The Andersen Effect: Meaning and History in the Enron Scandal
What is the Andersen Effect?
The Andersen Effect refers to auditors taking extra precautions and performing more extensive due diligence to prevent financial accounting errors and mishaps similar to those that led to the collapse of Enron in 2001.
The term “Andersen Effect” is derived from Arthur Andersen LLP, a prominent accounting firm based in Chicago. By 2001, Arthur Andersen had become one of the Big 5 accounting firms, alongside 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 renowned globally for its ability to deploy experts internationally, providing auditing, tax, and consulting services to multinational businesses.
History: From a “Big 5” to Collapse
Arthur Andersen’s reputation and success were shattered in 2002. The firm faced severe consequences as more flawed audits were uncovered during the Enron investigation and subsequent indictment. In June of that year, Andersen was convicted of obstruction of justice for destroying documents related to its audit of Enron, which became infamous as the Enron scandal. The Securities and Exchange Commission (SEC) also faced criticism for its perceived failure in overseeing the situation. However, Arthur Andersen, previously highly reputable and respected, suffered the most significant damage.
Arthur Andersen’s involvement in faulty audits extended beyond Enron. Other high-profile accounting scandals associated with the firm included Waste Management, Sunbeam, and WorldCom.
The Sarbanes-Oxley Act of 2002
In response to the series of accounting scandals, Congress passed the Sarbanes-Oxley Act of 2002 (SOX). This federal law established new or enhanced requirements for all U.S. public companies, management, and public accounting firms, aiming to prevent another Enron scandal and the Andersen Effect. Key points regarding SOX and its impact include:
- Requirements: SOX mandated new or expanded obligations for public company boards, management, and public accounting firms.
- Strong Corporate Governance: The accounting and corporate scandals triggered by Arthur Andersen led to a push for stronger corporate governance and heightened accounting controls to prevent similar incidents.
- Positive Outcomes: An unexpected positive outcome of SOX is that it introduced a higher level of scrutiny, resulting in companies voluntarily restating their earnings even if there was no intentional misrepresentation of accounting information.
The Bottom Line
The collapse of even the largest and most reputable accounting firms can occur due to mismanagement or mistakes made on behalf of a client. The Sarbanes-Oxley Act was enacted to protect clients and investors. However, the increased scrutiny mandated by the act also safeguards companies and public accounting firms, preventing errors that could potentially lead to their downfall.
Further Resources on the Andersen Effect and the Sarbanes-Oxley Act
Websites and Online Resources:
- Securities and Exchange Commission (SEC) – Official website providing comprehensive information on regulations, enforcement actions, and corporate governance related to the Sarbanes-Oxley Act and other financial matters. Link
- Public Company Accounting Oversight Board (PCAOB) – The official resource for audit standards and oversight, offering insights into auditing practices and measures taken to prevent accounting scandals. Link
- “The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron” by Bethany McLean and Peter Elkind – An in-depth exploration of the Enron scandal and its connection to Arthur Andersen, shedding light on the events that led to the Andersen Effect. Link
- “Sarbanes-Oxley For Dummies” by Jill Gilbert Welytok – A comprehensive guide to understanding the Sarbanes-Oxley Act, its implications, and the measures it introduced to prevent corporate fraud and enhance transparency. Link
Academic Journals and Research Papers:
- “The Sarbanes-Oxley Act and Corporate Governance” by Reinier Kraakman, George Triantis, and Howell Jackson – A research paper discussing the impact of the Sarbanes-Oxley Act on corporate governance and financial reporting. Link
- “Arthur Andersen and the Enron Case: A Critical Analysis of the Law and Ethics of Corporate Governance” by James M. Olson – An academic examination of the ethical and legal issues surrounding the Enron scandal and the role of Arthur Andersen. Link
Reports and Studies:
- “The Impact of the Sarbanes-Oxley Act on American Businesses” – A report by the U.S. Chamber of Commerce assessing the effects of the Sarbanes-Oxley Act on American businesses and financial markets. Link
- “Lessons from the Enron Scandal On Corporate Governance, Executive Compensation, And Auditor Independence” – A study by the U.S. Senate Committee on Governmental Affairs analyzing lessons learned from the Enron scandal and implications for corporate governance. Link
Professional Organizations and Associations:
- American Institute of Certified Public Accountants (AICPA) – The leading professional organization for CPAs, offering resources and guidelines related to auditing and accounting practices, including those influenced by the Sarbanes-Oxley Act. Link
- The Institute of Internal Auditors (IIA) – A global organization providing guidance and standards for internal auditing, relevant to corporate governance and internal controls required by the Sarbanes-Oxley Act. Link