Marketing and Finance short answer questions

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A C C O U N T I N G C O N T A G I O N : T H E C A S E O F E N R O N

By Aigbe Akhigbe, J e f f Madura, and Anna D. Martin*

Abstract The Enron scandal offers the opportunity to assess the degree to which misleading accounting

can affect connected firms and industry rivals. While the market was inept at detecting the inaccuracy o f Enron's financial statements, it swiftly punished many connected firms once Enron's faulty accounting was publicized. A cross-sectional analysis documents that the market punished connected firms that had greater exposure to Enron's business, whose financial statements were viewed as more complex, and that had greater financial leverage. Most o f the negative news indicating concern with Enron's accounting corresponded with a significant decline in the stock prices offirms in the energy and natural gas (ENG) indust~, regardless o f an explicit connection to Enron. Furthermore, rival firms with direct exposure to Enron and more aggressive earnings- reporting methods also experienced more detrimental effects. (JEL G39, G14)

I n t r o d u c t i o n

The ability o f financial m a r k e t s to revalue stocks based on Financial statements and other related information has r e c e i v e d m u c h attention in the financial literature. Because firms c o m m o n l y possess a s y m m e t r i c information, investors m a y rely o n information about o n e fLrm as indirect signals for the valuation o f others. While the sluggish m a r k e t recognition o f E n r o n ' s p r o b l e m s b e c a u s e o f m i s l e a d i n g financial statements is well documented, less is k n o w n about h o w these p r o b l e m s triggered a c c o u n t i n g concerns a b o u t the industry and other fu-ms that had relationships with Enron. T h e d a m a g e caused b y E n r o n ' s misleading a c c o u n t i n g statements is not limited to the shareholders a n d e m p l o y e e s o f Enron but c a n affect firms with linkages to Enron. The losses m a y extend to a d v e r s e effects on c o n n e c t e d t-n-ms that have business relationships with E n r o n and also on rival f'n-ms in the same industry w h o s e financial condition m a y h a v e been overstated i f they had used similar m e t h o d s as E n r o n to report Financial information.

Since E n r o n ' s collapse is attributed to its a c c o u n t i n g irregularities, l the adverse effects o f E n r o n ' s collapse o n firms with linkages to E n r o n can be viewed as a f o r m o f accounting contagion. T o the extent that misleading financial statements cause erroneous valuations o f a reporting fn-m, they can cause erroneous valuations o f fh'ms with linkages to that firm.

O u r goal is to m e a s u r e the extent and breadth o f corrected valuations f o l l o w i n g news o f E n r o n ' s misleading f m a n c i a l statements. 2 W e d o c u m e n t negative valuation effects for connected t-n-ms that h a v e a high d e g r e e o f relative exposure to E n r o n and for all fLrrns in the e n e r g y and natural gas ( E N G ) industry, regardless o f an explicit c o n n e c t i o n to Enron. These results v e r i f y the existence o f a c c o u n t i n g c o n t a g i o n resulting f r o m the recognition o f E n r o n ' s problems. Furthermore, w e identify potential sources o f these significant valuation effects using cross- sectional analyses. F o r the c o n n e c t e d firms, those variables that help explain the cross-sectional variation in the valuation effects are relative e x p o s u r e to Enron, n u m b e r o f footnote disclosures,

* Aigbe Akhigbe, Department of Finance, College of Business Administration, University of Akron, Akron, OH 44325; Jeff Madura, Department of Finance, College of Business, Florida Atlantic University, Boca Raton, FL 33431; Anna D. Martin, Department of Finance, Charles F. Dolan School of Business, Fairfield University, N. Benson Rd., Fairfield, CT 06824, [email protected].

Abdel-khalik (2002), Benston and Hartgraves (2002), Demski (2002), Gillan and Martin (2002), Healey and Palepu (2002), Lev (2002), and Revsine (2002) identify accounting irregularities that caused Enron's collapse.

2 Lev (2002) reports that, as of December 31, 2000, the market value for Era'on was $75.2 billion while its book value was $11.5 billion.

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membership in the ENG industry, financial leverage, and fLrm size. For the firms in the E N G industry, the significant explanatory factors are direct exposure to Enron, degree o f earnings aggressiveness, financial leverage, prior stock price performance, and correlation in returns. These cross-sectional results substantiate that analysts are considering h o w firms they m o n i t o r are indirectly subjected to a related f i r m ' s misleading financial statements.

Chronology of Events Leading to Enron's Demise

Eleven months before going bankrupt, E n r o n ' s stock price was $80 per share. T w o months before going bankrupt, its stock price was $30 per share. The chronology o f important events that indicate concern over E n r o n ' s accounting information is summarized in Table 1.3 The stock price chart o f Enron is shown in Figure 1, with points indicating these critical events identified in the chronology.

Figure 1: E n r o n ' s 2001 S t o c k P r i c e .

90 80

70

~ - 60 .~ 50 12. -~ 40 O o

Ca0 ~ 1 7 -Oct 30 20 41. 22-Oct

~ [ ~ 4 - O c t 10 k~k,~Nov

28-Nov ~ t-Dec'_

Date

The chronology can be summarized as follows. Event 1 (Feb. 1, 2001) hinted at potential problems for Enron and other energy firms. The first strong indication o f concern o v e r Enron financial statements m a y have been revealed inadvertently on April 18, 2001 (Event 2), during an analysts' conference call to discuss fnrst-quarter earnings. According to the H o u s t o n C h r o n i c l e , a n analyst complained to E n r o n ' s CEO, " Y o u ' r e the only f'mancial institution that c a n ' t c o m e up with a balance sheet or cash flow statement after earnings." About four months later, Skilling resigned (Event 3). The n e x t month (Event 4, September 10, 2001), E n r o n ' s accounting statements were questioned b y the media. The following month (Event 5, October 17, 2001), Enron reported a large third-quarter loss. Five days later, Enron confirmed its complex accounting transactions (Event 6); this was followed two days later b y E n r o n ' s announcement that CFO Andrew Fastow

3 Although Enron had several issues of concern to investors (e.g., reports of price fLxing in California, abusing political connections, etc.), this study identifies those events related to the issue of inaccurate or insufficient accounting disclosure. Our events are similar to those 'critical events' identified by Healy and Palepu (2002) in their study that also focuses on the accounting disclosure problems at Enron.

