

costly to plaintiffs. The first case was Lampf, Pleva, Lipkind & Petigrow v.Gilbertson, 501 U.S. 350,

359–61 (1991) which created a federal rule requiring plaintiffs to file within one year after they should

have known of the violation underlying their action, but in no event within more than three years after the

violation. Previously, the state-law-based rule allowed a lawsuit from five to six years. The second case

was Central Bank of Denver, N.A., v. First Interstate of Denver, N.A., 511 U.S. 164 (1994). In this case

the courts ruled that liability did not extend to “aiders or abettors” that participate in misstatements or

omissions in connection with the sale of securities. Thus, the Supreme Court's ruling reversed a long

history of court decisions and SEC enforcement actions where aiders and abettors, often banks,

accountants, trustees, and attorneys, were found liable under Rule 10b-5.

5.3 Class action lawsuits as complementary private enforcement

In this section, we report data on private class action litigation against auditors. The data on class

action litigation, and the parties charged, is gathered from the Stanford Class Action Clearinghouse

Database for the period January 1st 1996 to September 30

th, 2009. We find 728 class actions stemming

from alleged GAAP violations, as classified by the Stanford Clearing House. Information about the audit

firm signing off on the financial statements alleged to be misrepresented is available for 603 observations.

Because 43 of these cases involve a change in auditor from a Big N to a non-Big N auditor during the

class action period, we restrict our final sample to 560 class actions.

Panel A of Table 10 reports that about 90% of these financial statements underlying these 560

class action suits (503/560) were audited by Big N firms. This share of the Big N auditors among firms

with misconduct is significantly higher than their share (72%) of all public firms (see Table 10). Auditors

are named as defendants in 151 cases (27%). This is higher than the 18% of cases in which auditors are

named in SEC enforcement actions, suggesting that class action lawyers are more likely to pursue

auditors than the SEC.

24

Class action lawyers are more likely to pursue auditors in general and Big N firms in particular

relative to the SEC. In class action lawsuits where auditors are named as defendants, 80% of such cases

involve Big N auditors. This share of Big N is significantly lower than their share of misrepresenting

firms (90%). However, the gap between the Big N’s share of lawsuits versus their share of tainted

financial statements (80%-90%) is smaller than the analogous gap of -32% for SEC actions, discussed in

Table 2. Panel B of Table 10 examines the pre SOX and the post SOX period separately. Overall, the

patterns in pre and post SOX samples are similar to the patterns in the full sample. In sum, the data

suggest that private enforcement, via class action lawsuits, is more aggressive than public enforcement,

via SEC action, especially against Big N audit firms.

6.0 Reputation based enforcement

Finally, we turn to an evaluation of whether the market penalizes audit firms by taking away their

business if they or their client firms are subject to SEC enforcement. Prior work has reported little

evidence consistent with such a reputation hypothesis in the context of U.S firms (e.g., Johnson and Lys

1990, Wilson, Jr. and Grimlund 1990, Menon and Williams 1994, Baber et al. 1995, Shu 2000, Chaney

and Philipich 2002, Barton 2005, Brown, Shu and Trompeter 2008, Landsman et al. 2009) partly because

it becomes difficult to empirically disentangle (i) whether clients did not defect from a tainted auditor,

especially a Big N firm, because the reputation hypothesis does not work or; (ii) whether the client prefers

to stay with the Big N auditor because the threat of litigation against such an auditor ensures a higher

quality audit (“ insurance hypothesis”).15

We believe our setting has more power ex ante to identify

reputational effects, should they exist, as the SEC, the apex monitoring body in the U.S., has directly

charged the auditor with negligence. Hence, one would think that the ability of that tainted auditor to

insure the client against the risk of litigation has been severely compromised, thereby rendering the

insurance cover against litigation less effective.

15

Authors have had greater success in documenting evidence in favor of the reputation hypothesis from the

litigation hypothesis abroad where the risk of the client getting sued is negligible (e.g., Lennox 1999, Weber et al.

2008; Skinner and Srinivasan 2012).

25

To shed light on the reputational losses, if any, we evaluate whether enforcement activity against

an audit firm or against a client leads to greater loss of clients for that tainted audit firm. The dependent

variable is the change in the number of clients served by a specific audit firm relative to the previous year

(i.e., the number of clients in year t minus the number of clients in year t-1, where t is the year of issue for

an SEC action). The key treatment variable is the number of SEC actions in which an audit firm or its

partner is named as a defendant by the SEC in the previous year (SEC AUDITORS). Because auditors

are likely to be tainted by association with a culpable company, we include the variable, SEC CLIENTS,

which equals the number of clients of the auditor that had a SEC action issued against them in the

previous year. We also introduce the number of client firms in the previous year as a control variable.

To control for re-assignment of client portfolios following the passage of SOX, we add an

indicator variable for the post SOX period that takes the value of one for the years 2003 and later, and

zero otherwise. BIG N, the indicator variable for Big N audit firms, is added to examine the possibility

that such firms are differently impacted by SEC action relative to the smaller audit firms. As reputational

losses and the resulting change in clients are larger for more severe violations, we control for the nature of

the violation. Like before, we include EWCAR, the average cumulative abnormal return for the three

days centered on the trigger date for client firms that were subject to SEC action in the previous year.16

We also insert VIOLENGTH, the average length of the violation period of all SEC enforcements issued

against client firms in the previous year, CLIENT LIT the number of clients that were subject to both

SEC enforcement and class action litigation, and CLIENT RESTATE, the number of clients that were

subject to SEC action and had to restate their financial statements.

