An Economic Analysis of Audit and Non-Audit Services: The Tradeoff between Competition Crossovers and Knowledge Spillovers

Martin G. H. Wu
University of Illinois at Urbana–Champaign

Abstract: In this paper I point out a significant economic force—the competition crossover effect—that auditors ought to consider when they provide non-audit services (NAS) for their audit clients. If the audit market is perfectly competitive, this effect equals zero; and, therefore, it would be appropriate to focus on auditors’ cost structure in order to examine knowledge spillovers as the primary reason for providing both audit and NAS. The audit market, in practice, however, tends to be imperfectly competitive (oligopolistic): Auditors react to each other. Changes in productivity and competition for NAS in the consulting market can induce auditors to alter their strategies and competition in the audit market so that some or all auditors could be hurt. The competition crossover effect is non-zero. Consequently, auditors must consider not only the benefit of knowledge spillovers, but also the “cost” of competition crossovers. This benefit-cost tradeoff helps to explain the audit fee puzzle, to analyze the impact of restricting NAS (e.g., the Sarbanes-Oxley Act of 2002), and to shed light on auditor independence in appearance. Empirically, recognizing this benefit-cost tradeoff requires both explanatory variables of audit-market concentration and auditors’ specialization (in terms of NAS, particularly) be included in audit-fee regressions to appropriately examine audit fee “premiums.”

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