The Economic Consequences of Limiting the Joint Provision of Audit and Nonaudit Services

Abstract

The supply of nonaudit services by auditors to their audit clients has long remained a contentious issue to the accounting profession. The primary concern is whether such supplies lead to increased bonding between auditors and their clients, thereby adversely affecting actual or perceived auditors' independence. This paper provides a formal economic framework with which to analyze the effects of limiting the scope of nonaudit services that auditors can provide to their audit clients on capital investment and auditors' effort and report decisions. In the model, auditors are strategic in choosing both effort and audit report, and incur costs for both incorrectly rejecting a true unaudited report (i.e., making a type I error) and incorrectly accepting a false unaudited report (i.e., making a type II error). It is demonstrated that limiting the scope of nonaudit services that auditors provide to their audit clients results in auditors reporting more conservatively (i.e., being less likely to issue unmodifed reports) instead of increasing their effort. Moreover, I show that the equilibrium audit fee is higher, on average fewer investments will be undertaken, the initial owner's ex ante expected payoff is lower, and under some conditions, both the market price of the firm and social welfare are lower.

Keywords: Auditor independence, Auditors' liability, Audit quality, Nonaudit services

JEL Classification: M49, G38