2010 - Beck - Learning by Doing and Audit Quality PDF

Learning by Doing and Audit Quality*
PAUL J. BECK, University of Illinois
MARTIN G. H. WU, University of Illinois
Abstract
In this study, we present a nonstrategic, dynamic Bayesian model in which auditors’ learn-
ing on the job and their choice of professional services jointly affect audit quality. While
performing audits over time, auditors accumulate client-specific knowledge so that their
posterior beliefs about clients are updated and become more precise (that is, precision is our
surrogate for audit quality) — what we call the learning effect. In addition, auditors can
enrich their knowledge accumulation by performing nonaudit services (NAS) that, in fact,
may influence clients’ managerial decisions — what we call the business advisory effect.
This advisory effect permits auditors to anticipate and to learn about changes in clients’ busi-
ness models, which in turn improves their advisory capacity. These dual “learning” and
“advisory” effects are interdependent and mutually reinforcing.
The advisory effect of NAS may increase or reduce auditors’ engagement risk. We
show that large professional fees can induce auditors to provide NAS that increase engage-
ment risk and diminish audit quality. However, when NAS reduce engagement risk and
increase audit quality, auditors may provide NAS without charging clients. The feature that
distinguishes our study — the interdependence between the learning and advisory effects —
provides new insight into the trade-off between audit fees and audit quality. Consequently,
our analysis helps explain why the scope of the audit has evolved over time and why the
boundaries between audit and NAS are constantly shifting. A recent example of such a shift
is that the Sarbanes-Oxley Act adds control attestation to audits for public companies traded
in U.S. markets.
Keywords Advisory effects; Audit engagement risk; Business-risk evolution; Learning;

Nonaudit services
JEL Descriptors D83, M4
* Accepted by Ronald R. King. We wish to acknowledge the helpful comments from Ronald R.
King (associate editor) and two anonymous reviewers. We also thank A. Rashad Abdel-Khalik
and Ira Solomon for comments on early drafts as well as participants of the accounting workshops
at the University of Illinois and Indiana University, the Canadian Academic Accounting Association
(CAAA) meeting at Vancouver (May 2004), and the American Accounting Association (AAA)
meeting at Orlando (August 2004), including Rajib Doogar, Bob Halperin, John Hassell, Ella Mae
Matsumura, Linda Myers, Mark Peecher, Joel Pike, Richard Rogers, Rachel Schwartz, Reed
Smith, Joyce Tian, Bob Tucker, Ping Zhang, and David Ziebart. Professor Martin G. H. Wu is
grateful to the Department of Accountancy at the University of Illinois for the summer financial
support.
Contemporary Accounting Research Vol. 23 No. 1 (Spring 2006) pp. 1–30 © CAAA
19113846, 2006, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1506/AXU4-Q7Q9-3YAB-4QE0 by Gavle University College, Wiley Online Library on [26/04/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
2 Contemporary Accounting Research
L’apprentissage par la pratique et la qualité de la vérification
Condensé
Les vérificateurs emmagasinent des connaissances relatives à leurs clients au fur et à mesure
qu’ils réalisent des missions de vérification auprès de ces clients ; leurs convictions à l’égard
des clients sont mises à jour à chaque exercice et se précisent au fil du temps (la précision
ultérieure étant considérée comme un substitut à la qualité de la vérification). Les auteurs
désignent cet effet bayesien de « rétroaction des résultats des travaux » sous l’appellation
d’effet d’apprentissage. En outre, les vérificateurs peuvent également enrichir leur bagage
de connaissances en assurant la prestation de services autres que la vérification (SAV) qui,
en fait, influent sur les décisions de gestion de leurs clients et, par conséquent, modifient la
dynamique des bénéfices des sociétés clientes dans le temps. Les auteurs désignent cet effet
d’« action directe des résultats des travaux » sous l’appellation d’effet de conseil. Cet effet
de conseil permet aux vérificateurs d’anticiper les changements dans la dynamique des
bénéfices des sociétés clientes et de se renseigner sur ces changements, ce qui en retour
améliore leurs capacités de conseil. Ces effets, d’« apprentissage » et de « conseil », sont
interdépendants et se renforcent mutuellement.
L’effet d’apprentissage a une incidence favorable sur la qualité de la vérification (voir
Simunic, 1984 ; Morgan et Stocken, 1998 ; King et Schwartz, 1999 ; Solomon, Shields et
Whittington, 1999 ; Low, 2004). Dans les environnements stables où les bénéfices des
sociétés clientes sont distribués de façon identique et indépendante dans le temps, le vérifi-
cateur finit par connaître à fond cette distribution. Les erreurs de jugement en matière de
vérification s’en trouvent éliminées à long terme — ce qui maximise le degré de qualité de la
vérification —, bien que l’effet d’apprentissage marginal diminue avec le temps. La majorité
des clients des services de vérification évoluent dans des environnements commerciaux et
économiques qui se transforment constamment, cependant ; ils doivent modifier continuelle-
ment leurs stratégies de gestion, leurs activités et leurs contrôles. Ces changements sont sus-
ceptibles d’accroître la complexité des modèles de gestion des sociétés clientes, ce qui, par
ricochet, stimule la demande de SAV. Ces SAV permettent aux vérificateurs d’en apprendre
encore davantage au sujet de leurs clients. Contrairement à ce qui se produit dans les envi-
ronnements stables, l’effet d’apprentissage marginal persiste donc dans le temps lorsque
l’environnement est dynamique. Fait extrêmement important, toutefois, les SAV peuvent
aussi influer sur les décisions de gestion des sociétés clientes et modifier ainsi la distribution
de leurs bénéfices, ce qui risque en retour d’avoir une incidence sur la qualité de la vérification.
Les chercheurs se sont jusqu’à maintenant intéressés principalement aux retombées
des connaissances entre services de vérification et SAV sur les coûts et les honoraires de
vérification (voir Simunic, 1984 ; Antle et Demski, 1991), mais ils ne se sont pas penchés
sur l’effet de conseil des SAV et, en conséquence, sur son interdépendance avec l’effet
d’apprentissage. Les auteurs de la présente étude prennent en considération cette inter-
dépendance et ses répercussions sur la qualité de la vérification dans un environnement
dynamique. Étant donné que les activités d’acquisition de connaissances du vérificateur
exercent une influence endogène sur la qualité de la vérification, l’analyse des auteurs fournit
de nouvelles indications relatives au compromis entre la qualité de la vérification et les inci-
tatifs liés aux honoraires professionnels. Puisque les effets interdépendants d’apprentissage
CAR Vol. 23 No. 1 (Spring 2006)

Learning by Doing and Audit Quality 3
et de conseil entraînent la production endogène de retombées des connaissances, l’analyse

des auteurs contribue à expliquer l’évolution de l’étendue de la vérification dans le temps.
Les auteurs ont recours à un modèle bayesien dynamique non stratégique dans lequel
le processus de génération des bénéfices de la société cliente évolue continuellement dans le
temps et dont les éléments de « tendance » et de « dispersion » sont influencés par la partici-
pation du vérificateur à des SAV. Les auteurs procèdent à la dérivation endogène du risque
de mission et de la qualité de la vérification, dans un contexte d’interdiction des honoraires
conditionnels comme celui qui prévaut aux États-Unis et au Canada, où les honoraires de
vérification ne dépendent pas des résultats des travaux du vérificateur. Dans ce type de situa-
tion, le vérificateur anticipe l’incidence relative des SAV sur les éléments de tendance et de
dispersion de la dynamique des bénéfices de la société cliente, en vue de choisir la stratégie
optimale pour acquérir les connaissances nécessaires à l’efficacité de la vérification.
Lorsque les SAV contribuent à « resserrer » la distribution des bénéfices de la société
cliente (c’est-à-dire à réduire la volatilité des bénéfices) et à diminuer le risque de mission du
vérificateur, l’avantage d’une hausse de la qualité de la vérification peut, en fait, surpasser le
coût des SAV. Dans certaines conditions (que les auteurs décrivent à la section 4), le vérifi-
cateur peut, de fait, être disposé à offrir au client des SAV sans les lui facturer. Toutefois,
comme nous l’avons vu dans l’affaire Enron, les honoraires élevés de SAV peuvent inciter les
vérificateurs à fournir ce genre de services même si cette décision a pour résultat d’augmenter
le risque de mission et de réduire la qualité de la vérification. Par conséquent, même lorsque ni
les vérificateurs ni leurs clients n’adoptent un comportement stratégique, les compromis
sont probables entre les incitatifs que représentent les honoraires de SAV et la qualité de la
vérification.
Une conséquence notable de l’étude des auteurs est qu’elle contribue à expliquer pourquoi
l’étendue de la vérification a évolué avec le temps. Ainsi, même avant l’imposition, en 2002, de
restrictions relatives aux services de consultation par la Securities and Exchange Commission
des États-Unis et avant l’adoption de la loi Sarbanes-Oxley (SOX — 2002), trois des « Cinq
Grands » cabinets d’expertise comptable internationaux avaient déjà commencé à regrouper
certains services conseils en matière de risque et certains services de certification liés à
l’évaluation de la performance avec leurs services de vérification. Sans doute a-t-on opéré
ce regroupement pour tenir compte de la valeur de l’information pertinente à la vérification
fournie par ces services professionnels supplémentaires. De la même façon, la SOX exige
des sociétés ouvertes inscrites aux bourses des États-Unis qu’elles fassent évaluer leurs sys-
tèmes de contrôle interne chaque année par leurs vérificateurs externes. Cette obligation
repousse clairement les « frontières » traditionnelles de la vérification. Des réglementations
analogues sont actuellement à l’étude au Canada.
La suite de l’étude se présente ainsi. À la section 2, les auteurs dérivent le risque de
mission à partir d’une dynamique simple en ce qui a trait aux bénéfices de la société cliente.
« Simple » signifie que la qualité de la vérification n’est pas assujettie à l’effet de conseil.
Bien que les auteurs tiennent compte de la décision du vérificateur en ce qui a trait à la
nature de l’opinion exprimée, leur intérêt porte avant tout sur la décision du vérificateur
quant à l’opportunité de fournir au client des SAV. Ils simplifient donc la caractéristique de
leur modèle liée à l’opinion exprimée en supposant que le vérificateur a pour incitatif principal
de s’assurer que soient produits à chaque exercice des rapports sur les bénéfices exempts de

