Auditor independence and non-audit services - ICAEW

low cost strategies to protect and/or enhance reputation• ensure reputational penalties are in line with breaches, i.e. avoid undue loss ofreputation for relatively minor infringements;• the existence of client-specific assets acts as a safeguard for firms with a variedclient base (if independence is compromised in respect of one client, the quasirentsassociated with that client are retained, but those relating to all other clientsare endangered);• the provision of non-audit services means that the protection of reputation andother safeguards are used more intensively;high-cost strategies to protect and/or enhance reputation• advertising and other marketing investments that generate ‘brand name capital’(though this is banned or restricted in many countries);• raise the barriers to entry (though this involves a serious risk of monopoly andregulatory capture); and• reinforce regulatory supervision (though costs can be excessive and the beneficialeffect on audit quality is unproven).Auditors seek to provide NAS because of the considerable economies of scope that ensue,i.e. cost savings that arise when both types of service are provided by the same firm.These economies of scope are of two types: knowledge spillovers that originate in thetransfer of information and knowledge; and contractual economies that arise frommaking better use of assets and/or safeguards already developed when contracting andensuring quality in auditing.Arruñada’s analysis of the consequences of NAS provision focuses on the impact oncosts, quality, competition and independence. The central debate concerns whether thepositive effect of reduced costs due to economies of scope outweigh the potentialnegative impact on quality, competition and independence.Addressing quality issues first, NAS provision enhances the auditor’s technicalcompetence (by broadening his knowledge of the business) and make it possible for auditfirms to employ specialised experts in a cost-effective manner, thus improving andextending their professional judgement.The discussion of competition issues draws upon Arruñada’s careful presentation of theeconomic rationale for introductory pricing and inter-temporal competition. It is shownthat standard industrial organisation analysis shows that cost savings obtained from thejoint provision of both audit and NAS will be passed on to clients as a price reduction inboth markets and at different times (at time of initial or subsequent contracts) dependingupon the competitive circumstances (such as the bargaining power of each party). It isfurther shown that ‘using introductory pricing in auditing or using auditing as a lossleader then appears as the simple spontaneous outcome of inter-temporal competitionwhen there are learning and rotation costs’ (1999a, p.169). He goes on: ‘[t]hisintertemporal competitive process is optimal from the public point of view. A better6