Researchers, regulators, and practitioners have long-standing concerns about the negative effects of non-audit services (NAS) on audit quality. On the one hand, payments for NAS by client firms can impair auditor independence and motivate auditors to ignore client deficiencies. On the other hand, knowledge transfer across audit and NAS employees at the same firm can lead to positive spillovers from NAS provision to audit quality.
These conflicting arguments are generally constructed in a single-client setting, in which one auditor provides services to one client. Such a setting precludes a number of interesting economic forces from operating, including the potential for auditors to target audit and NAS client segments via quality and pricing decisions. A single-client model also cannot distinguish between auditor-wide and engagement-specific investments. The distinction is important, as the Public Company Accounting Oversight Board has highlighted firm-wide investments in human capital and infrastructure as important aspects contributing to audit quality.
In our paper, recently published in the Journal of Accounting Research, we develop a model to focus on interactions between audit and NAS in a setting where firm-wide quality investments and inter-firm competition play central roles. We examine how competition in the market for NAS can affect the audit firm’s choices including investments in audit quality and the pricing of audit services. The model allows us to examine the implications of regulations prohibiting auditors from offering NAS and provides a novel perspective on how economic forces related to NAS can affect audit outcomes through channels involving the industrial organization of the audit and NAS markets.
Our model features three types of economic agents and two services markets. A set of client firms with different demands for audit quality (e.g., due to differences in underlying transactions or business complexity) demand professional services from auditors and consultants. Auditors provide assurance about financial reports, and consultants provide NAS to help firms gain value. Our primary interest lies in the choices made by a high-quality audit firm that can make audit-improving investments and offers both audit and NAS to clients. A low-quality audit firm offers a base-level audit and competes with the high-quality auditor in the audit market, while a NAS-only consultant competes with the high-quality auditor in the NAS market. Our setup follows from our primary focus on how features of the NAS market can influence the high-quality auditor’s offerings.
Audit services for each client firm are modeled as in previous single-engagement models. Each client firm has a project that can be either good or bad, with good projects providing higher cash flows in expectation. We refer to the probability of having a bad project as the business risk of a client firm and allow this risk to vary across client firms. Each client firm’s investors must choose whether to make a fixed investment in the firms’ project. To value each client firm’s project and subsequently make an informed investment, the investors require each client firm’s manager to issue an accounting report. Absent an audit, each client firm’s manager would report that the firm’s project is good. The audit probabilistically detects misreporting in this accounting report, and therefore exposes bad projects with a probability that depends on the quality of the audit purchased by the firm.
Before offering its services to clients, the high-quality auditor can invest in firm-wide audit quality, with higher audit quality increasing the probability that its audits successfully detect misreporting. Firm-wide audit quality captures constructs such as audit firm culture, internal controls, or reputation. Such firm-wide audit quality can also be interpreted as capturing the probability that any given engagement partner or staff member acts in good faith and avoids shirking. The cost of audit quality is increasing both in the quality delivered and the number of clients it is delivered to, which captures costs of hiring and training high-quality employees to deliver services. For simplicity, we treat the low-quality auditor’s audit quality as fixed (e.g., at the quality required by auditing standards). The high-quality audit firm’s investment in quality is observable to client firms, reflecting, for instance, the auditor’s reputation. This reputation affects client firms’ willingness to pay for audit services, and it is this audit revenue channel that motivates investment in audit quality.
Client firms also can purchase NAS, which increase client firm value, either from the high-quality auditor or from a NAS competitor, i.e., a pure-play consulting firm. In the baseline model, we focus on the case in which client valuation of audit and NAS are positively correlated. Indeed, positive demand correlation seems the most relevant case as auditors would then like to sell audit services and NAS to the same clients and NAS restrictions would prevent this. Both the high-quality auditor and the NAS competitor offer equivalent-quality NAS, and neither can use NAS quality or client business risk to price discriminate and segment the market. However, the high-quality auditor and NAS competitor choose how to price the services they offer, and clients choose whom to purchase services from.
In equilibrium, in the audit market, clients choose auditors based on their investment risk. The high-quality auditor sells auditing services to the high-risk client whereas the low-quality auditor sells auditing services to the low-risk client. When the per-client cost of quality is high, the high-quality auditor targets only the high-risk client, and thus chooses a high level of audit quality that matches the high-risk client’s willingness to pay. If the per-client cost of audit quality is low, then the high-quality auditor targets both the high- and intermediate-risk clients, and thus chooses a lower audit quality and charges a lower audit fee. Conditional on the client allocation, an increase in the cost of audit quality causes the high-quality auditor’s audit quality and the average quality of audits provided to clients to decrease. However, if an increase in the cost of audit quality causes the high-quality auditor to switch from targeting the intermediate- and high-risk clients to only the high-risk client, the increased audit cost can cause the high-quality auditor’s audit quality to increase. The intermediate-risk client then switches from the high-quality auditor to the low-quality auditor, which can reduce the economy-wide average audit quality if the low-quality auditor’s quality is low enough. Overall, this reflects a central economic force, that there is a tradeoff between the high-quality auditor’s audit quality and the number of client firms who receive a high-quality audit.