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had been replaced. Two weeks later, Enron admitted some accounting errors (Event 8), and its credit was downgraded to below-investment grade status 20 days later (Event 9). Just four days later, Enron filed for bankruptcy (Event 10). All 10 events are hypothesized to signal potential accounting irregularities o f Enron.

Figure 2 shows the cumulative returns o f Enron, Nasdaq, and the CRSP equally weighted composite during 2001. Notice that, during the fourth quarter o f 2001, the Nasdaq and CRSP composite indices were experiencing upward trends while Enron was experiencing a downward trend.

F i g u r e 2 : 2 0 0 1 C u m u l a t i v e R e t u r n s for E n r o n a n d M a r k e t I n d e x e s .

0,6

0.4

0.2

0 E

=r --0.2

-~ -0.4

~ -0,6

-0,8

-I i ! I

-I,2 '

i I t ~ ~

i i

-i i

i

Date

Enron . . . . CRSP ...... NASDAQ

Related Intra-Industry Literature

Our focus is on the extent to which news about Enron's accounting discrepancies can affect the valuations o f firms that conducted business with it and In'ms that are in the same industry. Several studies have documented that valuation effects from various events extend to industry rivals. However, there have been no studies that we are aware o f that have examined whether the valuation effects extend to f'trms connected through business relationships.

In perhaps the most closely related research to the study at hand, Fenn and Cole (1994) investigate whether life insurance competitors were adversely affected b y the asset write-down announcements o f First Executive and Travelers. They fmd that negative valuation effects are greater for competitors with more junk bonds and commercial mortgages and for competitors with customers that could easily switch suppliers.

Past studies have found that corporate announcements can influence the values o f competitors. It is common for intra-industry studies to predict contagion and/or competitive effects for industry rivals. Lang and Stulz (1992) recognize the coexistence o f contagion and competitive effects as they evaluate the intra-industry effects from bankruptcy announcements. They f'md that competitors experience an average reduction o f 1 percent in value with bankruptcy

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a n n o u n c e m e n t s , s h o w i n g that the c o n t a g i o n effects d o m i n a t e the c o m p e t i t i v e effects. N o n e t h e l e s s , t h e y d o c u m e n t t h a t b a n k r u p t c y a n n o u n c e m e n t s in c o n c e n t r a t e d industries b e n e f i t t h o s e c o m p e t i t o r s t h a t a r e in a p o s i t i o n to g a i n m a r k e t share.

T a b l e 1: E v e n t s that I n d i c a t e C o n c e r n w i t h E n r o n A c c o u n t i n g S t a t e m e n t s .

Event Date Description Source

1 Feb. 1,2001 General comments about potential problems from Financial Times volatility, misplaced bets, rogue traders, etc. for the energy industry, including Enron.

2 Apr. 18, 2001 Enron CEO, Jeffrey Skilling, used vulgarity towards analyst, Houston Chronicle Richard Grubman. Grubman asked to see Enron's balance sheet, Skilling responded that it would not be available until later, in disbelief Grubman stated that Enron was "the only financial institution that can't come up with a balance sheet or cash flow statement," and Skilling responded with vulgar language. Enron CEO, Jeffrey Skilling, resigned, becoming the sixth senior executive to leave in a year. Lay said in a conference call with stock analysts, "I never felt better about the company" yet deflected analysts' pleas for more disclosure. Some analysts expressed concern that other surprises may be lurking. Report described Enron's poor stock price performance as New York Times stemming from "heavy insider trading, indecipherable accounting practices and a stream o f executive departures." In general, the credibility o f Enron's accounting statements was questioned. Enron reported a third-quarter loss o f $618M due to $1B in New York Times one-time charges. Enron Chairman, Kenneth Lay, confirmed that part o f the one-time charges to earnings was due to complex transactions with limited partnerships created and run by Enron's CFO, Andrew Fastow. Enron confirmed that the SEC opened an informal inquiry PR Newswire into Enron's complex transactions with limited partnerships tied to an Enron senior executive. Enron CFO Andrew Fastow was replaced in an attempt to Press Release by restore investor confidence. A class-action lawsuit was filed Enron & against Enron and its executives for misleading accounting Business Wire statements. Enron admitted accounting errors, inflating income by $586M Press Release by and understating debt b y $2.6B since 1997. This was Enron's Enron first assessment o f the degree to which their accounting statements were misleading. Enron notified b y Dynegy o f merger termination. Enron's Business Wire credit was downgraded to below investment grade. Enron filed for bankruptcy. PR Newswire

3 Aug. 14,2001 P R N e w s w i r e a n d L A T i m e s

4 Sep. 10,2001

5 Oct. 17,2001

6 Oct. 22,2001

7 O ~ . 2 4 , 2 0 0 1

8 Nov. 8, 2001

9 Nov. 28, 2001

10 Dec. 2, 2001

Notes: These 10 major event dates reveal some degree of concern over the validity of Enron's accounting statements that ultimately led to the filing of bankruptcy; we obtain the event dates and descriptions from Lexis-Nexis daily news articles.

I n t r a - i n d u s t r y s t u d i e s h a v e b e e n c o n d u c t e d to e v a l u a t e r i v a l effects f r o m n o t o n l y b a n k r u p t c y a n n o u n c e m e n t s b u t also a n n o u n c e m e n t s s u c h as l o a n - l o s s r e v i s i o n s , s t o c k r e p u r c h a s e s , and

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takeovers, among others. Aharony and Swary (1996) documented dominant-bank contagion effects, whereby adverse news about one bank's loan prospects causes downward valuations o f other banks with similar characteristics. Erwin and Miller (1998) find that rivals o f fn'ms conducting share repurchases experienced net competitive effects and suffered significant reductions in their share prices. Song and Walking (2000) fred that rivals o f takeover targets generate positive valuation effects from the acquisition announcements. Their cross-sectional analyses confirm that the rival valuation effects vary with characteristics that indicate the probability o f takeover o f the rival.

Hypotheses for Firms Linked to Enron

The Enron debacle is expected to cause the following effects. First, the events associated with Enron are expected to adversely affect firms with which it had business relationships. We evaluate whether the adverse news releases about one firm have contagion effects for these connected firms, such as suppliers, institutional investors, counterparties to Irading, and creditors. To the extent that misleading accounting statements cause erroneous valuations o f the reporting firm, they can cause erroneous valuations o f those firms that rely on the reporting firm for their business.

