When you’re being paid to audit a company, how do you give them bad news—especially news that could upset their investors and send their stocks plummeting?
And if you’re also doing consulting work for the company, which pays more than your auditing, you’re likely to be even more reluctant to displease them.
Fallen giant Arthur Andersen became a spectacular example of why not to do consulting work for your auditing clients when it became the center of the Enron, Waste Management and WorldCom accounting scandals some 20 years ago.
The 2002 Sarbanes-Oxley Act seemed to provide a solution by banning firms from offering nonaudit consulting services to their auditing clients. But the real picture is decidedly more complex.
A study by UCLA Anderson’s Henry L. Friedman and Tilburg University’s Lucas Mahieux, in the Journal of Accounting Research, suggests that separating services not only brings complications for firms but also impacts the price and quality of services for clients.
The authors modelled three different regulatory scenarios to demonstrate possible outcomes, assuming that clients with a higher risk profile would be more willing to pay for high-quality audits, and that any client in need of auditing was also likely to want consulting.
With no restriction on the consulting services auditors can offer, the auditing and consulting markets don’t interact in a way that disadvantages or benefits either type of provider. The main decision auditors face is whether to serve more clients cheaply or to offer high-cost, high-quality services to fewer clients. This decision will affect the average quality of auditing in the market, with higher quality obviously being better for social welfare.
2. Auditors banned from consulting for their audit clients
This approach cuts competition in the consulting market, allowing firms that are still able to compete to charge higher prices. High-quality auditors can maximize profits by selling high-quality auditing services to their high-risk clients, and consulting services (now also priced higher) to the rest. Lower-risk clients will turn to lower-quality firms for auditing, potentially impacting social welfare. This is the scenario we’ve been in for the past two decades.
3. Auditors banned from any consulting
With a blanket ban, the two markets are back to not interacting at all, and the situation for auditors is similar to the first scenario.
The consulting ban is not the only barrier
Other issues facing audit firms include an increasingly oligopolistic market, with the former “Big Eight” firms reduced to a “Big Four”; the growth in consulting services; the dominance of audit firms in the consulting market; the tendency for execs at audit firms to jump ship for roles at client companies; and the fact that auditors are expected to be tough on the companies that are paying them.
Does cross-selling services make for better audits?
While there are ways to work around the consulting ban, it can land auditors in hot water, as PwC found out when it was fined $7.9 million by the Securities and Exchange Commission for allegedly selling consulting services mischaracterized as part of its audit package to 15 clients.
However, auditing professionals say that far from affecting their independence, offering consulting across other areas of a client firm gives them a better understanding of its operations and risk potential, enabling higher quality audits.