The results are displayed in Table 11. As seen in model 1, the coefficient on both SEC_CLIENT

and SEC_AUDITOR is not statistically significant, implying no loss in market share after clients or

auditors are subject to SEC action. To examine whether the loss in clients occurs only when the

16

The trigger date is the date of discovery of the violation. The three day cumulative abnormal returns is the equally

weighted CAR from a market adjusted model. The variable included is the average CAR for all client firms that

were subject to SEC enforcement during the year. Similar methodology was also used to estimate the other proxies

for the severity of the violation.

26

frequency with which clients or auditors are named is extreme, we create a variable labeled SEC_90 that

takes the value of one if the sum of the number of clients that are subject to SEC action in the previous

year and the number of cases in which the auditor was named in the previous year is in the top 10% over

our sample period. We also include a variable titled SEC_500, defined as the number of clients that are

members of the S&P 500 index that are subject to SEC actions in the previous year, to capture the

differential impact of high profile and visible clients facing charges of financial misrepresentation. As

can be seen in model 2, the insertion of SEC_90 and SEC_500 do not change the results – there continues

to be little to no evidence of a loss of market share after clients or the auditing firm is subject to SEC

enforcement action.

The years 2001 and 2002 were special given that the demise of Arthur Anderson caused a lot of

Anderson clients to leave and join other audit firms. This turmoil potentially caused patterns in gain and

loss of clients to be different during these years (Barton 2005). However, eliminating these years from

the sample is not conceptually straightforward as the loss of Anderson’s clients potentially constitutes a

powerful test of the reputation hypothesis. Nevertheless, as a sensitivity check, we repeat our analysis

after excluding the years 2001 and 2002. As seen in model 3, the coefficient of SEC_CLIENTS is

negative and almost significant with a p value of 0.13. In model 4, we find that the coefficient of SEC90

is negative and significant at the 4% level. Most of the other control variables are insignificant suggesting

that the underlying reasons for changes in the number of clients are difficult to model and predict. In

summary, there is some evidence of a loss in market share for audit firms that, along with their client

firms, experienced a high incidence of SEC enforcement actions, when we exclude the years 2001 and

2002.

6.1 Do better clients switch auditors?

Finally, we examine the nature of firms that leave the auditor versus those that decide to continue

with them after the SEC sanctions an auditor. Our objective is to better understand which clients care

about their auditors being accused of negligent behavior by the SEC. In particular, we investigate

whether better quality companies – bigger, more profitable, or less risky – decide to change auditors, if

27

their auditor has named in an SEC enforcement. If the reputation hypothesis were to be supported, we

would expect such better quality clients, who care most about their own reputations, to defect. Consistent

with Choi et al. (2004), Table 13 reports the financial characteristics of Big N clients that changed their

auditor and those that continued with the same auditor in the year following the SEC actions against their

auditor.17

Panel A of Table 12 reports characteristics (total assets (TA), the current ratio (CR), the net profit

margin (NPM), the ratio of cash flows to liabilities (CFTL) and Zmijewski’s distress score (ZMJ)18

of the

clients that stay and leave for each of the Big N auditors separately. In Panel B of Table 12, we compare

the defecting clients with continuing clients for all the Big N auditors as a single group and find that

smaller clients and those with lower cash flow to liabilities ratios are more likely to depart. Overall, it

does not appear as though better quality clients impose significant penalties on auditors by switching

away from tainted audit firms. Our findings are consistent with those of Wilson, Jr. and Grimlund (1990)

who document that Big 8 audit firms that were sanctioned by the SEC during the period 1976-1986 were

more likely to lose market share in smaller client market segment. We would have found evidence

suggesting defections by larger and less distressed companies, if loss of reputation were a driving factor.

This evidence contrasts with (i) earlier work that has documented severe negative penalties for managers

and directors associated with fraudulent financial statements (Srinivasan 2005; Desai et al 2006; and

Karpoff et al. 2008b); and (ii) audit firms’ claims that reputational mechanisms are enough to ensure that

they function effectively (U.S. Treasury 2008). Absence of reputational penalties from the product

market is potentially consistent with the “too big to fail” hypothesis. Audit clients perhaps believe that

switching auditors on reputational grounds is too costly given that they will have to switch to another Big

N firm, which, on the margin, is equally immune to failure caused by regulatory pressure.

17

We are unable to perform this analysis for non-Big N audit firms because in 41 out of the 44 cases of AAERs

against non-Big N auditors we are unable to identify the exact identity of the audit firm. COMPUSTAT codes these

cases as “other auditors” and lumps several non-Big N auditors together in this category. 18

Zmijewski’s distress score is calculated as -4.336 – 4.512EBITA + 5.679TLTA + 0.004CR; where EBITA is

earnings before interest and tax, TLTA is the ratio of total liabilities to total assets and CR is the ratio of current

assets to current liabilities.

28

7. Conclusions

Several recent developments such as the accounting scandals of the past decade, the demise of

Arthur Andersen, and legal obstacles against suing auditors, have raised questions about the effectiveness

of regulatory enforcement against auditors. Some critics are also worried that the revolving door between

the SEC and Big N audit firms, in particular, could lead to a cozy relationship between the regulated and

the regulator. Our paper offers some of the first comprehensive empirical account of the enforcement

record, especially that of the SEC, against audit firms and audit firm partners.

