(15)

This expression, which is increasing and convex    in

qc , shows that the enforcement necessary   to

uphold a given audit standard  qc

exceeds the second-best level identified in equation (10)  because

the possibility of obtaining the rent R from consulting raises the enforcement activity needed to prevent collusion。 The optimal audit standard is correspondingly lower: intuitively, the potential bribe raises the cost of enforcement, inducing the regulator to choose a less ambitious standard。 The larger is the rent R from advisory services, the greater the potential for corruption, and therefore the less ambitious the auditing standard must be:

Proposition 3 (Audit standard with conflict of interest)。 If the rent R from advising is positive,

then the optimal standard R。

qc (R) is lower than the second best

q* for

R 0

and it is decreasing in

Note that the conflict of interest may induce the regulator not to intervene: the rent R increases

discretely  the  incentive  to  deviate  and  thereby  in  certain  cases  the  maximal  value  of welfare

attainable with intervention would fall below zero: Wˆ        0  for any  qc 0 。 In this case, the regulator

will rather choose qc 0 , in contrast with the second best。

One might suggest that an even better policy would be to eliminate the conflict of interest at its root,  by  severing  the  link  between  auditing  and  advisory  activity。  In  this  case,  the     optimal

accounting standard would increase to the second best level q*。  However, this does not necessarily

increase welfare: even though auditing standards would increase, society would forgo the cost savings arising from the joint provision of auditing and advisory services。 The next section analyzes under which circumstances a ban on such joint provision is justified。

5。Conflict of interest versus efficiency gains from non-audit services

Now we consider the case in which the regulator, beside setting an auditing standard and an enforcement level, may forbid the provision of advisory services by auditors。 Indeed, this is one of the provisions contained in the Sarbanes-Oxley Act (SOX)。 SOX prohibits all registered public accounting firms from providing audit clients, contemporaneously with the audit, certain non-audit services including internal audit outsourcing, financial-information-system design and implementation services and expert services。 These scope-of-service restrictions go  beyond previous SEC independence regulations。 In addition, all other services, including tax services, are permissible only if pre-approved by the issuer’s audit committee and all such pre-approvals must be disclosed in the issuer’s periodic reports to the SEC。 Similar reforms have recently been approved also in other countries。 For instance, Italy’s 2005 “Law for the Protection of Saving and Financial Market Regulation” (article 18) contains a prohibition that is very similar to that of SOX。

If regulation allows bundling of auditing and advisory services, society reaps the efficiency gain arising from economies of scope, but opens the door to the managers’ attempt to “bribe” their auditor。 If instead the regulator forbids bundling of these services, it forgoes the efficiency gain R

arising from economies of scope。 If this strategy is chosen, the problem reverts to that of Section  3,

and the resulting auditing standard becomes simply the second-best level Section 3。

q* , derived at the end of