Correspondence: Gopal V. Krishnan, VSCPA Northern Chapter Professorship in Public Accounting, School of Management, MSN 5F4, George Mason University, Fairfax, VA 22030, USA. Tel: +1 703 993 1966; Fax: +1 703 993 1809; E-mail: gkrishn1@gmu.edu

¹holds the Northern Chapter of the Virginia Society of Certified Public Accountants Professorship in Public Accounting at the George Mason University in Fairfax, Virginia. He holds a PhD from the University of North Texas. His research addresses issues concerning auditor independence, corporate governance, earnings management and fraud.

²is an assistant professor of Accounting at George Mason University in Fairfax, Virginia. He received his PhD from New York University. His research interests include deferred taxes, audit committee expertise, and corporate governance.

Received 22 October 2007; Revised 22 October 2007; Published online 22 November 2007.

EXECUTIVE SUMMARY

The unexpected demise of Big 5 accounting firm Arthur Andersen is an important event in the history of the accounting profession. Were the Enron fiasco and related failures at WorldCom, the Baptist Foundation of Arizona, and several others relatively isolated events or were they symptomatic of an audit firm that allowed clients to push the envelope too far? This study asks whether Andersen tolerated more earnings management by its clients relative to other Big 5 auditors, particularly in the Houston office that served Enron. In seeking an answer, we examine several measures of earnings management, earnings persistence, and a measure of earnings manipulation. We study all clients audited by Andersen and its then Big 5 competitors as well as the clients served by these firms' Houston offices during the years 1996–2000 to examine whether Andersen's clients exhibited greater earnings management in their audited financials. Our analysis indicates greater earnings management among clients served by Andersen's Houston office relative to Houston-based clients of other Big 5 auditors. The decision to indict Andersen continues to be a controversial one and our study contributes to the debate by finding evidence that is consistent with the characterisation that Andersen, particularly the Houston office, was somewhat more tolerant of earnings management relative to other Big 5 auditors. These results are important for auditors, regulators, investors, and creditors who are users of audited financial information. Audit quality is central to the integrity of financial reporting and understanding differences in audit quality among auditors is vital for investors who rely on the audited outcome. The results of the study are useful to readers in that they can apply similar analyses to existing auditors and compare them on dimensions of earnings management examined in this study.