The Impact of Consulting Services on Audit Quality: An Experimental Approach

• DOI: http://doi.org/10.1111/1475-679X.12197
• Published date: 01 May 2018
• Date: 01 May 2018

DOI: 10.1111/1475-679X.12197

Journal of Accounting Research

Vol. 56 No. 2 May 2018

Printed in U.S.A.

The Impact of Consulting Services

on Audit Quality: An Experimental

Approach

ZACHARY T. KOWALESKI,

∗BRIAN W. MAYHEW,

∗

AND AMY C. TEGELER

†

Received 29 October 2015; accepted 11 November 2017

ABSTRACT

We use experimental markets to examine whether providing consulting ser-

vices to a non-audit client impacts audit quality. Our paper directly addresses

concerns raised by the Public Company Accounting Oversight Board that the

largest public accounting firms’ growth in their consulting practices threatens

audit quality. Weconduct an experiment proposed using a registration-based

editorial process. We compare a baseline where the auditor does not pro-

vide consulting services to conditions where auditors provide consulting to

audit clients or where auditors only provide consulting services to non-audit

∗University of Wisconsin–Madison; †University of Wisconsin–Milwaukee.

Accepted by Philip Berger. This paper is the final Registered Report resulting from

the Registration-Based Editorial Process (REP) implemented by JAR for its 2017 confer-

ence; details of the process are available here: https://research.chicagobooth.edu/arc/

journal-of-accounting-research/2017-registered-reports. The accepted proposal and an On-

line Appendix for this report is available here: https://research.chicagobooth.edu/arc/

journal-of-accounting-research/online-supplements. We thank the editor and referee for in-

sightful comments and suggestions in revising our proposal. We thank JAR conference atten-

dees and workshop participants at the University of Wisconsin–Madison for providing helpful

comments and suggestions. We thank the University of Wisconsin–Madison BRITE Lab for use

of its facilities and funding for our pilot studies. We also thank the University of Wisconsin–

Madison for research support. While Zach Kowaleski was an economic research fellow at the

PCAOB between October 2016 and October 2017, he co-wrote this paper in his personal ca-

pacity. The views expressed in this paper are the views of the authors and do not necessarily

reflect the views of the Board, individual board members, or staff of the PCAOB.

673

Copyright C, University of Chicago on behalf of the Accounting Research Center,2018

674 Z.KOWALESKI,B.W.MAYHEW,AND A.C.TEGELER

clients. Our unique design provides evidence on whether providing consult-

ing to non-audit clients strengthens the salience of a client-cooperative social

norm that reduces audit quality. We do not find differences in audit quality

by condition in our planned analysis, however we find greater variation in au-

dit quality in the conditions where auditors provide consulting services com-

pared to the baseline. In unplanned analyses, our results suggest providing

consulting services increases auditor cooperation with managers, increasing

audit quality when managers prefer high audit quality and decreasing audit

quality when managers prefer low audit quality.

JEL codes: G41; M42

Keywords: auditor independence; consulting; social bonds; experimental

economics

1. Introduction

We use experimental markets to examine whether the provision of consult-

ing services to a non-audit client impacts audit quality. Our paper directly

addresses concerns raised by members of the Public Company Accounting

Oversight Board (PCAOB) that the largest auditing firms’ evolving busi-

ness model to a heavy emphasis on their consulting practice threatens au-

dit quality (Doty [2015], Harris [2015]). Over the past 10 years, the largest

firms have built non-audit service practices that generate 41% of U.S. Big 4

total revenue.1These services now exceed the 34% of revenues generated

by the audit practice. With non-audit service revenue growing at a 10% rate,

and assurance revenue at a smaller 4% rate, the gap will continue to grow

(Harris [2014]).

We examine the impact of a client-cooperative social norm arising from

the consulting practice on audit quality. In 2002, legislators created rules

restricting the types of non-audit services that can be performed for audit

clients to address the perception that these services negatively impact au-

dit quality (Sarbanes-Oxley (SOX) [2002]).2This constraint requires the

Big 4 to shift consulting growth to non-audit clients. As such, the recent

non-audit service growth does not threaten auditor independence. Nev-

ertheless, regulators have raised new concerns around the changing cul-

ture within large accounting firms (Harris [2014]). In support of these

concerns, analytical models of endogenous social norms suggest organi-

zation boundaries matter in preserving high professional norms (Fischer

and Huddart [2008]). As accounting firms have become diversified and

1Practice revenue percentages are calculated from the Big 4 firm’s annual reports to trade

magazine Accounting Today as presented in figure 1.

2We use the terms non-audit services and consulting interchangeably in this paper. We

intend both labels to encompass consulting and advisory services that exclude tax and audit

services. The SEC requires separate disclosure for tax services in recognition of the difference

between tax and consulting.

IMPACT OF CONSULTING SERVICES ON AUDIT QUALITY 675

0

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50

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19961997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

%AUDIT %NAS %TAX

FIG. 1.—Revenues from audit and assurance (AUDIT), tax, and non-audit services (NAS) as a

percentage of total U.S. revenue for the Big 4 public accounting firms. Source: “Top100 Firms”

annual report published by the Accounting Today trade magazine, consistent with Dey, Robin,

and Tessoni [2012]. For 2003, 2004, and 2005, KPMG included NAS revenue in reported

assurance revenue. We do not include KPMG data for these years.

complex organizations focused on goals of commercial growth and suc-

cess, the norms of accounting professionalism can come in conflict with

the consultants’ commercial norms.

We test whether the provision of consulting services impacts audit qual-

ity by strengthening the salience of client-cooperative social norms. Con-

sulting services rely on providers to reciprocate a client’s hiring decision

by cooperating with management. This strategy leads to repeat hiring that

maximizes the consultant’s profit. In contrast, an auditor who is hired by a

client serves both the client management and the investing public. At times,

auditors must set aside manager preferences for those of investors. We ex-

plore whether a cooperative social norm from a consulting task influences

subsequent auditor decisions to cooperate with management’s reporting

preferences.

Our experiment was subject to a registration-based editorial process in

which our experimental design and planned analysis were subject to ref-

eree and editor critique prior to acceptance. We employ a 1 ×3design

where we manipulate the provision of a consulting project and the rules

governing the managers’ choice of auditor. The Baseline condition consists

of an audit market similar to previous audit market experiments (Mayhew

[2001], Mayhew and Pike [2004], Hurley, Mayhew, and Obermire [2016]).

In this market, managers produce and sell assets to buyers, and hire au-

ditors to verify the manager’s report of the asset’s value.3We measure the

auditors’ verification decisions to capture audit quality. In our non-audit

3Audit committees officially hire auditors for publicly traded companies. We simplify the

hiring decision and allocate it to managers in our experimental setting. In our experiment, the

manager role represents the client as a whole—both manager and board committees. Further,