Auditor independence and non-audit services - ICAEW

CHAPTER 8ASSOCIATIONS BETWEEN JOINT PROVISION, PRICING AND AUDITTENURE8.1 IntroductionAs business practices became more complex, it was natural for companies to seekadvice and professional services from their auditor. The reason why both auditor andclient company are happy to have services provided that complement the audit is dueto the existence of economies of scope. If production efficiencies lead to cost savingsthat are retained in whole or in part by the auditor (i.e., not wholly passed on to theclient company), then economic rents accrue to the auditor, increasing the economicbasedthreats to independence through increased bonding. For this reason the pricingeffects of joint audit and NAS provision have been studied as an indirect means ofassessing auditor independence.The nature of economies of scope is discussed in section 8.2. Attempts at modellingthe pricing consequences of knowledge spillovers are briefly discussed in section 8.3.The available evidence regarding such economies is presented in sections 8.4 and 8.5(the former reviews the many studies using archival (i.e., publicly available) data,while the latter reviews those few studies using proprietary (i.e. private) data. Section8.6 looks at evidence from initial bid pricing. Section 8.7 presents the evidence fromstudies that focus on auditor tenure and auditor change as proxies for the level ofeconomic bonding. A final section summarises and concludes.8.2 Economies of scopeEconomies of scope refer to cost savings that arise when the same person or firmprovides two types of service (i.e., joint production). These savings are also referredto as externalities or spillovers. Economies of scope are of two types: ‘knowledgespillovers’ and ‘contractual economies of scope’ (Arruñada, 1999a, pp.75-77).Knowledge spillovers occur when two different services require elements of the sameinformation set and/or the same professional qualifications. Contractual economies ofscope arise because the provision of professional services has associated with it hightransactions costs due to the informational asymmetry existing between supplier andclient. Joint provision reduces the cost of searching for a credible consultant and thecost of ensuring contractual performance.Arruñada argues that the relative significance of contractual economies of scope isgrowing for the large audit firms (now more commonly known as professional serviceorganisations or multi-disciplinary partnerships). It is noted that different divisions oreven companies commonly provide the different services. Knowledge spillovers areseen to be increasingly non-client-specific.8.3 Modelling knowledge spilloversSimunic (1984) provides a model of knowledge spillovers (or cost interdependencies)that relates to client-specific spillovers. He notes that the form of the knowledgespillover can be complex:• knowledge may flow from auditing to NAS, from NAS to auditing or inboth directions;• the fixed cost, variable cost or both may be affected; and• the knowledge spillover may be client-specific or general.46