{"id":3368,"date":"2022-05-15T17:19:51","date_gmt":"2022-05-15T15:19:51","guid":{"rendered":"https:\/\/eaa-online.org\/arc\/?p=3368"},"modified":"2022-10-16T21:00:54","modified_gmt":"2022-10-16T19:00:54","slug":"auditors-incentives-and-audit-quality-non-audit-services-versus-contingent-audit-fees","status":"publish","type":"post","link":"https:\/\/eaa-online.org\/arc\/blog\/2022\/05\/15\/auditors-incentives-and-audit-quality-non-audit-services-versus-contingent-audit-fees\/","title":{"rendered":"Auditors\u2019 Incentives and Audit Quality: Non-audit Services versus Contingent Audit Fees"},"content":{"rendered":"<p><em>This blog has been written by Lucas Mahieux about his recently accepted paper &#8220;Auditors&#8217; Incentives and Audit Quality: Non-audit Services versus Contingent Audit Fees&#8221;.<\/em><\/p>\n<p>&nbsp;<\/p>\n<p>What are the incentive effects of the provision of non-audit services (NAS) on auditors? This important<br \/>\npolicy question is of concern to regulators given the debate that has been raging for years on whether<br \/>\naudit firms should provide NAS to audit clients. This debate is often reduced to a simple cost and<br \/>\nbenefit tradeoff. On the one side, joint NAS and audit services provision is likely to be more efficient<br \/>\nin terms of production costs because of knowledge spillovers (Simunic, 1984). On the other side, NAS<br \/>\nmay threaten auditor independence because it creates an economic bond between the auditor and the<br \/>\nclient (DeAngelo, 1981). In the absence of a clear sense of the incentive effects, the conventional wisdom<br \/>\nthat \u201cproviding both NAS and audit services to the same client threatens auditor independence and may<br \/>\naffect audit quality\u201d seems to prevail (Causholli et al., 2014). Nevertheless, Ewert (2004) emphasizes that<br \/>\n\u201cthe incentive problems of combining NAS and auditing are still an open issue.\u201d More recently, auditor<br \/>\nindependence rules related to NAS appear to be headed in opposite directions in the US and in the UK,<br \/>\nwhich indicates a disagreement among regulators (CFO, 2020).<\/p>\n<p>In my recent paper, I depart from the conventional wisdom and analyze a novel tradeoff related<br \/>\nto the provision of NAS by auditors to audit clients. I also investigate the joint implications of NAS<br \/>\nand contingent audit fees (CAF) for audit quality. Specifically, I build a framework that highlights<br \/>\na positive incentive effect of NAS: the possibility of providing NAS contingent on detecting financial<br \/>\nmisstatements may increase the auditor\u2019s effort to detect those misstatements. This represents a benefit<br \/>\nof the provision of NAS by auditors. Nonetheless, my analysis also underlines that the provision of NAS<br \/>\nreduces auditor independence and may decrease audit quality. When considering a single firm, there is no<br \/>\nrole for regulation as investors trade off the cost and benefit of using NAS to provide effort incentives to<br \/>\nthe auditor. However, in the presence of multiple client firms, I highlight the negative externalities caused<br \/>\nby the decrease in audit quality when investors rely on peer-firms\u2019 financial statements to make investment<br \/>\ndecisions. Restricting auditors from providing NAS may then be desirable. Thus, regulators face a tradeoff<br \/>\nbetween the ex ante positive incentive effect and the ex post decrease in auditor independence. Removing<br \/>\nthe current restrictions on CAF for unfavorable audit opinions may offset the ex post decrease in audit<br \/>\nquality while preserving the ex ante incentives.<\/p>\n<p>The results of the paper contribute to both the regulatory and academic communities. Regulators<br \/>\nand practitioners fear that auditors would be unwilling to challenge a client if a negative audit opinion<br \/>\nwould mean losing future NAS contracts (e.g., Bell et al., 2015). However, regulators seem to focus on the<br \/>\nex post lack of auditor independence without considering the ex ante incentive effects. My findings shed<br \/>\nsome light on the desirability of the provision of NAS to audit clients, and suggest regulators may need<br \/>\nto investigate more carefully the tradeoff between ex ante incentives and an ex post decrease in auditor<br \/>\nindependence. In particular, I show that having fully independent auditors may not always be optimal.