Centre for Economic Policy Research

partners to focus on who hires or fires them, as well as who negotiates the fee
paid. In a highly competitive environment, local branches serving dominant
firms, coupled with a lack of independence from management created the 
potential for lower quality audits.
3.7
Litigation risk and rules-based audits
While supplying non-audit services and fee pressure reduce the independence of
auditors from managers, thus creating conflicts of interest, it is unlikely that these 
conflicts were exploited to an extent that can explain the recent, huge audit 
failures, as there is evidence that auditors understood that the audit firm’s primary
asset is its reputation. In fact, paradoxical as it may seem, it may have been audit
firms’ heightened concerns to protect their reputation and guard against litigation
Accounting: Conflicts of Interest in Auditing and Consulting 37

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risks that were a driving factor in the audit failures. There was a sharp rise in 
litigation risk for US audit firms in the 1970s and 1980s in the United States, as
class action lawsuits were filed on behalf of shareholders, claiming that declines
in share prices were caused by faulty auditing (Palmrose, 1991). Litigation defeats
provide both an immediate direct cost in the penalty and higher insurance costs,
and an indirect cost in reputational loss that can cause firms to lose audit clients.
For audit firms, the cost of defence in these lawsuits and the large settlements
focused attention on reducing litigation risk. The national offices of audit firms
began to perform risk assessments of clients and practices to manage these costs.
Firms adjusted their activities to protect themselves from litigation.
36
The threat
of such lawsuits against company managers increased the incentive for earnings
management and, as auditors were often part of the litigation, there were large
negative incentives to force companies to ‘miss’ earnings targets especially over
‘judgement’ calls. 
One reaction to counter the growing legal threat to the auditing profession and
the corporations themselves was to seek and rely on increased codification of
auditing and accounting standards that facilitated a legal defence of compliance
with rules (Dye, 1993). Since the creation of the Financial Accounting Standards
Board in 1973, there has been a proliferation of codified accounting rules in the
United States. These rules have allowed for a clear shift in auditors’ focus from
opining on whether financial statements fairly present the ‘true’ financial 
condition and performance of the company to a focus on compliance with the
detailed ‘Generally Accepted Accounting Principles’ (GAAP) rules. This focus 
permitted managers to argue that audit opinions should concentrate on compli-
ance with the rules, shifting attention from the ‘true’ condition and performance
of the company. Managers and auditors could also use the rules to create struc-
tures that allowed them to obscure the true economic condition of companies by,
for example, placing assets and obligations in unconsolidated entities. 
The Enron debacle has all of the elements described above, including the focus
on rules rather than the true condition of the firm. While it remains to be seen
who bears legal responsibility for the failure of the firm, many of the conflicts 
discussed above existed at Enron. Several financial executives were ex-auditors
from Andersen. Non-audit service fees were greater than the audit fees. Enron 
purportedly was the prize audit client of the Houston office and its growth
appeared to be spectacular. In addition, it had complex structures that distorted
the economic reality but were constructed, with the help of their auditors and
legal advisers, to meet codified standards. Finally, Anderson was the only big firm
to devolve decisions on some accounting principles to its local offices.
Two examples serve to illustrate how an audit and accounting system based on
prescriptive GAAP rules aided in distorting the economic picture. Enron was 
listed in the top ten of the Fortune 500 companies based on its consolidated sales.
The sales measure had no bearing on reality, however, as it reflected trading 
activity in energy contracts that were recorded on a gross rather than a net basis
because of a GAAP rule EITF 98-10.
37
(This rule was recently rescinded.) Enron also
created Special Purpose Entities (SPEs) that placed assets, associated liabilities and
guarantees off the balance sheet. These SPEs were acceptable as long as there was
a ‘minimum’ outside equity position based on interpretations of existing rules.
When the chairman of Arthur Andersen testified before a congressional commit-
tee on Enron he commented that the problem was with the interpretation of the
consolidation rules not that the structures had totally distorted the economic 
realities. This typifies the way in which many in the audit profession perceived
their role, opining on compliance with arcane rules, irrespective of the economic
substance. 
38 Conflicts of Interest in the Financial Services Industry

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The evolution of audit practice over the last 50 years has been rapid, especially
in the United States. Increased competition for audit clients put pressure on audit
revenue and pushed firms to cut costs to sustain profits. Simultaneously non-audit
services, especially the installation of management information systems, grew
dramatically leading to growing concern about auditors’ independence. As the
revenues from these non-audit services increased, profit-sharing structures that
favoured audit partners created internal tensions that often led to audit partners
and local offices being pushed to deliver audit revenues and profits. Furthermore,
there was an increase in litigation against audit firms in the 1980s resulting in 
rising costs and damage to reputations. To defend themselves, audit firms sought
to reduce litigation risk, most notably by demanding and obtaining legally 
defensible rules in regulatory accounting and audit principles, even if these 
practices limited the auditors’ ability to provide relevant and reliable information
about the financial performance and condition of firms. As competition for audits
heated up and risks increased, the governance structure around hiring and 
audit-fee decisions shifted away from boards of directors to the senior executives
of the companies being audited. Each of these factors contributed to the conflicts
of interest in the audit system of the late 1990s that were part of the spectacular
business failures.