distorsion. Compte tenu de cette absence de distorsion, le risque de mission et, par conséquent,
la qualité de la vérification seront déterminés de façon endogène.
À la section 3, les auteurs introduisent une relation récursive pour définir la dynamique
des bénéfices de la société cliente. Ils supposent non seulement que le vérificateur acquiert
des connaissances en assurant la prestation de SAV, mais également que la prestation de ces
SAV influe sur les décisions de gestion du client, qui modifient la dynamique des bénéfices
de sa société. En tenant compte explicitement de l’effet de conseil, les auteurs sont en
mesure d’examiner l’incidence conjuguée de l’apprentissage par la pratique du vérificateur
(provenant de la rétroaction des résultats des travaux) et des choix du vérificateur en matière
de SAV (provenant de l’action directe des résultats des travaux) sur la qualité de la vérification.
À la section 4, les auteurs élargissent l’analyse pour prendre explicitement en considération
le compromis entre la qualité de la vérification et les incitatifs que représentent les honoraires de
SAV. Ils définissent plus précisément les circonstances dans lesquelles les vérificateurs peuvent
assurer la prestation de SAV qui diminuent la qualité de la vérification afin de toucher des
honoraires élevés de SAV. La section 5 contient les conclusions de l’étude et ses répercussions.
Tous les éléments de la démonstration figurent en annexe.
1. Introduction
Auditors accumulate client-specific knowledge as they perform audit engage-
ments; their beliefs about clients are updated each period and become more precise
over time (that is, posterior precision is the surrogate for audit quality). We refer to
this Bayesian “outcome feedback” as the learning effect. Additionally, auditors can
also enrich their knowledge accumulation by performing nonaudit services (NAS)
that, in fact, influence their clients’ managerial decisions and, hence, alter clients’
earnings dynamics over time.1 We refer to this “outcome feed-forward” as the
business advisory effect.2 This advisory effect enables auditors to anticipate and to
learn about changes in clients’ earnings dynamics, which in turn enhances their
advisory capacities. These “learning” and “advisory” effects are interdependent
and mutually reinforcing.
The learning effect has a favorable impact on audit quality (see Simunic 1984;
Morgan and Stocken 1998; King and Schwartz 1999; Solomon, Shields, and Whit-
tington 1999; Low 2004). In stable environments in which a client’s earnings are
identically and independently distributed over time, the auditor eventually learns
about the client’s earnings distribution completely. Thus, audit-judgement errors
will be eliminated in the long run — resulting in the highest possible level of audit
quality — although the incremental learning effect diminishes over time. Most audit
clients do, however, face “ever-changing” business and economic environments;
they must continuously modify their business strategies, operations, and controls.3
These changes are likely to increase the complexity of clients’ business models,
which in turn spurs the demand for NAS. Such NAS will enable auditors to acquire
still more knowledge about their clients. Therefore, in contrast to the stable environ-
ment setting, the incremental learning effect persists over time in the dynamic
environment setting. Most importantly, however, such NAS may also influence
clients’ managerial decisions, thus altering the clients’ earnings distributions, and,
in turn, affecting audit quality.

Prior studies have focused on the effect of knowledge spillovers between audit
services and NAS on audit costs and fees (see Simunic 1984; Antle and Demski
1991), but have not considered the advisory effect of NAS and, hence, its inter-
dependence with the learning effect.4 Our study considers this interdependence
and the resulting impact on audit quality in a dynamic setting. Because auditor
knowledge-acquisition activities affect audit quality endogenously, our analysis
provides new insights into the trade-off between audit quality and professional fee
incentives. Inasmuch as the interdependent learning and advisory effects cause
knowledge spillovers to arise endogenously, our analysis helps to explain the evo-
lution of the scope of the audit over time.
We employ a nonstrategic, dynamic Bayesian model in which the client’s earn-
ings process evolves continuously over time, and both its “trend” and “dispersion”
components are influenced by the auditor’s NAS involvement. We endogenously
derive the auditor’s engagement risk and audit quality in a noncontingent-fee environ-
ment such as prevails in the United States and Canada, where audit fees are inde-
pendent of audit reporting decisions. In this situation, the auditor will anticipate
the relative impact of NAS on the trend and dispersion components of the client’s
earnings dynamic in order to choose the optimal strategy to acquire the knowledge
needed for an effective audit.
When NAS help to “tighten” the client’s earnings distributions (that is, reduce
earnings’ volatility) and to reduce the auditor’s engagement risk, the benefit from
an increase in audit quality may actually outweigh the cost of NAS. Under certain
conditions (identified in section 4), the auditor may actually be willing to provide
NAS without billing the client. However, as was the case at Enron, large NAS fees
can induce auditors to undertake NAS even when the result will increase engage-
ment risk and reduce audit quality.5 Therefore, even if neither auditors nor their
clients behave strategically, trade-offs are likely to occur between NAS fee incen-
tives and audit quality.6
A notable implication of our study is to help explain why the scope of the
audit has evolved over time. For example, even before enactment of restrictions on
consulting services by the U.S. Securities and Exchange Commission (SEC) in
2002 and by the Sarbanes-Oxley Act (SOX) (2002), three of the then Big 5 interna-
tional accounting firms had already begun bundling some risk advisory- and per-
formance measurement-related assurance services with their audits.7 Presumably,
such bundling was done to acknowledge the value of audit information provided
by these additional professional services.8 Similarly, SOX requires public compan-
ies registered on U.S. exchanges to have their internal control systems evaluated
annually by their external auditors. This clearly extends the traditional “bound-
aries” of the audit. Parallel regulations are currently under consideration in Canada.
The remainder of our study proceeds as follows. In section 2, we derive the
auditor’s engagement risk with a simple dynamic for the client’s earnings. By
“simple” we mean that audit quality is not subject to the business advisory effect.
Although we consider the auditor’s audit reporting decision, our primary focus is
on the auditor’s decision about whether to perform NAS for the client. Accord-
ingly, we simplify the audit reporting feature of our model by assuming that the

auditor’s primary incentive is to ensure that unbiased earnings reports are issued
each period. Given an unbiased report, the auditor’s engagement risk and, hence,
audit quality will be endogenously determined.
In section 3, we introduce a recursive relation to characterize the client’s earn-
ings dynamic. We assume that not only does the auditor acquire knowledge by
performing NAS, but also the NAS influence the client’s managerial decisions that
alter the client’s earnings dynamic. By considering explicitly the advisory effect,
we are able to examine the joint effect of the auditor’s learning by doing (from out-
come feedback) and the auditor’s choices of NAS (from outcome feed-forward) on
audit quality.
In section 4, we extend the analysis to consider explicitly the trade-off
between audit quality and NAS fee incentives. We delineate more precisely the cir-
cumstances under which auditors may undertake audit-quality-decreasing NAS in
order to collect large NAS fees. Section 5 contains concluding remarks and implica-
tions. All proofs are in the appendix.
2. Auditor’s engagement risk

Our model consists of an auditor and a client in a nonstrategic, dynamic, Bayesian
decision-making setting. In each period t, the client has an earnings distribution
that is conditional on its business model (for example, strategy, core products and
services, business processes, controls, customer and supplier relations, and markets).
Because the client’s business model is dynamic, the client’s earnings distribution
will evolve continuously over time. Accordingly, we model the client’s earnings
distributions over time as a stochastic process:
{ Xn t , t ; nt ≥ 1, and t = 1, 2, …} (1).
We employ parameter nt to denote a particular member of a family of distribu-

tions (that is, a stochastic process). In other words, nt reflects the events influencing
the client’s earnings production in period t so that we may express the client’s
earnings as Xnt , t = Xt(nt).9 Hereafter, we interpret nt as reflecting the auditor’s
knowledge about the evolution of the client’s business model over time. A repre-
sentative period is illustrated in Figure 1.
To derive the auditor’s engagement risk endogenously, we first consider the
benchmark case in which the auditor’s professional services do not influence
the client’s business model (that is, the outcome feed-forward or business advisory
effect is absent) and, hence, do not affect the client’s earnings process over time. In
other words, nt is exogenously given.10 (In section 3, we allow the auditor to
choose NAS to acquire client-specific knowledge and influence the managerial deci-
sions of the client, so that the outcome feed-forward or business advisory effect
will be present.) As parameter nt is subscripted by time t, we hereafter drop the
separate time index t from the client’s earnings to simplify our notation. Neither
the client nor the auditor directly observes Xn ; but each has prior beliefs that
t
may differ. We assume that the auditor’s information technology (through various

analytical procedures and sample testing) yields a private noisy representation of

