An Analysis of Auditor's Learning Costs and Non-Audit Services on Audit Quality

Abstract

This study uses a very simple but intuitive model to examine how audit quality is determined. It concludes that audit quality is higher if two forces have opposite effects on an auditor’s conservatism are balanced and significant. A force that makes an auditor less conservative is the benefit from future engagements with a client, while the force that makes the auditor more conservative is the expected liabilities from overstated accounting values. Given that the expected auditor’s liabilities from overstated accounting values are usually significant, we find that significant rents from future engagements with a client improve audit quality through inducing greater audit efforts and less biased reports. Our analysis suggests that learning costs and non-audit services would be sources for these future rents, and auditors should be allowed to provide non-audit services to their clients and these revenues should be higher as auditor tenure lengthens. Furthermore, our analysis shows that mandatory auditor rotation is detrimental to audit quality since it reduces the future rents to auditors which lead to lower audit effort and more biased report. Finally, well-developed auditing standards need to be properly enforced by the regulator/profession for auditors to render appropriate audit quality when the costs associated with over and under reporting are low and/or not balanced.