How Do Auditors Behave During Periods of Market Euphoria?

The Case of Internet IPOs

ANDREW J. LEONE, University of Miami

SARAH RICE, University of Connecticut

JOSEPH P. WEBER, Massachusetts Institute of Technology

MICHAEL WILLENBORG, University of Connecticut

Contemporary Accounting Research Vol. 30 No. 1 (Spring 2013) pp. 182–214

Abstract:

• We are interested in how auditors behave during periods of market euphoria. Given their gatekeeper responsibility to act in the public’s interest, along with the seeming inevitability of bubbles (Rampell 2009), it is important to study how auditors behave during euphoric market conditions.
•  To address this question, we examine auditor going-concern (GC) opinions around the time of the wave of stressed Internet firms filing to go public on NASDAQ, the capital markets entry point for the companies that went on to constitute ‘‘dotcom mania’’.
• Consistent with literature on stressed public companies, we find that the presence of GC opinion in the IPO registration statement of a stressed Internet company varies positively with financial distress and negatively with company age (for Big 5 registrants) or start-up status (for non–Big 5 registrants). 
• In addition, a GC opinion for Big 5 registrants varies positively with IPO cash burn and negatively with the presence of a prestigious underwriter and venture backing.  
• Consistent with the descriptive statistics, regression results show that the Big 5 firms rendered significantly fewer GC opinions during the audit market bubble from January 1999 to April 2000 in comparison to the surrounding periods and to the non–Big 5. 
• We also document negative associations between a GC opinion and the fees a given Big 5 firm received from auditing stressed Internet IPO clients during the three months prior to signing their opinion and whether the Securities and Exchange Commission (SEC) filing date follows soon after audit opinion date. 
• These latter two findings, also new to the literature, are not reconcilable by appeal to professional audit standards and, instead, are suggestive of less independence or less skepticism on the part of the Big 5 during the Internet IPO bubble.

Discussions:

A rather disturbing findings. "Independent auditors play a crucial role in the capital-raising process, though this role is largely invisible. Indeed, from a financial statement user’s perspective, the two visible aspects are the audit firm and their opinion. While these facets have ongoing value, they are of special value during periods of market euphoria because auditors are in arguably the best position among gatekeepers to be objective".