the client’s earnings distribution in period t,11
Yn = Xn + ω t (2),
t,t t
where Xn and ω t are independent of each other, and ω t is an identically and inde-
t
pendently distributed (iid) normal variable with mean m and precision s (that is,
positive s denotes the reciprocal of the variance). For simplicity, we assume that
the mean and the precision are common knowledge.
Figure 1 The time-line
t t+1
Xn , t Xn t+1
t t + 1,
Y n , t = Xn , t + ω t Yn t+1 = Xn t+1 + ωt + 1
t t t + 1, t + 1,
2 2
ERn , t ≡ F ( E t [ ( Y n , t – z n ) n t ] ) ER n t+1 ≡ F ( Et + 1 [ ( Y n t+1 – zn ) nt + 1 ] )
t t t t + 1, t + 1, t+1
–1 –1
q n , t ≡ var t ( Xn , t yn , t ) qn t+1 ≡ var t + 1 ( X n t+1 yn t + 1)
t t t t + 1, t + 1, t + 1,
nt + 1 = nt + k
Notes:
This figure depicts a representative period (denoted by time index t = 1, 2, …). A few
explanations are in order:
• The client’s earnings process in (1) is indexed both by time index t and
distribution index nt. The latter index represents the auditor’s knowledge about the
evolution of the client’s business model, and is assumed not directly observable.
• The auditor’s information technology yields a noisy representation Y n , t in (2) of
t
the client’s earnings process.
• The auditor issues an unbiased earnings report (denoted by z n ) in period t. We
t
define the auditor’s engagement risk (see ERn , t in (3)) as an increasing function
t
of the expected least-squared reporting errors.
• Assume that the auditor observes Y n , t = yn , t at the end of each period. Then,
t t
we define audit quality to be the precision of the auditor’s posterior beliefs about the
client’s earnings.
• The auditor chooses the optimal NAS strategy to increase the client-specific
knowledge, so that the recursive relation, n t + 1 = n t + k , helps to link the client’s
earnings process given by (6), where k is interpreted as the knowledge increment
for each period.

Conceptually, the entire distribution of earnings (for example, a range of earn-

ings) could be reported in companies’ annual financial statements. The generally
accepted accounting principles in the United States and Canada, however, do not
permit companies to do so. Therefore, we assume that only a single summary sta-
tistic (denoted by z) for the entire distribution of the client’s earnings is reported
(for detail about this approach, see, in particular, Scott 1973, 307-8).12 Because we
do not consider strategic behavior of either the client or the auditor, we simply
assume that the auditor “controls” the reporting decision as in Scott (306). Consis-
tent with the extant professional standards (see American Institute of Certified
Public Accountants [AICPA] 2003, AU section 220, 41) and the auditor’s loss
function used by Scott, we assume that the auditor is “primarily” concerned with
the expected least-squared reporting errors: E t [( Ynt , t − z nt )2 | nt], where E t[⋅]
denotes the conditional expectation on all information available in period t. For
simplicity, we initially assume that the scope or size of the audit has been deter-
mined and, hence, both auditing costs and fees are fixed (in sections 3 and 4, we
will relax these assumptions). Thus, we represent the auditor’s engagement risk as
an increasing (convex) function F(⋅) of the expected least-squared reporting errors.
Under these assumptions, the auditor’s objective function is
min ERn , t ≡ F(Et [( Yn , t − z n )2 |nt]) (3).

zn t t t
t
Without loss of generality (for our results), we henceforth simplify (3) by

using a linear function F(a) = a (a dollar amount of loss). The first-order condition
is linear in z n and can be solved to yield the auditor’s optimal audit reporting
t
strategy (note, the second-order derivative is positive):13
z n * = E t[ Yn , t | nt] = Et [ Xn ] + m (4).
t t t
Substituting (4) into (3) yields the auditor’s minimum engagement risk as follows:
ERn , t* ≡ Et[( Xn − Et[ Xn | nt])2 + (ω t − m)2 + 2( Xn − Et[ Xn | nt])(ω t − m) | nt]

t t t t t
= vart ( Xn ) + 1/s (5),

t
where vart (⋅) denotes the conditional variance on all information available in
period t.
Note that (5) is a composite of the client’s business risk associated with varia-
tions in the client’s earnings (that is, var( Xn )), and the audit technology risk (that
t
is, 1 / s). We assume that the auditor observes Ynt , t = yn t , t at the end of each
period by means of the auditor’s information technology. Though imperfect, the
auditor’s technology enables learning about the client’s earnings dynamic over
time through outcomes. Hence, given nt and the end-of-period observation ( yn t , t ),
the auditor will learn more about Xn and, thus, will be able to make a better audit
t

reporting decision z n . Given (5), we can interpret the posterior precision, qn t , t ≡

t
vart−1( Xn | Ynt , t = yn t , t ), as a measure of audit quality (see (7) for detail).14
t
If the client’s earnings distributions were to remain unchanged over time (that
is, Xn t , t were iid), it is then implied that the distribution index, n t , would not
discriminate — that is, nt = n (for all t = 1, 2, …). Consequently, in the long run,
the auditor will completely learn the parameters of the client’s earnings process from
outcomes. This can be verified by observing (for a sufficiently long outcome series
of earnings that are drawn from the same distribution) that t → lim qn,t = +∞. Thus,
+∞
the auditor’s engagement risk converges to the variance of the auditor’s informa-
tion technology specified by (2).
REMARK 1. If the client’s earnings distributions over time are iid, the auditor
will learn about the client’s earnings dynamic completely in the long run:
q*n ≡ lim q = +∞.

t → + ∞ n,t
The intuition underlying Remark 1 is as follows. The longer an auditor’s tenure

with a client, the more the auditor learns about the client by observing noisy earn-
ings outcomes and performing Bayesian updating. As the auditor’s tenure
increases, so will audit quality. The key assumption for this result, however, is that
the client’s earnings distributions are iid over time.
3. Auditor’s learning and advisory effects on audit quality

In practice, however, the client’s business models (strategies, operations, and
controls) are unlikely to remain constant over time. In addition to the outcome
feedback or Bayesian updating described in the previous section, auditors have a
unique opportunity to make their learning an anticipatory process when they also
perform NAS. This is particularly true when such NAS influence clients’ managerial
decisions that in turn alter clients’ earnings process. For example, mergers and
acquisitions – related advisory services may allow auditors to learn more about
their clients’ business strategies and future growth opportunities than would a tra-
ditional audit. Such learning not only reduces audit costs (the audit efficiency argu-
ment; also see Wu 2006), but also enriches auditors’ client-specific knowledge that
enhances audit quality (the audit effectiveness argument).
We now introduce a second decision available to the auditor: the opportunity
to perform NAS and obtain a knowledge increment (denoted by k and normalized
so that k ∈ [0, 1]).15 Nonzero k values imply that the auditor is elevating NAS
involvement in order to gain additional knowledge about the client’s earnings
process. Given nt in period t, the auditor’s knowledge (about the evolution of the
client’s business model) for the auditor’s knowledge parameter in the next period
will be nt + 1 = nt + k.
To incorporate this advisory effect of the auditor’s knowledge increment on
the client’s earnings process, we assume that the earnings process exhibits the fol-
lowing recursive relation:16

Xn = α k/2 Xn + ρ k/2ε t (6),

t+1 t
where α ≥ 0, ρ ≥ 0; ε t ∼ N(0, 1/u), u > 0, cov( Xn , ε t ) = 0, and cov(ετ , ε t ) = 0 for all

t
τ ≠ t, and {ε t ; t = 1, 2, …} is a white noise process.
The auditor’s knowledge increment (k) affects both the trend component ( Xn t )
and the dispersion component (ε t ) through two non-negative, client-specific param-
eters (α and ρ ) of the earnings process in (6).17 The size of α helps to determine the
magnitude of the impact of k on the trend component of the earnings process. For
larger α values, k will have a greater impact on the trend of the client’s earnings
process, and vice versa. Only in the special cases when α = 1 and α = 0 will k not
affect the trend.
Parameter ρ is a key parameter because it impacts the diffusion of the client’s
earnings process. By “diffusion” we mean that the variance ρ k /u of the entire dis-
persion term of (6) changes with k. Specifically, this variance increases with k
when ρ > 1, and decreases in k when ρ ∈ (0, 1). Alternatively, when ρ equals either
0 or 1, this variance is unaffected by k, making the client’s earnings a “nondiffu-
sion” process.
The evolution of the earnings process over time in (6) encompasses several
popular time-series models, depending on combinations of α and ρ . Several archival
empirical studies have found that earnings time series follow random walks or
autoregressive processes over time (e.g., Collins and Kothari 1989, Table 1). For
example, when ρ = 1, (6) represents a first-order autoregressive process. In particu-
lar, when α = ρ = 1, (6) represents a simple random-walk process. Because the k
variable has no effect on the earnings process when α = ρ = 0, we henceforth
assume away this trivial case.
In addition, we assume that Xn in period t = 1 is a normal random variable
1
with a positive mean: E[ Xn ] > 0. Then, (6) implies that each Xn t + 1 (for all t ≥ 1)
1
will also be a normal random variable with a non-negative mean: E[ Xn ] ≥ 0.
t+1
For any given nt in period t, the posterior distribution over Xn is normal and
t
its posterior precision (note that Xn and Ynt , t are now jointly normal) is
t
qn t , t ≡ vart−1( Xn | Ynt , t = yn t , t ) = vart−1( Xn ) + s (7).

t t
At the end of period t, the auditor may decide to acquire additional informa-
tion through NAS (that is, adopt the k strategy) in period t + 1. The auditor
increases his or her knowledge by a factor k so that the auditor can perform the
audit in period t + 1 with the increased knowledge level of nt + k about the evolu-
tion of the client’s business model. Thus, the auditor’s prior variance in period t + 1
over X n + k given by (6) will be
t
vart + 1( X n ) = α k vart( Xn | Yn t , t = yn t , t ) + ρ k/u

t+k t
= α k/ q nt, t + ρ k/u (8).

