When you hear the name Arthur Andersen, the first thing that usually comes to mind is … well … you know. But here’s some good news associated with the Andersen name: audit partners who worked at Arthur Andersen during its collapse and who currently work in the Big 4 provide higher-quality audits than audit partners at other public accounting firms who weren’t at Andersen during the Enron scandal, according to a new study.
The study, Fool Me Once, Shame on You; Fool Me Twice, Shame on Me: The Long-Term Impact of Arthur Andersen’s Demise on Partners’ Audit Quality, which was published in Contemporary Accounting Research, concluded that:
[A]udit partners who directly experienced Andersen’s demise impose stricter monitoring evident in their clients exhibiting a lower propensity for misstatements and small profits, and paying higher audit fees. Importantly, these findings reconcile with research in finance and economics implying that firsthand experiences matter more to subsequent behavior than general economic conditions or second- or thirdhand experiences. Collectively, the results shed light on one facet of how partners’ audit quality evolves over time. Our findings suggest that major failures associated with the audit firm in which an auditor works can ultimately result in these affected individuals later delivering higher audit quality, which should benefit audit committees in partner selection decisions and audit firms in designing partner assignment policies.
The six university researchers who authored the study compared recent audits by 199 former Arthur Andersen employees—who are now partners at PwC, Deloitte, KPMG, and EY—to recent audits by 1,446 of their peers by examining Forms AP on the PCAOB website. Here’s a breakdown of the 199 ex-Andersen partners who currently work in the Big 4:
- PwC: 21
- Deloitte: 52
- EY: 59
- KPMG: 67
The researchers stated:
In compiling our sample, we match Form AP data downloaded from the PCAOB’s website with the audit partner’s LinkedIn profile where available. We restrict the sample to clients of Big 4 audit firms since partners formerly affiliated with Andersen now working at a non–Big 4 audit firm might not be comparable to non–Big 4 audit firms’ other partners who were not initially recruited at the start of their career by Big 4 audit firms, making it difficult to disentangle the effects of personal experiences from differences in talent and the effects of different recruiting strategies.
The researchers then used three proxies that correlate with audit quality: the propensity to misstate the financial statements, the propensity to meet or just beat the zero earnings threshold, and audit fees. Here’s what stood out:
[T]he likelihood of misstatements, identified by a subsequent restatement of the audited annual financial statements, is 0.8% for AA partners’ clients and 2.3% for those audited by non-AA partners. We find that the propensity to report small profits (a sign that a company is manipulating earnings to avoid reporting a loss), on average, is 12% for AA partners’ clients, which is significantly lower than the frequency for clients audited by non-AA partners (14.8%). These results lend preliminary support to the narrative that partners who directly experienced Andersen’s demise exhibit a more conservative auditing style. Audit fees of clients audited by an AA partner are 4.4% larger than those of clients with a non-AA partner.
As I mentioned earlier, the researchers concluded, based on their evidence, that “major failures associated with the audit firm in which an auditor works can ultimately result in these affected individuals later delivering higher audit quality. This should alert audit committees to the importance of weighing whether to appoint an auditor who has perhaps been tainted by, but not directly involved in, such an event. Similarly, these results should matter to audit firms’ recruitment, promotion, and retention decisions.” And the researchers said their analysis could benefit audit firms attempting to design optimal partner assignment policies. For example:
[A]udit firms may prefer to assign partners who experienced Andersen’s demise to clients known to undertake more aggressive financial reporting positions. Relevant to the public policy discourse, our research lends support to the movement toward requiring the disclosure of engagement partner identities since this may provide valuable information to the capital markets.
You can read the entire study below: