2 Firms A Joint Test of the Agency Hypothesis and Insurance Hypothesis Chiawen Liu National Taiwan University Abstract The paper examines the audit cl

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1 The International Journal of Accounting Studies 1-22 * Wallace (1980) Market Reaction to the Merger of CPA *

2 2 Firms A Joint Test of the Agency Hypothesis and Insurance Hypothesis Chiawen Liu National Taiwan University Abstract The paper examines the audit clients stock price reactions to the announcement of a CPA-firm merger. According to the agency hypothesis proposed by Wallace (1980), the inconsistence between shareholders and the owner-manager s interests will decrease if the audit quality increases after a CPA-firm merger. While the insurance hypothesis indicates that the join up will raise the expected compensation to shareholders should the company go bankru. Therefore, the two hypotheses imply that, ceteris paribus, the stock price of the audit clients will have positive abnormal return when CPA firms announce their merger plan. In this paper, I focus on the data from three merger cases and use the modified event-study approach to empirically examine the market reaction to these mergers. Results show that there is no consistent evidence of considerable abnormal returns around the event date. However, it seems that the CPAs legal liability has increased after the episode of Cheng I Food Company case. Further analysis shows that the cumulative abnormal returns of the CPAs clients for the two mergers after the incidence are higher than those of the single merger before the incidence, which is consistent with the insurance hypothesis. Keywords: CPA-firm merger, Agency hypothesis, Insurance hypothesis. Submitted Dec Acceed Aug

3 (1) (agency hypothesis) (2) (insurance hypothesis) (3) (information hypothesis) (Wallace 1980, 1987) 1 (agent) (principal) / (owner-manager (Jensen and Meckling 1976) 1 (signaling)

4 4 DeAngelo (1981) (deep-pocket) 2 Chow (1982) Palmrose (1984) Eichenseher and Shields (1985, 1986) Healy and Lys (1986) Simunic and Stein (1987) Francis and Wilson (1988) Johnson and Lys (1990) Copley et al. (1995) Blackwell et al. (1998) Deloitte Touche Tohmatsu

5 - 5 Menon and Williams (1994) Baber et al. (1995) Laventhol and Horwath Laventhol and Horwath Chung (1998) 1994 (limited liability partnership) Willenborg (1999) (1997) (1997) (1999) (2000) (2001) (1999) DeAngelo (1981)

8 Touche Ross Deloitte Haskins & Sells

9 - 9 a b a b (cross-sectional correlation) t (clustering) Brown and Warner (1980,1985) Collins and Dent (1984) SUR (seemingly unrelated regression) SUR Gibbons (1982) Stambaugh (1982) Schipper and Thompson (1983) Hughes and Ricks 1984; Marais

10 ; Bernard and Ruland 1987 SUR (asymotic theory) (Schipper and Thompson 1985) SUR Chandra and Balachandran (1990) SUR GLS (generalized least square) (specification) GLS (power) Chandra and Balachandran Baber et al. (1995) Bernard (1987) Chandra and Balachandran (1990) = p + p Rmt β i= 10 R α D + e (1) pi it t t [ 260,10] t [ 260, 11] t [ 10,10] t = 0 R t R = R M / M R t j j jt jt j jt jt M t j jt Rmt t Dit 0 1 (dummy variable) i t = Dit = 1 D = 0 i = 10, 9,...,0,...,9, 10 it e pi i = 10, 9,..., 0,...9, 10

11 - 11 (Sefcik and Thompson 1986) R R qt = α + β R p q q p = α + β R mt mt i= pi qi i= 10 D D it it + e + e qt (2) R R qt + k i= k + k pi = qi, k = 0,1,..., 10 i= k Chow Test F (likelihood ratio test) χ 2 Chow Test F e e qt (1) pi i = 5,..., 5 5 (2) 5 pi i = 10,..., 6,6,..., 10 5%

12 12 p p p p α p β p ** ** ** ** p p p p p p p p p p p R F (22,248) 0.000** 0.000** 0.000** 0.000** ** 1% = p + p Rmt α β pi i= 10 qt = q + q Rmt α β qi i= 10 + k + k R D + e R D + e H 0 : pi = qi, k = 0,1,..., 10 i= k i= k χ 2 p χ 2 it it qt p [0,0] [-6,6] [-1,1] [-7,7] [-2,2] [-8,8] [-3,3] [-9,9] [-4,4] [-10,10] [-5,5]

13 - 13 (1) 1% p 2 Coopers & Lybrand Price Waterhouse p p p α p β p ** ** ** p p p p ** ** p p p p p p p R F 22, ** 0.000** 0.000** ** 1% (2)

14 14 = p + p Rmt α β pi i= 10 qt = q + q Rmt α β qi i= 10 + k + k R D + e R D + e H 0 : pi = qi, k = 0,1,..., 10 i= k i= k χ 2 p χ 2 p [0,0] [-6,6] [-1,1] [-7,7] [-2,2] [-8,8] [-3,3] [-9,9] [-4,4] [-10,10] [-5,5] it it qt (1) p5 5% (2) Wallace (1980) DeAngelo (1981)

