Does a Restriction of Nonaudit Services Improve Audit Quality and the Reliability of Audit Report?

Abstract

This paper examines the economic consequences of prohibiting auditors from providing many types of nonaudit services (NAS) to their public company audit clients. We model an audit market where auditors are strategic in choosing both effort and audit report, and the joint provision of audit and NAS to the same client creates synergies. We show that while restricting NAS can restore faithful reporting, it also adversely influences the audit effort. Counter to conventional wisdom that restricting NAS is most needed when legal penalty is inadequate to discipline auditors, we show that this regulatory change also has unintended negative consequences on the reliability of audit report and the value of audit if the auditor’s legal liability is sufficiently small. In contrast, this regulatory change can enhance the reliability of audit report if the auditor’s legal liability is sufficiently large.