sealPurdue News

March 21, 2002

Researcher: Oversight reforms needed, not divesting consulting

WEST LAFAYETTE, Ind. – A Purdue University professor says tightening the oversight of corporate governance and the auditing profession, proposed in the wake of the Enron implosion, is a much-needed reform. But the proposals to force accounting firms to divest their consulting practices will have little practical effect.

Sanjay G. Kallapur

Sanjay G. Kallapur, an assistant professor of accounting at the Krannert School of Management, has done two research projects: one on changes in litigation laws affecting auditors and another on the relationship between audit and non-audit fees of Big Five audit firms.

"The Litigation Reform Act of 1995 was a reaction to what people felt at the time were too many shareholder lawsuits based on allegedly misleading disclosures," he says. He wrote a paper on the subject with Ashiq Ali, an associate professor at the University of Arizona. The paper was published in the July 2001 issue of The Accounting Review.

The Reform Act made it harder for shareholders to sue companies and auditors for misleading disclosures. It also reduced auditors' litigation exposure by introducing proportional liability when there was no deliberate wrongdoing on their part. Previously the auditors had joint-and-several liability – plaintiffs could recover their full damages from the auditor even if the auditor was assigned 10 percent of the blame and management, 90 percent.

"Our research shows that shareholders lost market value at the passage of the law," Kallapur says. "Lawsuits have a favorable effect of deterring misleading disclosures. We concluded that the decrease in potential lawsuits reduced this deterrence effect and increased the information uncertainty faced by shareholders."

Kallapur says that a range of oversight reforms could finally be adopted by the Securities and Exchange Commission, government bodies and the courts. His bottom line is that new oversight should be driven by fairness and meaningful redress of wrongs for shareholders of companies' stock.

However, Kallapur says that investors and the general public are unlikely to benefit from a ban on auditors supplying consulting services, as has been proposed in numerous quarters.

In research that is currently under peer review, Kallapur and Krannert School graduate student Hyeesoo Chung examined whether the provision of non-audit services by Big Five audit firms to their audit clients affected their independence, as reflected in companies' earnings. These fees have been discussed in commentary on Enron's demise because in 2000 Arthur Andersen billed the company $25 million for audit services and $27 million for non-audit services.

The working paper, "Client Importance, Non-audit Fees, and Abnormal Accruals," concludes there is no evidence of a relationship between auditor independence and fees the client pays for non-audit services. The study examines auditor independence by estimating the degree to which a company's non-cash earnings, which are easier to manipulate, are out of line with those of other firms in the same industry.

The researchers' sample consists of 1,864 clients of Big Five audit firms using proxy statements filed between Feb. 5, 2001, and June 30, 2001.

"What has not been disclosed in the Enron-Arthur Andersen case is what kind of consulting fees were involved," Kallapur says. "That matters a great deal because tax preparation and planning services that auditors have always provided are likely to account for a large part of the $27 million, and management consulting is only a small part of the non-audit services that accounting firms provide."

This means that forcing audit firms to divest their management consulting practices, as has been proposed in Enron's wake, is not likely to reduce non-audit services substantially, Kallapur says. In his study's sample, Ernst and Young divested its consulting practice in May 2000, and Arthur Andersen was separated from Andersen Consulting as of Aug. 7, 2000. Yet these firms had substantial non-audit services to audit clients during 2000.

Besides, audit firms are already divesting their consulting units. In addition to Ernst and Young and Arthur Andersen, Big Five audit firm KPMG divested its consulting practice in February 2001. Since Enron's collapse, PricewaterhouseCoopers and Deloitte & Touche have announced plans to divest their consulting practices.

Citing his research, Kallapur says these consulting divestitures have little to do with auditor independence, although they may increase the appearance of independence.

One of the reasons it is difficult to hold auditors to a completely objective standard, Kallapur says, is that accounting is, and always has been, as much art and interpretation as objectivity and numbers. Even if audit failures were proven in Enron and other cases, it would not necessarily imply that the system was broken – some audit failures are bound to occur, given the inherent subjectivity of the process.

To the extent that there is a problem of excessive audit failures, however, there is no evidence that providing non-audit services is a contributing factor, Kallapur says. The separation of auditing and consulting is therefore unlikely to reduce auditing failures, he says.

Writer: J.M. Lillich, (765) 494-2077,

Source: Sanjay G. Kallapur, (765) 494-4516,

Purdue News Service: (765) 494-2096;

Related Web sites:
"Securities Price Consequences of the Private Securities Reform Act of 1995 and Related Events" paper


Securities Price Consequences of the Private Securities Reform Act of 1995 and Related Events

Sanjay G. Kallapur and Ashiq Ali

The Private Securities Litigation Reform Act (PSLRA) increases restrictions on private litigation for securities fraud. We examine stock price reactions on legislative-event-related days of firms in four high-litigation-risk industries. Two other studies on this issue, Spiess and Tkac (1997) (ST) and Johnson et al. (2001) (JKN), conclude that shareholders considered PSLRA beneficial. While we find largely similar daily abnormal returns for event-related days that they examine, we present evidence that the timing of multiple confounding events makes the interpretation of these daily returns ambiguous. Results from additional analyses beyond those conducted by ST and JKN (market price reversal tests, analysis of additional legislative-event-related days, cumulative abnormal returns over the legislative period, and analysis of other events affecting investors' ability to bring securities-related lawsuits), are largely inconsistent with their interpretation, suggesting instead that shareholders in the four high-litigation-risk industries react negatively on average to PSLRA's restrictions on their ability to bring securities-related lawsuits.

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