Joint Provision of Audit and Non-Audit Services, Audit Pricing and Auditor Independence

46 Pages Posted: 29 Oct 2015

See all articles by Paul V. Dunmore

Paul V. Dunmore

Haim Falk

The Technion, Israel Institute of Technology

Date Written: September 1, 2001

Abstract

The SEC recently amended its auditor independence rule, prohibiting auditors from providing certain non-audit services to their audit clients. The International Federation of Accountants (IFAC) has also released a draft revision to its Code of Ethics, which will have a similar effect. These changes are intended to reduce motivation for auditors to compromise their independence.

We present an economic model, based on earlier work by DeAngelo and by Magee and Tseng, to examine the economic impact of the provision of non-audit services on the pricing of audits and on the incentives for auditors to compromise independence. The model extends earlier work in that it (i) allows for both consensus and genuine differences of opinion among auditors about a disputed accounting issue; (ii) permits opinion-shopping by clients; (iii) explicitly considers the legal and disciplinary costs for an auditor both of wrongly agreeing and of wrongly disagreeing with the client; (iv) includes the effect of profits from consulting work which is ‘tied’ to the audit engagement; and (v) examines the situation in which an auditor compels a client to change a treatment with which the auditor privately agrees, in order to avoid the costs for the auditor of defending that treatment publicly.

The model enables the calculation of audit prices when the incumbent auditor either agrees or disagrees with the client, facing competing auditors who unanimously agree, unanimously disagree, or have divided opinions; this leads to the wealth change for an auditor who compromises independence. Profits from non-audit services reduce ongoing audit fees, but do not affect any initial fee discount (low-balling). We infer that audit firms which cannot cross-subsidize audit work from consulting profits will suffer a competitive disadvantage in the audit market.

Profits from non-audit services do not contribute to auditors’ economic incentives to compromise independence. The main incentive comes from the economic benefit to the client from a preferred treatment, but competition and the threat of legal or disciplinary action usually limits the incentive. However, incentives to compromise may exist even when the client does not benefit, because economic pressure to compromise comes from the regulatory environment as well as from the client. When auditors are unanimous that the client’s treatment is wrong, the incentive to compromise may be unlimited.

It thus appears that the new SEC and IFAC rules may lead to an increase in the prices for audit services, while doing little to reduce the economic incentives for auditors to compromise independence.

Keywords: Audit fees, MAS, independence

Suggested Citation

Dunmore, Paul and Falk, Haim, Joint Provision of Audit and Non-Audit Services, Audit Pricing and Auditor Independence (September 1, 2001). Available at SSRN: https://ssrn.com/abstract=2681624 or http://dx.doi.org/10.2139/ssrn.2681624

Haim Falk

The Technion, Israel Institute of Technology ( email )

Faculty of Industrial Engineering & Management
Haifa 32000
ISRAEL
+972 4 829 4419 (Phone)

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