Auditors' Risk Management and Reputation Building in the Post-Enron Environment: An Examination of Earnings Conservatism of Former Andersen Clients

Abstract

In the post-Enron world, the spot light is on the auditors who face a higher risk of litigation. This study provides evidence on one strategy employed by auditors to mitigate litigation risk and rebuild their reputation by enhancing earnings conservatism of their clients. I examine the earnings conservatism for a sample of former Arthur Andersen clients who switched to a Big 4 auditor in 2002. I find that prior to the switch earnings of former Andersen clients are less sensitive to bad news about future cash flows than earnings of non-Andersen clients. In 2002, earnings conservatism has increased for both former Andersen clients and non-Andersen clients. Further, the increase in earnings conservatism is more pronounced for Houston-based former clients of Andersen. The results are consistent with the notion that brand name auditors attempt to mitigate litigation risk by prevailing on their clients to recognize bad news in a timely fashion.

Keywords: Asymmetric timeliness, Earnings-return relation, Capital markets

JEL Classification: M41, M49, M44, D82, G14, K22