As the auditor observes Yn + k , t + 1 = yn + k , t + 1 at the end of period t + 1, a

t t
Bayesian updating will yield the posterior precision over X n + k (for all t = 1, 2, …)
t
as follows:
qn ≡ var t–+11 ( X n | yn )
t+k,t+1 t+k t+k,t+1
= var t–+11 ( X n )+s

t+k
1
= ------------------------------------- +s (9).
α k⁄q n t , t + ρ k ⁄ u
Note that (9) relates the audit quality at the end of period t + 1 to the audit
quality at the end of the preceding period t, assuming that the auditor adopts the
k strategy. The learning effect arises from Bayesian outcome feedback in (9), while
the business advisory effect arises from outcome feed-forward in (8) due to the
influence of NAS on the client’s earnings process specified by (6).
Let us define the equilibrium level of audit quality in the long run (that is,
the asymptotic behavior of audit quality) to be q * (k) ≡ t → lim q n + k , t + 1 =
+∞ t
lim qn , t , due to these dual learning and advisory effects of NAS on audit qual-
t→ +∞ t
ity. Taking the limit, substituting the equilibrium level of audit quality q*(k) into
(9), and rearranging terms yield the following quadratic equation:
ρ kq*2(k) − [u(1 − α k ) + sρ k]q*(k) − usα k = 0 (10).
That is, the long-run equilibrium audit quality is the fixed point characterized
by the recursive relation in (9), or equivalently, is the solution characterized by the
quadratic equation in (10).
To provide a starting point, we first consider a special case: ρ = 0. Substituting
ρ = 0 into (9) yields qn + k , t + 1 = qn t , t /α k + s (for all t = 1, 2, …). When α ∈ (0, 1],
t
it is trivial to show that q n + k , t + 1 > qn t , t . That is, for any given k, the level of
t
audit quality is strictly increasing over time. In the limit, it approaches infinity:
q*(k) = +∞. Or equivalently, we substitute ρ = 0 into (10) and get q*(k) = q*(k)/α k + s
that holds if, and only if, q*(k) = +∞. Further, as 1/α ≥ 1/α k, the level of audit quality
increases most rapidly over time when k = 1. Thus, k = 1 (the upper corner solution)
will be the optimal strategy for the auditor to increase audit quality. Alternatively,
when α > 1, the sequence of audit quality levels { qn t , t ; t = 1, 2, …} will no longer
be monotonic over time; it will, however, still converge to a fixed point.
PROPOSITION 1. Assume that ρ = 0. For any given k strategy, the long-run

equilibrium level of audit quality, q*(k), will be characterized by
q*(k) = q*(k)/α k + s (11).
It is critically dependent on the client’s business type: α .

(a) If α ∈ (0, 1], then the long-run equilibrium level of audit quality is
infinitely high — that is, q*(k) = +∞, despite k. However, k* = 1 is the
fastest strategy for the auditor to approach the long-run equilibrium
level of audit quality.
(b) If α > 1, then the long-run equilibrium level of audit quality equals
q*(k) = sα k /(α k − 1), which decreases in k. Thus, k* = 0 will be optimal
and results in the optimal level of audit quality as
q† ≡ q*(k*) = klim
→0
q*(k) = +∞ (12).
Proposition 1 shows that, depending on the client’s business type (denoted by

α ; note that ρ = 0 in this special case), the auditor may choose different NAS strat-
egies to increase his or her audit quality. As noted earlier, when ρ = 0, NAS have a
pure “scaling” effect on the client’s earnings dynamic. Whether NAS help to accel-
erate or attenuate the client’s earnings changes will depend on the endowed business
type of the client (that is, whether α is larger or smaller than one). Although the client
controls the ultimate trade-off between the expected value and volatility of earnings,
the most important concern for the auditor is with the volatility of the client’s earn-
ings distributions. The latter, in turn, directly influences the auditor’s engagement
risk and audit quality (see section 2 for the endogenously derived relations). There-
fore, whether NAS help to increase or to decrease the volatility of the client’s earn-
ings distributions determines whether the auditor chooses the “k * = 1” strategy or the
“k* = 0” strategy. Either one will permit the auditor to continue to increase audit
quality over time. These results extend the audit quality analysis from the special case
in Remark 1 where α = 1 and ρ = 0. However, the economic intuition from Remark 1,
that the long-run optimal level of audit quality is infinitely high, remains.
A further implication of Proposition 1 is that the quality-maximizing auditor
tenure horizon is infinitely long. Mandatory auditor rotation reduces audit quality
because it interrupts the auditor’s learning about the client’s earnings dynamic.
Further, any significant shifts in the client’s business type — that is, changes in α
(which are beyond the scope of this study) — will interrupt the auditor’s learning
process, decrease his or her audit quality, and alter the auditor’s tenure.
In practice, however, the impact of the auditor’s NAS on the client’s business
strategies and controls usually is not limited to a scaling effect. More generally, the
client’s earnings dynamic follows a real “diffusion” process (that is, when ρ > 0
and ρ ≠ 1): the variability of the client’s earnings distributions changes over time.
Thus, we solve (10) for the long-run equilibrium level of audit quality (when ρ ≠ 0),
and the following result is immediate.
PROPOSITION 2. Assume that ρ > 0. The long-run equilibrium level of audit

quality, for any given k strategy, is unique as follows:
1⎧ k –k 2 k⎫
q*(k) = --- ⎨ [ u ( 1 – α k) ρ – k + s ] + [ u ( 1 – α ) ρ + s ] + 4us (α ⁄ ρ ) ⎬ (13).
2⎩ ⎭

The equilibrium audit quality in (13) captures the joint effect of learning and
advisory effects of NAS on audit quality. When ρ > 0, the additive noise term in (6)
is also affected by k, thus implying that NAS have a nontrivial diffusion effect on
the client’s earnings dynamic. In contrast, when ρ = 0, the additive noise term van-
ishes, so that NAS have a pure “scaling” effect as shown in Proposition 1. Though
a long-run equilibrium of audit quality always exists, the optimal level of audit
quality is infinitely high when ρ = 0 (see Proposition 1), and will be finite when ρ ≠ 0
(see Proposition 2).
To highlight the pure “advisory” effect of NAS on audit quality, we consider a
special case where the auditor’s information technology is uninformative about the
client’s earnings dynamic (that is, s = 0). Thus, observing Yn + k , t + 1 = yn + k , t + 1
t t
at the end of each period will not enable the auditor to infer or to learn anything
about the client’s earnings dynamic.
COROLLARY. Assume ρ > 0 and s = 0. The long-run equilibrium level of audit

quality is
⎧ k –k
q*s = 0( k ) = ⎨ u ( 1 – α ) ρ , if α < 1
;
(14).
⎩ 0, if α ≥ 1
Further, if α < 1, then d q*s = 0( k ) / dk > 0. Thus, k* = 1 is optimal, and

results in the optimal level of audit quality to be q†s = 0 = u(1 − α )/ρ .
The most interesting feature of this corollary is that, despite the absence of
learning, the auditor will still adopt k* = 1 as the optimal strategy for the client
whose α < 1. The reason is that the auditor’s NAS help to reduce the business-risk
component associated with the client’s earnings dynamic, thereby increasing audit
quality. However, for the client of type α ≥ 1, the long-run equilibrium level of
audit quality will equal zero.
The corollary helps to distinguish between the advisory and the learning
effects associated with the auditor’s knowledge-acquisition decision and highlights
the role of α . In the following proposition, we examine their joint effect and,
hence, the optimal audit quality in the long run. Once again, the client’s α and ρ
parameters are important in determining the optimal k strategy for the auditor.
PROPOSITION 3. Assume that ρ > 0. Whether the long-run equilibrium level of

audit quality, characterized by (13), is increasing or decreasing in k
depends on the relation between α and ρ. Specifically,18
(a) If α ∈ [0, 1] and ρ ∈ (0, 1], then dq*(k)/dk > 0. Hence, k* = 1 is opti-
mal, and results in the optimal audit quality in the long run as
1⎧ ⎫
q† = --- ⎨ [ u ( 1 – α ) ⁄ ρ + s ] + [ u ( 1 – α ) ⁄ ρ + s ] 2 + 4usα ⁄ ρ ⎬ (15),
2⎩ ⎭
which is increasing with u and s.

(b) If α ∈ (1, ρ ] and 1 < ρ ≤ exp[α ln(α ) / (α − 1)], then dq*(k) / dk < 0.
Hence, k* = 0 is optimal, and results in the optimal audit quality in the
long run as
q† = --- ⎛ s + s 2 + 4us⎞
1
(16),
2⎝ ⎠
which is increasing with u and s.
The economic intuition is as follows. In Proposition 3a, both α and ρ are less
than or equal to one, and NAS will have a dampening effect on both the trend and
dispersion components of the client’s earnings dynamic. This dampening effect
increases and, hence, the long-run equilibrium level of audit quality increases, as
the auditor augments knowledge-acquisition activities by performing NAS. There-
fore, the optimal strategy of knowledge acquisition will be k* = 1, resulting in the
optimal audit quality in the long run (see (15)).
Conversely, in Proposition 3b, both α and ρ are larger than one, and NAS help
to accelerate both the trend and dispersion components of the client’s earnings
dynamic. Because α ≤ ρ , the effect of NAS on the trend component will not be
larger than that on the dispersion component. Then, the long-run equilibrium audit
quality will decrease in the auditor’s NAS, and the optimal NAS strategy is k* = 0.
This results in the client’s earnings dynamic’s following a random-walk process
and, thus, the optimal, long-run audit quality will be independent of α and ρ .
In contrast to the infinitely high level of audit quality in Proposition 1, the
optimal level of audit quality in Proposition 3 is finite. Further, the optimal level of
audit quality in Proposition 3 increases with the information precision u and s,
which is an intuitive result.
Consequently, in Propositions 1 and 3 we show that whether the auditor
optimally chooses to acquire client-specific knowledge through additional NAS
activities depends on the effects of NAS on the client’s earnings dynamic. Figure 2
depicts those areas characterized by the parameters of the client’s earnings process
in which the auditor’s NAS strategy is optimal.
4. Auditor’s fee incentive versus audit quality

In the previous section, we considered the auditor’s optimal NAS strategy to
acquire knowledge and its long-run effect on audit quality. In Proposition 1, we
showed that the auditor eventually resolves all uncertainty about the client’s business
risk, regardless of his or her NAS strategy to acquire knowledge. In Proposition 3,
we showed that whether the auditor’s NAS strategy increases or decreases the
long-run audit quality depends on the relative magnitude of the coefficients (that
depend on α and ρ ) on the trend and dispersion terms of the client’s earnings
dynamic. Consequently, the relation between the coefficients helps to determine
the auditor’s optimal NAS strategy.
In deriving the above results, however, we did not explicitly consider the auditor’s
professional fee incentives. Consistent with the U.S. and Canadian environments,

we assume that audit fees cannot depend on the auditor’s report. While the audit
fee is fixed in our model, NAS fees are allowed to vary with the amount of work
performed by the auditor. Thus, the presence of NAS fees (that are contingent on
the auditor’s NAS decision to gain knowledge) may provide an incentive for the
auditor to trade off professional fees against audit quality. This adverse incentive
effect is particularly of concern when NAS help to accelerate both the trend and
dispersion components of the client’s earnings process over time. Accordingly, in
this section, we will delineate more precisely those situations in which this adverse
incentive effect can arise.
The auditor in our model receives a fixed fee for audit engagements (denoted
by A). NAS fees are not allowed to vary with the auditor’s report, but do vary with
the knowledge-acquisition strategy. We denote these NAS fees as a function of
Figure 2 Auditor’s optimal knowledge-acquisition strategy through NAS

ρ
k* = ?
k* = 0
k* = 1 k* = ?
α
0 1
Note:
This figure depicts four different areas (that is, combinations of α and ρ ) in which the
auditor’s optimal NAS strategy is characterized. The southwest and northeast areas
present parts (a) and (b) of Proposition 3, respectively; the horizontal axis, α ,
presents the results of Proposition 1; and the other areas present the situations in
which the auditor’s optimal NAS strategy is indeterminate.

k: N(k). To avoid cost-allocation issues between audit and NAS, however, we use
one function to present the total cost of performing both audit and NAS: C(k).
Thus, the auditor’s benefit function from his or her professional fees is
B(k) ≡ A + N(k) − C(k) (17).
The only restriction placed on the form of B(⋅) is that its second-order deriva-
tive is nonpositive: B″(k) ≤ 0. We assume that the auditor is unable to raise B(k)
unilaterally, despite his or her control over C(k).19 Several arguments support this
assumption. First, competition among NAS suppliers places restrictions on the
magnitude of the fees that can be charged. Second, U.S. companies must now dis-
close annually the amount of professional fees paid to their external auditors in
proxy statement filings with the SEC. A third related argument is that corporate
audit committees of public companies must review and approve all NAS provided
by the external auditor (not explicitly prohibited by SOX or by the Canadian Insti-
tute of Chartered Accountants [CICA] rules) (CICA 2003). Therefore, because the
amount of professional fees must now be disclosed and reviewed, corporate audit
committees will be more reluctant to approve large NAS fee payments to auditors.
We denote the auditor’s current level of audit quality by q. If the auditor
adopts the k strategy at the end of period t, then substituting (8) into (5) yields the
auditor’s engagement risk as follows:20
* α k ρk 1
R(q, k) ≡ ER nt+ k , t = ------ + ----- + --- (18).
q u s
Because professional fees vary with NAS, the auditor may trade off such fees
against audit engagement risk considerations. Consequently, given the minimum
engagement risk function derived in (5), the auditor now will choose the k strategy
to maximize professional fees net of the engagement risk,21
max H(q, k) ≡ B(k) − R(q, k) (19).

k
The partial derivative with respect to k is
∂--------------------
H ( q, k )
- = B′(k) − Rk(q, k) (20),
∂k
where
∂ R( q, k ) α k ln (α ) ρ k ln ( ρ )
Rk(q, k) ≡ -------------------- = -------------------- + ------------------- (21).
∂k q u
Whether NAS elevate or reduce the auditor’s engagement risk (that is, Rk(q, k)
is positive or negative) depends on the relative magnitude of the most right-hand-

side two components of (8). The first component reflects the impact of NAS on the
trend of the client’s earnings dynamic and, hence, depends on the auditor’s current
level of audit quality (q) and the client’s business type (α ). The second component
reflects the impact of NAS on the dispersion of the client’s earnings dynamic. As
an illustration, Figure 3 depicts the auditor’s engagement risk as a function of audit
quality in two special cases: α > 1, ρ < 1, k = 0; and α > 1, ρ < 1, k = 1.
If the auditor’s NAS help to decrease the engagement risk (that is, Rk(q, k) ≤ 0),
then NAS fees are not required for the auditor to provide NAS to the client. The
intuition is simple: when NAS help to reduce the auditor’s engagement risk and,
hence, to enhance audit quality, NAS fees merely provide an economic rent for the
auditor.22 Thus, as in the competitive case analyzed previously in the corollary to
Figure 3 Auditor’s engagement risk is decreasing in the current level of audit quality q
α k ρk 1
(for α > 1, ρ < 1, and k = 0 and 1): R(q, k) = ------ + ----- + ---
q u s
R(q, 0)
R(q, 1)
1/s + 1/u
1/s + ρ/u
0 q
u (α – 1 )
q ° • ≡ ---------------------
1–ρ
Note:
This figure depicts the behavior of the auditor’s engagement risk (when k = 0 and k = 1).
Both functions are decreasing in the current level of audit quality, q: they cross only
once. This implies that the auditor’s knowledge acquisition strategy depends on the
auditor’s current level of audit quality. If the current level of audit quality is lower
(higher) than threshold level q ° • , the auditor’s engagement risk will be larger
(smaller) if the auditor adopts the “k = 1” strategy than the engagement risk if the
auditor adopts the “k = 0” strategy.

Proposition 2, the auditor would provide NAS to the client even if no additional
fees were to be provided.
Alternatively, if NAS increase the auditor’s engagement risk (Rk(q, k) > 0),
then NAS fee incentives must be sufficiently high to encourage the auditor to pro-
vide NAS to the audit client. In other words, NAS fee incentives must outweigh the
auditor’s engagement risk consideration: B′(k) > Rk(q, k) > 0. In the following
proposition, we delineate more precisely the conditions under which the auditor
does not require (or must have) significant fee incentives in order to provide NAS.
PROPOSITION 4. In order for the auditor to provide NAS to the audit client,
(a) Assume that ρ ∈ (0, 1). The auditor requires no fee incentives, regard-
less of the current level of audit quality, if α ∈ [0, 1]. Alternatively, if
α > 1, then two threshold levels of audit quality exist: q • > q° > 0,
such that when the audit quality level is high (q ≥ q • ) the auditor
requires no fee incentives, but when it is low (q ≤ q°) the auditor must
have significant fee incentives.
(b) Assume that ρ = 1. The auditor requires no fee incentives if α ∈ [0, 1],
but must have significant fee incentives if α > 1, regardless of the
current level of audit quality.
(c) Assume that ρ > 1. The two threshold levels of audit quality are that
q° > q • > 0 if α ∈ [0, 1]. Thus, when audit quality is high (q ≥ q°), the
auditor must have significant fee incentives, but when it is low (q ≤ q • ),
the auditor requires no fee incentives. Alternatively, if α > 1, then the
auditor must have significant fee incentives, regardless of the current
level of audit quality.
The results in Proposition 4 depend crucially on the magnitude of ρ because

the ρ parameter interacts with the auditor’s knowledge-acquisition strategy to
determine whether the dispersion term of the client’s earnings dynamic will dimin-
ish, remain constant, or increase over time (see Figure 4).
In part (a) of Proposition 4, where ρ < 1, the auditor’s k strategy helps to
“tighten up” the client’s earnings process over time. By tightening up the process,
we mean that the variance of the dispersion term of the client’s earnings dynamic is
decreasing in k. The auditor requires no fee incentives to provide NAS to the client,
when the client’s business is of type α ≤ 1. The reason is that NAS affect the auditor’s
prior beliefs over the client’s earnings distributions and that such effect is sufficient
to motivate the auditor to provide NAS. Alternatively, when the client’s business is
of type α > 1, the auditor’s current level of audit quality plays a significant role.
The auditor’s prior variance over the client’s earnings distributions decreases or
increases, depending on whether the current level of audit quality is high or low,
respectively. Therefore, when the current audit quality is high, the auditor requires
no significant fee incentives to provide NAS to the client. Alternatively, when the
current audit quality is low, the auditor must have significant fee incentives from
the client to provide NAS.

