RESEARCH Business Economy

ACCOUNTING
Change in auditing firmsÕ duties gave rise to conflicts of interest

Mark Reutter, Business Editor
(217) 333-0568; mreutter@uiuc.edu

5/1/02

CHAMPAIGN, Ill. -- Until the 1970s, the accounting profession stayed close to its green eyeshades origins, conducting annual audits of public companies in fulfillment of Depression-era legislation requiring an independent verification of corporate financial statements.

But with the rise of information technology, big firms like Arthur Andersen branched into "client services" – particularly internal financial consulting – that soon brought in more revenues than audits and paved the way to the improprieties exposed by the Enron bankruptcy and the Andersen indictment for document destruction by the U.S. Justice Department.

"The fact that audit fees are paid by the company audited poses a basic conflict of interest built into the Securities Acts," noted Andrew D. Bailey Jr., the Ernst & Young professor of accountancy at the University of Illinois at Urbana-Champaign. But these conflicts could be managed in the past when auditing was the primary focus of accounting firms, he said in an interview.

"Over the last 20 years, the audit has lost stature within the public accounting firms. It almost seemed as if the firms’ top management had lost faith in the financial reporting system and then in the value of the audit." As accounting firms "shifted to something more akin to marketing organizations" obsessed with cross-selling services to audit clients, the conflict between serving corporate managers and protecting the public interest was magnified.

The Illinois scholar got a first-hand look at the politics of the conflict as an academic fellow in the office of the chief accountant at the U.S. Securities and Exchange Commission. During his 2000-01 fellowship, the SEC attempted to draw up rules regarding accountancy independence.

"The SEC was not able to work with the profession toward what the agency thought was a satisfactory objective," Bailey said. "The SEC went into rulemaking, and the rules they proposed to separate consulting from auditing were met by resistance on the part of the public accounting firms, who lobbied Congress, and Congress put pressure on the SEC to compromise significantly."

While the discarded rules would have prohibited firms from most types of consulting for clients, they would have let firms do "as much consulting as they liked" for non-audit clients, Bailey noted.

During the hearings on the proposed rules, "much was made of the synergies gained from consulting arrangements that improved an accounting firm’s knowledge of a client, together with assurances that internal walls could be built between the consultant and auditor to protect the auditor’s independence," Bailey said. "I often wondered how one could capitalize on the supposed synergies if there were effective walls between the auditor and consultant."

Bailey said that industry "self-regulation" has not worked. "We need a regulatory process with bite and transparency. It should not be possible for the profession to withhold support if they do not approve of proposed government actions, as they did with the Public Oversight Board."