Discipline with Common Agency: The Case of Audit and Nonaudit Services

Using a common agency model, we investigate the interactions of a utility‐maximizing auditor (the agent) with managers (who hire the agent for nonaudit services) and shareholders (who hire the agent for conducting an audit) of the same firm. In a single‐period model, managerial discretion over consulting and other nonaudit service fees can influence auditors to issue unqualified opinions on reports that are more favorable than warranted. Shareholders, represented by an audit committee, cannot recover truth‐telling. Removing the current restriction on contingent audit fees allows audit committees to offset the incentives provided by management and instead provide the auditor incentives to accept only truthful reports. Extending the model to a multiperiod framework, the audit committee can motivate truth‐telling by making retention decisions that are contingent on outcome. Auditors will consider the impact of overreporting on their ability to generate future audit fees from the same client.