Effects of Non-Audit Services on Market Competition

  • Benito Arruñada


The previous Chapter showed that the provision of non-audit services by auditors generates substantial cost savings. This Chapter will examine the consequences of providing these non-audit services on competition in audit and non-audit service markets. Sections 6.1 to 6.3 firstly look at how these cost savings are transferred to clients as price reductions and, specifically, how this transfer is manifested in each market (auditing and non-audit services) at each point in time (when contracting the initial engagement and thereafter), depending on the competitive conditions in each of these markets at each contractual stage. In this respect it will be shown that the criticism leveled against the use of introductory pricing (or “lowballing”) in auditing, and against the use of auditing as a “loss leader” for selling other services, have no foundation from the point of view of the public interest. When they occur, both practices are benign and are a simple spontaneous consequence of the inter-temporal competition which is unleashed when, as in this sector, there are substantial learning and switching costs. Similarly, Section 6.4 shows, firstly, that the provision of non-audit services by auditors enhances competition and quality in the markets for such services. Contrary arguments, usually put forward by firms specializing in providing these services, who propose restrictions on the freedom of auditors to offer services, appear rather to be the result of the private interest of such producers in restricting competition.


Switching Cost Market Competition Audit Firm Audit Quality Predatory Price 
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  1. 1.
    See various commentaries in relation to different countries and points in time in Benoit (1987 p. 19), Berton (1989) and “Accountancy: All Change” (The Economist, 17 October 1992), in the media. As far as sector reports are concerned, it is found, in its eclectic zeal, in the EC Green Paper (1996), Section 4. 11.Google Scholar
  2. 2.
    It is stated, for example, that “auditors move into companies because the latter must have their accounts monitored, but they then take advantage of their position to offer related services in such a way that in many cases auditing is not the field generating most of the auditor’s income and neither, of course, the area generating most profit. For this reason [chwr(133)1 professionals and firms are capable of substantially reducing prices to gain a client, knowing they will then be able to recover possible losses many times over from the fees achieved from other services [chwr(133)1. Consequently [chwr(133)1, those auditors who do not invoice related services have difficulty in surviving in a world where the price is used as an inducement and not as adequate remuneration for the services to be provided” (Gonzalo Angulo, 1995, p. 618, own translation).Google Scholar
  3. 3.
    One aspect of the debate which may have been side-lined in the general analysis in Chapter 5 should be expressly mentioned. It has been said regarding quality that “the professional or firm will generally concentrate more effort on those other activities which earn more profit to the detriment of the time and attention properly due to auditing, which has simply been the gateway into the business” (Gonzalo Angulo, 1995, p. 618, own translation). This type of comment overlooks the fact that it is, by definition, impossible in a joint production situation to identify the cost of each product and, therefore, their profitability. Moreover, the price discount in one element making up a joint sale of services does not compromise the quality of that element more than the others. Finally, even allowing the argument that the audit is used as a gateway, the auditor who lowers the quality of his audits would have less opportunity to use it as an inducement, and would therefore suffer a penalty which would restrict his hypothetical opportunism.Google Scholar
  4. 4.
    For the United States, see Simon and Francis (1988) and Turpen (1990) and, for Australia, Francis (1984). After analyzing the US empirical evidence, the authors of a review of the literature concluded that the available evidence did not support the notion that non-audit services enable large firms to charge an additional premium on their audit fees, contradicting the results obtained in the first empirical study into the problem by Simunic (1984). See Yardley, Kauffman, Cairney and Albrecht ( 1992, p. 172 ).Google Scholar
  5. 5.
    See Section 2.2 of the Technical Audit Standards (ICAC, 1991 ). It can also be seen that standard form contracts of the main professional organizations usually establish a constant real price without including any changes to the nominal price other than as a result of inflation or substantial changes in the workload, using terms for the purpose such as those contained in the model contracts prepared by the Instituto de Censores Jurados de Cuentas de Espana (ICJCE, undated) and the Registro de Economistas Auditores (REA, 1993, p. 639 ).Google Scholar
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    For a more complete explanation of this argument, see Arrunada and Paz-Ares (1997, pp. 50–1, n. 58).Google Scholar
