Centre for Economic Policy Research

3.4
Conflicts of interest 
In auditing, threats to truthful reporting arise from several potential conflicts of
interest. The conflict most frequently discussed in the popular financial press 
arises from an auditor providing non-audit services, usually in areas of tax,
accounting or management information systems and strategic advice, commonly
referred to as management advisory services (MAS). In an early empirical study of
the potential audit/MAS conflict, Simunic (1984) defined an auditor’s conflict of
interest as ‘a setting where an auditor must evaluate (trade-off) the benefits and
costs of truthful reporting’, adding ‘In general, any situation which increases the
probability that an auditor will not truthfully report the results of his audit 
investigation can be viewed as a threat to independence’.
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Despite the potential cost from conflicts of interest in provision of joint 
services, there are also offsetting efficiency gains from economies of scope. For
example, auditing firms are natural consultants to companies because they 
gather and assess a wide array of information leading to their attestation of finan-
cial performance reported in the financial statements.
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Based on the historical
evolution of auditing we described, it has long been common practice for auditors
to supply management with an assessment of the company’s systems and 
practices at the end of an audit. There are clear economic efficiencies in using the
information already gathered to move to an advisory role in related areas. 
As companies became more complex and as technology advanced, corporate
accounting systems were increasingly computerized. It was a natural step for the
advisory role of auditing firms to specialize in computerized management infor-
mation systems. This practice developed rapidly, and from the early 1980s, the
Accounting: Conflicts of Interest in Auditing and Consulting 31

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auditing firms emerged as major powerhouses of the consulting business. The
largest auditing firms entered the ranks of the top ten of global consulting firms.
At the head of this list was Andersen Consulting, which was almost solely a 
systems-oriented consulting firm.
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All audit firms provided systems advice,
although not to the same scale as Andersen Consulting. 
To function efficiently in their primary audit attest function, audit firms need
to invest in specialized industry knowledge that enables them to evaluate 
management accounting decisions. Such investment in industry expertise has
natural information synergies with traditional strategic and structuring consulting
services. Thus, all audit firms have industry specializations that served both audit
and non-audit businesses. For example, Arthur Andersen had a long-standing
expertise in oil and gas and related energy businesses, which made it an obvious
choice for Enron, an energy firm with Headquarters in Houston, the hub of the
US energy industry. One of the conflicts that arose within Arthur Andersen was
the growth of the non-systems consulting business that Andersen Consulting