What is the Andersen Effect

The Andersen effect is a reference to auditors performing more careful due diligence when auditing companies in order to prevent accounting errors. This extra level of accounting scrutiny often leads to companies restating earnings even though they have not necessarily intentionally misrepresented material accounting information.

BREAKING DOWN Andersen Effect

The Andersen effect takes its name from the accounting firm Arthur Andersen LLP, which was indicted in a number of accounting scandals in relation to the Enron collapse. By 2001, Arthur Andersen, which was based in Chicago had grown into one of the Big Five 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 services.

By 2002 it all came tumbling down. That June, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron, resulting in what is known infamously as the Enron scandal. More faulty audits on behalf of Arthur Andersen were discovered in the course of the Enron indictment. 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, which now gives us the apropos idea of avoiding the Andersen effect or Andersen moments by employing strong corporate governance and heighten accounting controls.

In response to the series of accounting scandals setoff by Arthur Andersen, the U.S. Congress passed the Sarbanes–Oxley Act of 2002 (commonly known as SOX). The federal law established new or expanded requirements for all U.S. public company boards, management and public accounting firms. The bill was enacted in response the major corporate and accounting scandals which featured the wrongdoings of Enron, WorldCom, and their auditor, Arthur Andersen.