Some events could contain confounding signals. For example, it m a y be argued that the replacement o f Andrew Fastow could elicit a favorable market response, because it may imply that Enron is making efforts to improve its accounting situation. However, the accounting irregularities were not already recognized by the market, so any event that hints at or conftrms the potential accounting irregularities is expected to elicit a negative market response. A n y information that casts doubt about the future prospects o f Enron m ay result in negative valuation effects for connected firms.

Some events contained multiple pieces o f information. For example, On November 28, 2001 (Event 9), Enron's credit rating was lowered below investment-grade status, and Dynegy terminated its planned merger with Enron, yet both events led to a similar general conclusion o f more negative views about Enron's fmancial condition than were previously recognized from its financial statements. A likely interpretation by the market is increased concerns about the potential degree o f Enron's accounting irregularities.

Thus, we hypothesize that the market valuations o f connected t'n'ms are reduced in response to news about Enron's accounting irregularities. More formally, our first hypothesis is as follows:

H y p o t h e s i s 1: T h e announcements that indicate concern over Enron's accounting information are expected to be associated with negative abnormal returns for connected firms.

Second, the events signaling the potential accounting irregularities o f Enron could have affected rivals in the industry. To the extent that the misvaluation o f Enron was completely attributed to In'm-specific information, recognition o f Enron's accounting irregularities should not adversely affect industry rivals. [See, for example, Aharony and Swary (1983).] In fact, it can be hypothesized that the only possible effect on rivals under these circumstances would be positive, because rivals could capture market share that may be lost b y Enron due to reputational effects. These positive rival effects are considered to be competitive effects. Consistent with this view is the following hypothesis:

H y p o t h e s i s 2A: T h e announcements that indicate concern over Enron's accounting information are expected to be associated with positive abnormal returns for rival firms.

However, the news about Enron's faulty accounting could signal that rivals also overstated their respective financial condition i f they used similarly creative accounting methods that resulted

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in overstated earnings. Thus, it can alternatively be hypothesized that industry rivals experienced negative valuation effects, reflecting accounting contagion.

H y p o t h e s i s 2B: The announcements that indicate concern o v e r E n r o n ' s accounting irregularities are expected to be associated with negative abnormal returns for rival firms.

Since the competitive and contagion effects m a y coexist for rival fn'ms, an empirical examination would indicate which effect is dominant. A favorable share-price response o f industry rivals would support the existence o f competitive effects, while a negative share-price r e s p o n s e o f industry rivals would support the existence o f accounting contagion effects.

Samples, Data, and Methods

We investigate how the information disseminated about Enron significantly affected the valuation o f (1) Enron, (2) connected finns with business relationships with Enron, and (3) f'n-ms in the energy and natural gas industry. 4 The inclusion o f Enron itself in the analysis helps to identify which events cited earlier contain valuable information. The analysis o f the other sets o f firms addresses the main objectives o f our study. The data compiled to assess each o f the sets o f firms are described next.

S a m p l e o f C o n n e c t e d F i r m s We identify firms with exposure to Enron based on business relationships, using news reports

in L e x i s - N e x i s . According to the news reports, the business relationships primarily include bank credits, financial credits, insurance activities, investments operations, purchase and sale agreements for natural gas and crude oil, and commodity transactions (e.g., derivatives and trading contracts and storage management and natural gas hedging. O f the 96 firms that were reportedly exposed to Enron, 76 firms have share-price data available in CRSP and are used for the analyses.

Sample of Firms in the Energy and Natural Gas Industry Using Standard & P o o r ' s C o m p u s t a t database, we identify 73 firms in the energy and natural

gas industry ( S I C code 492X and 493X), o f which 14 were reportedly directly exposed to Enron and the remaining 59 are considered not to have been. The subset o f 14 directly exposed firms in the ENG industry effectively contains industry m e m b e r s who partner with Enron in some manner, whereas the subset o f 59 unexposed firms should contain the more traditional industry competitors.

M o d e l s U s e d to M e a s u r e Valuation E f f e c t s We test the share-price response o f Enron and various portfolios o f firms with linkages to

Enron to the information disseminated about Enron using daily c o m m o n stock returns o v e r the period leading up to its bankruptcy. To estimate the share-price response to the news about Enron, we use the seemingly unrelated regression (SUR) technique described b y Johnston (1984) and daily returns from CRSP for all trading days in 2001. H e shows that, in the presence o f contemporaneous correlation, the SUR m e t h o d generates more efficient estimates. The first model we use to estimate the share-price response is as follows in (1), where Rpt = the return o n the

portfolio on d a y t; Rmt = the return on the CRSP equally weighted market index on day t; Rmt-1 =

4 Based on potential reputational effects, we also examine whether the market penalized (rewarded) institutional investors that increased (reduced) their exposure to Enron during 3Q2001. We did not find statistically significant valuation effects for portfolios of publicly traded institutional investors.

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the lagged return on the CRSP equally weighted market index on day t - I ; Dkt = 1 on day 0 for

event k using the one-day window (1 on day 0 and day +1 for event k using the two-day window) 5 and 0 otherwise; ~t = 1 on the final event day (December 2, 2001) and all days following this

event and 0 otherwise; flop = the intercept term for the portfolio; flip = the market/systematic

risk o f the portfolio; fl2p = the coefficient on the lagged CRSP equally weighted market index for

the portfolio; ~'kp = the coefficient measuring the abnormal return for event k for the portfolio;

f 3 7 = the shift in systematic risk o f the portfolio due to the bankruptcy filing; and ept = the

disturbance term for the portfolio on day t.

10

Rpt = BOp dr fllpgmt dr f2pRmt-I dr Z ZkpOkt dr f3pf~tRmt dr ept k = l

(1)

W e estimate model (1) using daily returns for 2001. Following Saunders and Smirlock (1987) and Bhargava and Fraser (1998), we include the lagged market return to control for nonsynchronous trading and a d u m m y variable to account for shift in systematic risk. 6

W e also use an alternative model that deemphasizes any specific event dates and tests the valuation effect overall (for all event dates combined). A single d u m m y variable is used to designate all event dates. This alternative model is specified in (2) where Dkt = 1 on day 0 for

each event k using the one-day window (1 on day 0 and day +1 for each event k using the two-day window) and 0 otherwise, Ycomb,p = the coefficient measuring the average abnormal return to the

set o f events return for the portfolio, and all other variables were previously defined.