In part (b) of Proposition 4, where ρ = 1, the auditor’s k strategy does not

affect the dispersion term of the client’s earnings process. Thus, the client’s busi-
ness type becomes the sole determinant of the auditor’s knowledge-acquisition
strategy through NAS.
In part (c) of Proposition 4, where ρ > 1, the auditor’s k strategy helps to “dif-
fuse” the client’s earnings process over time. By “diffusing the process” we mean
that over time the auditor’s NAS will increase the variance of the dispersion term
of the client’s earnings dynamic. Thus, it is intuitively clear that large fees are
required to induce the auditor to provide NAS, when the client’s business is of type
α > 1 (see the second result in part (c) of Figure 4). On the other hand, the results
when α ≤ 1 — although somewhat counterintuitive — can be explained. When the
Figure 4 Auditor’s fee incentives versus audit quality

ρ
Proposition 4(c) Proposition 4(c)

High-quality auditor Auditor must have
(i.e., q ≥ q°) must have fee incentives
fee incentives
Low-quality auditor
(i.e., q ≤ q•) requires
no fee incentives
1 Proposition 4(b) Proposition 4(b)
Proposition 4(a) Proposition 4(a)

Auditor requires High-quality auditor
no fee incentives (i.e., q ≥ q•) requires
no fee incentives
Low-quality auditor
(i.e., q ≤ q°) must have
fee incentives
α
0 1
Note:
This figure depicts the situations in which the auditor optimally engages in additional NAS
that also influence the client’s managerial decisions and, hence, alter the client’s
earnings process. The latter in turn affects audit quality. Thus, the auditor faces a
trade-off between professional services fees and audit quality. The four shaded areas
present parts (a) and (c) of Proposition 4, and the horizontal line, 1, presents part (b)
of Proposition 4.

current level of audit quality is high, the marginal impact of NAS on the trend
component of the client’s earnings is outweighed by the impact on the dispersion
component (see (A.9)) so that the auditor’s engagement risk will increase with k.
Therefore, in order for the auditor to provide NAS, significant fee incentives must
outweigh the audit engagement risk increases. Alternatively, when the current level
of audit quality is low, the marginal impact of NAS on the trend component of the
client’s earnings outweighs the impact on the dispersion component (see (A.8)) so
that the auditor’s engagement risk will decrease in k. Such a decrease in the audi-
tor’s engagement risk alone will induce the auditor to provide NAS; fee incentives
are not required.
The key implication is that auditors do not always require fee incentives to
provide NAS for their clients. Yet, large fees may induce an auditor to undertake
even those NAS that reduce audit quality. The challenge is to identify the circum-
stances under which auditors’ NAS help to increase their audit quality and, hence,
NAS fees merely present an economic rent. In this proposition, we have delineated
more precisely those conditions. If the auditor’s NAS help to “tighten up” the cli-
ent’s earnings dynamics over time ( ρ < 1), then when the current audit quality is
high the auditor will be motivated to provide NAS without fee incentives, even
though those NAS may increase the trend variance of the client’s earnings dynamic
(α > 1) over time. Alternatively, if the auditor’s NAS help to increase the dispersion
of the client’s earnings dynamic over time (ρ > 1), the auditor must receive significant
fees to provide NAS, even though those NAS may help to decrease the variance in
the trend component (when α ≤ 1). Of course, when α ≤ 1, the exception is that the
auditor might still provide NAS without fee incentives in order to increase the cur-
rent level of audit quality so as to reduce the auditor’s engagement risk.
We now turn to the characterization of the optimal interior solution for the
auditor’s knowledge-acquisition strategy. This solution depends critically on
the assumption that the NAS fees paid to the auditor are subject to some con-
straints: B(k) cannot be very large. As noted previously, a competitive NAS fee
structure and / or audit committee oversights will be necessary to provide such
fee constraints. Note that the second-order derivative of (19) is negative. So, the
first-order condition,
B′(k*) − α k*ln(α )/q − ρ k*ln( ρ )/u = 0 (22),
characterizes the optimal interior NAS strategy: k*.
PROPOSITION 5. The optimal interior k* strategy will increase with (independ-

ent of, or decreasing in) q and u if both α and ρ are less than (equal to, or
greater than) one, respectively. Furthermore, it is independent of s.
Whether NAS elevate or diminish the trend and dispersion components of the
client’s earnings process depends on parameters α and ρ . Therefore, the auditor’s
optimal interior k* strategy will depend on α and ρ . Note, the optimal interior
k* strategy is not affected by s.

5. Concluding remarks and implications

In this study, we examined the joint effect of auditors’ learning on the job (due to
outcome feedback) and their choice of NAS (due to outcome feed-forward) on
audit quality. To the extent that NAS engagements deepen auditors’ understanding
of their clients’ business models, NAS engagements provide unique opportunities
for auditors both to anticipate and to influence changes in their clients’ business
models and the resulting earnings dynamics over time. Thus, NAS engagements
may help auditors enrich and accelerate their knowledge accumulation. This inter-
relationship between the “learning” and “advisory” effects on audit quality is a key
feature that distinguishes our study from others examining knowledge spillovers in
the auditing literature.
We have derived three main results. (1) The sequence of audit quality levels
always converges to a fixed point in the limit. (2) Auditors’ optimal knowledge-
acquisition strategy, resulting from minimizing engagement risk, depends on the
relative impact of NAS on the “trend” and “dispersion” components of their clients’
earnings dynamics over time. (3) Auditors may be able to substantially reduce their
uncertainty about clients’ earnings dynamics because their NAS help to improve
their clients’ business models. In these situations, auditors may be willing to per-
form NAS for small or no incremental fees. Nonetheless, large fees can provide an
incentive for auditors to provide NAS that, in fact, increase the volatilities of their
clients’ earnings dynamics over time and, hence, reduce audit quality.
Two key implications have emerged from our analysis. First, our analysis
helps to explain the evolution of the scope of audit services over time. Even before
enactment of the SEC’s restrictions on consulting services in 2000 and the further
NAS restrictions imposed by SOX (2002), three of the then Big 5 international
accounting firms had already begun bundling some risk advisory- and performance
measurement-related assurance services with their audits. Presumably, this bundling
was done to acknowledge the value of audit information provided by these NAS.
Similarly, SOX requires that public companies registered on U.S. exchanges have
their internal control systems evaluated annually by their external auditor. This
clearly extends the “traditional” boundaries of the audit. Parallel regulations are
currently under consideration in Canada.
A second implication of our analysis relates to the problems posed by large
professional audit fees. Our analysis showed that, even under the strong assump-
tions that auditors issue unbiased reports and that neither the auditor nor the client
behaves strategically in our model, large professional audit fees could induce audit-
ors to accept engagements that will increase earnings volatility and decrease audit
quality. This result confirms the concerns raised by previous studies that examine
the incentive effects of NAS (see, e.g., Parkash and Venable 1993; Kornish and
Levine 2004). In order for the potential benefits of NAS to be realized without
jeopardizing audit quality, it is necessary that there be constraints that prevent
managers from manipulating auditors’ incentives through the payment of very
large NAS fees. The “regulatory” solution to the incentives problem (see, e.g., SOX)
was to prohibit auditors from performing certain categories of NAS, and to require
corporate audit committees to review and pre-approve other categories of NAS on

a case-by-case basis. A possible extension of the pre-approval process is to require

corporate audit committees to solicit several proposals and bids for the nonprohibited
NAS so that reasonable pricing levels can be determined and implemented (see Wu
2006 for an economic analysis of audit services and NAS in two oligopolistic
markets). A competitive NAS fee structure would likely help auditors to internalize
both the “learning” and “advisory” effects of NAS efficiently in order to continue
to enhance audit quality while helping to avoid incentive problems associated with
very large NAS fees.
Appendix: Proofs
Proof of Proposition 3
Part (a)
Denote Δ ≡ u(1 − α k )ρ −k + s. If α ∈ [0, 1] and ρ ∈ (0, 1], we obtain
dΔ
------ = u[ ρ −k ln( ρ −1) − (α /ρ )k ln(α /ρ )] = u[(1 − α k )ln( ρ −1)
dk
+ α k ln(α −1)] ρ −k ≥ 0 (A.1).
Differentiating both sides of (13) with respect to k and rearranging terms yield
d q* ( k ) 1 dΔ
Δ 2 + 4us (α ⁄ ρ )k ----------------- = --- Δ + Δ 2 + 4us (α ⁄ ρ )k ------
dk 2 dk
+ us(α /ρ )k ln(α /ρ ) (A.2)
dΔ
≥ Δ ------ + us(α /ρ )k ln(α /ρ ) (A.3)
dk
dΔ
= u ( 1 – α k ) ------ + sln ( ρ –1 ) ρ −k
dk
>0 (A.4).
Inequality (A.3) follows from (A.1) and the fact that Δ 2 + 4us (α ⁄ ρ )k ≥ Δ. Inequal-
ity (A.4) follows from (A.1) because α ∈ [0, 1] and ρ ∈ (0, 1]. Thus, dq*(k)/dk > 0.
The rest of the proof of part (a) is straightforward. ■
Part (b)
Note that exp[α k ln(α ) / (α k − 1)] is decreasing in k. Because k ≤ 1, we get that
exp[α kln(α ) / (α k − 1)] ≥ exp[α ln(α ) / (α − 1)]. Thus, assumption ρ ≤ exp[α ln(α )/
(α − 1)] implies that ρ ≤ exp[α k ln(α ) / (α k − 1)] or, equivalently, ln( ρ −1 ) ≥
α k ln(α ) / (α k − 1). Multiplying this inequality by α k − 1 if α > 1 yields that ln( ρ −1)
− α k ln(α /ρ ) ≤ 0, which shows that dΔ/dk ≤ 0. In addition, because α ≤ ρ implies that
ln(α / ρ ) ≤ 0, we immediately get from (A.2) that dq*(k) / dk ≤ 0. The rest of the
proof is straightforward. ■