The analysis shows that the SEC is less likely to initiate disciplinary proceedings against audit

firms and partners, relative to companies and managers that are charged with fraudulent misrepresentation

of financial statements. In particular, the SEC charges an auditor in 18% of the cases where the SEC files

an enforcement action against the company or a manager. Conditioned on charging an auditor, the SEC is

less likely to name a Big N auditor as a defendant relative to a non-Big N auditor, after controlling for

both the egregiousness of the reporting fraud committed by the company and for the characteristics of

companies more likely to be audited by Big N auditors. A closer look at the enforcement data indicates

that the SEC is more likely to pursue an administrative action against auditors rather than escalate the

matter to a civil action that is heard before an outside judge. With regard to penalties, monetary sanctions

and disgorgements are rarely imposed. Considering the absence of material differences in the nature of

the violations with which the Big N and non-Big N auditors are charged, the penalties imposed by the

SEC on the non-Big N auditors appear harsher.

However, private enforcement via class action lawsuits is more aggressive than public

enforcement via the SEC. That is, class action lawyers are more likely to pursue auditors, especially the

Big N firms, more frequently than the SEC. There is some evidence to suggest that an extreme number of

SEC actions against an auditor results in a loss of that auditor’s market share. However, the reputational

damage stemming from the loss of clients is limited because the clients that leave are not the bigger,

better or more visible clients. Collectively, we view our findings as a starting point for a broader and

29

deeper academic inquiry into the SEC’s efficacy at monitoring one of the most important gatekeepers of

capital markets - the auditors.

30

Appendix A: Auditors of clients that are subject to SEC enforcement actions in the sample The table displays the number of SEC enforcement actions against the client firm of each auditor over the sample

period of 1996 to September 2009. The year reflects the year of the first regulatory enforcement action issued by the

SEC against the client firm.

96 97 98 99 00 01 02 03 04 05 06 07 08 09 Total

Arthur Andersen 1 2 1 1 4 4 5 7 3 1 1 30

Arthur Young 1 1

Coopers & Lybrand 6 3 1 2 1 4 2 1 20

Ernst & Young 4 1 3 1 3 6 4 9 2 5 10 9 3 8 68

Deloitte & Touche 2 2 1 5 2 5 7 8 8 3 8 5 3 3 62

KPMG 2 2 1 4 1 6 7 9 9 6 5 4 4 2 62

PWC 1 4 1 1 6 1 12 9 9 6 9 13 9 6 87

BDO Seidman 1 1 1 1 1 1 1 7

Grant Thornton 2 1 1 2 1 7

Laventhol & Horwath 1 1

Moore Stephens 1 1 2

Pannell Kerr Foster 1 1 2

Richard A. Eisner 1 1 2

Others 12 10 5 4 5 4 6 9 5 7 4 1 4 8 84

Total 33 25 14 21 23 27 48 53 37 30 36 36 24 28 435

31

Appendix B: Auditors that are specially named in SEC enforcement actions as culpable

The table displays the auditors that have been specifically named in SEC enforcement action over the sample period

of 1996 to September 2009. The year reflects the year of the first regulatory enforcement action issued by the SEC

in which the auditor is named as a defendant.

.

96 97 98 99 00 01 02 03 04 05 06 07 08 09 Total

Arthur Andersen 1 2 2 3 3 11

Coopers & Lybrand 1 1

Ernst & Young 1 1 1 3

Deloitte & Touche 1 2 1 4

KPMG 1 1 1 1 1 5

PWC 1 1 3 1 1 2 1 10

BDO Seidman 1 1

Moore Stephens 1 1 2

Others 7 4 3 4 3 3 3 4 3 1 3 1 2 41

Total 8 5 4 6 6 7 13 11 5 4 6 0 1 2 78

32

Appendix C: Description of penalties imposed by the SEC

Penalties imposed under administrative proceedings

Censure An expression of strong disapproval or harsh criticism.

Cease-and-Desist Order An order prohibiting a party from committing or causing any

violations and future violations of an act or law.

Undertaking (policies and procedures) An undertaking by the defendant to introduce reforms and changes

in their policies and procedures.

Undertaking (monetary) An undertaking by the defendant to pay a certain amount of money

as a penalty.

Undertaking (temporary suspension of

service)

An undertaking by the defendant to suspend service temporarily to

implement undertakings concerning policies and procedures and not

accept new engagements for public company audits during this time.

Disgorgement Order forcing the giving up of profits obtained by acts deemed

illegal or unethical.

Denial of Privilege An order denying the subject the privilege to appear or practice

before the Commission as an accounting. The denial of privilege

maybe temporary (i.e., the subject can submit an application to be

reinstated as an accountant) or permanent.

Penalties imposed under court proceedings

Civil actions Disgorgement Order forcing the giving up of profits obtained by acts deemed

illegal or unethical.

Civil Monetary Penalty A punitive fine imposed by a civil court on the defendant that has

profited from illegal or unethical activity.

Permanent Injunction A final order of a court that the defendant refrain from certain

activities permanently (e.g., refrain from future violation of certain

rules and laws).

Criminal Actions Special Assessment An order requiring the defendant to pay a special fine or fee.