~ t = BOp dr flpgmt dr f2pRrat-1 dr ~comb,pOkt dr f3p~tRrat dr ept (2)

When the d u m m y variable coefficients for individual event dates have the same sign and are significant in model (1), the average valuation effects in model (2) will likely be significant as well. However, i f the valuation effects (as measured b y the d u m m y variable coefficients) in model (1) have opposite signs, such an offset could cause an insignificant d u m m y variable coefficient in model (2).

W e expect the estimated coefficients for )~l to Aw in model ( I ) and ~omb in model (2) to be negative for Enron and for the connected firms. The sign on these coefficients for firms in the energy and natural gas industry should be positive i f the competitive effects dominate and negative i f the contagion effects dominate.

C r o s s - S e c t i o n a l A n a l y s i s o f V a l u a t i o n E f f e c t s o n C o n n e c t e d F i r m s Accounting contagion effects on In-ms with linkages to Enron m a y vary with their respective

f'mancial characteristics. Using average abnormal returns (AAR) estimated in model (2) as a measure o f accounting contagion effects on each connected fh'm j with reported exposure to Enron, we explore factors that m a y explain the cross-sectional variation in these valuation effects. Following Boehmer, Musumeci, and Poulsen (1991), we correct for event-date clustering and event-induced variance in abnormal returns b y normalizing the A A R s to obtain standardized AARs (SAAR). More specifically, the model w e estimate is (3), where SAARy = standardized

s We use the two-day window of [0, +1] because the majority of the events are reports from newswire services or from press releases by Enron, making it less necessary to use day -1.

6 Since we have a special case where the independent variables are the same across the portfolios, OLS and SUR generate the same coefficient estimates.

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average abnormal return for firm j from model (2); Expy = dollar value o f exposure divided b y market capitalization for firm j ; the exposed value is gathered from news reports in L e x i s - N e x i s ; Earnaggy = scaled accruals as specified b y Bhattacharya, Daouk, and Welker (2003) for firm j 7; Footnotej = n u m b e r o f footnotes in the 2000 annual report (taken directly from the annual report) scaled b y market capitalization for fLrrn j ; E n g i n d y j -= d u m m y variable set equal to 1 i f firm j operates in SIC 492X and 493X; F i n l e v / = b o o k value o f long-term debt to total assets for firm j ; L n s i z e / = natural log o f equity market value for f i n n j ; and ej- = error term for firmj.

S A A R j = a o + a l e x p j + c t z E a r n a g g j + a a F o o t n o t e j + ct 4 E n g i n d y j + c t s F i n l e v j + o~6Lnsize j + e j O)

The data for the independent variables used in the cross-sectional analysis are pulled from annual reports filed in the year 2000 and compiled in C o m p u s t a t unless indicated otherwise. Market capitalization is calculated as the n u m b e r o f shares outstanding multiplied b y the share price as o f the end o f the year 2000 as reported in CRSP. T h e regressions are conducted on a sample o f 76 firms that have business relationships with Enron using weighted least squares to control for heteroskedasticity. The expected direction o f influence on the connected firms is discussed in turn.

E x p o s u r e ( E x p ) . In particular, the firms that h a v e a higher degree o f exposure to Enron as a result of their business relationship have m o r e to lose. The exposures arise through bank credits, financial credits, insurance activities, investment operations, purchase and sale agreements for natural gas and crude oil, and commodity transactions (e.g., derivatives and trading contracts and storage management and natural gas hedging). Many fn'ms had arrangements with Enron that could have led to substantial benefits. However, E n r o n ' s problems signaled that these firms would not be able to capitalize on the benefits. T h e firms that have a greater degree o f exposure had m o r e to lose and should therefore experience large declines in their valuations. As a result, we expect a negative sign on the t~l coefficient.

E a r n i n g s a g g r e s s i v e n e s s ( E a r n a g g ) . Finns that engage in business with Enron m a y use s o m e w h a t similar accounting treatments when reporting transactions related to natural gas contracts or when creating partnerships, even i f they are not classified in the same industry. In response to the events associated with Enron, the market m a y have penalized those firms doing business with Enron that are perceived to use questionable accounting methods. Since m o r e accruals m a y be taken b y fLrrns who seek to delay losses and accelerate gains, accruals can be a p r o x y for the degree o f earnings aggressiveness. Given that Enron had aggressive accounting practices, we hypothesize that firms with aggressive accounting experience contagion effects to a greater extent than those with less aggressive accounting. Therefore, firms with m o r e accruals are expected to be m o r e heavily penalized in response to news about E n r o n ' s questionable accounting practices. A negative sign on the ct2 coefficient would be consistent with this reasoning.

A n n u a l r e p o r t f o o t n o t e s ( F o o t n o t e ) . Another p r o x y for questionable accounting is the disclosure o f information through footnotes. A January 20, 2002, N e w Y o r k T i m e s article (among others) indicates that Enron had some degree o f disclosure o f its complex transactions related to special- purpose entities i f the reader can navigate a "tortuous path through the footnote section." Thus, it is possible that, with a greater number o f footnotes, the financial standing and valuation o f the firm is less clear. W e expect that firms with more footnotes experience contagion effects to a

7 Scaled accruals is defined as (ACurrent Assets - ACurrent Liabilities - ACash + ACurrent portion of long term debt - Depreciation and amortization + Alncome taxes payable)/Total assets in 1999. The changes are calculated as the figure for 2000 minus the figure for 1999.

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greater extent and a m o r e negative share-price reaction. This view supports an inverse relation between valuation effects and footnote disclosure, thus a negative sign on t~3.

E n e r g y a n d n a t u r a l g a s i n d u s t r y ( E n g i n d y ) . To the extent that the m a r k e t believes that misleading accounting is a widespread practice in this particular industry, share prices o f firms in the energy and natural gas industry may be adversely affected. While all firms in this subsample have exposure to Enron through some type o f business relationship, those firms that are in the same industry may be subjected to greater punishment i f they are more likely to apply the same accounting methods as Enron. The estimated ~ should be negative.