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    Inter-temporal competition was originally studied in the literature on franchise bidding. See,in this respect, the works of Demsetz (1968), Stigler (1968) and Posner (1972), as well as the critique of Williamson (1976), related to situations in which a repeated auction is necessary and there are substantial physical assets.Google Scholar
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    It is clear that the difference between the initial audit prices with and without services is negative in expression [37] and the same applies to the difference between the prices of recurrent audits in expression[38], since./307-r).Google Scholar
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    In the terms of the model, these effects appear in the audit price since this represents payment for all services. In reality, such effects should not necessarily be seen in the audit prices but also in those of the non-audit services, although always translated into a drop in price.Google Scholar
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    See, for example, Berton (1989) and Gonzalo Angulo (1995, p. 618).Google Scholar
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    Gigler and Penno (1995, p. 329) demonstrate how an independent price fixing policy can generate inefficiencies.Google Scholar
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    In a sample of US companies it was estimated that non-audit fees are much less in the first year of audit than in subsequent years. In the first year, fees from non-audit services represented a weighted average of 12.35% of auditing turnover; in subsequent years this percentage increased to 64.13% (Turpen, 1990, p. 66).Google Scholar
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    It is doubtful whether prohibitions could be enforced because, even if it could not be avoided by billing innovations, firms would resort to competition in areas other than price, stepping up service quality (Stigler, 1968).Google Scholar
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    See, on this point, DeAngelo (198la, pp. 124–5) and Grout et al. (1994, pp. 329 and 343).Google Scholar
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    In fact, this outcome could be seen during the course of 1997 in the mobile telephone market in Spain: the year began with nil hook-up prices for low-range telephones, which rose to 10,000 pesetas in February and 15,000 in July. The increases were simultaneous, although the two companies concerned denied any type of agreement between them. See “Airtel y Telefonica entierran la guerra de los teléfonos móviles al subir los precios un 50%” (Expansion, 1 July 1997, p. 3) and “Defensa de la Competencia investiga un posible pacto entre Airtel y Telefónica” (Expansion,2 July 1997, p. 4).Google Scholar
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    This, for example, was the apparent intention of a Texan Act of 1991 which prohibited lowballing with the argument that “chwr(133) who performs or offers to perform a service involving auditing skills for compensation that is less than the direct labor cost reasonably expected to be incurred in performing the service creates a presumption of loss of independence” (cited by Grout et al.,p. 325).Google Scholar
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    This was already the opinion of DeAngelo (198la, p. 125). Dewatripont (1994, p. 344) has recently expressed a similar opinion, from outside the accounting field.Google Scholar
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    This usually happens in a somewhat confused manner since, on occasions, they are mixed with other accusations of anti-competitive conduct which merit even less attention. This is the case with accusations of unfair competition, according to which the provision of non-audit services would give rise to expropriatory activities. This type of criticism, however, merits little credit if, as is usually the case, it is not substantiated by making a claim or beginning legal or administrative proceedings. Moreover, the argument based on the greater financial muscle of the large firms also has little substance due to the nature of the capital, basically human, and this added to the scant general consistency of this type of argument.Google Scholar
  19. 19.
    Initial works on non-audit services already examined the lack of credibility of the predatory pricing argument in this context (Simunic, 1984, p. 698, n. 13).Google Scholar
  20. 20.
    It is said, for example, that “although Bain’s point of view prevailed for 40 years, many economists felt uncomfortable when applying it to the analysis of competition policy. To condemn a business for making consumers pay too little seems paradoxical. Even more important, it was not clear how a low price could discourage entry” (Tirole, 1988, p. 368). See also Demsetz (1997, pp. 208–10).Google Scholar
  21. 21.
    The problem was reformulated by considering informational asymmetry at the beginning of the 1980s. The basic works are separate articles by Milgrom and Roberts in which they deal with practices aimed at preventing entry (1982a) and inducing exit (1982b) amongst competitors. According to these models, predatory pricing policy can make sense for the purpose of signaling to possible entrants or existing competitors that, if they persist in their policy, they will suffer losses and that therefore they should not enter or leave the market, respectively. For this reason, modem competition policy usually takes into account that a price below marginal cost in the short term does not constitute an indication that the price is predatory, since prices below cost can be perfectly competitive, but tends to require indications that the monopolist has the intention of eliminating the current or potential competition, as indicated by Tirole ( 1988, p. 373 ).Google Scholar
