This paper draws from the service science and professional service literatures to conceptualize financial auditing as an economic service. A central characteristic of economic services is the participation of the customer/client in the production process. The necessity of having the customer/client be a co-producer introduces greater heterogeneity to the provision of services relative to the manufacturing of goods which, in turn, creates a tension between service quality and service efficiency. One implication of this tension is that standardization of the audit process may not increase audit quality. We further argue that audit research should give more attention to the idiosyncratic nature of audit engagements and the importance of successful cooperation between the service provider (the audit firm) and the client for improving audit quality. Utilizing research on service networks, we draw attention to a broader perspective than the dyadic relations of service provider and client to show that the possible frictions between the value of co-creation of the service and the independence of the service professional are endemic to the service process, implying that efforts to maximize auditor independence may have unexpected costs that impair audit quality.

Responsive regulation (RR) theory posits that effective regulators enforce compliance by escalating penalties only if persuasion fails, otherwise risking formation of a culture of resentment. Using RR theory as a lens, we examine the interactions between large audit firms and the PCAOB during the initial years of PCAOB regulation, when annually-inspected auditors utilized negative tone within their inspection response letters to express public disagreement with their inspection reports. Consistent with our expectations, we find that negative tone within response letters is positively associated with (1) future Part I inspection findings that result in a restatement of a client’s financial statements and (2) the likelihood that Part II of a future inspection report will be publicly disclosed. We triangulate these results and the underlying theory in semi-structured interviews of eight PCAOB inspectors and six audit partners involved in these early interactions between the largest firms and the PCAOB. Consistent with RR theory, the PCAOB viewed public disagreement as indicators of noncompliance, incorporated public disagreement into subsequent inspections, and escalated penalties for noncompliance. Contrary to RR theory’s prescriptions, the PCAOB did not use persuasion as a first reaction to noncompliance. In response, the firms stopped publicly disagreeing, but may have formed a culture of resentment toward the PCAOB.