F i n a n c i a l l e v e r a g e ( F i n l e v ) . One o f the key issues regarding Enron's financial statements was its lack o f complete disclosure about its debt. Gillan and Martin (2002) conclude that Enron accumulated leverage to manipulate reported earnings. Firms with greater financial leverage may be m o r e tempted to use misleading accounting statements. Thus, we anticipate that f'trms with greater financial leverage are penalized to a greater extent than those with less financial leverage, resulting in a negative t~5 coefficient.

S i z e o f t h e f i r m ( L n s i z e ) . Based on the work o f Atiase (1985), it can be argued that the contagion effects are inversely related to firm size. [See, for example, Slovin, Sushka, and Bendeck (1991).] Since larger firms m a y have greater analyst following and less information asymmetry, incremental information should be conveyed about relatively small firms. More specifically, smaller firms would experience more adverse valuation effects in response to incremental information, and a negative sign on t~6 would be revealed. However, Enron was the eighth largest firm in the U.S. and still exhibited major asymmetric information. Moreover, for this particular analysis, larger firms m a y be viewed as more complex and, as a result, m a y be subject to greater suspicion. A positive sign on ct6 could also occur. Ultimately, the sign on o~6 is an empirical question.

Cross-Sectional Analysis o f Valuation Effects on R i v a l F i r m s Accounting contagion effects on firms in the same industry as Enron m a y vary with their

respective financial characteristics. Once again, w e evaluate factors that m a y explain the cross- sectional variation in standardized average abnormal returns based on the estimates in model (2) for rival f'mns. The model that we estimate is (4) where E x p i = dummy variable set equal to 1 i f firm i has direct exposure to Enron; P e r f o r m i = percentage stock price change o v e r the year prior to the first important news release on February 1, 2001, for firm i; Corri = correlation between the stock returns o f Enron and firm i calculated over the 250-day period prior to the fu'st important news release on February 1, 2001; M v b v i = equity m a r k e t value divided b y equity book value for f i r m i; and all other variables were previously defined.

S A A R i = a 0 + alF-,xpi + a 2 E a r n a g g i + a a F o o t n o t e i + a s F i n l e v i +

+ o~6Lnsize i + a 7 P e r f o r m i + a s C o r r i + a 9 M v b v i + e i (4)

Again, accounting data used in these cross-sectional analyses are pulled from annual reports filed in the year 2000 and compiled in C o m p u s t a t . Stock price data are gathered from C R S P . The regressions are conducted on the sample o f 67 firms in the energy and natural gas industry using weighted least squares. 8 All o f the independent variables listed in the previous cross-sectional

s We are unable to identify the number of footnotes for six firms in the sample; thus the sample size in these regressions is 67.

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analysis are included in this analysis o f industry rivals, with one exception. The Engindy d u m m y variable is not included in the cross-sectional analysis o f rival firms because all f'Lrms in the sample are in the ENG industry and would be designated as 1.0. Plus, the following additional independent variables are included in this analysis.

E x p o s u r e ( E x p ) . The fLrrns in the same industry as Enron that also have some business relationship with Enron are expected to suffer to a greater degree. Thus, they should experience more severe contagion effects in response to the events related to Enron's misleading accounting and reveal a negative sign on the t~l coefficient. This variable replaces the exposure p r o x y from the previous analysis, since some fLrms in the sample o f rivals do not have any direct exposure.

R e c e n t s t o c k - p r i c e p e r f o r m a n c e ( P e r f o r m ) . Some firms in the same industry as Enron could have had large stock price runups prior to the events surrounding Enron because o f the industry hype and momentum. These firms would be more vulnerable to large corrections once the market recognized that Enron's f'mancial condition was overstated. Therefore, a negative sign on the tx7 coefficient is expected.

C o r r e l a t i o n i n s t o c k r e t u r n s (Corr). Not all firms that are classified with the same SIC code have similar operations. Some fLrms in the ENG industry had operations more similar to Enron than others. Firms that have operations that are most similar to Enron m ay be expected to experience a more pronounced market correction. A negative sign on the m8 coefficient would be consistent with this reasoning.

M a r k e t - t o - b o o k ratio ( M v b v ) . High ratios o f market value to book value tend to occur when a fLrm is perceived to have strong growth opportunities. Some industry rivals m ay have inflated ratios due to exaggerated growth expectations for the industry. These rival firms may be penalized by news releases that indicate an industry leader, such as Enron, had exaggerated their accounting information. Thus, an inverse relation between market-to-book ratio and valuation effects, and hence a negative sign on tx9, may be expected.

Results

Table 2 displays the results o f the analyses for Enron using one- and two-day event windows. The valuation effects are measured by the dummy variable coefficients. Panel A shows that Enron experienced significant negative valuation effects during several o f the one-day event windows, although the strongest effects did not occur until Enron confirmed that the SEC launched an informal investigation into its accounting practices. In panel B, the average abnormal share-price response across all events is significant at the 1 percent level for both the one- and two-day event windows. The fit o f the model is slronger when each event is separated (panel A), since that model enjoys the flexibility to derive a distinct estimated market response (as measured b y the coefficient) per event. Conversely, the simpler model (panel B), which classifies all events in the same category, can only generate one estimated market response that is forced to be the same across all events. When using either model to derive the market response, it appears that the market underreacted to the various events that signaled Enron's fmancial problems. The only positive share-price response for Enron occurs at the time it filed for bankruptcy. This may have occurred since the share price was already close to zero and bankruptcy could possibly protect against creditors and therefore transfer wealth from creditors to shareholders. Some investors may have attempted to benefit from the possible wealth transfer. In this case, the favorable share-price response should be specific to Enron and would not be a favorable signal for connected fn-ms or industry rivals.

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Table 2: One-Day and Two-Day Abnormal Returns for Enron.

