Auditing and Consulting in Accounting Firms

Traditionally, an auditor reduces the information asymmetry between a firm's managers and its shareholders by checking the firm's books and monitoring the quality of the information the firm produces. Auditors play an important role in financial markets because they can reduce the inevitable information asymmetry between the firm's managers and its shareholders.

Threats to truthful reporting in an audit arise from several potential conflicts of interest. The conflict of interest that has received the most attention in the media occurs when an accounting firm provides its client with auditing services and nonaudit consulting services—commonly known as management advisory services—such as advice on taxes, accounting or management information systems, and business strategies. Accounting firms that provide multiple services enjoy economies of scale and scope, but have two potential sources of conflicts of interest. First, clients may pressure auditors into skewing their judgments and opinions by threatening to take their accounting and management services business to another accounting firm. Second, if auditors are analyzing information systems or examining tax and financial advice put in place by their nonaudit counterparts within the accounting firm, they may be reluctant to criticize the advice or systems. Both types of conflicts may potentially lead to biased audits. With less reliable information available to investors, it becomes more difficult for financial markets to allocate capital efficiently.

A third type of conflict of interest arises when an auditor provides an overly favorable audit in an effort to solicit or retain audit business. The unfortunate collapse of

Conflicts of Interest. The Collapse of Arthur Andersen

In 1913, Arthur Andersen, a young accountant who had denounced the slipshod and deceptive practices that enabled companies to fool the investing public, founded his own firm. Until the early 1980s, auditing was the most important source of profits for this firm. By the late 1980s, however, the consulting part of the business began to experience high revenue growth with high profit margins, even as the audit profits slumped in a more competitive market. Consulting partners began to assume more power within the firm, and the resulting internal conflicts split the firm in two. Arthur Andersen (the auditing service) and Andersen Consulting were established as separate companies in 2000.

During the period of increasing conflict before the split, Andersen's audit partners had faced increasing pressure to focus on boosting revenue and profits from audit services. Many of Arthur Andersen's clients that later went bust—Enron, WorldCom, Qwest, and Global Crossing—were also the largest clients in Arthur Andersen's regional offices. The combination of intense pressure to generate revenue and profits from auditing and the fact that some clients dominated the business of regional offices translated into tremendous incentives for regional office managers to provide favorable audit stances for these large clients. The loss of a client such as Enron or WorldCom would have been devastating for a regional office and its partners, even if that client contributed only a small fraction of the overall revenue and profits for Arthur Andersen as a whole.

The Houston office of Arthur Andersen, for example, ignored many problems in Enron's reporting. Arthur Andersen was indicted in March 2002 and then convicted in June 2002 for obstruction of justice for impeding the SEC's investigation of the Enron collapse (the conviction was overturned by the Supreme Court in May 2005). Its conviction—the first ever against a major accounting firm—barred Arthur Andersen from conducting audits of publicly traded firms and so effectively put it out of business.

Arthur Andersen—once one of the five largest accounting firms in the United States— suggests that this may be the most dangerous conflict of interest (see the Conflicts of Interest box, "The Collapse of Arthur Andersen").

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