Fine A monetary charge imposed on the defendant.

Probation A period of supervision over the defendant ordered by the court.

Imprisonment Order requiring the confinement of the defendant in a prison.

33

Appendix D: Description of the violations charged by the SEC

Violation

Type

Relevant Regulation and

Rule

Description of the rule

Unethical or

improper

professional

conduct

Rules 102(e)(1)(ii), 102(e)(2),

and 102(e)(3)(i) of the

Commission’s Rules of

Practice

Under Rule 102(e), the Commission can censure, suspend or

bar professionals who appear or practice before it. Specifically,

pursuant to the rule, the Commission can impose a sanction

upon a professional whom it finds, after notice and an

opportunity for hearing:

(i) Not to possess the requisite qualifications to represent

others; or

(ii) To be lacking in character or integrity or to have engaged in

unethical or improper professional conduct by violating

applicable professional standards; or

(iii) To have willfully violated, or willfully aided and abetted

the violation of, any provision of the Federal Securities laws or

the rules and regulations thereunder.

Periodic (annual

and quarterly)

filing provisions

Rules 13a-1 and 13a-13 under

Section 13(a) of the Securities

Exchange Act of 1934, and

Rule 12b-20 promulgated

thereunder

Rules 13a-1 and 13-13 require issuers with securities registered

under Section 12 of the Securities Exchange Act to file

quarterly and annual reports with the Commission to keep this

information current, true and correct. Rule 12b-20 requires

disclosure of such additional information as may be necessary

to make the required statements not misleading.

Antifraud

provisions

Rule 10b-5 under Section

10(b) of the Securities

Exchange Act of 1934

Rule 10b-5 prohibits a person, in connection with purchase or

sale of a security, from making an untrue statement of a

material fact or from omitting to sate a material fact necessary

to make statements made, in light of the circumstances under

which they were made, not misleading. An auditor violates

Rule 10b-5 if he/she prepares and certifies publicly-filed

financial statements that he know, or is reckless in not

knowing, are false or issues a false audit report.

Record keeping

provisions

Section 13(b)(2)(A) of the

Securities Exchange Act of

1934

Section 13(b)(2)(A) requires Section 12 of the Securities

Exchange Act registrants to make and keep books, records, and

accounts that accurately and fairly reflect the transactions and

dispositions of their assets.

Fraudulent

interstate

transactions

Section 17(a) of the Securities

Act of 1933

It shall be unlawful for any person in the offer or sale of any

securities or any security-based swap agreement by the use of

any means or instruments of transportation or communication

in interstate commerce or by use of the mails, directly or

indirectly—

(1) to employ any device, scheme, or artifice to defraud, or

(2) to obtain money or property by means of any untrue

statement of a material fact or any omission to state a material

fact necessary in order to make the statements made, in light of

the circumstances under which they were made, not

misleading; or

(3) to engage in any transaction, practice, or course of business

which operates or would operate as a fraud or deceit upon the

purchaser.

34

Appendix D: Description of the violations charged by the SEC (cont’d)

Internal control

provisions

Section 13(b)(2)(B) of the

Exchange Act of 1934

Every issuer with registered securities shall devise and

maintain a system of internal accounting controls to ensure –

1) Transactions are executed in accordance with management’s

general or specific authorization

2) Transactions are recorded as necessary (I) to permit

preparation of financial statements in conformity with GAAP

or any other criteria application to such statements, and (II) to

maintain accountability for assets;

3) Access to assets is permitted only in accordance with

management’s general or specific authorization; and

4)The recorded accountability for assets is compared with

existing assets at reasonable intervals and appropriate action is

taken with respect to any differences.

Accountants’

reports

Section 210.2-02 of

Regulation S-X

This comprises (a) Technical requirements, (b) Representations

as to the audit, (c) Opinion to be expressed, and (d) Exceptions.

Audit

requirements

Section 10(A) of the Securities

Exchange Act of 1934

In general, Section 10(A) details procedures that shall be

included in in each audit of a registrant under the Securities

Exchange Act by a registered public accounting firm and the

required response to audit discoveries. Section 10(A) provides

that each audit shall be conducted in accordance with generally

accepted auditing standards, as may be modified or

supplemented from time to time by the Commission.

Others This includes violations under Prohibitions relating to interstate

commerce and mails, Registration requirements for securities,

Registration and regulation of broker dealers, Reporting

provisions relating to forms 10-K and 10-Q, Anti-bribery

provisions, Making false statements, Fraud by wire, radio or

television, Falsification in federal investigations and

bankruptcy, Money laundering, racketeering, conspiracy and

racketeering conspiracy

35

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39

Table 1: Sample selection

This table lists the sample selection procedure.

Total AAERs issued by the SEC between January 1st, 1996 and September 30

th, 2009

Less:

AAERs with missing auditor information

AAERs involving a change in auditor during the violation period

Final Sample

AAERs in which either the audit firm, an audit partner (s), or both are named as

defendants

592

48

109

435

78

40

Table 2: SEC enforcement actions

Panel A: This table presents the frequency of enforcement actions filed by the SEC over the entire sample period

sorted by the type of the auditor. All percentages have been rounded off to the nearest whole percent. The t-statistic

for the difference in means is presented in parentheses. *, **, *** - represent significance at 10%, 5% and 1% levels

based on two-sided p-values. a

represents all firm years on COMPUSTAT that for which we can find an audit firm.