197

O n e - D a y W i n d o w T w o - D a y W i n d o w P a r a m e t e r E s t i m a t e t - s t a t i s t i c E s t i m a t e t - s t a t i s t i c

P a n e l A : A b n o r m a l R e t u r n s f o r Each E v e n t

[3o - 0 . 0 0 6 -0.84 -0.007 - 1.53

[31 1.271 2.26*** 1.131 3 . 2 7 " * *

[32 - 0 . 1 6 9 -0.39 -0.167 - 0.49

~,1 - 0 . 1 0 9 - 1 . 7 9 " -0.028 - 0.65

~,2 -0.108 - 1.74* -0.042 - 0.94

~,3 -0,098 -1.61 -0,043 - 1.00

~,4 - 0 . 0 9 6 -1.57 0.026 - 0.59

~ - 0 . 1 1 0 - 1.80* - 0 . 0 7 0 - 1.64*

- 0 . 1 6 0 -2.61 *** -0.112 - 2.63***

~7 - 0 . 1 4 7 -2.41 ** -0.092 - 2 . 1 6 " *

~8 -0.122 -2.00** -0.047 - 1.11

k9 -0.313 - 5 . 1 2 " * * -0.425 - 9.93***

~L10 0.139 2 . 6 1 " * * 0.536 1 3 . 0 1 " * * 113 -2.685 -0.69 -2.512 - 0.91

A d j u s t e d R 2 0.277 0 . 6 3 6 F - V a l u e 8.26*** 3 4 . 1 5 " * *

P a n e l B: A b n o r m a l R e t u r n s A c r o s s A l l Events

11o -0.005 -0.65 -0.003 - 0 . 3 4

111 1.325 2.43** 1.203 2.21 **

112 - 0 . 1 6 4 -0.30 -0.090 - 0 . 1 7

Tcomb -0.141 -3.52*** -0.103 - 3 . 5 6 * * *

113 - 2 . 7 5 0 -0.62 -2.671 ~

A d j u s t e d R 2 0.052 0.053 F - V a l u e 4 . 4 1 " * * 4 . 4 9 " * *

Notes: Estimates are obtained using SUR and daily returns for all trading days in 2001; ***, **, and * indicate significance at 1, 5, and 10 percent, respectively; the OLS adjusted R 2 and F-values are also provided.

T a b l e 3 s h o w s h o w c o n n e c t e d f i r m s w i t h e x p o s u r e to E n r o n are a f f e c t e d b y the e v e n t s u s i n g b o t h o n e - a n d t w o - d a y w i n d o w s . A g a i n , p a n e l A r e p o r t s t h e a b n o r m a l r e t u r n s f o r e a c h event, a n d p a n e l B r e p o r t s the a v e r a g e a b n o r m a l return a c r o s s all t h e events. I n b o t h p a n e l s f o r e a c h e v e n t w i n d o w , the effects o n t h e p o r t f o l i o o f all 76 c o n n e c t e d fn-ms are d i s p l a y e d as w e l l as t h e effects f o r the q u a r t i l e o f f i r m s w i t h l o w r e l a t i v e e x p o s u r e a n d the q u a r t i l e o f f i r m s w i t h h i g h r e l a t i v e e x p o s u r e . R e l a t i v e e x p o s u r e is d e f i n e d as the d o l l a r v a l u e o f the e x p o s u r e to E n r o n d i v i d e d b y m a r k e t c a p i t a l i z a t i o n . T h e fit o f the m o d e l is n o t as s t r o n g f o r the s u b s e t o f f i r m s w i t h r e l a t i v e l y l o w e x p o s u r e to E n r o n ( b o t h p a n e l s in T a b l e 3), l i k e l y d u e to the l o w e r e x p o s u r e .

198 JOURNAL OF ECONOMICS AND FINANCE �9 Volume 29 �9 Number 2 �9 Summer 2005

T a b l e 3: O n e - D a y a n d T w o - D a y A b n o r m a l R e t u r n s f o r P o r t f o l i o s o f C o n n e c t e d F i r m s .

O n e - D a y W i n d o w T w o - D a y W i n d o w Parameter All Firms L o w exp. H i g h exp. All F i r m s L o w exp. H i g h exp.

P a n e l A: A b n o r m a l Returns f o r E a c h E v e n t

[$0 0.000 -0.001 0.000 0.000 -0.001 0.000 ~1 0.454*** 0.307*** 0.648*** 0.453*** 0.307*** 0 . 6 4 6 * * *

[$2 0.004 0.066 0.080** 0.007 0.069 0.084**

~1 - 0 . 0 0 4 -0.005 -0.005 -0.002 0.002 -0.002

9~2 -0.006* -0.007 -0.009** -0.004 -0.002 -0.005**

~3 -0.004 -0.004 -0.005 -0.003 0.002 -0.001

~4 -0.005 -0.006 -0.007* -0.002 0.000 -0.004

~,5 -0.004 -0.004 -0.005 -0.002 0.002 -0.003

-0.005 -0.005 -0.006* -0.002 0.001 -0.003

~7 -0.005 -0.005 -0.006 -0.002 0.002 -0.003

3-8 -0.005 -0.005 -0.007* -0.002 0.002 -0.003

-0.005 -0.006 -0.007* -0.005 0.001 -0.003

~10 - 0 . 0 0 6 " -0.008 - 0 . 0 1 1 " * * -0.002 0.000 -0.004

[53 0.140 -0.266 0.464 0.142 -0.260 0.467

Adj. R 2 0.328 0.033 0.552 0.334 0.051 0.533 F-Value 1 0 . 2 6 " * * 1.64" 24.45*** 10.52"** 2 . 0 1 " * 2 2 . 6 9 * * *

P a n e l B: A b n o r m a l Returns A c r o s s A l l E v e n t s [$0 0.000 -0.001 0.000 0.000 -0.001 0.000

[$1 0.453*** 0.306*** 0.647*** 0 . 4 5 1 " * * 0.304*** 0.643***

[$2 0.004 0.066 0.080** 0.005 0.067 0.082**

~/comb -0.005* -0.006 -0.007** -0.002 0.001 -0.003** [$3 0.141 -0.265 0.466 0.144 -0.257 0.470

Adj. R 2 0.324 0.044 0.517 0.319 0.041 0.510 F-Value 30.55*** 3.84*** 6 7 . 0 1 " * * 29.92*** 3.61"** 65.34***

Notes: Estimates are obtained using SUR and daily returns for all trading days in 2001; ***, **, and * indicate significance at 1, 5, and 10 percent, respectively; the OLS adjusted R 2 and F-values are also provided.

