Auditor Capacity Stress and Audit Quality: Market-Based Evidence from Andersen's Indictment

Abstract

The unprecedented migration of Andersen's clients that followed Andersen's indictment in March 2002 potentially placed a large burden on successor auditors' audit resources. We refer to this strain, measured at the local-office level, as auditor capacity stress. We examine the effect of auditor capacity stress on investor assessments of audit quality by examining changes in earnings response coefficients (ERCs) of Big-4 client firms. We observe larger decreases in marginal ERCs in fiscal 2002 relative to a base period of 1999-2001 for clients at successor auditors' offices that experience high capacity stress than for clients of low-capacity-stress offices. That is, capacity stress appears to adversely impact perceived audit quality in the first year with successor auditors. However, we also find that marginal ERCs recover more substantially in fiscal 2003 relative to 2002 for clients of high-capacity-stress audit offices than low-capacity-stress offices. This finding suggests that clients experience relief from capacity stress in 2003, with greater relief for more highly-stressed auditors. The evidence indicates that auditor failures can be quite disruptive to audit markets but a quick recovery is possible.

Keywords: audit quality, Arthur Andersen failure, auditor capacity stress, earnings response coefficients, recovery, successor auditors

JEL Classification: G12, G14, M41, M49