COMPUSTAT Firm-Years SEC Enforcement Actions SEC Actions against

Auditors

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Totala

116,007

100

435

100

78

100

Audited by Big

N Auditors 83,082 72 330 76 34 44

Audited by

Non-Big N

Auditors

32,925 28 105 24 44 56

Tests for the difference in means for the proportion of Big N auditors

COMPUSTAT sample vs. SEC enforcement sample (72% vs. 76%) -4%

(-2.06)**

All SEC actions sample vs. SEC actions against auditors sample (76% vs.

44%)

32%

(5.37)***

41

Table 2: SEC enforcement actions (cont’d)

Panel B: This table presents the frequency of enforcement actions issued by the SEC sorted by auditor type before

and after the passage of the Sarbanes-Oxley Act (SOX). The enactment date of SOX is July 30th

, 2002. All

percentages have been rounded off to the nearest whole percent. The t-statistic for the difference in means is

presented in parentheses. *, **, *** - represents significance at 10%, 5% and 1% levels based on two-sided p-values.

a represents all firm years on COMPUSTAT that are audited and have auditing firm information available.

PRE-SOX

COMPUSTAT Firm-

Years

All SEC Actions SEC Actions against

Auditors

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Totala

54,618 100 174 100 47 100

Audited by Big

N Auditors

43,579 80 116 67 18 38

Audited by

Non-Big N

Auditors

11,039 20 58 33 29 62

Tests for the difference in means for the proportion of Big N auditors

Pre-SOX: COMPUSTAT sample vs. All AAERs (80% vs. 67%) 13%

(3.66)***

Pre-SOX: All AAERs vs. AAERs against Auditors (67% vs. 38%) 28%

(3.54)***

POST-SOX

COMPUSTAT Firm-

Years

All SEC Actions SEC Actions against

Auditors

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Totala

61,389 100 261 100 31 100

Audited by Big

N Auditors

39,503 64 214 82 16 52

Audited by

Non-Big N

Auditors

21,886 36 47 18 15 48

Tests for the difference in means for the proportion of Big N auditors

Post-SOX: COMPUSTAT sample vs. All AAERs (64% vs. 82%) -18%

(-7.38)***

Post-SOX: All AAERs vs. AAERs against auditors (82% vs. 52%) 30%

(3.22)***

COMPUSTAT sample: Pre-SOX vs. Post-SOX (80% vs. 64%) 16%

(59.70)***

All AAERs sample: Pre-SOX vs. Post-SOX (67% vs. 82%) -15%

(-3.56)***

AAERs against Auditors sample: Pre-SOX vs. Post-SOX (38% vs. 52%) -14%

(-1.15)

42

Table 3: Descriptive Statistics

This table presents summary statistics for the sample of firms that were subject to SEC enforcement actions over the

period 1996 to September 2009. AUDITOR_NAMED takes the value of one if an audit firm and/or audit partner are

named as defendants in the SEC action. BIG N takes the value of one if the defendant firm is audited by a Big N

audit firm. POST SOX takes the value of one if the first regulatory action was initiated after the passage of SOX in

July 30 2002. EWCAR is the equally weighted cumulative abnormal return over three days centered on the trigger

date, which is the date on which the market finds about potential fraud. VIOLENGTH is the length of violation

period in months. TARGET_LIT takes the value of one if the firm is subject to class action litigation.

TARGET_RESTATE takes the value of one if the firm restates and TARGET_COURT takes the value of one if the

firm is subject to SEC court proceedings. MKTCAP is the market capitalization of the defendant firm two days

prior to the trigger date. SALES/AT is prior year sales (year t-1) scaled by average total assets of year t-2. CA/CL

is current assets in year t-1 scaled by current liabilities in year t-1. DEBT/AT is the long term debt plus debt in

current liabilities in year t-1 scaled average total assets in year t-2. NI/AT is net income of year t-1 scaled by

average total assets in year t-2.

Mean Median Min Max Std. Dev. N

AUDITOR_NAMED 0.1777 0 0 1 0.382 434

BIG N 0.758 1 0 1 0.429 434

POST SOX 0.601 1 0 1 0.490 434

EWCAR -0.210 -0.144 -0.938 0.278 0.227 300

VIOLENGTH 34 24 3 219 29.8 434

TARGET_LIT 0.638 1 0 1 0.481 434

TARGET_RESTATE 0.763 1 0 1 0.426 434

TARGET_COURT 0.846 1 0 1 0.361 434

MKTCAP (in millions) 5,830 321.32 1.32 351,203 27,698 328

SALES/AT 482 51 -2.48 10,593 1,343 324

CA/CL 2.70 1.9 0.003 33.5 3.22 298

DEBT/AT 152.24 8.01 -1.11 9,335.5 642.06 309

NI/AT 12 0.32 -425.18 1,024.20 98.84 324

43

Table 4: Model of the SEC’s likelihood of naming the auditor in an enforcement action This table reports the coefficients from a PROBIT regression where the dependent variable is AUDITOR_NAMED

that takes the value of one when the auditor is named in the SEC action. The sample includes all firms that were

subject to SEC actions over the period 1996 to Sept, 2009 with available data. The independent variables are

described in the prior table. *, **, *** represent significance at 10%, 5% and 1% levels based on two sided p-values.