The results based on t w o - d a y event w i n d o w s are less revealing than those based o n o n e - d a y event windows; h e n c e our discussion here is focused o n the results f r o m the one-day event w i n d o w . Panel A shows that the m o s t significant impact o n the group overall occurred on April 18, 2001 (event 2), w h e n C E O Skilling cursed at an analyst for questioning the accounting methods, and on D e c e m b e r 2, 2001 (event 10), when E n r o n filed for bankruptcy. Panel B shows that the portfolio o f firms that c o n d u c t e d business with Enron experienced negative and significant valuation effects from the events in aggregate. T h e quartile o f firms most exposed t o Enron exhibits significant adverse effects o n the s a m e two event dates as the entire portfolio as well as on four additional event dates. The subset o f firms with relatively low exposure is not significantly affected. 9

9 We also examine whether the exposed firms that use Arthur Andersen as their auditor during this time are more greatly penalized by these events. Our results for exposed finns using Andersen arc not significant. Since the role of Andersen was not revealed until mid-November 2001, it is likely that this particular set of events would not yet have drawn attention to other Andersen clients. Indeed, Chaney and Philipich (2002) only found significant auditor reputation effects

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T a b l e 4 r e p o r t s t h e r e s u l t s f o r f i r m s in t h e e n e r g y a n d n a t u r a l g a s ( E N G ) i n d u s t r y u s i n g a one- d a y ( t w o - d a y ) e v e n t w i n d o w . P a n e l A ( p a n e l B ) r e p o r t s the A R s for each e v e n t ( A A R s a c r o s s all events). ~~ In b o t h p a n e l s f o r e a c h e v e n t w i n d o w , t h e r e s u l t s are first d i s p l a y e d f o r the p o r t f o l i o o f all 73 r i v a l firrns, n e x t for t h e s u b s e t o f 14 f i r m s w i t h r e p o r t e d e x p o s u r e to E n r o n , and t h e n for the s u b s e t o f t h e r e m a i n i n g 59 f i n n s that a r e c o n s i d e r e d n o t to h a v e been d i r e c t l y e x p o s e d to Enron. T h e s u b s e t o f 59 u n e x p o s e d f i r m s c o n t a i n s the m o r e t r a d i t i o n a l i n d u s t r y rivals.

Table 4: One-Day and Two-Day Abnormal Returns for Portfolios o f Energy and Natural Gas Rival Firms.

Parameter

One-Day Window Two-Day Window

All Rivals Exposed Unexposed All Rivals Exposed Unexposed

P a n e l A : A b n o r m a l R e t u r n s f o r E a c h E v e n

~0 0.000 0.001 0.000 0.000 0.001 0.000 ~t 0.301"** 0.250*** 0.311"** 0.298*** 0.245*** 0.308*** ~2 -0.077** -0.076 -0.084** -0.075** -0.072 -0.082** ~1 -0.005* -0.008* -0.005 -0.003 -0.005* -0.002 ~2 -0.006** -0.009* -0.006* -0.003 -0.006* -0.003 ~3 -0.005 -0.008* -0.004 -0.003 -0.005* -0.002

-0.005* -0.008* -0.005* -0.003 -0.006* -0.003* -0.005 -0.007 -0.004 -0.003 -0.006* -0.003 -0.005* -0.008* -0.005 -0.003 -0.006* -0.003

~7 -0.005* -0.008* -0.005* -0.003 -0.006* -0.003 ~8 -0.004 -0.008* -0.004 -0.002 -0.005* -0.002 X9 -0.005* -0.008* -0.005* -0.003 -0.005* -0.003 ~10 -0.005 -0.010"* -0.004 -0.003 -0.005* -0.002 []3 0.219 0.537 0.123 0.222 0.539 0.125 A ~ . R 2 0.243 0.113 0.276 0.239 0.091 0.268 F - V ~ u e 7.09*** 3.42*** 8.23*** 6.95*** 2.91"** 7.94***

P a n e l B: A v e r a g e A b n o r m a l R e t u r n A c r o s s A l l E v e n t s 130 0.000 0.001 0.000 0.000 0.001 0.000 I$f 0.300*** 0.249*** 0.310"** 0.298*** 0.245*** 0.308*** I]z -0.077** -0.076 -0.084** -0.075** -0.073 -0.082** ~'comb -0.005** -0.008** -0.005* -0.003* -0.005** -0.003 113 0.220 0.537 0.124 0.222 0.540 0.126 Adj. R z 0.231 0.097 0.257 0.227 0.095 0.253 F-Value 19.54"** 7.66*** 22.39*** 19.13"** 7.48*** 21.89"**

Notes: Estimates are obtained using SUR and daily returns for all trading days in 2001; ***, **, and * indicate significance at 1, 5, and 10 percent, respectively; the OLS adjusted R 2 and F-values are also provided.

F i r s t , a c r o s s b o t h e v e n t w i n d o w s , n e a r l y e v e r y e v e n t results in a s i g n i f i c a n t effect o n the p o r t f o l i o o f e x p o s e d f i r m s in t h e E N G industry. I t a p p e a r s t h a t the n e g a t i v e n e w s a b o u t E n r o n was i n t e r p r e t e d b y i n v e s t o r s a s a n e g a t i v e s i g n a l a b o u t fin-ms in the i n d u s t r y w h o h a v e a b u s i n e s s r e l a t i o n s h i p with Enron. S e c o n d , for the o n e - d a y w i n d o w , the valuation effects a r e s i g n i f i c a n t for

following the news report on January 10, 2002, that revealed Andersen shredded documents related to the Enron scandal. 10 As a robustness check, we looked at the nonparametric signed-rank test statistic for the AARs for the sample of

connected firms and the sample of rival firms. These statistics confirm what we report in panel B of Tables 3 and 4.

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the portfolio o f all rivals and the portfolio o f unexposed firms across several event dates and for the events in aggregate. A negative signal suggests a dominant accounting contagion effect, whereby Enron's faulty accounting elicits suspicion about the financial statements provided b y other industry rivals. Thus, even though the r i v a l ' s financial statements are not directly altered as a result o f Enron, the interpretations o f the r i v a l ' s financial statements that followed s o m e o f the conventional (but perhaps also misleading) accounting standards m a y have been altered. Consequently, just as the deflation o f a f i r m ' s accounting numbers m a y cause a reduction in the f i r m ' s stock price, it m a y also cause a reduction in the stock prices o f competitors.

