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Subtraction by Addition — How adding consulting services can lessen auditing quality

Sep 12, 2022, 09:08 by Aaron Bennett
Erik Beardsley joined Gies this fall after six years at the University of Notre Dame’s Mendoza College of Business. Erik’s research focuses on taxation, the intersection of tax and financial reporting, the effects of non-audit services on audit quality, and executive incentives.

In May 2022, The Wall Street Journal reported that Ernst & Young was considering a worldwide split of its audit and advisory businesses. If it happens, it could be the biggest structural change to impact the Big Four accounting firms in decades. Consulting services have become a big money maker for these firms. In fact, of the $115 billion generated by these firms collectively last year, more than half came from consulting services. So why would any firm want to let that go? In the long run, the answer might be that they have to, as industry regulators become increasingly concerned about a potential conflict of interest.

Erik Beardsley“An auditor should be independent from its client,” explains incoming Gies assistant professor Erik Beardsley, “But a lot of times they’re also providing other types of services. So, the big question is whether this hinders their independence.”

A lot of previous research has been done on this topic, using client-level data to explore how this potential conflict of interest affects specific clients. But in a study that was the first of its kind, Beardsley and two coauthors looked at how this division of firm resources was impacting audit quality at the office level. To examine this distraction effect, they sifted through a decade of data, using financial statement restatements as an indicator of audit quality, and what they discovered could shed new light on the debate.

Their study, which was referenced in separate Wall Street Journal in June, showed that while a limited addition of some non-auditing services could have a positive effect on auditing quality, overall the trend was in the opposite direction, just as many industry experts had feared.

“Basically, we’re finding that if an office focuses too much on non-auditing services, it’s affecting their entire client portfolio,” said Beardsley. “This points to a broader concern of having a business model that includes both audit and consulting services. Too great a focus on consulting relative to auditing can harm audit quality, even if a particular client does not purchase consulting themselves.”

How much is too much? According to the study, there is a tipping point. In their findings, Beardsley and his collaborators found that a strong reduction in quality occurred when an auditing office received around a quarter of its fees from public clients in the form of non-audit fees. Does this mean that consulting services at auditing firms should be limited — or should the two be separated altogether? That may be a matter for future business leaders to decide. And as one of the newest faculty members at the Gies College of Business, Beardsley looks forward to providing input to that debate.

Beardsley joins Gies from the University of Notre Dame, Mendoza College of Business, where he served as an assistant professor of accountancy for six years. This fall at Gies, he’ll be teaching ACCY 451: Advanced Income Tax Problems. It’s a topic on which he’s well versed, having spent three years as a tax senior associate at PricewaterhouseCoopers in Milwaukee, Wisconsin, prior to entering the Accounting PhD program at Texas A&M University.

For a big firm, it was a relatively small office, which gave him the opportunity to assist a broad range of clients with a lot of different tax needs. “My favorite area was actually auditing the tax provision,” said Beardsley. “For some of my bigger clients, it was amazing. We’d have a team of five or six tax people that were working on a project for months — all for a couple of lines on their financial statements and the accompanying footnotes. But they were really complex, so it takes a long time.”

The Wisconsin native says he’s looking forward to many things at Gies, including the opportunity to work with a PhD program, which he didn’t have at his previous school. He’s also excited to work with the school’s outstanding faculty and help learners push through their limitations. The latter is inspired in part by his own student journey. As an undergrad, Beardsley says he once struggled with taxation. Today, it’s one of his favorite subjects, and he looks forward to helping students make similar leaps.

“I like the light bulb moments,” says Beardsley. “There are some topics where everyone gets it. But then then there are topics that end up being a challenge. You’re pushing somebody, and they’re understanding something that they didn’t before.” Beardsley says he wants to give his students the tools to do that, gaining the confidence they need to move successfully through life.