<br \/>\nMoreover, regulators have banned CAF in most jurisdictions. However, CAF could be used to provide<br \/>\nincentives to auditors to exert audit effort in environments in which market-based incentive forces are<br \/>\nnot sufficient. My results show that removing the current restrictions on contingent audit fees jointly<br \/>\nwith banning non-audit services may increase auditor independence while preserving the ex ante effort<br \/>\nincentives.<\/p>\n<p>Finally, my model also generates several testable empirical predictions. The main empirical takeaway<br \/>\nis that a ban on the provision of NAS to audit clients could increase auditor independence but decrease<br \/>\naudit quality. This result is important given that many empirical studies use proxies of audit quality to<br \/>\nassess auditor independence. My analysis suggests that the relation between those two key variables may<br \/>\nbe more complex. A direct consequence is that a positive relationship between NAS fees and financial<br \/>\nmisstatements does not imply that NAS negatively affect audit effort and audit quality. On the contrary,<br \/>\nI show that a positive relationship may indicate that incentives are provided to auditors using NAS and<br \/>\nthat this mechanism improves audit effort and ex ante audit quality.<\/p>\n<p>&nbsp;<\/p>\n<p>This paper has recently been accepted at the European Accounting Review, and its permanent link will be<\/p>\n<p>https:\/\/doi.org\/10.1080\/09638180.2022.2066011<\/p>\n<p>&nbsp;<\/p>\n<p>References<br \/>\nBell, T. B., Causholli, M. and Knechel, W. R. (2015), \u2018Audit Firm Tenure, Non-Audit Services, and Internal Assessments<br \/>\nof Audit Quality\u2019, Journal of Accounting Research 53(3), 461\u2013509.<br \/>\nCausholli, M., Chambers, D. J. and Payne, J. L. (2014), \u2018Future Nonaudit Service fees and Audit Quality\u2019, Contemporary<br \/>\nAccounting Research 31(3), 681\u2013712.<br \/>\nCFO (2020), \u2018SEC Planning to Loosen Auditor Independence Rules\u2019.<br \/>\nDeAngelo, L. E. (1981), \u2018Auditor Independence,\u2018Low Balling\u2019, and Disclosure Regulation\u2019, Journal of Accounting and Economics<br \/>\n3(2), 113\u2013127.<br \/>\nEwert, R. (2004), \u2018Audit Regulation, Audit Quality, and Audit Research in the Post-Enron Era: an Analysis of Nonaudit<br \/>\nServices\u2019, The Econonomics and Politics of Accounting. Oxford University Press, Oxford pp. 239\u2013264.<br \/>\nSimunic, D. A. (1984), \u2018Auditing, Consulting, and Auditor Independence\u2019, Journal of Accounting Research pp. 679\u2013702.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>This blog has been written by Lucas Mahieux about his recently accepted paper &#8220;Auditors&#8217; Incentives and Audit Quality: Non-audit Services versus Contingent Audit Fees&#8221;. &nbsp; What are the incentive effects of the provision of non-audit services (NAS) on auditors? This important policy question is of concern to regulators given the debate that has been raging [&hellip;]<\/p>\n","protected":false},"author":61,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"ngg_post_thumbnail":0},"categories":[108,105],"tags":[],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v20.12 - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Auditors\u2019 Incentives and Audit Quality: Non-audit Services versus Contingent Audit Fees - ARC<\/title>\n<meta name=\"robots\" content=\"noindex, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Auditors\u2019 Incentives and Audit Quality: Non-audit Services versus Contingent Audit Fees - ARC\" \/>\n<meta property=\"og:description\" content=\"This blog has been written by Lucas Mahieux about his recently accepted paper &#8220;Auditors&#8217; Incentives and Audit Quality: Non-audit Services versus Contingent Audit Fees&#8221;. &nbsp; What are the incentive effects of the provision of non-audit services (NAS) on auditors? 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