Centre for Economic Policy Research

partnership organizational structure meant that the non-audit partners also
incurred a share in the audit risk with little ability to exert any control over it. 
Nowhere was this conflict more extreme than at Arthur Andersen, where the
audit and consulting partners fought publicly about power and profit sharing. It
was clear from anecdotal evidence and press reports of infighting that a split was
inevitable and that significant amounts of management effort were focused on
trying to deal with the internal battles.
33
The internal conflicts moved to a 
difficult court battle leading to the final split of Arthur Andersen and Andersen
Consulting in 2000. During this contentious period, Andersen’s audit partners
were pushed to focus on revenue generation and profitability as these were the
focus of the ‘battle’. Other firms had less contention between the audit and 
consulting services, with different routes taken to eliminate related conflicts of
interest. KPMG spun off its consulting entity into a public company;
PricewaterhouseCoopers and Ernst & Young sold their consulting businesses to
other firms; while Deloitte and Touche recently decided to retain the consulting
business. 
There was, however, another very important dimension to the Andersen case.
Many of the largest recent corporate failures that were Arthur Andersen clients –
Enron, Worldcom, Qwest and Global Crossing – were also the largest companies
in their local regions.
34
With an incentive structure that puts pressure on man-
agers to deliver audit revenue and profit at every unit, the manager of a regional
or city office would be wary of taking a negative stance on an audit that would
risk the client selecting an alternative audit firm in that region. The loss of an
Enron or Worldcom account would have been devastating to a local office and its
partners, even if it was only a small part of firm-wide revenues and profits.
35
This
pressure on any branch office would have been exacerbated by the competition
withconsulting for power and profits within Arthur Andersen. Thus, the conflicts
of interest may not necessarily have been linked to pressure to sell non-audit 
services to the audit client. The point is not to minimize the potential conflicts
from the existence of non-audit services to a client but to emphasize that the 
elimination of conflict by separation of audit and non-audit services is unlikely to
solve the problem if the incentive structures for the audit partners are focused on
local short-term profitability, rather than sustainable quality that provides 
reputational value for the whole firm. From a strict economic perspective the
firm-wide reputational cost of an audit failure has to outweigh any short-term
benefits from avoiding a qualified audit. It is difficult, however, for local office
performance measurement and incentive systems to capture such long-run costs. 
In principle, in the United Kingdom, the United States and increasingly in
other countries, firms have an audit committee of the Board of Directors that is
supposed to monitor auditing to prevent any conflict of interest between the 
auditors and managers. Audit committees are, however, rarely in complete charge
in practice, and it is the executive officers who are the primary decision-makers.
If both the fees and the decision of which audit firm is engaged rests with the 
36 Conflicts of Interest in the Financial Services Industry

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senior managers being audited, there is a conflict of interest that can only be
remedied by a change in the governance structures. The dependence on local
office auditors by managers probably became more acute over the last twenty
years because of changes in the industry. 
The role of the audit committees including board of directors and governance
structures in the United States is under review as part of the Sarbanes-Oxley 
legislation. The United Kingdom has taken a slightly different approach. The
Financial Reporting Council (FRC) appointed a committee chaired by Sir Robert
Smith to prepare a report summarizing the guidance under existing codes and
rules. The Smith Report entitled ‘Audit Committees – Combined Code Guidance’
includes specific guidance on reviewing auditor independence (ICAEW, 2003a).
The approach recommended has three broad elements for the audit committee to
consider:
1. fundamental principles to be followed by the auditor with objectivity 
being primary;
2. identification and consideration of threats to independence; and 
3. consideration of safeguards. 
The threats and safeguards are considered in some detail and as such a clear 
framework is set out for audit committees to evaluate and control auditor 
independence. The interesting point of the Smith Report is that it provides a
framework for a governance-based supervisory process to control auditor conflicts
of interest.
The 1980s and 1990s were a period of increased competition among audit firms
and possibly excess capacity in the audit profession, especially as growth in 
corporate mergers and acquisitions reduced demand for audit services by reducing
the number of firms. An audit firm became easily replaceable in the 1990s, as each
firm was actively engaged in seeking out competitors’ clients. This was a 
relatively new phenomenon beginning in the 1970s when the Federal Trade
Commission, worried about an oligopoly of large audit firms, required the 
profession to change its standards and permit audit firms to advertise and 
compete for clients (Healy and Palepu, 2003). During this period of competition
for audit clients, combined with pressures to compete with non-audit partners,
the ‘cost’ of losing a client appeared to be steep. Contracting profit in audit 
activities contributed to the consolidation of the large accounting firms from the
Big 8 to the Big 5 (and now the Big 4) as the firms sought to exploit scale
economies. With competition for revenue intense, it was natural for audit firm