Understanding the Andersen Effect
The Andersen Effect is a reference to auditors performing even more due diligence than previously required in order to prevent the kinds of financial, accounting errors, and mishaps that precipitated Enron's collapse in 2001.
The Andersen Effect gets its name from former Chicago-based accounting firm Arthur Andersen LLP. By 2001, Arthur Andersen had grown into one of the Big 5 accounting firms, joining the likes of PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, and KPMG. At its peak, Arthur Andersen employed nearly 28,000 people in the U.S., and 85,000 worldwide. The firm was known globally for its ability to deploy experts internationally to advise multinational businesses across its auditing, tax, and consulting practices.
- The Andersen Effect gets its name from the former Chicago-based accounting firm Arthur Andersen LLP and its connection to what became known as the Enron scandal.
- By 2002, it all came tumbling down for Arthur Andersen as more faulty audits were discovered in the course of the Enron indictment and investigation.
- The Sarbanes-Oxley Act of 2002 was passed by Congress to establish new or expanded Federal requirements for all U.S. public companies, management, and public accounting firms to prevent another Enron and Andersen Effect.
From a "Big 5" to Collapse
By 2002, all of the trust and glory came tumbling down. That June, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron, resulting in what infamously became known as the Enron scandal. Even the Securities and Exchange Commission (SEC) did not emerge unscathed. Many accused the oversight commission of being "asleep at the wheel." But aside from Enron, the up-until-then highly reputable and respected Arthur Andersen stood the most to lose, and it did.
More faulty audits on behalf of Arthur Andersen were discovered in the course of the Enron indictment and investigation. Big-name accounting scandals linked to Arthur Andersen went on to include Waste Management, Sunbeam, and WorldCom.
The subsequent bankruptcy of WorldCom, which quickly surpassed Enron as the biggest bankruptcy in history at that time, resulted in a classic domino effect of accounting and corporate scandals. The industry's reaction was a swift attempt to avoid the Andersen Effect by employing strong corporate governance and heighten accounting controls.
In response to the series of accounting scandals set off by Arthur Andersen, the U.S. Congress passed the Sarbanes–Oxley Act of 2002 (SOX). The federal law established new or expanded requirements for all U.S. public company boards, management, and public accounting firms. An unexpected additional positive outcome of SOX is that this extra level of scrutiny has resulted in companies restating their earnings even if they have not necessarily intentionally misrepresented accounting information.
The Bottom Line
Even some of the biggest, most well respected, and most trustworthy accounting firms can collapse due to mismanagement or missteps taken on behalf of a client. Sarbanes-Oxley was passed to protect the client or investor. But while not always acknowledged, the added scrutiny also protects companies and public accounting firms from making the kinds of mistakes that could ultimately contribute to their undoing.