When there is no restriction on the provision of NAS to client firms, equilibrium in the NAS market is characterized by Bertrand competition on fees that pushes the rents from NAS to zero. This causes the high-quality auditor’s choice of audit quality to be independent from the features of the NAS market. As a result, there is no interaction between the audit market and the NAS market absent NAS restrictions.
Perhaps surprisingly, regulatory bans on the provision of NAS to audit clients can make the high-quality auditor and the NAS competitor better off. Essentially, such restrictions create niches in which each supplier earns rents where before the rents were dissipated by Bertrand competition. When client demand for audit services and NAS are positively correlated, these additional rents push the high-quality auditor towards choosing a higher audit quality targeted only at the high-risk client. This opens up the possibility of earning NAS rents from the intermediate-risk client and allows the high-quality auditor to charge a higher NAS price. The price increase results from the NAS competitor pricing its services to extract maximum rent from the high-risk client who, given positive demand correlation, places the highest value on NAS. The intermediate-risk client may switch to the low-quality auditor, and the directional effects on average audit quality and social welfare depend on the quality of low-quality audits and the riskiness of the intermediate-risk client, respectively.
We show that restrictions on NAS provision to audit clients are more likely to have the effects on audit quality and welfare described above if either client valuation of NAS is higher or the association between client valuation of audits and NAS is higher. These increase the high-quality auditor’s potential rents from NAS and thus the importance of reduced competition via bans on the provision of NAS to audit clients.
Some regulators and practitioners have proposed breaking up integrated audit-consulting firms, i.e., prohibiting audit firms from offering NAS to all clients. In the UK, the Financial Reporting Council told the biggest audit firms to separate their audit and consulting businesses by 2024. The main concern is that providing both services may create conflicts and inherent biases across services, even if not provided to common clients. Our analysis shows that a regulatory ban on the provision of NAS to non-audit clients may increase or decrease average audit quality and social welfare relative to a prohibition on providing NAS solely to audit clients, because this removes the potential for the high-quality auditor to benefit from competition-related price increases in the NAS market.
In extensions, we explore the implications of a negative correlation between audit and NAS demand, additional competition and differentiation in the NAS market, audit standards, and agency problems within firms that cause managers to prefer lower-quality audits. With a sufficiently negative relation between demand for audits and demand for NAS, a restriction on NAS to audit clients can cause the high-quality auditor to choose a lower audit quality. This occurs because, with negative correlation, the intermediate-risk client has a higher valuation of NAS than the high-risk client, so choosing a lower audit quality and targeting audits at both intermediate- and high-risk clients can induce the NAS competitor to set a high NAS fee targeted at the intermediate-risk client. The high-quality auditor can then charge a higher fee for NAS sold to the low-risk client, who places the highest value on NAS.
Differentiation in the NAS market can cause NAS restrictions to audit clients to lead to higher or lower audit quality, depending on the nature of the differentiation, due to the effect that differentiation has on the ability for the high-quality auditor to charge for NAS in equilibrium. Changes to audit standards can reduce the quality and fee differential between the low- and high-quality auditor but can reduce average audit quality if they cause the intermediate-risk firm to switch from the high- to low-quality auditor. As result, there are optimal interior auditing standards that maximize social welfare. Finally, separating managers (i.e., preparers) from investors (i.e., users) and introducing an agency problem can cause managers to prefer low-quality audits. However, our main mechanisms remain as long as investors influence auditor choice (e.g., via the audit committee), or if the conflict of interest between managers and investors is not too large. We acknowledge that, if the conflict of interest within client firms is severe and managers select the auditors, our results would be different as managers would hire either no or low-quality auditors.
Overall, our results highlight the importance of the competitive landscape when considering potential regulatory interventions in the joint audit and NAS market. Nonetheless, much remains to be done in understanding the distribution of client demands for audit and NAS, market segmentation, the consequences of investments in audit quality, and the implications for regulations that restrict the services that audit firms can sell to clients.
Henry Friedman is an Associate Professor of Accounting at the UCLA Anderson School of Management
Lucas Mahieux is an Assistant Professor of Accounting at Tilburg University
This post is adapted from their paper, “How Is the Audit Market Affected by Characteristics of the Nonaudit Services Market?,” Journal of Accounting Research, 2021, Volume 59(3): 959-1020.
 In our main analysis, we abstract away from features well-understood from prior research such as audit independence, knowledge spillovers, audit standards, and costs of audit failure. Instead, we focus on features related to competition and the NAS market. Our results are robust to allowing for additional competition in the NAS market as long as there continues to be some degree of NAS differentiation.