Part (a)
Assume that ρ ∈ (0, 1). Then, it is trivial from (21) that Rk(q, k) ≤ 0 if α ∈ [0, 1].
On the other hand, if α > 1, then there are two threshold levels of audit quality,
ln (α ) α ln (α )
q° ≡ − ------------- u, and q • ≡ − ----------------- u (A.5),
ln ( ρ ) ρ ln ( ρ )
such that 0 < q° < q • . Therefore, if q ≥ q • , then
k –1
α k ln (α ) ρ ln ( ρ ) ρk ln ( ρ –1)
Rk(q, k) ≤ ------------------- − ------------------------ = −(α 1 − k − ρ1 − k ) ------------------------ ≤ 0 (A.6),
q• u uα 1 – k
and if q ≤ q°, then
k –1
α k ln (α ) ρ ln ( ρ ) ln ( ρ –1)
Rk(q, k) ≥ ------------------- − ------------------------ = (α k − ρ k ) ------------------ > 0 (A.7). ■
q° u u
Part (b)
Assume that ρ = 1. Then, Rk(q, k) = α k ln(α )/q > 0 if, and only if, α > 1. ■
Part (c)
Assume that ρ > 1. Then, it is trivial from (21) that Rk(q, k) > 0 if α > 1. On the
other hand, if α ∈ [0, 1], the relation of the two threshold levels of audit quality
reverses, that is, q° > q • > 0. Hence, if q ≤ q • , then
α k ln (α ) ρk ln ( ρ ) ρk ln ( ρ )
Rk(q, k) ≤ ------------------- + ------------------ = −( ρ 1 − k − α1 − k ) ------------------ ≤ 0 (A.8),
q• u uα 1 – k
and if q ≥ q°, then

α k ln (α ) ρk ln ( ρ ) ln ( ρ )
Rk(q, k) ≥ ------------------- + ------------------ = ( ρ k − α k ) ------------ > 0 (A.9). ■
q° u u
Differentiating (21) with respect to q and u yields
⎧ > 0, if α < 1,
2
∂-----------------------
R( q, k ) α k ln (α ) ⎪
- = − ------------------- ⎨ = 0, if α = 1, (A.10),
∂ k∂ q q2 ⎪ < 0, if α > 1
⎩
and

⎧ > 0, if ρ < 1,
2
∂-----------------------
R( q, k ) ρ k
ln ( ρ ) ⎪
- = − ------------------ ⎨ = 0, if ρ = 1, (A.11).
∂ k∂ u u2 ⎪
⎩ < 0, if ρ > 1
Totally differentiating (22) yields (see (20))
∂ 2 R( q, k ) ∂ 2 R( q, k ) ∂ 2 R( q, k )
B ″ ( k ) – ------------------------ ∂ k* − ------------------------ ∂ q − ------------------------ ∂ u = 0 (A.12).
∂k2 ∂ k∂ q ∂ k∂ u
Note that ∂ 2 R(q, k)/∂ k 2 = α kln2(α )/q + ρ k ln2( ρ )/u > 0. Thus, by the assump-
tion that B′′(k) ≤ 0, we obtain that B′′(k) − ∂ 2 R(q, k)/∂ k 2 < 0. Therefore, dividing
(A.12) by ∂ q and ∂ u yields the following comparative static results:
⎧ < 0, if α < 1,
∂--------
k* ∂ 2
R( q, k ) ⁄ ∂ k∂ q ⎪
- = -------------------------------------------------------
-2 ⎨ = 0, if α = 1, (A.13)
∂ q B ″ ( k ) – ∂ R( q, k ) ⁄ ∂ k ⎪
2
⎩ > 0, if α > 1
⎧ < 0, if ρ < 1,
∂--------
k* ∂ 2
R( q, k ) ⁄ ∂ k∂ u ⎪
- = -------------------------------------------------------- ⎨ = 0, if ρ = 1, (A.14).
∂ u B ″ ( k ) – ∂ 2 R( q, k ) ⁄ ∂ k 2 ⎪
⎩ > 0, if ρ > 1
Furthermore, because ∂ 2R(q, k)/∂ k∂ s = 0, we get ∂ k* /∂ s = 0. ■
Endnotes
1. Since auditing is a knowledge profession (see, e.g., Mautz and Sharaf 1964),
distinctions between audit services and NAS are somewhat tenuous (see, e.g., Bell,
Marrs, Solomon, and Thomas 1997). During the past several decades, the service
boundaries have changed (also see note 7, infra, for specific examples). Therefore,
throughout the paper, the term “nonaudit services” (NAS) is used to represent all those
knowledge acquisition activities and/or services of the auditor that are yet to be
recognized as a part of the audit by all auditors as well as regulators.
2. Auditors’ NAS activities may serve as anticipatory controls for audit clients’ business
models. Schoderbek, Schoderbek, and Kefalas (1990, 89) use the following analogy to
describe these controls: “The operator anticipates the loss of control and makes
adjustments before the machine begins turning out defective parts.”
3. See, for example, Bell et al. (1997, ix) and Stein (1997, 265). More recently, the U.S.
General Accounting Office (GAO 2003, 12-3) reports: “First, the trend toward
corporate globalization led to an increased demand for accounting firms with greater
global reach. Second, some firms wanted to achieve greater economies of scale as they
modernized their operations and built staff capacity and to spread risk over a broader
capital base. Third, some firms wanted to build industry-specific or technical expertise

as the operations of their clients became increasingly complex and diversified. …

Moreover, by the mid-1990s, the overall economic environment was changing
dramatically as technological and telecommunications advances changed the way
businesses operated.”
4. Studies of knowledge transfers from NAS to the audit include Palmrose 1986; Abdel-
Khalik 1990; Solomon 1990; O’Keefe, Simunic, and Stein 1994; and Dopuch, Gupta,
Simunic, and Stein 2003. In addition, Wu (2006) points out that a trade-off arises
between knowledge spillovers (for example, cost savings) and competition crossovers
(for example, price reductions) in two oligopolistic markets for audit services and
NAS. Other studies examine the impact of NAS on auditor tenure (Beck, Frecka, and
Solomon 1988a, b), auditor independence (Parkash and Venable 1993; Ashbaugh,
LaFond, and Mayhew 2003), auditor effort and client investment decisions (Davis,
Ricchiute, and Trompeter 1993; Chan 2004), audit reporting (DeFond, Raghunandan,
and Subramanyam 2002; Zhang 2003), and earnings management and restatements
(Frankel, Johnson, and Nelson 2002; Whisenant, Sankaraguruswamy, and
Raghunandan 2003).
5. Enron gradually evolved from an energy company to a trading company that had
substantial business risk with the assistance and support of its then auditor, Arthur
Andersen. Further, Enron’s reliance on complex special-purpose entities (SPEs) and
financial structures encouraged aggressive risk-taking behavior by concealing the large
losses from its investments in broadband and international power plants. Arthur
Andersen approved these SPEs and earned approximately $50 million from both audit
and consulting fees in 2001.
6. Studies of corporate governance issues related to NAS include Abdel-Khalik 2002,
Benson and Hartgraves 2002, Demski 2002, and Kornish and Levine 2004.
7. For example, in the late 1990s, Ernst & Young introduced the “Risk Wheel” framework
in which they provide a qualitative assessment of clients’ major risk exposures. KPMG
introduced the Kaplan-Norton “Balanced Scorecard” into its strategic-systems audits
in 1997, and Arthur Andersen incorporated a “Balanced Risk Scorecard” into its audit
at about the same time. In 2004, PricewaterhouseCoopers began to incorporate features
of its “Value Reporting” assurance service into its “integrated” audits.
8. See, for example, Blocher, Roussey, and Ward 1988; Chow, Kramer, and Wallace 1988.
9. One may wish to specify a functional form with respect to nt ; but such form is
unnecessary because this section of the paper focuses on the auditor’s learning from
Bayesian outcome feedback. In section 4, we consider the influence of NAS over the
client’s business model (that is, the outcome feed-forward or business advisory effect).
10. Our benchmark case is similar to that considered by Morgan and Stocken 1998,
because the evolution of the client’s earnings distributions is exogenous in this
benchmark case where the advisory effect is absent. For simplicity, we do not
explicitly consider the audit client’s business decisions that determine the client’s
earnings distributions. Of course, audit clients may pay significant, large fees to induce
their auditor to provide certain types of NAS they desire, or terminate their auditor who
refuses to supply them. Thus, considering strategic interactions between audit clients
and their auditor would be a fruitful extension (e.g., Schwartz 1997; Hillegeist 1999;
Pae and Yoo 2001).