15 - 15 p p p α p β p ** ** ** p p p p p p p p p p p * * R F (22,248) 0.000** 0.000** 0.000** * 5% ** 1% = p + p Rmt α β pi i= 10 qt = q + q Rmt α β qi i= 10 + k + k R D + e R D + e H 0 : pi = qi, k = 0,1,..., 10 i= k i= k χ 2 p χ 2 it it qt p [0,0] [-6,6] [-1,1] [-7,7] [-2,2] [-8,8] [-3,3] [-9,9] [-4,4] [-10,10] [-5,5]

16 16 1. (1996) 2. DeAngelo (1981) DeAngelo DeAngelo (1981) (quasi-rent) DeAngelo (1981) (1) 2000 (2)

17 $71,017, (1) 5 CAR( 5, t) t = 5, 4,...0,...4,

18 18 p p α p * β p ** ** p p p p ** p p p p p p p R F 0.000** 0.000** * 5% ** 1% (1) 1% 2

19 % Enron

20 Meta-Analysis 2000 Baber, W. R., K. R. Kumar, and T. Verghese Client security price reactions to the Laventhol and Horwath bankrucy. Journal of Accounting Research 33 (Autumn): Bernard, V. L Cross-sectional dependencies and problems in inference in market-based accounting research. Journal of Accounting Research 25 (Spring): Bernard, V. L. and R. G. Ruland The incremental information content of historical cost and current cost income numbers: time-series analysis for The Accounting Review 62 (October): Blackwell, D. W., T. R. Noland, and D. B. Winters The value of auditor assurance: evidence from loan pricing. Journal of Accounting Research 36 (Spring):

21 - 21 Brown, S. J. and J. B. Warner Measuring security price performance. Journal of Financial Economics 8 (Seember): Brown, S. J. and J. B. Warner Using daily stock returns: the case of event studies. Journal of Financial Economics 14 (March): Chandra, R. and B. V. Balachandran A synthesis of alternative testing procedures for event studies. Contemporary Accounting Research 6 (Spring): Chow, C. W The demand for external auditing: size, debt and ownership influences. The Accounting Review 57 (April): Chung, S., R. Narasimhan, and P. Wei Market reaction to LLP formation: a test of the insurance hypothesis. American Accounting Association Annual Meeting. New Orleans. Coillins, D. W. and W. T. Dent A comparison of alternative testing methodologies used in capital market research. Journal of Accounting Research 22 (Spring): Copley. P. A., J. J. Gaver, and K. M. Gaver Simultaneous estimation of the supply and demand of differentiated audits: evidence from the municipal audit market. Journal of Accounting Research 33 (Spring): DeAngelo, L.E Auditor size and audit quality. Journal of Accounting and Economics 3 (December): Eichenseher, J. W. and D. Shields Corporate director liability and monitoring preferences. Journal of Accounting and Public Policy 4 (Spring): Eichenseher, J. W. and D. Shields Corporate capital structure and auditor fit. Working paper, University of Wisconsin, Madison, WI. Francis, J.R. and E.R. Wilson Auditor changes: a joint test of theories relating to agency costs and auditor differentiation. The Accounting Review 63 (October): Gibbons, M. R Multivariate tests of financial models: a new approach. Journal of Financial Economics 10 (March): Healy, P. and T. Lys Auditor changes following big eight takeovers of non-big eight audit firms. Journal of Accounting and Public Policy 5 (Winter): Hughes, J. S. and W. E. Ricks Accounting for retail land sales: analysis of a mandated change. Journal of Accounting and Economics 6 (August): Jensen, M. C. and W. H. Meckling Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 4:

22 Johnson, W. B. and T. Lys The market for audit services: evidence from voluntary auditor changes. Journal of Accounting and Economics 12 (January): Marais, M. L An analysis of a multivariate regression model in the context of a regulatory event study by computer intensive resampling. Working paper, University of Chicago. Menon, K. and D. D. Williams The insurance hypothesis and market prices. The Accounting Review 69 (April): Palmrose, Z The demand for quality-differentiated audit services in an agency-cost setting: an empirical investigation. Auditing Research Symposium. University of Illinois at Urbana-Champaign Schipper, K. and R. Thompson The impact of merger-related regulations on the shareholders of acquiring firms. Journal of Accounting Research 21 (Spring): and The impact of merger-related regulations using the exact distribution of test statistics. Journal of Accounting Research 23 (Spring): Sefcik, S. E. and R. Thompson An approach to statistical inference in cross-sectional models with security abnormal returns as dependent variables. Journal of Accounting Research 24 (Autumn): Simunic, D. and M. Stein Product differentiation in auditing: a study of auditor effects in the market for new issues. Working paper, The Canadian Certified General Accounts Research Foundation. Stambaugh, R. F On the exclusion of assets form tests of the two-parameter model: a sensitivity analysis. Journal of Financial Economics 10 (November): Wallace, W. A The Economic Role of the Audit in Free and Regulated Markets. New York: Touche Ross & Co. Aid to Education Program. Wallace, W.A The economic role of the audit in free and regulated markets: a review. Research in Accounting Regulation 1: Willenborg, M Empirical analysis of the economic demand for auditing in the initial public offerings market. Journal of Accounting Research 37 (Spring):

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