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    The authors of the NERA report stated their conviction in this respect in regard to the rules in force in France and Portugal and did not rule it out in the case of Italy (Ridyard and de Bolle, 1992, p. 67). The EC Green Paper is of the same view (Section 4.13).Google Scholar
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    See, for example, Gonzalo Angulo (1995, p. 618).Google Scholar
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    This is particularly the case with the report issued by the European Council of Bar Associations on the European Commission Green Paper, in which it is proposed that the auditor’s role is made equivalent to that of the professions which enjoy authority conferred by public authority, such as judges or civil servants, demanding that auditor independence be determined by a strict system of incompatibilities (“El eterno dilema del limite de actividad,” Expansion, 7 May 1997 p. 48).Google Scholar
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    In this matter, experience in the advertising field is illustrative since, being a more dynamic and little-regulated sector, the main firms adopted one-stop shopping strategies much earlier. The response of clients varied, with some clients seen to value the advantages of geographical and service consolidation more, but others, on the other hand, continuing to give priority to the benefits provided by diverse providers. See, for example, “Advertising: a Passion for Variety” (The Economist,30 November 1996, pp. 82–3).Google Scholar
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    For this reason, audit firms themselves and their professional associations have the greatest interest in structuring the linkage between services in such a way that both conflicts of interest and the appearance of conflict are minimized, as described in Section 5.3. It should be mentioned here that such structures for preventing conflicts include forming separate firms without common partners, and prohibiting or abstaining from providing services which could be or appear more conflictive.Google Scholar
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    The following references are taken from Benston (1979–80, pp. 26–7).Google Scholar
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    The transfer of executives has a certain importance for the efficient management of human resources amongst large audit firms, who make use of a professional career structure of the “up or out” type (for an introduction to the functioning of such up or out systems, see Milgrom and Roberts [1992, pp. 37982]).Google Scholar
  29. 29.
    An illustration of the minimal consequences in terms of concentration of service provision by auditors is provided by the much discussed merger of the law firm of J. & A. Garrigues and Andersen ALT, which took place in Spain at the beginning of 1997. The merger had virtually no consequences on concentration in the Spanish market since the Herfindahl index moved from 668 to 917, a level at which the market is considered deconcentrated, according, for example, to the criterion of the US Department of Justice’s Merger Guidelines ( 1992, p. 84 ).Google Scholar
  30. 30.
    The increasing competition from law firms forming part of multinational networks could be already as significant as that from law firms linked with audit firms.Google Scholar
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    See, in general, OECD (1985). For example, up to a few years ago, Spanish law firms could not have more than 20 lawyers or open more than one office in each Bar Association area or be formed as a company (TDC, 1992, p. 32 ).Google Scholar
  32. 32.
    Analysis by competition authorities is along the same lines, generally being favorable to the introduction of new business structures in the professional service field. See, particularly, the OECD report on the professions (OECD, 1985, pp. 70–3). With respect to the specific case under study here, the favorable assessment of multidisciplinary practice, including law, of the Australian Trade Practices Commission in its review of the competitive position of auditing, is of interest (TPC, 1991, pp. 12–3; or, for a summary, Kestigian, 1992, p. 16 ).Google Scholar
  33. 33.
    The financial press constantly reports how, for example, European law firms link up with foreign firms, often justifying this by the need to provide global services. Such links usually begin with a client exchange agreement and proceed to the use of a common name or include common elements and eventually result in a merger.Google Scholar
  34. 34.
    See “Accountancy: All Change” (The Economist, 17 November 1992).Google Scholar

Copyright information

© Springer Science+Business Media New York 1999

Authors and Affiliations

  • Benito Arruñada
    • 1
  1. 1.Pompeu Fabra UniversityBarcelonaSpain

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