Reexamining the relationship between audit and nonaudit fees: dealing with weak instruments in two-stage least squares estimation

Abstract

The authors introduce some new econometric tests and techniques for identifying and overcoming the problem of weak instruments in the context of joint provision of audit and nonaudit fees. The authors use this context because identifying appropriate instruments is difficult due to the lack of theoretical guidance as well as due to the difficulty in intuitively identifying instruments that satisfy the econometric requirements. The authors introduce a battery of empirical tests based on recent developments in econometrics to test for the appropriateness of the instruments. The authors then illustrate two approaches of using instruments from existing data: the size industry average portfolio approach and the synthetic-instrument approach. Although the approach using synthetic instruments sidesteps issues of identifying proxies with desirable properties, it requires some stringent assumptions that cannot be directly tested. However, as a methodological alternative, this approach can be used for robustness tests. The authors find that when the instruments are not weak, audit and nonaudit fees are positively associated. This relationship holds for audit and tax-related nonaudit fees as well. Overall, the evidence suggests the existence of economies of scope benefits from the joint supply of audit and nonaudit services. Methodologically, the authors illustrate the importance of testing the appropriateness of the instruments utilized when accounting for endogeneity. © The Author(s) 2012.