Model 1 Model 2

Estimate p-value Estimate p-value

Intercept 0.3560 0.001*** 0.2401 0.14

BIG N -0.3282 <.001*** -0.2416 0.04**

POST SOX 0.0768 0.61 -0.2747 0.14

Severity of the Violation

VIOLENGTH 0.0036 0.03** 0.0038 0.07*

TARGET_LIT -0.0777 0.31 0.0582 0.60

TARGET_RESTATE 0.0617 0.39 -0.0795 0.45

TARGET_COURT 0.0568 0.47 0.0086 0.93

EWCAR - - -0.1547 0.49

Interactions with SOX

BIG N*POST SOX 0.0698 0.50 0.2867 0.02**

VIOLENGTH*POST SOX -0.0037 0.03** -0.0038 0.08*

TARGET_LIT*POST SOX 0.1416 0.11 -0.0338 0.78

TARGET_RESTATE*POST SOX -0.2101 0.03** 0.0438 0.75

TARGET_COURT*POST SOX -0.0704 0.47 -0.0134 0.90

EWCAR*POST SOX - - -0.0310 0.90

Firm Characteristics

MKTCAP - - 0.0000 0.851

SALES/AT - - 0.0000 0.09*

CA /CL - - -0.0075 0.32

DEBT /AT - - 0.0002 0.34

NI /AT - - -0.0007 0.46

Interactions with SOX

MKTCAP*POST SOX - - 0.0000 0.83

SALES/AT*POST SOX - - -0.0000 0.53

CA /CL*POST SOX - - 0.0276 0.02**

DEBT/AT*POST SOX - - -0.0002 0.28

NI/AT*POST SOX - - 0.0002 0.80

N 434 244

N (Auditor_Named=1) 77 30

Adj-R2 0.15 0.09

44

Table 5: Individual vs. corporate liability

This table tabulates the number of SEC actions that named audit firms, partners and both. The t-statistic for the

difference in means is presented in parentheses. *, **, *** - represents significance at 10%, 5% and 1% levels based

on two-sided p-values.

Defendants: Audit partner, audit firm, or both

Partner only Firm only Both Total

SEC actions against all auditors 54 3 21 78

SEC actions against Big N auditors 25 3 6 34

SEC actions against non-Big N auditors 29 0 15 44

Test for the difference in means

Between the audit firm being named in SEC

Actions against Big N auditor vs. non-Big N

auditor (“Firm only” and “Both” considered for

the test: (i.e., (6+3)/34 vs. (15+0)/44)

-0.08

(-0.72)

45

Table 6: Type of proceedings

This table presents the frequency with which the SEC launches administrative and civil proceedings. The

“Administrative only” column includes SEC cases with that are subject to only administrative proceedings. The

column “Civil” includes SEC cases subject to civil proceedings, many of which are also subject to administrative

proceedings. The t-statistic for the difference in means is presented in parentheses. *, **, *** - represents

significance at 10%, 5% and 1% levels based on two-sided p-values.

Proceedings: Administrative or

civil

Administrative

only

Civil Total

All SEC actions 67 368 435

SEC actions against auditors 61 17 78

SEC actions against Big N auditors 26 7 33

SEC actions against non-Big N auditors 35 10 45

Test for differences in means

Between the client firm vs. auditors being subject to civil

proceedings (i.e., 368/435 vs. 17/78)

0.63

(12.53)***

Between the Big N vs. Non- Big N auditors subject to a civil

proceedings (i.e., 7/33 vs. 10/45)

-0.01

(-0.11)

46

Table 7: Penalties imposed by the SEC against auditors

This table reports the penalties imposed by the SEC on audit firms and their partners. Detailed descriptions of what

the penalty entails can be obtained from Appendix C. Note that the total number of penalty events imposed in each

category does not add up to the number of SEC cases in which an auditor is charged as often more than one type of

penalty is imposed on the defendant.

Full Sample Upon Audit Partners Upon Audit Firms

Type of Proceedings Tot

al

Big N

Audit

ors

Non-

Big N

Auditor

s

Tot

al

Big N

Audit

ors

Non-

Big N

Auditor

s

Tot

al

Big N

Audit

ors

Non-

Big N

Auditor

s

Administrative Proceedings

Denial of Privilege

(temporary) 56 23 33 56 23 33 9 0 9

Cease and Desist Order 25 8 17 23 6 17 9 2 7

Denial of Privilege

(permanent) 20 8 12 19 8 11 4 0 4

Censure 11 9 2 3 2 1 10 8 2

Undertaking 10 7 3 0 0 0 10 7 3

Disgorgement 5 2 3 2 0 2 4 2 2

Total 77 33 44 74 30 44 23 8 15

Civil Proceedings

Civil actions

Permanent Injunction 12 7 5 12 7 5 3 2 1

Civil monetary penalty 7 3 4 6 2 4 2 1 1

Disgorgement 3 1 2 1 0 1 2 1 1

Total 15 7 8 15 7 8 5 3 2

Criminal actions

Imprisonment 2 1 1 2 1 1 0 0 0

Probation 1 1 0 1 1 0 0 0 0

Special Assessment 1 1 0 1 1 0 0 0 0

Fine 1 1 0 1 1 0 0 0 0

Total 2 1 1 2 1 1 0 0 0

47

Table 8 Nature of violations

This table reports the frequency of the type of violations committed by the defendant firms. The data is collected

from SEC enforcements actions against audit firms and their partners. Unethical or improper professional conduct

can arise if professional does not have requisite qualifications, engaged in unethical or improper professional

conduct or have willfully violated or aided in violating the regulations. Periodic filing provisions require the

professional to keep information current, true and correct. Antifraud provisions prohibit a person, in connection

with a sale or purchase of a security from making an untrue statement or omitting a material fact. A description of

other violations is provided in Appendix D. The t-statistic for the difference in means is presented in parentheses. *,