The results from the separate cross-sectional analyses o f finns that conducted business with Enron and firms in the s a m e industry as Enron are disclosed in Table 5. For each sample, two different dependent variables are used. A regression model is estimated using the standardized average abnormal return (SAAR), where the A A R is measured over both a one-day window and a two-day window. W e examine the variance inflation factors (VIFs) to assess the extent o f multicollinearity. All o f the VIFs are below four, indicating multicollinearity is not substantially influencing the coefficients.ll

T a b l e 5: Results o f C r o s s - S e c t i o n a l R e g r e s s i o n A n a l y s i s o n C o n n e c t e d a n d R i v a l F i r m s .

Expected Connected Firms Rival Firms Sign Variables l-day SAAR 2-day SAAR 1-day S A A R 2-day S A A R

+ o r -

Intercept 1.502 1.326 0.605 0.473 (2.86***) (2.65***) (1.06) (1.10)

Relexp -0.006 -0.006 - - (-3.08***) (-3.42***)

Exposed - - -1.338 -0.853 (-5.01"**) (-4.22"**)

Earnagg -0.169 -0.369 -0.477 -0.188 (-0.63) (-1.43) (-2.16"*) (-1.12)

Footnote -0.026 -0.007 -0.003 -0.002 (-2.84***) (-0.84) (-0.79) (-0.87)

Engindy -0.760 -0.803 - - (-3.55***) (-3.94***)

Finley - 1.748 - 1.445 -3.807 - 1.632 (-3.60***) (-3.12"**) (-3.65"**) (-2.07**)

Lnsize -0.126 -0.077 -0.002 -0.076 (-1.97"*) (-1.27) (-0.02) (-1.17)

Perform - - -0.308 -0.638 (-1.28) (-3.51"**)

Corr - - 0.845 1.454 (0.85) (1.93*)

Mvbv - - 0.203 0.156 (1.14) (1.16)

Adj. R 2 0.508 0.439 0.449 0.500 F-Value 12.19"** 9.49*** 8.76*** 10.51"**

Notes: The dependent variable is the firm's SAAR from model (2) using weighted least squares; ***, **, and * indicates significance at 1, 5, and 10 percent, respectively.

N VIFs greater than five often are used to indicate severe multicollinearity. [See Marquardt and Snee (1975).]

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V a r i a t i o n i n Valuation E f f e c t s o n C o n n e c t e d F i r m s The first two columns o f results in Table 5 are from the sample o f fwms that conducted business

with Enron. Several variables are significantly related to the valuation effects o f firms that conducted business with Enron. We find three variables that are consistently significant across both models; two additional variables are significant when the dependent variable is the one-day SAAR.

Both models indicate that the R e l e x p variable is negative and significant, which confirms the hypothesis that fLrms with a greater degree o f exposure to Enron experienced more pronounced adverse effects. The E n g i n d y variable is negative and significant, which implies that those f'Lrms within this specific sample that are also in the same industry as Enron were penalized to a greater degree. The F i n l e y variable is negative and significant, which suggests that firms with a higher degree o f f'mancial leverage were penalized to a greater degree.

Using the one-day SAAR as the dependent variable, F o o t n o t e and L n s i z e are also found to be significant. The F o o t n o t e variable is negative and significant, which indicates that firms with a greater number o f footnote disclosures experience greater contagion effects. Lastly, there is some evidence that fLrm size ( L n s i z e ) is inversely related to valuation effects. To the extent that f'mn size is a proxy for the degree o f complexity as in the case o f Enron itself, this ffmding indicates that misleading information may be underlying the financial statements o f larger, more complex firms.

V a r i a t i o n i n Valuation E f f e c t s o n R i v a l F i r m s The last two columns o f results in Table 5 are from the sample off'm-as in the same industry as

Enron. We fred two variables that are consistently significant across both models, plus three additional variables depending on which dependent variable is used. The fin-ms with direct exposure ( E x p o s e d ) to Enron are more adversely affected. Firms with greater financial leverage ( F i n l e y ) were penalized to a greater degree, which m a y result i f these firms are more tempted to use misleading accounting.

Using the one-day SAAR as the dependent variable, E a r n a g g is negative and significant. An inverse relationship between the degree o f earnings aggressiveness and wealth effects supports the hypothesis that firms with aggressive accounting experienced greater contagion effects than those with less aggressive accounting. Using the two-day SAAR, P e r f o r m and C o r r are also found to be significant. The negative sign on the P e r f o r m variable indicates that firms with a stronger runup were penalized to a greater degree. While the positive sign on the C o r r variable shows that firms in the ENG industry with operations more similar to Enron are more favorably affected. This result m a y arise due to competitive repositioning that is expected to benefit close rivals.

Summary

While the direct effect on Enron is known, the indirect effects on connected firms and industry rivals are not well documented. Our analysis measures the depth o f the damage caused by Enron's faulty accounting. First, the negative news about Enron on at least two event dates was transmitted to those firms that were known to have exposure to Enron. Second, the negative news about Enron adversely affected firms in the energy and natural gas industry. Overall, the findings substantiate how the inaccurate financial reporting by a single firm m ay affect not only its shareholders but also the shareholders o f connected firms and competitors. While the market was unable to detect the inaccuracy o f Enron's financial statements, it swiftly punished firms with linkages once Enron's faulty accounting was publicized.

The underlying reason for the negative effects o f fn'rns that did business with Enron or were in the same industry as Enron is not only attributed to exposure to Enron but also to suspicion about accounting methods. A cross-sectional analysis documents that the market punished firms that had greater exposure to Enron's business, that used more aggressive earnings reporting methods, and whose fmancial statements were more complex. In retrospect, the confusing financial statements

202 JOURNAL OF ECONOMICS AND FINANCE �9 Volume 29 �9 Number 2 �9 Summer 2005

allowed these firms to perform better than they should have before the demise of Enron but resulted in more pronounced corrections following the demise of Enron. Furthermore, any competitive effects that may have been enjoyed by the industry rivals were overwhelmed by adverse accounting contagion effects.

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