An Economic Analysis of Audit and Nonaudit Services: The Trade†off between Competition Crossovers and Knowledge Spillovers

In this paper, I present a model in which both markets for audit services and nonaudit services (NAS) are oligopolistic. Accounting firms providing both audit services and NAS will employ oligopolistic competition in each of these markets. In addition to auditors' gaining “knowledge spillovers†from auditing to consulting or vice versa, oligopolistic competition in one market will influence the counterpart in the other market †what I call “competition crossovers†. Although scope economies due to knowledge spillovers (for example, cost savings) are always beneficial to auditors, such benefits can entice accounting firms to adopt strategies (for example, price reductions) to compete aggressively in the audit market so that some, or all, firms become worse off. A trade†off arises between these two economic forces in the two oligopolistic markets. Given the trade†off between competition crossovers and knowledge spillovers, accounting firms may not reduce their audit prices, even though supplying NAS enables firms to decrease auditing costs — a nontrivial impact of oligopolistic competition in two markets on audit pricing. The empirical implication of my results is that because of competition†crossover effects between the auditing and consulting service markets, finding empirical evidence for knowledge†spillover benefits is likely to be difficult. Control variables for “audit†market concentration†concerned with competition†crossover effects and “auditor expertise†concerned with knowledge†spillover benefits should be included in audit†fee regressions to increase the power of empirical tests. With regard to policy implications, my analyses help explain the impact of the Sarbanes†Oxley Act on “market segmentation†and, hence, the profitability of accounting firms.