**, *** - represent significance at 10%, 5% and 1% levels based on two-sided p-values.

Type of Violation Frequency Type of Auditor

Big N Non-Big N

Unethical or improper professional conduct 79 35 44

Periodic (quarterly and annual) filing provisions a 25 10 15

Antifraud provisions b

23 6 17

Record keeping provisions 11 6 5

Fraudulent interstate transactions 8 4 4

Internal control provisions 6 4 2

Accountants’ reports 5 2 3

Audit requirements 5 2 3

Others c 11 4 7

Total 173 73 100

Tests for the difference in Big N vs. Non-Big N groups

Charged with unethical or improper professional conduct

(i.e., 35/73 vs. 44/100)

0.04

(0.51)

Charged with periodic (quarterly and annual filing

provisions violations (i.e., 10/73 vs. 15/100)

-0.01

(-0.24)

Charged with antifraud provisions violations (i.e., 6/73 vs.

17/100)

-0.09

(-1.77)*

48

Table 9: PCAOB actions against auditors

Panel A: This table reports PCAOB enforcement actions against auditors over the period May 24

th, 2005 to September 30

th, 2009.

Audit Partner Audit Firm Audit Partner and Firm Total

Total 7 2 17 26

Type of Auditor

Big N Auditor 4 1 0 5

Non-Big N Auditor 3 1 17 21

Panel B: This table reports the penalties imposed by the PCAOB in enforcement actions against auditor over the period May 24

th, 2005 to September 30

th, 2009

Total

Big N

Auditors

Non-Big N

Auditors

Against Audit

Firms

Against Audit

Partners

Number of Cases 26 5 21 19 24

Penalty Type

Barred from being an associated person of a registered public

accounting firm 21 4 17 0 21

Revocation of the registration with the Board 13 0 13 13 0

Censure 7 1 6 5 2

Civil monetary penalty 3 3 0 1 2

Undertakings by audit firm 1 1 0 1 0

Table 10: Class action lawsuits Panel A: The table reports summary statistics for class actions litigation (CALs) with GAAP violations over the

period 1996 to September 30th

, 2009. All percentages have been rounded off to the nearest whole percent. The t-

statistic for the difference in means is presented in parentheses. *, **, *** - represent significance at 10%, 5% and 1%

levels based on two-sided p-values.

COMPUSTAT Firm-

Years

Class Actions with GAAP

Violations

Class Actions with

Auditor Defendants

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Total

116,007 100 560

100 151 100

Big N Auditors 83,082 72 503 90 121 80

Non-Big N

Auditors 32,925 28 57 10 30 20

Tests for the difference in means for the proportion of Big N auditors

COMPUSTAT sample vs. All CAL sample (72% vs. 90%) -18%

(-4.16)***

All CAL sample vs. CALs with auditor defendants (90% vs. 80%) 10%

(2.77)*** Panel B: This table reports summary data for class action litigation with GAAP violations over the period 1996 to

September 30th

, 2009 by pre and post SOX periods. All percentages have been rounded off to the nearest whole

percent. The t-statistic for the difference in means is presented in parentheses. *, **, *** - represents significance at

10%, 5% and 1% levels based on two-sided p-values.

PRE-SOX COMPUSTAT Firm-

Years

Class Actions with GAAP

Allegations

Class Actions with

Auditor Defendants

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Total

54,618 100 278 100 67 100

Big N Auditors 43,579 80 255 92 56 84

Non-Big N

Auditors 11,039 20 23 8 11 16

Compustat sample vs. Class Action with GAAP violations (80% vs. 92%) -12%

(-7.17)***

All CAL sample vs. CALs with Auditor Defendants (92% vs.84%) 8%

(1.68)*

POST-SOX COMPUSTAT Firm-

Years

Class Actions with GAAP

Allegations

Class Actions with

Auditor Defendants

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Number of

observations

Percentage

(%)

Total

61,389 100 282 100 84 100

Big N Auditors 39,503 64 248 88 65 77

Non-Big N

Auditors 21,886 36 34 12 19 23

COMPUSTAT sample vs. Class Actions with GAAP Allegations (64 vs. 88%) -24%

(-12.1)***

All CAL sample vs. CALs with Auditor Defendants (88% vs. 77%) 11%

(2.12)**

50

Table 11: Impact on market share

This table reports the coefficients from an OLS regression where the dependent variable is the change in the number

of auditor clients from year t-1 to t. The sample period extends from January 1st, 1996 to September 30

th, 2009.

Panel A includes observations for all years from 1996 to 2009 while Panel B excludes years 2001 and 2002.

