An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Stephen C. Hansen
The George Washington University

Krishna R. Kumar
The George Washington University

Mary Sullivan
The George Washington University

Abstract: The indictment of Arthur Andersen by the Department of Justice in March 2002 was a major shock to the audit industry. Andersen’s clients, representing over one-fifth of the audit market, needed new auditors quickly. The unprecedented transfer of new clients that followed placed a large burden on successor auditors. We refer to the resulting strain on audit resources as auditor capacity stress. We examine the effect of auditor capacity stress on audit quality, as reflected in the earnings response coefficients (ERCs) of client firms. ERCs decline substantially in the first fiscal year (2002) following Andersen’s failure, but recover subsequently. The ERC decline varies directly with auditor capacity stress both in the new clients switching from Andersen and in the continuing clients. Successor auditors appear to experience a decline in audit quality associated with auditor capacity stress. The findings are relevant for policy makers engaged in oversight of the audit industry.

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