The Association between Actuarial Services and Audit Quality

Abstract

SUMMARY We examine the association between audit quality and the joint provision of audit and non-audit services (NAS) by accounting firms. We argue that differences in audit quality between joint and non-joint NAS conditions can only be assessed if the quality of the NAS service is held constant. Most prior work has not been able to do this because the identity of the NAS provider is unknown unless it is the audit firm itself. Our analysis is based on firms in the property-casualty insurance industry that purchase an actuarial certification of their loss reserves from an external party. The insurance setting is unique because the non-audit service that we examine is purchased by all firms in our sample, and we can identify both the audit and non-audit service provider. This allows us to directly address the NAS separation issue while holding NAS quality constant. We find that when actuarial work is obtained only from Big N firms (NAS quality is constant), audit quality is higher when separate Big N firms provide audit and actuarial services. The implication is that separating audit and NAS functions between two quality providers is beneficial, compared to allowing one quality firm to provide both services. We caution that this finding may not apply to other types of non-audit services, and a blanket prohibition on these activities is not warranted. JEL Classifications: M41; M42; M48; G22.