11. Many factors prevent the auditor from fully resolving uncertainty on audit
engagements (also see Scott 1973). First, time and budget constraints limit the extent
of testing that is performed. Second, some audit procedures like analytical procedures
are inherently imperfect. Finally, the accuracy of certain client measurements (for
example, assertions related to accounting estimates) depends on future events so that
definitive evaluations are not possible. Bayesian models of the audit decision process
reflect this uncertainty in the auditor’s posterior distribution over assertions.
12. An alternative and more realistic formulation is to allow z to be determined as the
outcome of a negotiation process between the auditor and client. Explicit modeling of
the negotiation game would be an interesting extension to our decision-making
framework (see Antle and Nalebuff 1991; Zhang 2003). It should be noted, however,
that SOX 2002 has reaffirmed that the audit committee must be regarded as the
auditor’s client (for public companies), and that SOX has imposed additional reporting
responsibility on the audit committee as well. Thus, the audit committee’s incentives
are less likely to be in conflict with the auditor than would management’s incentives.
Hence, our model is a more realistic formulation for public companies in the post-SOX
environment.
13. Some may question why it is not optimal for the auditor to just report the y signal
observed in period t because it is a white noise garbling of X. However, such a strategy
effectively ignores the auditor’s prior beliefs that have been developing over possibly
several periods. From the Bayesian perspective, the auditor should combine the current
period’s information signal with the prior beliefs using Bayes’s rule (see Scott 1973). It
is well known (see, e.g., DeGroot 1970) that reporting the mean of the posterior
distribution will minimize the expected quadratic loss function.
14. We may reinterpret qn , t as the auditor’s capability of “removing” the effects
t
associated with the error inherent in Yn , t . DeAngelo (1981) defines audit quality as
t
the probability of detecting errors and the probability of reporting the errors. Because
the auditor in our model is assumed to formulate reports in order to minimize posterior
reporting error, our definition of audit quality is most closely related to the detection
risk component of DeAngelo’s definition of audit quality.
15. This knowledge increment k can be linked to the auditor’s effort level a through the
following relation: k = 1 −exp[− a], for a ∈ [0, +∞). To highlight the importance of the
auditor’s client-specific knowledge, we use k rather than a as the decision variable.
16. Although Jovanovic and Nyarko (1996) consider a similar dynamic process to ours,
there are two key differences. First, the “dispersion” component in (6) remains if k = 0,
while theirs vanishes. This feature captures the learning effect through the course of
audit engagements when k = 0. Second, our “dispersion” component will either
increase or decrease in k, depending on whether ρ is greater or less than one. In
contrast, in the Jovanovic and Nyarko model, dispersion always increases with k. This
feature of our model permits the auditor to trade off the effects of NAS on the “trend”
and “dispersion” components of (6).
17. To focus on the learning and advisory effects that NAS have on audit quality, we do not
explicitly consider the client’s managerial decisions that affect the earnings process —
that is, we assume α and ρ to be constant over time. The interaction effect between the
client’s managerial decisions and the auditor’s NAS engagements presents a fruitful

future research venue, and we thank Joyce Tian and one reviewer for independently
making this suggestion.
18. Other combinations of α and ρ may result in optimal interior solutions for k, which are
examined in Propositions 4 and 5 in section 4. In general, however, we cannot
analytically characterize the auditor’s optimal NAS strategy in those situations:
numerical simulations show that the sign of q* ″(k) is undetermined.
19. If management or the auditor could unilaterally increase NAS fees to outweigh the
auditor’s engagement-risk consideration, then the auditor’s optimal decision would be
to provide NAS even when the auditor’s engagement risk increases. Two conditions must
be satisfied for the auditor to be able to charge such excessive NAS fees: (1) the absence
of alternative suppliers of NAS, and (2) audit clients’ willingness to pay. See Parkash
and Venable 1993 for considerations of agency factors influencing audit and NAS fees.
SOX (2002) now requires the audit committees of public companies to review and pre-
approve all NAS engagements that are to be performed by companies’ auditors in order
to evaluate potential threats to independence. Such reviews consider both the type of
services and the fees paid to the auditor. Thus, managers of public companies cannot
unilaterally negotiate fees with auditors as they may have done in the past.
20. We wish to thank a reviewer for suggesting the use of a general function F(⋅) in (3).
Nonetheless, we still use the simplified linear function, F(a) = a, to reduce the
complexity of the analyses. Regardless, our results do not change.
21. Bell, Landsman, and Shackelford (2001) analyze the relation between audit fees and
auditors’ business risk assessments (that is, audit engagement risk), and find evidence
that “audit fees are increasing in the engagement partners’ assessments of business
risk” (Bell et al., 37). Hence, this finding seems to suggest a special objective function
for the auditor, maxk H(q, k) = B(R(q, k)) − R(q, k), instead of (19). Then, the first-
order derivative is Hk(q, k) = [B′(R(q, k)) − 1]Rk(q, k). Thus, it is necessary to assume
that B′(⋅) < 1, in order to align “properly” the auditor’s incentives. Therefore, a
reduction in engagement risk (that is, Rk(q, k) < 0) will indeed have a positive impact
on the auditor’s “true” incentive (that is, Hk(q, k) > 0). Nonetheless, we accomplish this
incentive alignment without any restriction on the first-order derivative of B(⋅).
22. See Kanodia and Mukherji 1994 for a dynamic analysis of how equilibrium audit
prices sustain rents earned by auditors.
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Learning by Doing and Audit Quality*

PAUL J. BECK, University of Illinois

MARTIN G. H. WU, University of Illinois

Keywords Advisory effects; Audit engagement risk; Business-risk evolution; Learning;

JEL Descriptors D83, M4

L’apprentissage par la pratique et la qualité de la vérification

CAR Vol. 23 No. 1 (Spring 2006)

et de conseil entraînent la production endogène de retombées des connaissances, l’analyse

CAR Vol. 23 No. 1 (Spring 2006)

CAR Vol. 23 No. 1 (Spring 2006)

CAR Vol. 23 No. 1 (Spring 2006)

2. Auditor’s engagement risk

We employ parameter nt to denote a particular member of a family of distribu-

CAR Vol. 23 No. 1 (Spring 2006)

analytical procedures and sample testing) yields a private noisy representation of

Figure 1 The time-line

CAR Vol. 23 No. 1 (Spring 2006)

Conceptually, the entire distribution of earnings (for example, a range of earn-

min ERn , t ≡ F(Et [( Yn , t − z n )2 |nt]) (3).

Without loss of generality (for our results), we henceforth simplify (3) by

ERn , t* ≡ Et[( Xn − Et[ Xn | nt])2 + (ω t − m)2 + 2( Xn − Et[ Xn | nt])(ω t − m) | nt]

= vart ( Xn ) + 1/s (5),

CAR Vol. 23 No. 1 (Spring 2006)

reporting decision z n . Given (5), we can interpret the posterior precision, qn t , t ≡

q*n ≡ lim q = +∞.

The intuition underlying Remark 1 is as follows. The longer an auditor’s tenure

3. Auditor’s learning and advisory effects on audit quality

CAR Vol. 23 No. 1 (Spring 2006)

Xn = α k/2 Xn + ρ k/2ε t (6),

where α ≥ 0, ρ ≥ 0; ε t ∼ N(0, 1/u), u > 0, cov( Xn , ε t ) = 0, and cov(ετ , ε t ) = 0 for all

qn t , t ≡ vart−1( Xn | Ynt , t = yn t , t ) = vart−1( Xn ) + s (7).

vart + 1( X n ) = α k vart( Xn | Yn t , t = yn t , t ) + ρ k/u

= α k/ q nt, t + ρ k/u (8).

CAR Vol. 23 No. 1 (Spring 2006)

As the auditor observes Yn + k , t + 1 = yn + k , t + 1 at the end of period t + 1, a

= var t–+11 ( X n )+s

ρ kq*2(k) − [u(1 − α k ) + sρ k]q*(k) − usα k = 0 (10).

PROPOSITION 1. Assume that ρ = 0. For any given k strategy, the long-run

q*(k) = q*(k)/α k + s (11).

It is critically dependent on the client’s business type: α .

CAR Vol. 23 No. 1 (Spring 2006)

Proposition 1 shows that, depending on the client’s business type (denoted by

PROPOSITION 2. Assume that ρ > 0. The long-run equilibrium level of audit

CAR Vol. 23 No. 1 (Spring 2006)

COROLLARY. Assume ρ > 0 and s = 0. The long-run equilibrium level of audit

Further, if α < 1, then d q*s = 0( k ) / dk > 0. Thus, k* = 1 is optimal, and

PROPOSITION 3. Assume that ρ > 0. Whether the long-run equilibrium level of

CAR Vol. 23 No. 1 (Spring 2006)

which is increasing with u and s.

4. Auditor’s fee incentive versus audit quality

CAR Vol. 23 No. 1 (Spring 2006)

Figure 2 Auditor’s optimal knowledge-acquisition strategy through NAS

CAR Vol. 23 No. 1 (Spring 2006)

B(k) ≡ A + N(k) − C(k) (17).

max H(q, k) ≡ B(k) − R(q, k) (19).

The partial derivative with respect to k is

CAR Vol. 23 No. 1 (Spring 2006)

CAR Vol. 23 No. 1 (Spring 2006)

The results in Proposition 4 depend crucially on the magnitude of ρ because

CAR Vol. 23 No. 1 (Spring 2006)

In part (b) of Proposition 4, where ρ = 1, the auditor’s k strategy does not

Figure 4 Auditor’s fee incentives versus audit quality

Proposition 4(c) Proposition 4(c)

ρ kq2(k) − [u(1 − α k ) + sρ k]q(k) − usα k = 0 (10).

q(k) = q(k)/α k + s (11).

Further, if α < 1, then d qs = 0( k ) / dk > 0. Thus, k = 1 is optimal, and

B′(k) − α kln(α )/q − ρ k*ln( ρ )/u = 0 (22),