Effects of an audit split on consulting and audit quality

Abstract

The simultaneous provision of audit and consulting services to clients is of significant concern because it could impair an auditor’s independence. In 2002, the Securities and Exchange Commission (SEC) responded by restricting auditors from providing most non-audit services (NAS). This paper addresses the implications of such a ban. Using a game theoretic model, I examine the economic effects of separating NAS from audit services. Moreover, this study explores how an enforcement change affects the effort incentives of an auditor and a consultant within a combined firm as well as in separate firms. I show that despite lower auditor independence, the financial reporting quality in case of a combined audit firm is higher than in a split case, provided the enforcement level is sufficiently low. Finally, the magnitude of this effect increases as the consultant’s share of the combined audit firm decreases.