SEC_CLIENTS is the number of clients of the auditor that had a SEC action issued against them in the previous

year. SEC_AUDITORS is the number of SEC actions in which an audit firm/partner is named as a defendant in the

previous year. SEC_90 is an indicator variable that equals one if the sum of the number of clients of the auditor that

are named in SEC action in the previous year and the number of SEC actions in which the auditor was named as a

defendant in the previous year is in the top 10 percent over the sample period, and zero otherwise. SEC_S&P500 is

the number of clients of the auditors that were subject to SEC actions in the previous year that also happen to be

members of the S&P 500 index. BIG N equals one if the auditor is a Big N firm, zero otherwise. POST SOX equals

one for years 2003 and onwards, zero otherwise. EWCAR is the average 3-day cumulative abnormal return around

the trigger date for all client firms that were subject to SEC enforcements during the prior year. VIOLENGTH is the

average length of violation period in months for all client firms subject to SEC action in the prior year. CLIENT

LIT is the number of client firms that were named in SEC action in the prior year that were also subject to class

action litigation. CLIENT RESTATE is the number of client firms that were subject to SEC action in the prior year

that restated their financials. *, **, *** - represents significance at 10%, 5% and 1% levels based on two-sided p-

values.

Panel A Panel B

Model 1 Model 2 Model 3 Model 4

Intercept 7.82 7.87 7.28 6.94

0.01** 0.01** 0.02** 0.02**

SEC CLIENTS -3.23 -4.58

0.31 0.13

SEC AUDITORS -22.43 -22.62

0.39 0.41

SEC_90 -45.28 -119.43

0.45 0.04**

SEC_S&P500 21.30 44.24

0.43 0.16

BIG N 137.38 146.38 130.04 123.84

0.10 0.13 0.17 0.16

POST SOX -30.27 -41.30 -21.09 -25.03

0.48 0.37 0.62 0.56

EWCAR -14.43 -70.84 -7.69 -72.11

0.82 0.47 0.91 0.42

VIOLENGTH 0.46 -0.11 0.54 0.13

0.60 0.87 0.55 0.79

CLIENT LIT -23.51 -47.84 -19.64 -50.93

0.41 0.12 0.50 0.12

CLIENT RESTATE 14.10 18.24 11.38 30.72

0.71 0.60 0.76 0.36

NUMBER_CLIENT (t-1) -0.11 -0.12 -0.11 -0.12

0.03** 0.04** 0.05* 0.04**

N 236 236 199 199

Adj-R2

0.08 0.10 0.09 0.22

Table 12: Financial characteristics of continuing clients versus clients that depart following SEC action against the auditor

Panel A: This table presents the financial characteristics of clients of each of the Big N audit firms that changed their auditor (departing clients) and those that

continued with the same auditor (continuing clients) in the year following SEC action against an audit firm and/or partner of the audit firm. Averages are

reported throughout. TA is the total assets. CR is the current ratio defined as the ratio of current assets to current liabilities. NPM is the net profit margin. CFTL

is the ratio of cash flows to liabilities. ZMJ is Zmijewski’s 1984 distress score. *, **, *** - Represent significance at 10%, 5% and 1% levels based on two-sided

p-values. a The years 2001 and 2002 are not included in the sample for Arthur Andersen.

b The year 1998 is not included in the sample for Coopers and Lybrand

and PwC because there was a merger between Coopers and Lybrand and Price Waterhouse.

Panel B: This table presents the financial characteristics of the clients of Big N audit firms that changed their auditor (departing clients) and those that continued

with the same auditor (continuing clients) in the year following SEC action against the audit firm and/or partner of the audit firm. The data is presented

considering all the Big N audit firms as a single, homogenous group. TA is the total assets. CR is the current ratio defined as the ratio of current assets to current

liabilities. NPM is the net profit margin. CFTL is the ratio of cash flows to liabilities. ZMJ is Zmijewski’s 1984 distress score. *, **, *** - Represent

significance at 10%, 5% and 1% levels based on two-sided p-values.

Continuing Clients Departing Clients Difference (= Continuing –

Departing)

Statistics N TA CR NPM CFTL ZMJ

N TA CR NPM CFTL ZMJ

TA CR NPM CFTL ZMJ

MEAN 30,238 9,554 3.33 -4.47 0.04 -0,87 2,252 4,075 3.59 -4.73 -0.81 11.32 5,478*** -0.26 0.26 0.85*** -12.19

Continuing Clients Departing Clients Difference (= Continuing – Departing)

Auditor

N TA CR NPM CFTL ZMJ

N TA CR NPM CFTL ZMJ

TA CR NPM CFTL ZMJ

Arthur

Andersena

2452 2,367 2.71 -3.22 0.08 -0.88 109 1,349 3.59 -1.03 -0.57 4.28 1,018 -0.88 -2.18 0.64** -5.16**

Ernst

&Young 5253 7,490 3.34 -6.11 -0.12 -0.82 462 2,436 2.94 -3.05 -0.61 0.16 5.054*** 0.40* -3.06 0.49** -0.98*

Deloitte

& Touche 5237 9,106 2.80 -6.74 -0.51 -0.99 419 4,733 3.45 -10.04 -0.68 39.05 4,373 -0.65 3.31 0.17 -40.05

KPMG

8343 12,466 3.96 -4.71 0.83 -0.54 637 3,414 4.24 -5.76 -0.50 10.08 9,051*** -0.29 1.05 1.34** 10.63**

PwCb

8952 10,281 3.24 -2.27 -0.29 -1.10 614 6,028 3.55 -1.86 -1.44 3.54 4,252** -0.31 -0.40 1.15 -4.64