Reexamining the Relation Between Audit and Non-Audit Fees: Dealing with Weak Instruments in Two-Stage Least Squares Estimation

Abstract

We introduce some new econometric tests and techniques for identifying and overcoming the problem of weak instruments in the context of joint provision of audit and non-audit fees. We use this context because identifying appropriate instruments is difficult due to the lack of theoretical guidance as well as the difficulty in intuitively identifying instruments that satisfy the econometric requirements. We introduce a battery of empirical tests based on recent developments in econometrics to test for the appropriateness of the instruments. We then illustrate two approaches of using instruments from existing data: the size-industry average portfolio approach and the synthetic instrument approach. While the approach using synthetic instruments side-steps issues of identifying proxies with desirable properties, it requires some stringent assumptions that cannot be directly tested. However, as a methodological alternative, this approach can be used for robustness tests. We find that when the instruments are not weak, audit and non-audit fees are positively associated. This relationship holds for audit and tax-related non-audit fees as well. Overall, the evidence suggests the existence of economies of scope benefits from the joint supply of audit and non-audit services. Methodologically, we illustrate the importance of testing the appropriateness of the instruments utilized when accounting for endogeneity.